Transcript for the podcast: James Rickards: Paper, Gold, or Chaos?
Chris Martenson: Hello, this is another PeakProsperity.com podcast. and I am your host, of course, Chris Martenson. Today is February 10, 2012, and the world is in a bit of economic turmoil. Greece is flat out busted, the EU is in recession, Japan is struggling with a too-strong yen, and the US government is spending at least forty percent more than it is taking in revenue for the fourth year in a row.
To help us make sense of all this is Jim Rickards, seasoned financier, risk manager, and author of the recent bestseller, Currency Wars: The Making of the Next Global Crisis. In his book, he describes how currency wars are one of the most destructive and feared outcomes in international economics and that history shows they always end badly. He warns that today we are engaged in a new currency war posing risks that every prudent individual should be aware of. For those of you with smoldering concerns about the viability of the world’s fiat currencies, I sense this interview is going to toss some gasoline onto that fire. Jim, welcome. It is a pleasure to have you as a guest today.
Jim Rickards: Thank you, Chris. Thanks for inviting me.
Chris Martenson: Your newest book, Currency Wars: The Making of the Next Global Crisis is doing extremely well. It is sitting this morning at number two eighty on the Amazon booklist, I checked. Congratulations.
Jim Rickards: Thank you, yes. We have been very happy with the result. It has been a New York Times, a national bestseller and very highly ranked on Amazon. And they have some subcategories in the international economics category. We have been number one for three straight months. Very, very happy with the reception.
Chris Martenson: Well, fantastic. And the headline summary of your book, if I could, is that the Fed and other central banks are making a very dangerous gamble that might end well. But if history is any guide, as we have said, has a better chance of ending quite badly. Before we get to that endgame, though, can we set the stage? What does history tell us about currency debasement and these sorts of trade wars?
Jim Rickards: Sure. Well, a currency war in the simplest form, Chris, is basically when there is too much debt and not enough growth. The overhang of debt impedes growth because it clogs up bank balance sheets and clogs up the savings to investment mechanism and has a lot of negative effects. So there is not enough growth to go around. So countries, in effect, try to steal growth from their trading partners by cheapening the currencies. One way to think about it, imagine you live in a small town. There are four stores, they all sell sort of the same thing and one of them has a half-off sale. Well, naturally, everyone is going to go to the place that has the half-off sale.
It is no different in currencies. You know, you are looking out at the world, there are certain countries that manufacture aircraft. We have Boeing in the United States, there is Airbus in Europe, Embraer in Brazil, and China has got an up and coming aircraft industry. Well, imagine you are Thailand or Indonesia, a country that needs aircraft but does not manufacture them. You are going to buy them from one of those countries. And if you can cheapen the dollar, it makes the Boeing aircraft a little cheaper and helps with sales. From that, you get exports, which contributes to growth and you probably get some additional jobs on the Boeing assembly line. So it sounds good. It is very tempting. It sounds like a free lunch, why not do it?
And indeed, the Fed and the Treasury are trying to do that right now. They are trying to cheapen the dollar, probably for the reason I mentioned. The problem is it does not stop at that. It invites retaliation and this is where I give some of the historical examples, as well as analysis.
A couple things happen. Number one – we cheapen our currency but other countries try to cheapen their currency also, so you get into these tit-for-tat devaluations where nobody wins. All you do is unleash inflation, restrict world trade without anyone getting an advantage. I like to say that in the currency wars, all advantage is temporary. You give it up pretty quickly.
The other thing is that for countries that cannot necessarily devalue, they can use capital controls, they can use import excise taxes. Currency wars can turn into trade wars. Ultimately, they can even turn into shooting wars. So you get all these bad effects.
So if the US could cheapen the dollar in isolation, if nothing else happened, maybe there would be some quick advantage. But that is not what happens. But it is a temptation that politicians and policymakers cannot resist, but it ends very badly.
Just to give two specific examples I talk about in the book, I give a history of what I call Currency War One from 1921 to 1936 and Currency War Two from 1967 to 1987. And Currency War One was co-terminus to a great extent with the Great Depression. World trade collapsed, currencies collapsed, unemployment skyrocketed – just a set of disastrous outcomes. And Currency War Two, we had the opposite. We had borderline hyperinflation. You know, when President Nixon took the dollar off the gold standard in 1971, at the time his aides predicted this would create five hundred thousand new jobs over the next two years. Instead, the United States had one of the worst periods of economic performance in its history outside the Great Depression. We had three recessions back to back to back in 1974, 1979, 1981.
So what these historical examples show is that you either get depression or inflation, but either way it is a bad outcome. But you would think the policymakers and the politicians would understand and learn the lessons of history. But they do not and they just attempt to launch these currency wars over and over again, but they always end badly.
Chris Martenson: You know, right at the beginning, you said the debt is the original reason that we start these currency wars. So maybe in the first period you mentioned in the ‘20s, early ‘30s, that was arguably debt left over from World War I. And so ever since the 1970s, debt levels worldwide – but in the US, specifically – have consistently, year after year, risen faster than GDP. You know, just a few percentage points each year, but debt trumped income. And enabling all of that, I feel, was the steadily falling interest rates from the peaks in 1980 all the way on down through to current. And now, Bernanke has signaled rates are going to stay pegged at zero on the short end until 2014 and be lower than otherwise on the long end because of Operation Twist and whatever else might come next. How long can they keep playing this game, do you think?
Jim Rickards: Well, they can play it until they cannot. I mean, not to be glib but the problem I see – and Chris, you are absolutely right about the debt, going back to Currency War One – the debt, in that case, consisted of German war reparations, reparations that came out of the Treaty of Versailles that ended World War I and Germany owed un-payable debts to England and France. But England and France also owed un-payable debts to the United States because they had borrowed money to fight World War I. So you had the spectrum of the entire world in debt. None of it could be repaid. Ultimately, none of it was repaid. I mean, eventually, Adolph Hitler repudiated the reparations and the United States forgave the war debt and we ended up in World War II and the whole thing was forgotten. Then in 1944, we rebooted the international monetary system at the Bretton Woods conference. But that was one contributor to the Great Depression. There were others, but that helped to start the currency wars.
And in the 1970s, you had a different set of debt. You had what was known as the Guns and Butter policy really started by President Lyndon Johnson in 1965. But the effects of it were first seen in terms of currency wars in 1967. The Guns part was the massive expansion of the US presence in Vietnam. We had been in Vietnam for a long time, but Johnson started to send tens of thousands and ultimately, hundreds of thousands of troops there and that was very costly. But at the same time, they launched the Great Society program of entitlements and benefits, which added to the domestic spending. The combination caught up with the United States very quickly to the point that we were, as I said, the dollar was suffering and inflation was breaking out in the 1970s.
So debt was the problem in both cases, no different today. I see the same thing today when you look at the European sovereign debt crisis, Japan’s debt to GDP ratio over two hundred percent – far worse than Greece, by the way. The United States, it is officially a hundred percent, but that only counts the bonded debt. When you throw in Medicare, Medicaid, Social Security, Fannie Mae, and Freddie Mac, FHA, and Federal home loan bank systems, student loans, and all the other liabilities that the government has underwritten, the actual ratio is a thousand percent, meaning ten times GDP.
None of this debt can be repaid, by the way. So what will happen is governments are going to try to inflate their way out of it. It is as if we will say to the Chinese, “Hey, we owe you a trillion dollars. Here is your trillion dollars. Good luck buying a loaf of bread because we have completely debased the currency.
So there is no question. It is quite clear that the Treasury and the Fed are trying to inflate their way out of the problem and debase the dollar. The problem I see is they might not get there, and here is why. The Fed thinks they are playing with a thermostat. You know, you can, if the room is too cold you dial it up. If the room is too hot, you dial it down by adjusting the money supply and working a little bit with expectations on the behavioral side that can gradually tweak economic behavior and lending and spending velocity and money supply that achieve a desired result. The problem is they are actually playing with a nuclear reactor. They are playing with a complex system that is in or near the critical state. Now, you can dial a nuclear reactor up and down but if you get it right, the consequences are worse than having to put on a sweater. The consequences are catastrophic. You can melt down a reactor and ultimately, the entire financial world.
So the danger I see is the Fed thinks they are playing with a thermostat. They are playing with a nuclear reactor and they risk collapsing the entire system.
Chris Martenson: So this idea of complexity and stability, very important, I believe. Our economic and financial systems, they are complex systems, which means they are inherently stable until they are not. At which point, they often – and historically we can find they rather rapidly find a new equilibrium point once we are past some sort of disturbed threshold. How do you see the world financial system going forward? Is it a binary event? Either it survives or it crashes? Or is there some happy slower medium in there?
Jim Rickards: Well, I do not think there is necessarily a happy medium. I agree completely, Chris, with the way these things play out. You either have a catastrophic collapse or you do one or more smart things to step back from the brink. You know, sometimes in making my recommendations, people say you know, “Hey Jim, you want to go backwards.” And my answer is if you are about to drive off a cliff, going backwards is a very good idea.
But the other thing, you are right about how complex systems collapse. But the thing that is less well understood is that the risk or the degree of collapse in a complex system is not just a linear function of scale, it is an exponential function. And what that means in plain English is that if you triple or quadruple, let’s say, the amount of derivatives on bank balance sheets, Wall Street would tell you are not increasing risk at all because you have long and shorts offsetting. It is very clear that that is incorrect, that is not a proper understanding of the statistical properties of risk. In fact, the risk is not in the net, it is in the gross. So if you increase the gross volume of derivatives – let’s say by five times – you have increased the risk.
But a lot of people would say well, maybe then you have increased the risk by a factor of five. But the answer is no, if you increase the size by five times, you probably increase the risk by a hundred times or a thousand times. In other words, it is an exponential function. This is the way complex systems work. But again, it is not understood on Wall Street and this is why policymakers are surprised over and over.
You know, they did not see the crash in 2007, 2008 coming. When it started, they underestimated the severity of it. When they responded, they underestimated the duration of it. They got everything wrong. Well, again, if you are looking through the wrong end of the telescope, you are going to get everything wrong. It just comes as no surprise because they are using the wrong paradigms and the wrong methods of understanding how the world actually works. You know, I hear these Wall Street guys and they say they have this catastrophic so-called black swan type events. And they say well, you know, I need to go back and fix my models. And my answer is no, your models are fine. Your paradigm is wrong. In other words, you have correctly modeled a false reality. And until you understand how things actually work, you are never going to get it right.
So therefore, that kind of collapse is a likely outcome. You can step back from it, and the key is to descale the system, break the system into pieces so that if individual pieces fail it does not cause contagion and take down the system as a whole. My favorite example is JP Morgan. JP Morgan Bank today is the result of five different banks, each one quite large in and of itself. When I started banking and you had Manufacturers Hanover, you had Chemical Bank, you had the Chase Bank, you had an old version of JP Morgan, and other banks all merged into one. Why not break them up into pieces and why not ban over the counter derivatives? I think exchange trader futures are fine because they have a lot of controls around them. But the over the counter derivatives do not. And get rid of dangerous products, break up the big banks and then move forward. You still have an economy and a financial system, but you have a lot less risk.
Chris Martenson: So let me ask you something very specifically around this, which has been puzzling me for a while and I have dug and I cannot find an answer that satisfies me. So the ISDA and European regulators bent over backwards in order to avoid triggering a default event, a credit event on the Greek CDS paper that is outstanding. And so I looked at that and there is seventy eight billion notional on it, of which the net exposure was said to be in the vicinity of maybe three point eight billion of which at auction – if they settled that out at fifty cents on the dollar – there is maybe one point seven billion of total exposure. Why are they bending over so hard to avoid such a nominal amount of money?
Jim Rickards: I would not say the bending over hard, I would say they are utterly corrupt, meaning clearly it is a default. Their failure to call it that just shows how corrupt the system actually is. But to get into your specific question, Chris, the reason is that if you actually did declare a default, the exposure is not the net of you know, kind of one to two billion that you described. The exposure is the whole seventy eight billion because that is taking a single institution. Let’s say I am five billion long and I am four point nine billion short and I am going to lose the entire value of my four point nine billion short. Well, the only way I preserve myself if I can go to the five billion long and collect. But what if I cannot collect? What if it is AIG? In other words, this is not just about market risk and notional risk. It is also about credit risk. So the only way the net is meaningful is if I am certain that I can collect on my long in case my short has lost value. But they are not certain about that. When you start having institution go to institution to collect the entire gross value of the debt, you are going to have failures. You are going to have people who cannot pay, then that will have a set of dominos to collapse the entire system.
So the reason they are trying so hard to posture the way you describe, which is netting out the longs and shorts, going to the net amount, marking it to market, you know, sum value, etc. It is because the reality of the gross exposure is one that would take down the entire system. But that is the reality and otherwise, it just shows how desperate they are.
Chris Martenson: So let’s talk about the desperation then. Because if we take this dynamic of the past four decades which, simply enough, was just one of debt growth exceeding income growth, this seems to be what Bernanke, ECB, Bank of Japan, everybody is trying to preserve the system. But I think anybody with a sixth grade math skill and a calculator can tell you that that game ends sooner or later. Does the Fed lack sixth grade math skills? Or what is their end game here? I do not even understand how this game plays out. Sooner or later, you have to get your debt back in line with your income, period.
Jim Rickards: Right. Well, when you have this much debt overhang – and I think you described the problem correctly, Chris – there are only three ways out. The first way out is default, and we are seeing that increase today. The second way out is inflation, and this is the preferred method of the Fed and the Treasury. Now, you will never hear a Fed chairman say we are working really hard to get some inflation in the system. Although interestingly, Bernanke has said some things very recently that were very revealing along those lines. He said we do not want too much but he is very candid about targeting two percent inflation and has gone on to say you know, we might overshoot the target a little bit and things might get a little bit out of control and we could have something higher. To me, that is revealing because there is no doubt that what they are really shooting for is four percent inflation. They want the shock factor. In other words, they want to guide your expectations to two, then actually produce four so that people will sit up and take notice and say gee, you know, I had better do one of two things. I had better go out and buy that car or buy that refrigerator before prices get out of control, or buy that new house just to prop up asset values. The other thing is that at that point, you will have steeply negative real interest rates meaning if the nominal rate on the loan is one percent but inflation is four percent, then the real cost of borrowing is negative three. The lender is paying you to borrow. You can pay them back in cheaper dollars. So I like to say it is like renting a car, driving it around and returning it with the gas tank half empty without having to pay for the gas.
So that is what the Fed is trying to do. They are trying to get that lending/spending machine going again, get the velocity of money up and kind of inflate their way out of this problem. A couple problems with that. Number one, two percent inflation is not so benign. Two percent inflation cuts the value of a dollar in half – I am sorry – cuts the value of the dollar by seventy five percent in the course of a typical lifetime. So it cuts it in half in thirty-five years and then in the following thirty-five years, cuts it in half again. So now, you are down seventy five percent from where you started. So from the time you are born to the time you die, your dollar is going to lose seventy-five percent of its value. That is at two percent inflation. At four percent inflation, it will cut the value of a dollar in half by the time your children go to college.
So these are cancerous rates of inflation. Two percent sounds warm and fuzzy. It is not. The other thing economists say is, you know, who worries about inflation because your wages are going up and it all comes out in the wash. Well, I mean, this is the kind of thing that only an economist could say. But the fact is some of it does come out in the wash on average. But we do not live on average. We live our individual experiences. And the fact is in inflation, there are winners and there are losers. The winners are people who can see it coming, who understand what you and I and hopefully the listeners are talking about and hedge their position by getting gold or silver or land or fine art or investing in railroads as Warren Buffett is doing, some kind of hard asset play. The losers, those are savers, people with insurance policies, annuities, pensions, retirement plans – anything denominative dollars that are not going to go up when the inflation kicks in.
So inflation is really a form of theft, taking from everyday Americans and giving to leagues, hedge funds, bankers, and other people who understand, again, what we are talking about. So these are not benign numbers, but they do reveal the Feds’ hand. The Fed is out to inflate away the debt.
The third way out – in addition to default and inflation – is growth. And what happened to growth? And the neo-Keynesian economists like to talk about the tradeoff between consumption – which is just individual spending – and government spending. They have this concept of aggregate demand where they say well, gee, aggregate demand is falling short of target, like we are not spending enough money and consumers will not step up. So government has to step up and fill the gap between what consumers are doing and the theoretical aggregate demand. Well, whatever happened to investment? I mean, investment is part of GDP. The economists act as if consumption and government spending were the only two things that mattered. Of course, and exports is another part of it, but that is where the currency wars come in.
But what about investment? Investment is double beneficial. When you spend it, you get GDP immediately. And then if it is productive, you get improved productivity, GDP down the road so it is kind of a twofer. So we are going to move from a consumption driven economy to an investment driven economy. But instead, the neo-Keynesians just want to substitute government spending for individual spending and that is, yes, it is just part of this road to ruin.
Chris Martenson: Well, I think part of their flaw, as I see, is they were expecting that a couple of trillion dollars poured into the gas tank would have gotten us revved up and moving and it has not. And one explanation for that is when I check out an oil chart, I can find exactly zero historical examples of a recovery happening at the inflation adjusted equivalent of a hundred dollar per barrel oil.
Jim Rickards: Right.
Chris Martenson: Do you have any thoughts on peak oil or energy prices and how those factor into this pile of debt?
Jim Rickards: Well, certainly, high-energy prices are going to impede recovery and we are getting that not just from the kind of the prospect of inflation – which we talked about – but also because the geopolitical concerns in the Middle East. And I think those concerns are going to become more acute as the year goes on, the prices will go a little bit higher. So I am not really an expert on peak oil, but I am an expert on geopolitics and I can see that driving the price of oil significantly higher. And again, the data is unquestionably what you described, which is that is not the foundation or the basis for recovery. So in addition to all of the other headwinds I talked about, which is low money velocity, negative home equity, excess debt at the consumer level, deleveraging – in addition to all that, we have this high price of oil, which is just another headwind.
So again, it is all the more reason to think that the Feds have got their work cut out for them. But what concerns me is that instead of just sort of acquiescing to deflation and letting prices find the level, letting the housing market find its level to the point where people actually want to buy housing or buy stocks for fundamental reasons. Instead, they insist on propping up the asset bubbles to asset price inflation and ultimately, consumer price inflation. That will end badly, but it is hard to say when.
Chris Martenson: So let me back up, then, to where you said that Bernanke said two percent is what we are targeting – wink wink – but he would not be unhappy with four percent. So they have already got interest rates at zero, they have already got as much liquidity in the system as I have ever seen. It expanded their balance sheet by a factor of three. They have done all these things and we do not have a whole lot of inflation going on by official measures. Do we interpret that as another round of QE is on the way? And if so, when would you think that might happen, given politics or election cycles or anything else?
Jim Rickards: Sure. I think there are two interpretations, Chris, that we are consistently showing. I would like to say it is a sad thing, a sad sight when the Fed is trying to get inflation and cannot get it. So you are right. We have not – despite printing over two trillion dollars in the last three years – we have not seen much inflation in the United States. But there are two reasons for that. Number one; there is a very, very powerful deflationary vector coming out of the fact that we are in the depression. I do not really think in terms of double dips and recession cycles. I think we are in a depression. I think it began in 2007. It is probably going to continue until 2014; perhaps longer depending on policy. So there is a natural rate of deflation coming from that as balance sheets to leverage, assets are shed, prices get marked down, you know, etc. But then there is inflation, which is induced by the Fed through policy.
So what you have is sort of like two giant tectonic plates pushing against each other. It is the North Pacific plate pushing against the North American plate. Just because there is not an earthquake right now does not mean that tensions are not building up below the surface. I think the same thing is true when I see a CPI report coming in around two percent where it tells me that deflation is probably five or six and inflation is probably seven or eight. And it may net out to two, but the powerful, the underlying forces is very powerful and that could break one way or the other. So that is one reason.
But the other reason is that until recently, until about a year ago, China was maintaining a peg to the dollar. What that meant is that as the Fed was printing more and more money, a lot of those dollars were finding a way to China in the form of direct foreign investment, portfolio investment, and China’s net export account. And the People’s Bank of China said to Chinese companies and others that you cannot keep the dollars, you have to give them to us and we will give you our currency, the Yuan, the Chinese Yuan in exchange and then use that to pay your bills and your payrolls and all that. Well, what that meant was that the faster the Fed printed dollars, the faster the Chinese Central Bank had to print yuan to soak up the dollars. So the inflation actually broke out in China. Inflation took off with a vengeance in 2010 – say 2010, 2011 – which is highly destabilizing and worrying to the Chinese leadership because traditionally, it is the cause of political instability in China. So finally, they threw in the towel and did allow their currency to appreciate, go up, against the dollar. But that just means the inflation is now going to come back to the United States. Those chickens are going to come home to roost in the form of higher import prices.
And this is the flip side of the currency war. You know, currency wars start because people want to cheapen the price of exports. But they forget that the United States imports more than it exports and when you cheapen a currency, the price of all the things we buy from abroad – whether it is iPads, iPods, clothing, textiles, European vacations, etc. – all go up. So I think you can expect to see that inflation creeping in as a byproduct of the currency wars.
But yes, we are going to see QE3. They are not going to call it QE3. They are going to call it nominal GDP targeting, which is a fancy way of saying we want nominal GDP to go up and we do not care how much is inflation and how much is real. We just want the thing to go up because the debt is nominal. And you talked about fifth grade math. This is actually third grade math. You know, one plus four equals five and four plus one equals five. What the Feds are going to say is they care about the five. They care about that nominal growth. If it is one percent inflation and four percent real, that is a very happy outcome. But they are saying if it happens, it will be four percent inflation and one percent real. We do not care; we have to get to the five, one way or another.
So that is a signal that the Fed does not care about inflation. They are just going to print as much money as they have to. And you will see that probably at the April/May meeting, certainly before the summer. So yes, that is on the way.
Chris Martenson: All right. In your book, you describe the end game as paper, gold, or chaos. Give our listeners a brief summary of what you think that endgame looks like.
Jim Rickards: Yes, paper would basically be substituting a new global reserve currency. This is sponsored by the IMF, it is called the SDR, which stands for Special Drawing Rights. So basically, people understand that the Fed is a printing press and they can print dollars. Well, the IMS is a printing press, also. They can print SDRs and flood the world with liquidity that way. Except there is even less accountability at the IMS level than there is at the Fed level. This will happen the next time we have an acute stage of a financial crisis something like 2008. You know, the Fed papered it over the last time but the next time is going to be too big for the Fed. You know, the Fed increased their balance sheet to three trillion dollars. What are they going to do the next time, increase it to nine trillion? And there are political and practical limits to that. But the world has no limits, so we can just print this new world money on global money called the SDR.
So it is nothing new. They have been around since 1969 and some of them were issued, a couple hundred billion were issued in 2009. So that will be the new world money. Competing with that would be some kind of return to the gold standard where people do lose confidence in paper money and the SDRs do not do the trick, it is just another form of printing. Countries may have to go to the gold standard – not because they want to but because they have to restore confidence.
Third possibility – chaos – is the one I think that is actually the most likely. Not because anybody wants it or anyone plans for it but because of human nature, denial, wishful thinking, delay, kicking the can down the road, that things just collapse. As we have said before, these catastrophic collapses and complex systems come out of nowhere. They happen very suddenly and when you least expect it. And I think that may be what happens here.
Chris Martenson: Yes. Certainly, I love the description of the pressures are building because that is what I see. I see the derivatives are ac