October 7thth, 2015 Gold Chronicles topics:
*History of IMF, one of the big 3 Bretton Woods institutions
*The IMF has evolved into its most powerful role ever
*IMF is a functioning world Central Bank
*The Fed has in effect been operating in a 2 year tightening cycle
*China’s reserves are being consumed at a rate of $100B per month stabilizing the currency
*The Fed may easy by mid 2016. Available tools include: Forward guidance, Negative Interest Rates Policy (NIRP), Direct easing (Helicopter money), QE4
*Emerging markets debt crisis, $9.5 Trillion on emerging markets corporate debt denominated in USD
*IMF is warning about declining liquidity in the bond markets and is encouraging governments to take precautionary measures
*IMF: Bond market liquidity could dis-appear instantaneously
*Physical Gold in non-bank storage is one way to protect against what governments might do under conditions of seizing bond markets
*The IMF has a little less than 3000 tons of gold
*IMF gold assets are the third largest holding in the world according to the WGC
*19 Members of the Eurozone combined hold 19,000 tons
*IMF gold was contributed by members joining when it was originally formed
*IMF has not created SDR’s and purchased gold with it
*Gold price required to support world liquidity in this sense would have to be higher than $10,000 per troy oz
*What tools can investors use when it comes to gold in light of potential problems with liquidity
Listen to the original audio of the podcast here
The Gold Chronicles: 10-7-2015
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.
Jon: Jim, let’s start in Lima, Peru, where it is IMF Week. The IMF and the World Bank hold several days of meetings twice yearly. Would you begin by giving us a brief refresher on the IMF explaining what it is and why these meetings matter?
Jim: I’d love to. Just as an aside, I went down to Washington last Friday to work with some national security people and conduct financial war game scenarios. They’re not all quite as elaborate as the one I did in 2009, e.g., sometimes it’s just one day. Traveling to this one in Washington, Madame Lagarde, managing director and head of the IMF, happened to be on my flight. I was sitting right behind her on the plane but didn’t have the occasion to speak to her, because she had two bodyguards, a couple of assistants, and a small entourage. She’s as elegant in person as she is on TV or in pictures; quite tall and walks fast.
When we stood up in the plane, per normal airplane etiquette, we all got out in the aisle. Well, I got out between her and her bodyguard, and he was not pleased with me. He got into his protective mode and almost knocked me down, but I did at least have a fun encounter with the head of the IMF!
Now let’s do a little IMF history, and then we’ll bring it up to date in terms of what’s currently going on in Lima, Peru. Going back to the origins, the IMF is one of the big three Bretton Woods institutions. The Bretton Woods Conference was in July 1944 at the Mt. Washington Hotel in Bretton Woods, New Hampshire. I was up there a couple of years ago doing another financial war game with the Boeing Corporation, and they picked the Mt. Washington Hotel as their venue. It’s a beautiful spot that’s still a remote area today, as it certainly was in 1944.
The Bretton Woods conference was toward the end of World War II. At that point, the Allies could see victory although victory was not in hand. This was just literally weeks after D-Day when the Allies were pushing towards Paris. The war was not over, but they were looking through the end of the war, expecting victory at some point, and saying to themselves, “Victory on the battlefield is fine, but we’re going to have a world economy to run after that.” They could see that the inter-war problems between World War I and World War II – German reparations, the Great Depression, the original currency wars (as I call them), the beggar-thy-neighbor devaluations, and other financial developments – made Germany’s burden more difficult. It was never quite satisfactorily resolved and created resentment on the part of the Germans, and in different ways, led to World War II.
So they said, “Let’s not that repeat that mistake. Let’s have a better post-war system.” There were a lot of institutions (the United Nations was one of them), but on the financial side, Bretton Woods was the place that was really led by the United States. They created the architecture of the post-World War II world economy.
There were three big institutions that came out of the Bretton Woods Conference. One was the IMF (the International Monetary Fund), which is what we’re talking about today. Another was the World Bank. The third one was, at the time, the General Agreement on Tariffs and Trade, trying to tear down tariff walls and tariff barriers. That has now morphed into the World Trade Organization (WTO), but it’s still one of the three pillars of the post-war financial order.
Let’s talk specifically about the IMF. It was originally a swing lender, sort of a credit card for countries experiencing balance-of-payment difficulties. Remember, at the time, from 1944 to 1971, the world was on a gold standard. It had some problems, but it was a pretty solid gold standard. This meant that if you were running a trade deficit, your trading partners could take your money they had earned by trading with you and cash it in for gold.
Well, there wasn’t enough gold to go around, at least at $35 an ounce, and countries were running chronic deficits, which meant that they could ultimately lose their gold. As a swing lender, the IMF would then say, “We will lend you the money you need in U.S. dollars to satisfy your creditors for the time being,” because the dollar was as good as gold and was tied to gold, “But we expect you to make structural reforms. Do something to improve the situation. Lower your unit labor costs, improve productivity, impose taxes if you need to balance your budget. Do whatever you need to do.” So the IMF was there as a short-term lender in exchange for structural changes that would in theory solve the problem and get countries back to trade surplus.
The idea worked fairly well in the ‘50s and ‘60s, but then it all broke down in the late ‘60s mainly because the United States did not hold up its end of the deal. It’s one thing to help all these other countries that are trying to tie to the dollar, but the U.S. was not on a sound fiscal basis. We had twin deficits – a trade deficit, first of all, and Vietnam where we were running budget deficits to pay for the war.
I think most of our listeners know that the system broke down in 1971 when President Nixon ended the convertibility of dollars for gold. At the time, he said it was temporary. I’ve actually spoken to former chairman Paul Volcker about this, and he confirmed that. Volker said, “I’m not sure I would have gone along with it if I had known it was going to be permanent. We thought it was going to be a temporary suspension and that we could get back to a gold standard, maybe at a different dollar price.” I think that’s what they expected, but as it was, it turned out to be permanent.
That takes us up to 1971. From ’71 to ’80 it was a confused period where the world didn’t know if we’d be going back on a gold standard, off a gold standard, going to fixed exchange rates, floating exchange rates, and so on. It was a fairly tumultuous period of borderline hyperinflation.
The IMF at that point was a forum or place where major countries could get together to work out new rules of the game, and they eventually did. They said, “Now we’re going to have floating exchange rates. We’re going to go off the gold standard.” That’s when they officially demonetized gold. A lot of people say the gold standard ended in 1971 when President Nixon ended convertibility, but the gold standard didn’t officially end until 1975.
From 1980 to 2000 was a period when the IMF didn’t have a clear mission. The old mission of being a swing lender to deal with balance of payments was over, because you didn’t have to worry about balance of payments anymore in a world where there was no gold standard or fixed exchange rates. There wasn’t a lot for the IMF to do, but they did come up with a new role for themselves as a lender to emerging markets. This was the period of the Asian tigers and high growth in Taiwan, Singapore, Korea, and elsewhere. Those countries would occasionally get into difficulty, and the IMF would come along and help them out sort of like the fire department coming and putting out fires in emerging markets in the developing world.
That role blew up in 1997-1998 with the emerging markets crisis where I think most observers (most prominently Joe Stiglitz) said that the IMF role was badly flawed. They would come into a country that was running balance-of-payment stuff and budget deficits, lend money to deal with a deficit, but then they would say, “You need to raise taxes. You need to cut public payroll.” It was basically an austerity type of prescription, the same kind of thing that’s being complained about in Greece today.
A lot of people took the view that this made matters worse. At the time, the IMF was very opposed to exchange controls. They said, “No, you have to keep an open capital account, and you have to give money to the people who are owed money. But we’ll lend you the money to make these payments in exchange for all this austerity.”
The case could be made that austerity only made things worse and that maybe exchange controls were not a bad idea in certain cases. The prominent voice for that point of view was Prime Minister Mohamad Mahathir of Malaysia. He very famously got into a shouting match with the IMF and George Soros at the 1997 annual meeting in Hong Kong. We’re coming up to the Lima annual meeting right now, but they’ve done this every year for a long time. I was actually there in Hong Kong for that annual meeting in 1997 where this all came to a head.
That brings us up to 2000 at which time the original Bretton Woods mission of being a swing lender under the gold standard was gone, the fixed exchange rates were gone, the gold standard itself was gone, and the emerging markets fireman role, if you will, was discredited. So in the early 2000s, the IMF looked like an agency without a mission and with nothing to do. They did have experts who would write studies and do what they call Article IV Consultations. Article IV Consultations are when they come into your country, meet with your finance minister and various officials, and look at what you’re doing about your exchange rate. Then they would give you a report, but there really wasn’t a lot to do. It was a period of very solid growth in emerging markets. The developed economies weren’t growing quite as fast, but they were growing with no inflation to speak of. The world seemed like a pretty stable place financially. This was the period called the Great Moderation at the time, meaning moderation in deficits and moderation in inflation.
There was talk by 2005-2006 of possibly disbanding the IMF since it looked like they didn’t have anything to do. That all changed in 2007-2008 with the global financial crisis when the IMF took on a completely new role. You have to give the IMF credit for reinventing themselves. They’ve had at least four different personae, if you will, a few of which I’ve mentioned, but this new one was really to be a secretariat for the G20, a group of 20 nations.
Most important financial decisions in the international monetary system had been made prior to that by the G7. The G7 were the seven largest developed economies including the U.S., Canada, France, Germany, the U.K., Italy, and Japan. That had been the main forum, but by 2008 it was clear that because of globalization, the rise of China, and the BRICS, it could no longer be an exclusive rich countries’ club. They had to bring in developing economies including important ones obviously such as China. So that broader platform was the G20.
President Bush and President Sarkozy of France convened a G20 meeting in Washington in November, 2008. This was just weeks after Lehman, AIG, and the collapse of markets around the world. It was a pretty desperate time. The G20 started working on a plan which played out in subsequent meetings: London in April 2009 and Pittsburgh in September of 2009. There was a sequence of meetings where they worked out the currency wars – what became the weak dollar in 2011 and the strong dollar today.
The G20 was fine in terms of heads of state, but they had no permanent staff, no expertise, no research department, and no bureaucracy. It was just a bunch of leaders who got together, so they outsourced the hard work – monitoring and research – to the IMF. The IMF became, in effect, the bureaucracy bolted onto the G20. That’s a very powerful role, because the G20 were heads of state including President Bush, then President Obama, President Xi of China, and other heads of states. It was a very powerful organization and still is.
The IMF has evolved into probably its most powerful role ever considering that ten years ago people were seriously talking about disbanding it. Today it is the de facto central bank of the world. They have 3,000 tons of gold, they’re expanding their balance sheet by issuing liabilities and creating assets in the form of loans, and they have their own currency, the Special Drawing Rights (SDR). They can print as much SDR as they want and hand out, and I expect they will do so in the next crisis. So they are, for all intents and purposes, a functioning central bank of the world, and the bureaucracy, if you will, for the G20, which is the board of directors of the global economy. I don’t think any of that is an exaggeration. It’s really what they’ve become: a very powerful organization.
That brings us up to today with the IMF in Lima, Peru. They have two important meetings: an annual meeting in October and a spring meeting, usually in April. The spring meeting is always in Washington, and the annual meeting floats around. This year it happens to be in Lima, so a lot of your household names in addition to Madame Lagarde – finance ministers and some essential bankers – are all down there now with quite an ambitious agenda. We’ll be hearing a lot about it in the next two weeks.
Jon: Thanks for that recap. It’s really helpful not only to get the definition, but to get the historical context and bring it up to date. There’s been quite a lot of buzz about this year’s meeting, and the IMF has been pretty vocal. They’ve been putting out some strong alarm signals on several topics, and I’d like to take them one by one.
Let’s go first with the state of the world’s economy. Growth is below expectations, there’s particular anxiety about Chinese manufacturing, and U.S. job numbers, even with the rosiest spin, which we see plenty of, are disappointing. How seriously should we take this economic hand-wringing by the IMF?
Jim: We should take it very seriously because they have the expertise. They have a lot of smart people, PhDs, and quite a few graduates of my old school where I got my graduate training in international economics, The School of Advanced International Studies which is part of the Johns Hopkins University. The main campus of Johns Hopkins is in Baltimore, but what’s called SAIS (School of Advanced International Studies) is in Washington, D.C.
Think of it as an intellectual boot camp for the IMF where people from around the world, not just U.S. students, go. It’s a rather small group of about 300 students and tends to have some fairly elite experiences coming out of finance ministries and elsewhere around the world. They feed into the IMF.
I graduated from SAIS in 1974. A few years later, one of our prominent graduates named Tim Geithner came through. He went to work for the IMF and later became President of the Federal Reserve Bank of New York and Secretary of the Treasury. That’s an example of the kind of training you get there. So I do think what the IMF does is important and should be taken seriously. They have the expertise and the added role I described earlier. If anything, being at the beck and call of the G20 enhances their clout.
I’ve always said the IMF is what I call transparently non-transparent. Let me explain what I mean by that. When I say they act transparently, they put everything on their website. You can go to the IMF website and browse around a little bit to find the world economic outlook and global financial stability report. You’ll find a lot of these papers including the famous paper from 2011 that lays out a ten-year plan on how to evolve the Special Drawing Rights into a world currency.
There’s not much they do that you can’t find out about on the website, but good luck understanding it. It is written in very dense jargon, even more dense than the kind of jargon we’re used to seeing from the Fed. They use a lot of buzz words that, if you’re an expert in the international monetary system, will seem familiar to you, but if you’re just a smart, interested person who would like to learn more, it’s tough to get through. The stuff is there, so I give them credit for putting it out there, but as I said, good luck understanding it all.
That’s where the specialized training I and others have received is helpful. Sometimes I’m like a translator. I read these really technical reports and have some ability to put it into plain English for the audience, so I feel like a missionary going out, exploring the territory, and reporting back.
You mentioned some of the reports that came out this week. Let’s take them one at a time. The world economic outlook is the one that gets the most attention. It’s basically a forecast for the entire world. They go country by country, region and region, and for the whole world. In it they have been lowering their forecasts. Now I must add that the IMF has a pretty bad forecasting record. They have talented people, but they have the same problem as the Fed and others; they have consistently overestimated growth for the last seven years.
This is endemic. You see it everywhere from the Fed, from Wall Street, and from the IMF. They say 3%, but it turns out to be 2%. They lower their forecast to 2.5%, and it turns out to be 1.8%. There are reasons for this regular overestimate of growth. I don’t think it’s some deep, dark conspiracy where they’re trying to lie to people. I think they just have obsolete models. They’re using regressions that deal with over 30 business cycles and business expansions since the end of World War II. They take all that data, do the regressions and correlations, and say, “Based on where we are now, we ought to be growing at such-and-such a rate.” There are some other factors that go into the analysis, but the problem with that system of methodology is that it doesn’t apply because we are not in a cyclical recovery. We’re in a growth depression, really the first global depression since the 1930s. You can have a lot of data, but if you’re in a different world, a different situation, that data is not going to tell you very much. And that is the situation we’re in today. I use very different models such as complexity theory, inverse probability, some economic history and behavioral economics, and a lot of other things to get my forecast, but I can see where the IMF and the Fed go off-track.
On the one hand, their forecasting record is pretty poor and they’ve overestimated growth, so I see no reason why they’re not doing that again. On the other hand, they have lowered the growth estimates, almost as if they’re learning by doing. If you get hit in the head with a 2X4 enough times, you’ll learn to duck. I still think they’re overestimating global growth, but they did lower the global forecast to about 3.1% for 2016.
That’s not a lot when you consider economies in the emerging markets like Brazil, Russia, China, India, and other important economies not quite as large like Turkey and Malaysia. When you consider that their potential growth can be 5% to 7% and the world is only growing at 3.1%, that’s a pretty sad story.
The U.S. does not have potential for 7% growth. Maybe that’s possible in the very short run, but it’s unlikely. The central tendency for U.S. long-term growth is higher than we’ve been doing. I think it is 3.5%, but we’ve been doing around 2% since the end of 2008. For global growth to come in at 3.1% is pathetic given the high potential growth in a lot of the important economies around the world. That tells you how weak things are.
Based on what I just said about their forecasting methodology, it could be worse than that. Imagine global growth coming in around 2% or 2.5%. This means that the big emerging economies probably come down to 4%, and the developed economies are getting closer to 0%. That is what that implies, so I think this is a pretty sobering and dour forecast.
To give the IMF credit, they’re not sugarcoating it. They’re warning the world that the slowdown is taking place. This brings us around to the Fed, because when you ask, “Why is this slowdown taking place if there’s all this potential growth out there and you have a lot of under-utilized factors of production, whether it’s labor or capital investment, infrastructure improvement, or structural changes? If there are a lot of things you can do to get growth, why are we not getting it? What’s the problem?” I would trace a lot of the problem back to the Federal Reserve.
You do have a circular flow of cause and effect. On September 17th, when the Fed decided to not raise their target for Fed funds (not to raise interest rates, in other words), it surprised a lot of people. It didn’t surprise us or the listeners of this podcast because we had said all along that they would not raise rates, but it surprised a lot of people on Wall Street. Janet Yellen gave us a reason, and that was the slowdown of global growth, exactly the kind of thing IMF is talking about.
That has now in effect come back to the United States in the form of reduced exports, i.e., the strong dollar slowing U.S. exports and importing deflation from around the world in the form of lower import prices. When the Fed said they wanted inflation, they threatened to raise rates, which strengthened the dollar, which caused deflation. So the Fed’s own policy is pushing in the opposite direction of the Fed’s stated goal. We said months ago that this makes no sense and would have to be resolved, probably to the detriment of the Fed. It turned out that they were unable to raise interest rates.
Janet Yellen blamed it on global growth and mentioned China specifically. That’s fine, but one of the reasons China was slowing down was because they had pegged their currency to the U.S. dollar, and the Fed has been tightening for two-and-a-half years. When I say that, people look at me like I have two heads. “What do you mean the Fed has been tightening? The interest rate has been 0% since 2008. We’ve never seen so much money around. They printed four trillion dollars. How on earth could they be tightening?”
The answer is they have been tightening since May 2013 when Ben Bernanke started the taper talk. He didn’t actually taper in May of 2013 but said they were thinking about it. ‘Tapering’ means reducing money printing. Under QE3, the Fed had been buying about $85 billion a month of Treasury Securities, which meant they were printing $85 billion a month to buy the securities. He said, “We’re tapering that. Instead of $85 billion, we’ll lower it to 70, then 60, then 50,” and so forth until they got to 0. A lot of people say that’s not tightening because you’re still printing money. It’s true you’re printing money, but you’re printing less than you did the month before.
Things don’t happen in black and white in markets; everything happens at the margins. Small moves change expectations and affect various kinds of behaviors, so just talking about tapering caused the “taper tantrum,” or the emerging markets crisis. Capital started to flow out of emerging markets, emerging markets’ currencies collapsed, the stock market collapsed, and money started coming back into the U.S.
They actually started tapering in December 2013 after talking about it for seven months. Then in November 2014, they finished the tapers and weren’t printing any money, but they still had forward guidance in those statements saying, “We in fact promise not to raise rates.” In March 2015, Janet Yellen removed forward guidance by taking the famous word “patient” out of the statement. So the Fed was no longer promising not to raise rates but was in effect saying, “We’re getting ready to raise rates. Anyone in a carry trade, shorting dollars, or borrowing dollars to invest in emerging markets assets better watch out, because we’re going to raise rates and pull the rug out from under you on that trade.”
People heard her. They started covering their short dollar positions, the dollar got stronger, and there were huge capital outflows from emerging markets. Even without changing rates, they were talking and acting their way through a tightening cycle for two-and-a-half years.
Back to China, they pegged to the dollar and the Fed was tightening. To maintain the peg, they also had to tighten. To do this they had to buy their own currency. If the market wants to take the yuan down and lower the exchange value of the Chinese yuan, and they want to keep it up at a higher level, they have to go buy it to maintain the peg. What were they using to buy it? They were using dollars. They were selling Treasuries, taking the dollar, and buying their own currency from their exporters or anyone who had it. That was causing huge capital outflows from China which caused the dollar to get stronger and the yuan to be too strong.
The Chinese government was propping up the yuan. At the same time, they were trying to ease because their economy was slowing down, so they were lowering interest rates to ease. We had this crazy situation where they were easing and tightening at the same time using two different policy tools. They were using interest rates to ease and they were using exchange rates to tighten. What kind of policy eases and tightens at the same time? That makes no sense. China eventually threw in the towel on the peg and famously broke the peg in August this year, letting the yuan devalue. That started the U.S. stock market collapse.
My point is this is all connected. The Fed blundered by tightening, because the U.S. economy was not strong enough to bear a strong dollar caused by the tightening. The time to tighten was 2010, yet they missed the whole cycle. They should have tightened in 2010/2011 when we had the cheap dollar, which gave the economy a tail wind. They blew it, but two wrongs don’t make a right. Just because you should have tightened in 2010 and failed to doesn’t mean you should tighten today when the economy is getting weaker and the U.S. is probably heading into a recession.
The Fed was not tightening only for the U.S. They took the U.S. economy and the Chinese economy down causing the Chinese to break the peg. Now here we are. The Fed is stuck with a strong dollar and deflationary tendencies. They have no way out.
This whole thing is a mess, and it’s working through the interest rates and exchange rate mechanism. That’s what the IMF was warning about. About a week prior to the September 17th meeting in Turkey at the end of the G20 financial summit, Christine Lagarde issued a statement – a warning – that was as blunt as anything I’ve ever heard. There was no polite language around it. She just said to Janet Yellen, “Do not raise rates.” If you recall, the BIS, the G20, the World Bank, Larry Summers, and IMF – everybody was saying the same thing to Yellen: “Do not raise rates.”
She listened and to her credit, she didn’t, but that dialogue is going to keep happening. Now the IMF was out again this morning with a world economic outlook saying, in effect, “Don’t raise rates. The world is too precarious. Growth is too slow.” So that’s one of the big statements they’ve issued. We could talk about some other ones as well.
Jon: Let’s do that. You mentioned the emerging markets a couple times in your answer. In one of their anxiety bulletins, the IMF has also been talking about the threat of a potential debt crisis engulfing the emerging markets. As I read it, the concern seems to be primarily with corporate debt. How real is that threat in your view? And if defaults happen on a large scale, will the impact be limited to the emerging markets themselves?
Jim: Those are great questions, Jon. First of all, the threat is very real. Let’s put some numbers on it. The whole idea that the world was over-leveraged, there was too much debt in 2008, we had a financial crisis that destroyed tens of trillions of dollars of wealth, but we learned our lesson so we’re going to de-leverage – that is not true.
The world is more highly leveraged today than it was in 2008. There’s been over $60 trillion of new debt created since 2008, so the world is actually more leveraged and dangerous than it was then. That’s the starting place and is part of what the IMF is talking about. Specifically, there is $9 trillion of dollar-denominated emerging markets corporate debt.
Let me unpack it a little bit. That huge number of $9 trillion is slightly more than 10% of global GDP. This is emerging markets only, so we’re not talking about developed countries like Australia, Canada or Europe. These are just emerging markets, primarily the BRICS, with a lot of it in China. And it’s corporate debt, not sovereign debt. Sovereign debt can usually be finessed. If sovereigns get into trouble as we’ve seen in Greece, Ukraine, and a few other places, the IMF is equipped to bail them out. The IMF is not around to bail out corporations and cannot do so. What they could do is bail out countries, then the countries take the money and bail out their own corporations.
So we have $9 trillion of dollar-denominated corporate debt in emerging markets, and the dollar’s getting stronger. What does that mean? It means your debt burden is going up. If you’re a hotel operator or an airline or a manufacturer – any business in Brazil, India, Indonesia, Turkey or China, for that matter – why would you borrow dollars? You borrow dollars because the interest rate is cheap. You’re paying 1% – 3% in money and using it to expand local operations. If you make money by getting paid in yuan, Turkish lira, Indonesian rupiah, Brazilian reals or any of these foreign currencies, but you owe dollars to the bond market or J.P. Morgan or whoever and the dollar gets stronger, your debt burden just went up.
You’re caught between a rock and a hard place. You have a slowing economy, so your revenues in local currency are probably going down, but the value of your debt is going up because the dollar is getting stronger. That’s a recipe for default, and we’re beginning to see that.
Where do these emerging markets even get dollars to pay off the dollar debt? They have to go to their central banks. That means they have to cash in some of their reserves. We’re seeing huge reserve drawdowns in Russia, China, Malaysia, and all over the world. Not that long ago, China threw around the $4 trillion in reserves number. Guess what? That $4 trillion is now down to $3.5 trillion, and the money is coming out at a rate of over $100 billion a month. There are huge capital outflows coming out of China.
A lot of these reserves have been built up since 1998. The emerging markets were not hurt that badly in the global financial crisis in 2008. Yes, everyone suffered to some extent, but that was very much of a developed market crisis. It was a U.S./European crisis more so than the rest of the world. China got through it okay. Part of the reason was that a lot of these emerging markets had been the center of gravity in the 1998 crisis. They had learned their lesson, built up their reserves, were managing their economies better, etc., so they got through it in a lot better shape than the U.S. and some others.
Here we are almost ten years later, and they seem to have forgotten those lessons. Now their reserves are draining out very quickly, so there is a potential for crisis in emerging markets debt. It’s not just the IMF but also the BIS (Bank for International Settlements) in Basel, Switzerland, that have warned about it as well.
The second part of your question – if that crisis breaks out – I think is likely because growth is slowing down. We already talked about how growth is probably worse than the IMF forecasted. The Fed shows no signs of easing, at least so far. A lot of this could be alleviated if the Fed eases. I do think they will maybe at the end of the first quarter or beginning of the second quarter of next year.
People ask, “How can the Fed ease with interest rates at 0%?” They ease by words; by going back to forward guidance. They put some words in their statements telling the markets that they’re not going to raise rates anytime soon. Think of the phrases they’ve had: “extended period,” “a considerable time,” “patient.” These are all buzzwords the Fed has used to signal the markets that they’re not going to raise rates.
What’s the significance of these words? I talked to the person who writes these statements for the Fed. He said they just make it up, call Jon Hilsenrath at the Wall Street Journal and tell him what they think they mean, and then Hilsenrath reports it. He’s a good reporter, so I’m not criticizing him. He’s just doing his job, and it’s nice to have these kinds of sources. After he reports it, everybody says, “We get it.” So the process is sort of picking words out of a thesaurus, sticking them in a statement, calling the Wall Street Journal to tell everyone what it means, and everyone nodding and saying, “Okay, we get it.” That’s how we conduct monetary policy today.
Again, the Fed could go back to easing. That would make the dollar weaker, take some pressure off this emerging markets debt, and give the U.S. economy a break. But then, of course, you’re back to the currency wars just like in 2011 with the weaker dollar. All the countries that are complaining because the dollar is too strong and causing capital outflows will then start to complain that the dollar is too weak causing them to lose exports. You can’t have it both ways, but that is the problem with currency wars. It’s a zero-sum game. There are always losers. All you’re doing is picking different sets of losers at different times. You’re not really solving global problems.
This emerging markets debt crisis is serious. In the intermediate, I think by the middle of next year, you may see the U.S. try to weaken the dollar through some Fed easing policy, but right now today that’s not happening. The Fed continues to talk tough and the markets continue to expect a rate increase, maybe in October or December. I personally don’t have that in my forecast, but a lot of people do.
It’s a very messed up world. The bigger picture is that there’s too much debt and not enough growth. It’s that simple. There are only three ways out: 1) You have to have inflation to get rid of the debt; 2) You have to default to get rid of the debt; or 3) You have to have real growth. Real growth requires structural reforms that governments don’t seem to be willing to step up to. Central banks can’t get inflation because the deflationary forces are too challenging, and nobody wants to talk about the D-word, which is “default,” because that has consequences and spillover effects that could cause a global financial panic.
It’s not a great menu of policy choices, but there are no other ways out of this. Emerging markets will start to melt down unless the Fed eases. My guess at the end of the day is that the Fed will ease, but if they don’t and that meltdown starts, there is no way it will be contained to the emerging markets. It will come back to effect the U.S. through a contagion.
I’ll explain how that works. Hedge funds, banks, and other leverage traders who start to lose money in one market, and get margin calls because they are leveraged, will sell something else. They won’t sell the thing they want; they’ll sell the thing they can. Even if they like the U.S. stock market, if they have U.S. stocks that seem liquid, they’ll sell the U.S. stocks to get cash to meet the margin call on their emerging markets bonds that are going into default. They lever them up with a deal, and the dealer is calling them for margins. That’s how the contagion spreads, so there’s no way it’ll be confined to the emerging markets, which brings up the whole subject of liquidity in bond markets.
Jon: That is another one of those warning signs coming out of the IMF. They’re worried about declining liquidity in the bond markets. This is something you’ve addressed in these conversations before, but I’m wondering if you have any new thoughts to share with us on that.
Jim: I do. It’s one of these papers coming out of the IMF meeting regarding their global financial stability report. The paper is called “Chapter 2: Market Liquidity – Resilient or Fleeting?” It is 60 pages of pretty densely-argued stuff, so it’s not exactly light reading.
Here’s the bottom line. They say something that’s very odd. They say that liquidity is okay – not great, but okay. They don’t sound as dismal on it as some other analysts do, probably because they don’t want to panic people, but then they say it can disappear instantaneously. That’s a weird thing to say. Instead of saying, “Market liquidity is getting weaker and weaker and weaker,” they’re saying, “No, it’s okay, but it could go away in the blink of an eye.” That’s pretty scary.
By the way, we’ve seen examples of that. We’re near the first anniversary of the October 15, 2014, flash crash in the U.S. treasuries market. That was a funny kind of crash because prices went up but interest rates went down. That was not the smooth, continuous trading and price-level adjustment that the academics always assume. It was what’s called a gap move where prices in one instant are at one level and then they just drop four standard deviations in the blink of an eye. They reset at a different level, and that’s what happened. We’re going to see more of that when there will be a panic triggered by some catalytic event causing everyone to get on one side of the boat and it tips over. That’s what the IMF is warning about.
What they go on to say is the part I found intriguing. What was the point of giving a warning? The IMF can talk about it all day long, but they don’t run the bond market. They’re not the U.S. Treasury or Exchequer or French finance ministry, so they’re giving a warning but can’t really do anything about it.
What do they recommend governments do? They say governments ought to take preparatory moves or basically have preemptive strategies to deal with the fact that liquidity can disappear. What would that preparation be? If you think about what they’re really saying, it’s this: “You better get ready to lock down the system. If liquidity disappears, it will be like a run on the bank on steroids, and you can’t make it come back. You can’t print any more money, because you’re at the outer limit of confidence.”
What can governments do? They can close markets, freeze bank accounts, do what they did in Greece, and put on capital controls. These are things they could do, but they’re all really ugly if you’re an investor trying to get your money.
This is one of those times when I do think it helps to not even read between the lines. At least understand that the IMF uses words like “spillover” instead of “contagion” and “macroprudential” instead of “lock down the system.” When you hear the word “macroprudential” coming out of the mouths of an elite global financial regulator, you should think to yourself, “They’re saying I can’t get my money.”
I think it’s an ominous warning, but what’s even more ominous is what they’re recommending people do about it. They’re saying, “We don’t have a magic wand to restore liquidity, so we’re suggesting that if you’re not prepared to print the money or hand it out or guarantee deposits ad infinitum, you better be prepared to close your markets.”
That’s one of the reasons I like gold. One great thing about physical gold in non-bank storage is that it’s not in a bank, it’s not in a market, it’s not digital, and it can’t be locked down by executive order. I’ve never recommended that investors go all in on gold, but I’ve recommended 10% allocation. Some people think that it’s more ideal for clients to have 20% or even 50%. I think that’s a little high, but the truth is, the average institutional investor has less than 2%. A lot of people I talk to have 0%. They listen, they’re kind of interested, but at the end of the day, they don’t actually make the move.
The bottom line with all of that is they’re not prepared for what we’re talking about. This is not fantasy or scare-mongering. People accuse me of being a scare-monger to which I reply, “I’m not a scare-monger. I’m an analyst, and I’m not making things up. I’m telling you what the BIS, the IMF, the G20, and the World Bank are saying. They are saying that liquidity can disappear in the blink of an eye, and the solution is to basically lock down markets. If you don’t want to be frozen in that situation, then you should have some gold in non-bank storage so you can have access to it. That’s your liquidity.
Jon: Thanks, Jim. Now Alex Stanczyk is here with questions from our listeners.
Alex: Steve M.’s question is, “Is there a scenario where the Fed would be forced to raise rates regardless of the state of the economy?”
Jim: There is. I think it’s unlikely and it’s not in my forecast, but people talk about it and it could happen. Just because I have a forecast doesn’t guarantee that something’s going to play out.
I find the whole debate about raising rates just a little sterile, because the quality of the analysis is poor. A lot of people say, “It’s been a long time, so you ought to raise rates.” That’s not analysis; that’s a claim, that’s a declaration. What kind of analysis is that? It’s like saying, “I’m tired of playing Russian roulette, so I think I’ll blow my brains out and get it over with.” Just because it’s been a long time is not a reason to raise rates,.
As I said, they should have raised rates in 2010. In an interview I did on CNBC in August 2009, Joe Kernen turned to me and asked, “What should the Fed do now?” I said, “They should raise rates 25 basis points. There’s no global financial panic. There’s plenty of liquidity.” It’s true that unemployment was still 10% and the economy was still recovering, but so what? What does the Fed have to do with it? This idea that they can create jobs is nonsense. The Fed doesn’t create jobs.
But they didn’t raise rates – not that they were listening to me in particular. That was the time to raise rates, but they failed. However, just because they failed to do the right thing then doesn’t mean they should do the wrong thing today. Today they should be easing because the economy is slowing down. The IMF just told us that.
There’s plenty of evidence with the data that’s coming in. I’m used to seeing data that’s mixed, bad data and good, so I try to parse it and look for trends. On balance, I’ve probably been more than a little bit bearish on the economy, but now I don’t see any good data. I don’t see the other side of the argument. All the data – exports, deflation, labor force participation, wage growth, manufacturing surveys, service surveys – Everywhere you look, it’s all trending down.
I don’t see the case for raising rates, but if there is a case, it would be because they’re worried about bubbles. Their argument would be, “We need to let the air out of these bubbles. If we don’t, these bubbles are going to burst and it’s going to be a lot worse. Whatever damage we caused by raising rates at the worst possible time will not be as bad as letting the bubbles persist and having those things blow up.”
There’s one problem with that argument: I cannot think of a single case where the Fed actually correctly identified a bubble and tried to finesse the air out of the balloon. They didn’t do it in ’94 in Mexico, they did not do it in ‘97/’98 in the emerging markets crisis, they didn’t do it in 2000 with the tech bubble, and they did not do it in 2007 with the mortgage crisis. First of all, they have no history of correctly identifying bubbles, and secondly, they have no history of knowing how to let the air out before they explode.
It’s a pretty unappetizing scenario for the Fed if the economy’s getting weak but they are the one to raise rates and make it weaker. We’ll have people driving tractors up the steps of the Fed again like in 1980 when they had a tractor march because farmers were complaining about the back-to-back recession. If not trackers up the steps of the Fed, maybe torches and pitchforks on Constitution Avenue.
Could they raise rates? Yes. What would be the argument? “We know we’re doing damage, but it’ll be less damage than letting the bubbles come and trying to pop them.” I do find it extremely unlikely though, because there’s just no history or policy of it. Are they going to do that in an election year 2016? I don’t think so.
The other scenario where they could raise rates would be if the economy actually got better. I agree with that. If inflation gets up to 1.8%, growth gets up to 2.3%, unemployment comes down for the right reasons as opposed to the wrong reasons, and all those trends are moving Janet Yellen’s way, then they would raise rates. I would be the first one to say they’ll raise rates within 30 days.
But that is not what the data says. The data says we’re far from Yellen’s goals, and we’re moving in the wrong direction. If we get real growth and are moving towards her goals, she’ll raise rates. That will come as no surprise, but that is not how the data is coming out. The only reason to raise rates in a weak economy would be to pop bubbles, and there’s no history of that, so I don’t expect it.
Alex: That makes a great deal of sense. Moving on, I think some people know that the IMF does own gold as an asset. I was recently reading a report by the IMF that shows gold and gold bullion on a chart listed higher than SDRs and currencies of sovereigns. I don’t know if they actually emphasize it that way internally or if that in fact means anything, but according to the IMF it is important as a reserve asset.
The next question is coming from Jim H. who wants to know, “Does the IMF simply print SDRs and then buy their gold? If they’re just printing SDRs, isn’t that inflationary by definition?”
Jim: Great question. The answer is that the IMF has about 3,000 tons of gold. That’s a lot of gold, in fact that’s the third largest stash of gold of any individual country. The United States has a little over 8,000 tons, Germany has a little over 3,000 tons, and the IMF comes in third at 3,000 tons.
This is from the World Gold Council data, not how I analyze it. I take all the members of the Euro Zone – there are 19 countries behind the euro – and combine all their gold to determine the amount of gold available to back up the single currency. That number is over 10,000 tons, so the 19 members of the eurozone have 10,000 tons, which is why I count them as number one. I count the U.S. as number two with 8000 tons. China officially has just under 1,700 tons, but there’s very good evidence that they have 4,000 tons, perhaps more. Using that evidence, I would give the Chinese credit for 4,000 tons, so I’d make them number three, and then the IMF as number four.
Even at number four, it’s a lot more than the next closest. We have Switzerland and Russia with just over 1,000 tons, then we drop off to Japan with around 700 and the Netherlands with 600. It really goes down fast from there. Interestingly, Greece has 100 tons, although it’s in hoc to the European Central Bank.
The IMF has one of the largest gold hordes in the world. They got it from their members. When you join the IMF, it’s like joining a club. If you join a club, you have to pay dues. There’s usually a pretty high initiation fee and then monthly dues. Going back to the 1940s/1950s, when you joined the IMF, you had to buy in. Like in a poker game, you had to put up some chips. At the time, those chips were partly in gold. You could give them currencies as well, but mostly you gave them gold, so that’s where the IMF got their gold.
This goes all the way back 70 years to 1944, but it is not true today. If a new country joins the IMF, they don’t make them give gold. They can actually give their local currency which is pretty inferior.
The IMF used to have more gold but they sold 700 tons between 1975 and 1980 as part of a secret plan. When I say “secret,” these were classified documents at the time that have since been declassified, so scholars have access to them. President Ford, Henry Kissinger, and the IMF did a secret dumping plan between 1975 and 1980 and dumped 1,700 tons of gold on the world markets, 1,000 from the U.S. and 700 from the IMF. They used to have about 5,000 tons but they returned 700 to the members.
The IMF also sold 400 tons of gold in 2010 as part of a gold dumping exercise. Two hundred tons was sold to Mauritius, India, and Sri Lanka, but the buyer of the other 200 tons is a secret. I don’t know who it was, but I’m pretty sure it was China. I can’t prove that, so I’ll label that as speculation.
So even as recently as 2010, the IMF was dumping gold to suppress the gold price. The problem is that when you dump the gold, you eventually run out of it. In answer to your question, they got their gold the old-fashioned way – people paid in to get stock in the IMF.
As far as SDRs are concerned, they do print them and hand them out. There’s nothing more to it than that; it’s just printed money. They have not been using it to buy gold although it would be interesting if they did. That would be a gold-backed SDR in the making, which is one solution to the global liquidity problem. The only problem is, to make that work, you’d have to have the price of gold around $10,000 an ounce. I think we’ll get there as the situation deteriorates, but you can’t print money and buy gold or go back to a global gold standard unless you’re willing to raise the price of gold significantly in order to have enough liquidity for world finance. I’ve done that analysis, and the answer comes out to about $10,000 an ounce, possibly higher. You could get numbers, depending on assumptions you want to make, as high as $44,000 an ounce, but I’ll stick with $10,000 an ounce for now.
To recap, the IMF does have a lot of gold. They’ve stopped dumping it, and I think they’re going to sit tight with what they have. SDRs are printed and handed out, but they’re not using them to buy gold although they could. That would be a radical change in the so-called rules of the game.
Alex: Our next question is something I’ve thought about as well many times, and I think it’s important for people to consider. This question coming from Roberto C. is, “What’s the best product to buy gold and have access to your money if you want to sell when liquidity becomes an issue?”
Jim: There are a number of funds that tailor their product to exactly what Roberto is asking. I’m on the Board of Advisors of Physical Gold Fund, so of course that would be my first choice, but in fairness to the listeners, there are a couple other programs out there.
Here are the key things: Number one – You want physical bullion. You do not want ETFs or COMEX futures or unallocated gold forwards from London Bullion Market Association banks. And you certainly don’t want any cheesy dealer over-the-counter contracts, so you don’t want paper gold. You want physical gold.
Number two – You want it in non-bank storage. You don’t want to put any significant amount of gold in your home because of obvious security issues, so look for storage in vaults. You want vaults that are reputable, insured, bonded, and have been around for a while. Physical Gold Fund qualifies in all those respects. When I visited the Physical Gold Fund vaults as part of my due diligence and to get acquainted with Physical Gold Fund, we visited their vault in Switzerland. Sure enough, there was the gold. It wasn’t just Physical Gold Fund people, either. We went into the vault with auditors and guards and a lot of third parties. They brought it up in a forklift, opened the seals, and opened the lid. It was a bit like Raiders of the Lost Ark. There was the gold, and all the serial numbers checked out. It’s a very first-class operation.
Again, there are others out there, but with the Physical Gold Fund, if you buy one of the units, the money goes straight to the Physical Gold Fund. They’re not hedging with futures or anything like that. If you want gold, you can call them up and say, “I’d like to take delivery.” Shipping could take a day or two to show up on your doorstep, but it is delivered to your house. Considering that you could be living in a world where banks are closed, ATMs have been reprogrammed to dispense only $300 a day for gas and groceries, and the stock exchange and money market funds are closed, you can call Physical Gold Fund and they’ll ship the gold to your house. That is very commendable.
Alex: Jim, thank you very much, as always.
Jon: Thank you, Alex, and thank you Jim Rickards. It’s always a pleasure and an education having you with us.
Jon: Most of all, thank you to our listeners for spending time with us today. You can follow Jim on Twitter. His handle is @JamesGRickards.
Goodbye for now, and we look forward to joining you again soon.
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