Monday, December 15, 2014

Paul Singer: Looking Ahead to 2015 and Risks to the World Economy



Hedge fund manager Paul Singer, founder and president of Elliott Management Corporation, on global financial and political issues and the risks they engender.

Mr. Singer was interviewed by Andrew Ross Sorkin at the New York Times DealBook Conference, December 11, 2014 at 1 World Trade Center, New York.

Monday, December 8, 2014

How to Get Your Bonds Ready For a Fed Rate Boost in 2015

Rising yields are a matter of when, not if. You can reduce the risk and add to returns.

By Michael A. Pollock
Wall Street Journal
December 8, 2014

Will investors get the bond market right in 2015?

Many didn't this year. They flocked to mutual-fund and ETF strategies that mainly offered protection against a surge in long-term yields, but instead of rising, those yields fell.

Read more at this link.

Tuesday, October 7, 2014

The Lehman Rescue Efforts: What Went Wrong; Was a Better Way Available?

By Yusuke Horiguchi
October 7, 2014

1. In a systemic financial crisis, strong forces of contagion--a virulent form of negative externality--put even the solidest financial firms with no faults of their own at serious risk, because of other firms' plight. This is a notorious example of market failure, providing a justification for public intervention aimed at preventing the financial system's collapse, typically involving taxpayer money. This is a standard economic analysis, widely accepted, at least at this level of generality, and with a straightforward prescription on the general direction of policy to be followed when coping with severe system-wide financial stresses.  It needs emphasis, however, that the prescription is applicable only to systemic crisis situations. 

2. The situation of September 2008 and the ensuing few months was none other than that of an epochal systemic crisis. It in fact was the epitome of "unusual and exigent circumstances", in which the Fed was authorized to exercise extraordinary lending power under Section 13-3 of the Federal Reserve Act (in particular pre Dodd-Frank). What was needed then was not just one but a series of decisive public interventions, with the Fed playing a critical role using its Section 13-3 power. Not bailing out a big financial firm in trouble in such a situation could cost taxpayers much more dearly than the direct cost of bailout, as witnessed in the wake of Lehman's collapse, an event which should have been prevented.

3. Why did the Lehman rescue efforts fail? It does not take a rocket scientist to figure out that then Treasury Secretary Paulson's dogged adherence to his policy of no public money for a Lehman rescue made an already very difficult task of preventing Lehman's collapse an almost impossible one, as documented amply in Ross Sorkin's Too Big To Fail, and former Treasury Secretary Geithner's Stress Test. What caused Paulson's absolute aversion to another use of public money was the political flak he had been getting, especially following the bailouts several days earlier of Fannie and Freddie. He could not stomach any more politicians' damning refrain "here goes Paulson again with his checkbook". As pointed out in those books, had Paulson chosen to take a higher road and indicate, at a strategic moment, his potential readiness to be less inflexible, at the end of the day,  perhaps contingent on certain conditions, the process and the outcome of rescue efforts could well have been different.

4. Paulson found a convenient defense for his position in an analytical assessment circulating at the Treasury and the Fed with considerable top-levels support, that financial firms were ready to cope with a Lehman failure given their preparation over the six months since the Bear Stearns event. This analysis, however, was a cavalier one, to say the least, ignoring altogether a fallacy of composition typical in a panic whereby individual firms' rational behavior to run from risks collectively acts almost like a death sentence for the financial system already on its knees. A sloppy analysis should be accorded no place as a basis for a strong policy position like that of Paulson's, especially in a moment of truth. 

5. Strangely, post Lehman's bankruptcy, Paulson's public statements on why Lehman was not bailed out cast aside his policy of no public money for Lehman. Paulson instead contended, like then Fed chairman Bernanke, that, given the lack of adequate collateral on the part of Lehman, they had no legal authority to lend to Lehman, even under Section 13-3, an amount sufficient for it to weather the storm and survive. Aside from a question why Paulson had to be so vehemently opposed to something that, according to him, they were not even legally authorized to do, a set of "circumstantial evidences" points to rather shaky grounds on which this contention stood. 

6. To begin with, contrary to their public statements, the real legal authority issue in Lehman's case was not whether the Fed had legal authority to lend to Lehman under Section 13-3 but rather whether the Fed had legal authority to proffer a guarantee for Lehman's trading obligations during the interim between the time of Barclays (a UK bank, the only potential buyer of Lehman in the final stage) and Lehman signing an acquisition agreement and the time of the deal's closure. On Sunday September 14, with a consortium of major banks having already agreed, to meet Barclays' demand, to put up $33 billion to fund a special vehicle to purchase Lehman's toxic assets--a la Maiden Lane the NY Fed created for Bear Stearns rescue--the last hurdle blocking Barclays top executives' signing of an agreement in New York that day to acquire Lehman was the absence of a Barclays shareholders' yes vote on proffering trading obligations guarantee. 

7.  With the UK authorities refusing then to waive the country's requirement of a shareholders' vote on this, the only way viewed as potentially available for the merger deal to get signed that day was for the Fed, instead of Barclays, to proffer such a guarantee to Lehman, until the time of Barclays shareholders' yes vote. And that was what was deemed legally impossible for the Fed to do, as articulated by NY Fed general counsel Baxter in his statement to the Financial Crisis Inquiry Commission. So, Paulson and Bernanke were right in claiming that they did not have legal authority, but the legal authority in question was not one related to lending to Lehman in the alleged absence of adequate collateral but one related to proffering a temporary guarantee for Lehman's trading obligations. This distinction is critical. The Fed's lack of legal authority in this very specific and narrow matter cannot be considered as the last word on a broader issue of whether a legal way to use public money to rescue Lehman could not have been found. 

8. A key issue in that broader context is whether Lehman had adequate collateral for a Fed loan under Section 13-3. The assertion of Paulson and Bernanke notwithstanding, a strong support for a positive answer to this question is found in the bank consortium's unambiguous decision to provide $33 billion to fund a special vehicle to buy Lehman's toxic assets. According to the Sorkin's book, the way the consortium valued those assets for deciding how much to provide was merciless, with 25-50% writedowns from Lehman's own downbeat estimates being common across those assets. A reliable basis for assessing the suitability of those assets as collateral for the Fed's potential loan operation for a Lehman rescue is found in NY Fed lending for Bear Stearns rescue. In that bailout, the collateral for the NY Fed's $29 billion loan to Maiden Lane was valued using, as is, Bear Stearns marks as of March 14. It would be a mystery if the Fed indeed had no legal authority to lend for a Lehman rescue based on the far more stringently valued collateral.

9. These considerations indicate that a way could have been found to get around the aforementioned specific legal obstacle and let Barclays sign the purchase deal. For example, given the consortium's commitment to provide $33 billion, a plausible scenario for Lehman rescue would have been for the consortium, instead of the Fed, to proffer the needed guarantee, using that money as a means to boost the guarantee's credibility, and for the Fed in tandem to fund a special vehicle to purchase Lehman's toxic assets, as it did for Bear Stearns. Would the consortium have demanded that the guarantee be secured by collateral? Not likely, in the light of the total lack of any "fusses" on the part of JP Morgan Chase in proffering the required guarantee to Bear Stearns, in sharp contrast to its adamant refusal to proceed with the acquisition deal in the absence of the Fed's commitment in effect to covering the great bulk of possible losses associated with Bear's toxic assets. Had the consortium asked for collateral, it very likely would have found adequate collateral among Lehman's non-toxic assets valued then at more than $500 billion. 

10. As a final point on the legal issues, it should be emphasized that the Fed's lack of legal authority to proffer a guarantee as such should not have been taken as precluding a search for an instrument available within the Fed's legal power that performs a function equivalent to a straightforward guarantee for Lehman's trading obligations.  To leave no room for doubt that Lehman's commitment in trade deals be honored, all that the Fed would have had to do was to make a non-recourse loan to Lehman in the amount of any trading transaction that Lehman did not have resources to consummate, taking the assets acquired from the counterparty to the deal as primary collateral. The Fed had the authority to make such a loan (and could have prevented a bankruptcy) but did not use it.  Another possible channel through which to provide public financial support for a Lehman rescue was thus left unexplored. 

11. The absence of official financial support to underpin the Lehman rescue plan being developed in New York made the UK authorities highly skeptical of the plan's workability, causing them to refuse to go along with the US authorities' prodding to give Barclays the green light for its acquisition of Lehman. The sketch provided by Paulson of the deal in the works, notable for no official skin in the game, clearly indicated to the UK authorities that Barclays would be taking on more risk than it could manage. What they looked for, in order to be supportive, was an assurance that the deal was sufficiently watertight to cope with any worst-case scenario. In their view, such assurance was possible, in the midst of the raging systemic crisis, only with an unequivocal financial backing of the US authorities for the deal. While the UK authorities' strong disinclination to go along, including its refusal to waive the requirement of a shareholders' vote on proffering of the guarantee, was taken by the US side as the final nail into the coffin of the deal, it should have been crystal clear from the very outset that there was absolutely no way for the UK government-or any other government for that matter-to endorse the deal as envisaged, in effect bankrolling a US investment bank when the US authorities would not. 

 12. By way of concluding, a mention has to be made of a concern about the moral hazard affecting big financial firms, a concern almost certain to have been underlying all those individual reasons for the failure of the Lehman rescue efforts. Despite its powerful influence in politics, substantively moral hazard affecting such firms is merely an untested extrapolation of a concept relevant for individuals' behavior to organizations'. To begin with, an official bailout of such firms is for the system's stability and never for any individual stakeholder. In cases where a firm on the brink gets bought into a healthier firm, it loses its own identity, and its stakeholders typically lose big time. Even in the bailouts of AIG and Citi in which their identities were preserved, the losses incurred by their shareholders as well as top executives and highly paid staff, typically with substantial holdings of shares of their respective companies, were enormous. Given that, an idea that individual stakeholders behave recklessly just because of the knowledge that their firm would be bailed out in time of crisis is absurd. So, then, is the notion of the moral hazard affecting large financial firms. 

13. Moral hazard was not a driver of large financial firms' pre-crisis reckless behavior; greed and other basic frailties of many key individual stakeholders were. Despite its little substance, the concern about moral hazard has intensified in the aftermath of the repeated bailouts of unprecedented scales.  This is visible in certain recent regulatory changes, including in particular Dodd-Frank's elimination of the Fed's power to lend to individual nonbanks and of the broader FDIC guarantee authority. Making the collapse of systemic firms during a crisis less preventable while lessening the authorities' ability to keep the panic from spreading can prove a devastating combination. In contrast to significant regulatory reform achieved on crisis prevention side, retrogression is the clear trend for the crisis management apparatus charged with the imperative of preserving systemic stability, driven by moral hazard concern and anti-bailout sentiment. Last time, the authorities failed to make full use of available instruments; next time of a category-5 hurricane, they will find themselves short of instruments. This has to change without delay. 



Friday, July 18, 2014

Stanley Drukenmiller: Fed Making a Bad Bet




From Delivering Alpha, July 16, 2014, Pierre Hotel, New York

Joe Kernen of CNBC Squawk Box co-host interviews Stanley Druckenmiller, founder of Duquesne Capital Management and chief executive officer and chairman, Duquesne Family Office LLC

Rough transcript from CNBC:

The following transcript has not been checked for accuracy.

Joe Kernen: So when we have talked in the past, you were even more, I guess, strident about your biggest bets, biggest money and we know how well you've done. we heard Julian Robertson, we know compounded return for years ars and years. betting against central banks. If you can find a mistake, that's what you key on. Sounds like you found a mistake and given the depth of the recession in 2008, and now the type of measures the Fed has used, these were shock and awe measures compared to what was done -- 2002 and 2003, in the bubble, and it scares me. I'm not sure whether I'd hold anything at this point.

Stan Druckenmiller: It's a great question. First of all, at this point in time, I don't see this as systemic. what we believed in 2005 and 2006 was that you had double leverage going on. People borrowed to buy their home, and then they were borrowing against their home, and the shadow banking system had accumulated those debts. So while the Fed thought the crisis was containable, we saw no such thing, because when the bad stuff gets into the banking system itself, it has huge wider implication for the broader economy. The current situation is a little -- is a little trickier, Joe. first of all, like '04, I don't have great certainty how this mistake will end. In fact, I'm not even sure it's going to end badly.

Joe Kernen: And it wouldn't be housing this time. I mean, we're waiting for housing.

Stan Druckenmiller: No. What I am sure is they're making a bad bet. A bad risk/reward. You could go to the lottery and win the lottery, but it doesn't mean it was good bet. So when I look at this monetary policy and i look at all the money my firm has made in the past, due to improper monetary policies, yes, it looks extreme, but since it hasn't infiltrated the banking system, I don't think at this point we're looking at an '08 or an '09 in our future any time. in terms of our future, you said 2000, you gave a speech in 2004. You didn't make the bet for another year, in -- it was 2005 yes. and made the bet when? 2006? I -- I made a lot of are money in '05, because i wanted to ride the overly aggressive policy. '06 i stunk. made some money, but I had left the party, and -- you knew there was a housing bubble, about three, four years early before '08.

URL:http://video.cnbc.com/gallery/?video=3000293196

This transcript is generated by automated closed captioning, has been edited for capitalization and to identify who is speaking,  and may not be entirely accurate.
©2011 CNBC.com

Tuesday, July 15, 2014

Santelli's Epic Rant on the Fed, Easy Money & Markets on CNBC



CNBC, July 14, 2014

CNBC reporter and commentar Rick Santelli in Chicago says that the Fed needs to get back to a less volatile form of central banking. If not, there will be a lot of unintended consequences. When Steve Liesman asks should policy be run to please traders in Chicago, Santelli says that the traders didn't contribute a penny to the crisis and the traders erupted in a roar of approval. Santelli argues that the economy and the markets need a better feedback unaffected by the Fed's manipulation.


Rough Transcript:

The following transcript has not been checked for accuracy.
i think we need to get back to a more steak and potatoes mundane, less volatile form of central banking. we are not in a crisis. and janet yellen and ben bernanke still treating the economy as though it's in crisis. equity traders don't seem to be too bugged because they know in the end, what's in the new yorker that i've read, easy money will outlive any types of tailwinds -- excuse me, headwinds to the economy. and i think that's what stock traders are looking at. you're suggesting that the longer the fed waits to raise rates, the harder time the market is going to be able to digest that. and also the dangers of inflation coming into the picture down the road. is that what you're putting forth? reporter: i think you've just listed two unintended consequences. i think that the litany of unintended consequences is much larger. the list is much longer. and the ultimate questions about how it turns out are much more vague. in the end, this isn't what the central bank of the united states was created for 100 years ago. it was supposed to be a nudger. now it's embedded in a political, social type of financial engineering, not the least of which you would never go to an accountant on a personal level that treated your money in this kind of group feel-good setting. steve, the drumbeat appears to be getting louder. at least people are talking about it more than they have in the past several months as to whether the fed is truly gotten itself behind the curve and now how it rights the ship. drumbeats can be loud as you want them to be, but whether or not there's any actual action, i don't see it. i've been very careful to watch markets and see how there's some expression over this concern over inflation. it's very hard to find. it's just not out there. you asked the question is the federal reserve behind the curve? it's well to remember that it is the federal reserve's policy to be behind the curve. janet yellen said it in the new yorker article today. and the statement goes as follows, scott. that interest rates will remain lower than normal when markets return to normal. so the question about whether or not that engenders higher inflation or not, what we do know if there's been a certain wing of economic -- the economic profession that's been talking about the concern about inflation for many, many years and it has not materialized. and that remains their driver for what they think the federal reserve should do that they should end their qe policy earlier. some of the fed's own members have suggested that. closser has brought that up as well. hey, steve, you're talking about feedback loops, okay? come on, steve, be objective on this one. you don't think the feedback loops of a free market have been sufficiently pushed back, that it's very hard -- you sea, well, i don't see any signs of it. well, why would you? we're in a managed setting. we're in a managed setting. if a baseball league puts in their crummiest players, what's the feedback loop for the talent? rick, i think there are many ways that the market can express its concern over inflation. you can sell equities. the market has the ability to set an outlying fed funds futures rate. reporter: why? because we're giving expect xyz super low rates to artificially make pe ratios look handsome when they're still a pig. well, first of all, it strikes me that the pe ratios, as are traders here on the right have told us quite a bit, they're not particularly out of line. there is some bubblelike stocks that are out there, but overall -- reporter: because of the stock buybacks. what's that? reporter: that's the driving force. right. so however you get there -- reporter: however you get there. if you want me to trade on earnings and not per share, then, you know, i've got a bridge to sell you. reporter: the stock market had a hissy fit. we've deprived the market of hissy fits. but now they're going in a measured way. reporter: that's it. it's going. just like they said, we're just going to play the music. do you want to hear a social policy from the head of the biggest central bank who controls $4.5 trillion of america's money? i want the fed to do what it's supposed to do, which is to bring about an economy with low unemployment and low inflation. reporter: they're bankers! they're not psychologists! rick, it's not clinical. you know what i want to do? rick sort of alluded to it. why wouldn't you buy stocks in this environment, mike murphy? that's clearly what people have been doing. you guys don't seem to be overly concerned about this question we enter at the top of the show, though it is getting louder in the market. it is getting louder, but i think right now equities are the main game in town. i won't say the only game, but right now you wouldn't go out to rick's point a equities, but my take on the fed is they're trying to keep the market inflated because think back to where we were, rick, in 2008. this is still a reflection of where we were. the financial crisis. so i think they're going to err on the side of caution which i'm fine with. and that's given us this nice long rally in the equities market. and i think it continues. reporter: do you think there was easy money in front of the crisis? do you think that was one of the contributing factors? yes or no? in hindsight, it was, yes. reporter: okay. well, why don't we get some hindsight early now? hey, rick, this is one of the biggest non sequitur discussions i think i've ever heard because if you think about 79 million baby boomers who are entering retirement and you understand the fact that a quarter of them are going to make it to 93 years old, if we think that there is inflation coming down the pike, why would they want to buy bonds? they have three decades, they're guaranteed to lose money at face value in a ten-year treasury. they should be adding to stocks, not adding to bonds. reporter: demographics don't have money. they don't have jobs. they're living in their parents' basement. and at less than half of americans' own stock portfolios, so who exactly are we helping here? we have an unemployment rate that is now growing commensurate with the late '90s. reporter: you think they're going to be better educated to get a job? it's making it worse and isn't addressing the problem. how does monetary policy again address the problem of millennials that don't have skills for the job marketplace? explain to me. should they work for the fed? reporter: stand up and do. congress, we've done the most we can do. we've nudged the market. now the feedback loops happen and there's a big ruckus in november. problem solved. to congress what they should do? if i concede every point rick makes, he still cannot explain to me how higher interest rates brings about better economic outcomes. reporter: because if i'm a bank, why would i lend to some person in a subrisk/reward rate? -- better economic outcome. what is that? presumably higher interest rates would follow. if the issue is capital investment, what you don't want to do is raise the hurdle rate. you just complained about the idea of ceos -- reporter: if won't come out if it can get a decent return. it has little to do with the return of money, has more to do with the other side. reporter: personal feelings about social banking policy do? the question you want to ask yourself, rick, is whether or not -- reporter: that's the question i'm asking. that's the one i want answered! precisely, rick. that is what the fed, under bernanke and almost under every fed chair. what should it do, rick? reporter: created to be a feel-good institution. what's the policy for you and the traders down there in chicago, is that the correct policy? reporter: the traders never contributed one penny to the credit crisis! not one penny! not one penny! i'm not sure how that has anything to do with what i just said, and every applauded you. i would say from an investing point of view, just to bring it back to what we actually do, i think it's interesting that the late cycle sectors are doing well. and i think that's because people do expect inflation to come from all of this easy policy that we have seen over the last several years, that it's going to eventually work and that i think we are seeing some interesting signs now that we're getting better in jobs certainly. but if we look at manufacturing, if we look at auto sales, there are pockets of the economy that are getting better. and if this policy stays somewhat on the easy track, which i think it will for a little while longer, we'll continue to see the economy improve and again pain that leads to some inflation, but then you want to rotate into energy and materials. it's improving better than the fed is giving it credit for. but wage inflation is nowhere to be found. it's 2% on an annualized basis. there's a big and important debate as to how much slack is in the economy. and there are people on both sides who say that there's less slack than the federal reserve believes. it's well to remember -- why do we debate it? why don't we let the market tell us? okay? you tweak grades, you get bad feedback, you tweak them the other way. what is wrong with some mental flexibility? rick, i'm sorry, but the general consensus of the economic community -- reporter: i don't care about general consensus. i don't care that europe offers entitlement. we're america! we don't believe in consensus. they also reject talking over people, but that's another story. the general idea, rick, is if you put this on autopilot -- reporter: i don't want a general idea. i want the fed to be a banker. a banker. tweak rates a little up and down. let's bring many -- reporter: congress over. congress shouldn't allow them to keep going with crisis management. we got your point. let's bring in the head of foreign exchange distribution. paul, you've heard the argument from both sides. i think you would agree that certainly more people seem to be entertaining this question today and its relationship to where the market will go from here. what's your take? is the fed behind the curve? are they in danger of getting behind if they're not already there? who cares? i mean, a year ago the fed tried to message something very different, and look what happened to that summer market. there's no way they're making that mistake again. and now we've got yellen there who worked with bernanke. they put something together five years ago. and rick can argue that the fed shouldn't be doing these kinds of things, but if they hadn't, where would we be now five years on? reporter: counterfactual. we'd be three years into a recovery. that's what i say. disprove it! rick, are you trying to get another round of applause here? i don't need a round of applause! i have history on my side here! the way i look at it, rick, is this. let the job get done. tapering is almost done. then let the market get six months. reporter: it's not janet yellen's job, and somebody needs to say that! it is about patience. and patience is going to get this job done. reporter: patience. it's been 5 1/2 years. japan's got patience. whoopty doo. the jury's still out as to whether the fed is going to help -- reporter: no, no, there is no jury. who's the jury? who are you talking about specifically? i'm the judge. i'm talking to the jury that's here. reporter: professors? you let valet park your car? rick, you already decided this wasn't going to work five years ago. is some of your anger -- reporter: i was right! i was right! end of conversation. rick, it's impossible -- rick, it's impossible for you to have been more wrong, rick. your call for inflation, the destruction of the dollar, the failure of the u.s. economy to rebound. reporter: i'll tell you what. i wasn't wrong on inflation. i didn't think they could have policies so bad that we would get no velocity after 5 1/2 years. i thought the world would say huh-uh. it's taken too long. new strategy. there is no piece of advice that you've given that's worked. reporter: they have a better strategy for the cubs. there is no way to go. there's not a single one. reporter: oh, yes, there is. not a single one, rick. not a single one. the higher interest rates never came. the inability of the u.s. to sell bonds never happened. the dollar never crashed, rick. there isn't a single one that's worked for you. paul richards, i'll give you the last word. the last word is patience. you let the fed continue to do their job and all is going to be fine. be long equities going into tomorrow, scott.
URL:http://video.cnbc.com/gallery/?video=3000292243

Monday, July 7, 2014

T. Boone Pickens: Thanks To Private Sector Efforts, U.S. Energy Independence from OPEC 'In Sight'



On CNBC's Squawk Box, July 7, 2014, T. Boone Pickens said the U.S. has made great strides toward energy independence and it is all due to private sector initiative, which has succeeded despite foot dragging and opposition from Washington.


ROUGH PARTIAL TRANSCRIPT:

Becky Quick: Well, Boone, let's talk about where we are today as a nation. what's happened with our own energy production. Where do you think we're headed from here? And just the idea of reaching U.S.  independence from OPEC. Is it still a possibility?

Pickens: Oh, it's in sight. It is in sight. If we just, you know, if you go back six years ago, I said you're going to have all this gas, you remember that?

Becky Quick: I do.

Pickens: And now we're now number one in the world in gas. And then we were third. We were about sixth or seventh in oil, and now we're third in oil. So we're number one in gas, third in oil and moving on up. So, I'm not kidding you . . . hats off to the oil and gas industry in America because they provided jobs and oil.

I'll get off that subject, but they do need a -- they've done a good job no kidding. But here we are, sure, we can get off OPEC oil. We're down to 4 million barrels a day of OPEC oil --

Becky Quick: From what?

Pickens: At one time we were over seven [million barrels a day]. So we have come down to four, and we can knock that out within the next three years. All you have to do is switch natural gas over to the heavy duty trucks and that will take you out 3 million barrels.

[Note: Pickens also said that Obama had failed to lead on the issue of increasing energy independence and called Obama "the worst President in 60 years," referring to a recent poll from Quinnipiac in which Americas reported that they rated Obama the worst President since World War II. Pickens's "worst President" quote was omitted from the video posted at the CNBC website. ]

Pickens: We have these fabuluous resourece in America and Washington doesn't focus on it. And it moves along fairly smoothly. You know if you really wanted to help the economy, go ahead and press for the use of our natural gas here. Increase demand here for it. But don't ship it out of country. Our producers should get into any market they want to get into. They went out and spent the money, found the gas, found the oil, they have the right to get into any market. But if you had leadership in Washington, they'd say wait in a minute we have the cheapest energy in the world in America. Whya re we going to share that when we can use it here.

Becky Quick: Boone, the private sector is a beautiful thing the way it's done this because you said no one saw it, no one knew about it.

Pickens: Somehow it happens, and the capital flows downhill where all this happens. Do you think if let's say the obama administration had -- and there's not renewables. We all love renewables, I understand that. we want to do that. We want to do solar. We want to do everything we can to have a huge portfolio of energy. But what if they had been on board all along, where would we be? Because this is where we are without any help, really. Okay. If they'd gone with me six years ago you figure you could have . . .

Link to CNBC.

©2011 CNBC.com

Saturday, May 3, 2014

Federal Reserve’s Weak Dollar Policy Pushing Dollar Toward Collapse

Q and A with James Rickards
Part 1 of 3
Part 2 here
Part 3 here

May 3, 2014

By Robert Stowe England

James G. Rickards is a lawyer, economist and investment banker with 35 years of experience on Wall Street. His new book The Death of Money, published by the Penguin Group, is a New York Times bestseller. His first book, Currency Wars, published in 2011, and was also a Times bestseller. In his new book he explores further the consequences of the weak dollar policy pursued by the Federal Reserve Bank, coupled with the huge run up in deficits and debt by the United States, and the failure of Congress and the Obama Administration to devise policies that would spur faster economic growth. Rickards is a portfolio manager at West Shore Group, LLC, Haddonfield, N.J., an investment fund set up in 2013, and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community. He gained first-hand experience on the front lines of a financial crisis as counsel for the hedge fund Long-Term Capital Management, when he was principal negotiator in the 1998 bailout of the fund by the Federal Reserve Bank of New York.

Q: Obviously the Federal Reserve and the dollar are at the center of the story in your new book. What are the most important things Washington needs to understand to face the reality of a possible dollar collapse and possibly prevent it?

Rickards: Part of the thesis of the book is the fact that the people in charge – meaning the Treasury and the Fed, other central bankers and monetary elites – actually have very limited comprehension, if any, as to how dangerous the situation is. The idea that the elites see the danger and the everyday investor doesn’t – I would stand that on its head. And say it’s beginning to sink in to the everyday investor that there are serious problems and they need to take precautions because the central bankers are driving the bus over the cliff. But they don’t see the cliff.

Q: What are the things the people in charge of monetary and dollar policy in Washington least understand? What are they missing?

Rickards: Well, they’re missing everything. Let me say what I mean by that. All policy, at least the way it’s done today by central bankers, is based on some paradigm as to how the economy works, some specific models as to how certain functions and factors work within the economy. And if you get your model wrong – worst yet, if you get your paradigm wrong, then your policy is going to be wrong every time. And that is problem.

The central bankers are sort of a closed circuit. They all went to the same schools. You could pick five schools. You can say M.I.T. [Massachusetts Institute of Technology], Harvard [University], [University of] Chicago, Stanford [University], and maybe Yale [University] and [the University of California at] Berkeley and maybe throw in a couple of others.  And then go around the world and look at all the major central banks and where they went to school. They went to one of those five places. They took the same courses. They had the same professors. In a lot of cases they were each other’s professors. Stan Fisher walked into the Board of Governors having been thesis adviser to some of the other members. So, you have a groupthink problem.

They’re using general stochastic equilibrium models, which do not sync into reality. Their paradigm is they have an equilibrium model. There’s some perturbation that throws the economy out of equilibrium. And what you do is apply policy that gets it back to equilibrium and once it gets back to equilibrium the clock starts ticking again and it’s all good. That’s kind of how they think about things. 

But, in fact, the economy is a complex system. And if you look at complexity theory and I do that in The Death of Money and also in my first book Currency Wars, and I’ve done a lot of research along those lines, you see that what happens in complex systems is they kind of mimic an equilibrium system for awhile and then they just go off on a tangent and there are the so-called black swans. And I don’t really like the phrase black swan because it is amorphous and inexact. But that’s as good a term as any that everyday readers can understand. But the textbook term for that is emergent properties, which means that things just seem to come out of nowhere. There’s nothing about perfect information in the system that would allow you to infer what’s coming next because, as I say, it just kind of pops up out of nowhere.

And when it happens it’s an irreversible process. In many cases you can’t make it go back to what it was. And so therefore risk management in a complex system is all about mitigating the scale of the system so that you don’t have these mega-catastrophes in the first place. Whereas in an equilibrium system, if you think that printing money is the right policy to affect equilibrium, you may actually print so much money that you increase the scale of the system and increase the probability of a catastrophic result.

So, they’ve got the wrong model. I mean that’s empirical. It’s not just an opinion. You can look at the time series of prices in any market. It’s not normally distributed. It’s a power curve that signifies a complex dynamic underneath. And if you dig deeply, that’s exactly what you find. So, it’s not a surprise that they get it wrong every time. The Fed has a one year forecast that they do every year. It’s one year forward. So, in 2009 they’ll forecast 2010. And 2010, they’ll forecast 2011 and so forth. If you look at the last four years, they’ve been wrong every year by orders of magnitude – not just a little bit wrong, but completely wrong. [They forecast will] say 3.5 percent, it comes it at 2.4. It’ll say 3 percent. It comes in at 1.9. Those are big errors, big orders of magnitude in something like forecasting GDP, which is only ever going to go between something like negative 3 and plus 6, and it’s not a wide range.

So, if you go back to 2007, just look at [former Fed Chairman Ben] Bernanke’s own words taken from the minutes of the FOMC [Federal Open Market Committee] meeting where first he says the housing crisis will blow over. As late as 2008 they didn’t understand the magnitude of it. They underestimated the duration of it. Once they got a couple of years into it, they began to appreciate the duration, but they were still applying the wrong policy because this is a structural problem. We’re in a depression that began in 2007 and will continue indefinitely. And they’re applying a liquidity or cyclical solution. You can’t solve a structural problem with a cyclical solution. You need a structural solution. So they’re still applying to wrong medicine.

So, I would say the biggest problem in the world today in finance and economics is that the people in charge are using the wrong paradigm, the wrong understanding of how the world works, the wrong models, and they are applying the wrong medicine and we’re going to get disastrous results.

Q: Your book suggests there seem to be so many forces in play that the system has reached criticality. That is, things have become so critical that almost anything could set off a crisis or meltdown. If policy makers were on top of this, what should they be doing?

A: Well, that’s a very good question. They should be doing a lot of things, some of which in the short run would be painful, which is one reason they don’t do them. Your description of what I’m writing is actually a very succinct way to put it. The system is actually reaching criticality – what can you do about that? Well, the first thing they can do is to back away from it. Raise interest rates. Begin to reward savers instead of punishing savers. Begin moving to more of a savings and investment kind of model rather than a borrowing and debt and consumption driven model. And reverse QE as fast as they can and not just reduce purchases as they are doing now. They’re still printing money. They’re just printing at a slower pace.

They should actually get rid of some money and take it out of the system by reversing QE. Then they should normalize interest rates. Normalize the balance sheet and then say to the Congress, hey, look, this is not something that we the Fed can solve. Money printing does not create jobs. Cyclical programs don’t solve structural problems. You, the Congress please do your job and [come up with] actual structural solutions.  You say what are those? It would be a basket of things involving fiscal policy, labor policy, labor mobility, various cost uncertainties that are being imposed on the economy, the Keystone pipeline. There’s a long list of things to do there.

Q: You talk about de-scaling the complex system to reduce risk and uncertainty.

Rickards: You need to break up the system. I know I use the [single snow flake causing an] avalanche metaphor but I try to make the point that it’s more than a metaphor. The dynamics and the math are actually the same, just in a different phenomenological space. So what does the ski patrol do when you see snow building up and it’s going to cause an avalanche and kill some skiers? Well, they explode dynamite. They fire a cannon into it or throw some explosives and a charge and they break it up at a time when no one is skiing below and make it harmless and then after that the skiers can enjoy the skiing.

As applied to banks, that would mean breaking up the banks. Just take JPMorgan for Exhibit A and break it into five banks. It used to be when I started in banking that what is today JPMorgan was five different banks. It was Manufacturers Hanover, Chemical, the old J. P. Morgan, Chase Manhattan and Wachovia. This is not nostalgia on my part. This is what you would do prevent collapse and then you could say, hey, if one of these five banks were to fail, that might be a little painful but it’s not going to take down the system. Put them all together. They whole thing fails and obviously it does and then the government has to intervene and that just means more intervention and more distortion and then the whole thing just gets worse.

Q: You criticize the widespread use of derivatives by banks that are too big to fail.

Rickards: I would ban most derivatives, not all of them. I think exchange-traded futures, and a few tests having to do with transparency, good risk management and good collateral management [are OK]. The Chicago future exchanges have 150 plus years track record of doing things right. I think we can have some confidence in those. But, over-the-counter swaps and derivatives that are off the balance sheet of the books of the banks that don’t have good capital, I would ban most of those. So the combination of breaking up the big banks and banning most derivatives and increasing capital requirements – those three things taken together would be the equivalent of exploding some dynamite that isn’t dangerous now and preventing the avalanche danger. These are all ways of descaling the system. It’s not that there won’t be failure anywhere. It’s just that it won’t be systemic.

Q: I noticed that you also called for reinstating the Glass-Steagall Act, particularly provisions in the 1933 law that separates investment banking from commercial banking by deposit-taking institutions that was repealed in 1999 the Gramm-Leach-Bliley Act. Would separating those business into separate companies add another layer of protection for the financial system?

Rickards: Yes. Absolutely. When I say these [like bring back the Glass-Steagall Act,] I like to put some science, some data or analytics behind them so they don’t come off as political rants because I’m not that political and I try not to be a ranter. But take the whole history – the pre-history, the history and the post-history of Glass Steagall. What happened? Well, in the 1920s banks in the United States discovered they could create garbage products and sell them to their customers and essentially fleece the customers. And that collapsed in a pyramid and the stock market crashed and [we had] the aftermath of 1929.

So, in 1933 the Congress had hearings and said our job is to protect the public, so let’s find out what happened. And they had hearings and they reached a conclusion that there were inherent conflicts of interest[between taking deposits and lending, on one hand, and investment banking, on the other]. So, they said, OK, this is simple. From now on you can take deposits and make loans. That’s fine and you’ll be regulated. Or, you can underwrite and sell securities. And that’s fine. But you can’t do both. It’s a conflict of interest to take depositor money off the street of basically from people who trust you and then use that to speculate in the securities market and use your franchise or store window to sell garbage to customers. You can’t do that. Well, that was Glass-Steagall in a nutshell.

That was the law for 65 years until 1999 and in the entire 65-year period we did not have any systemic crises of the kind we saw in 2008. We’d have to go back to 1929 and before that to 1907 to find this type of crisis and then all the way forward to 2008 to find it – and in between we didn’t [systemic crises]. Now, we did have bank failures. Some of the were pretty big. We had Penn Square. We had Continental Illinois. We had problems in the banking system, the [savings and loan] crisis of the 1980s, which cost about $200 billion in real terms in today’s money to clean up. So, I’m not saying it was trouble free but we never had anything like the systemic risk or TARP. Now, come forward to 1999, Congress repealed Glass-Steagall. And then they repealed swaps regulation in 2000 [when they passed the Commodity Futures Modernization Act].

So what happens? Within years [of repealing Glass-Steagall] the banks originated garbage products and started selling them to their customers. So is that any surprise that eight years later we have a massive systemic crisis that almost destroyed the banking system? In other words, the minute you took the guard rails off the banks, they went right back to doing what they were doing in the 1920s, which should come as no surprise because they’re greedy and there are inherent conflicts of interest and once you take the guard rails off. And so, it’s almost as if the Congress in 1999 thought they were smarter than the Congress of 1933. But they weren’t. The Congress of 1933 had just lived through a disaster and they wanted to do something about it. And they did something that worked for 65 years. Why on earth would you repeal it? Why on earth would you think you’re smarter than the people who had first hand experience with it and came up with a solution? So, yeah, put Glass-Steagall back on as soon as possible.

That is also consistent with the idea of doing what I call de-scaling, which is what physicists would describe as what you are doing to the system. Break the system into smaller parts so that a failure of any part does not threaten the system as a whole. That’s the basic idea. Glass-Steagall does that. Breaking up the banks does that. Reducing derivatives does that. It all feeds in.





Gold Price Manipulation Masks Potential for Gold Demand Shock

Q  and A with James Rickards
Part 2 of 3
Part 1 here
Part 3 here

By Robert Stowe England

James G. Rickards is a lawyer, economist and investment banker with 35 years of experience in capital markets on Wall Street. His new book The Death of Money, published by the Penguin Group, is a New York Times bestseller. His first book, Currency Wars, published in 2011, and was also a Times bestseller. In his new book, he explores further the consequences of the weak dollar policy pursued by the Federal Reserve Bank, coupled with the huge run up in deficits and debt by the United States, and the failure of Congress and the Obama Administration to devise policies that would spur faster economic growth. Rickards is a portfolio manager at West Shore Group, LLC, Haddonfield, N.J., an investment fund set up in 2013, and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community. He gained first-hand experience on the front lines of a financial crisis as counsel for the hedge fund Long-Term Capital Management, when he was principal negotiator in the 1998 bailout of the fund by the Federal Reserve Bank of New York.

Q: Another thing I found intriguing in your book is the discussion of how gold prices have been manipulated to keep the price low to facilitate a stealth rebalancing of gold reserves from the west to the east, especially China. Obviously the central bankers know about this. How could they not?  The price manipulation has been done by selling numerous paper investments backed by same stash of gold in unallocated and leased sales. Could you explain how underlying stresses in the system could lead to a gold buying panic?  

Rickards: Well all these things are connected. They kind of work hand in glove. What’s the big thing that’s going on? The big thing that’s going on is that China needs to get gold. And Russia’s getting gold and other central banks are acquiring gold. But the 800 pound gorilla, if you will, is China rebalancing gold away from the west to China – a very well known story, very well documented. But the question is why and how. What’s going on here? Why is it being done? How is it being done? And that’s where the price manipulation comes in. Because if the price of gold took off, if there was sort of a buying panic, if you will, [it would create a] buying shock. I talked with the head commodities trader at one of the largest banks in the world. He told me that he’s looking for what he calls is a demand shock in China. The Chinese credit pyramid is clearly imploding, which I talk about in Chapter 4 of the book. [“China’s New Financial Warlords”]

When you look at the Chinese, they have a closed capital account so [the Chinese people] can’t buy stocks and bonds [outside of China]. The Shanghai stock market is a bit dismal. The real estate is the thing that’s going to collapse. And the banks pay them 25 basis points on savings. So you look around and say what the heck can I buy that will preserve wealth? And the answer is gold. And this is beginning already in certain ways but it will accelerate. So when this crash comes, it’s again a demand shock and that’s exactly right.

Now, China’s problem is they have the fastest growing economy in the world. Even with the problems and even with the slowdown it’s still the fastest growing economy in the world as a percent of global GDP. So, think about the right reserve mix of gold at the market price as a percentage of GDP, which is what I talk about in the book. It’s in that Chapter 9 [“Gold Redux”] and Chapter 11 [“Maelstrom”]. If you think about it, China is a moving target. No matter how much gold they buy, they have to keep buying more, first of all to reach the same ratio as the United States and they are not quite there yet – and then to maintain it because their economy is growing faster than the United States. That means they are going to buy more gold just to keep the ratio the same. If you combine that with a rising price, all of sudden the price goes to $2,000, $2,500, $3,000 et cetera, this gets to be out of reach.

I’ve got a moving target in the quantity. Now I’ve got a moving target in the price. Things are getting away from me. Things become more transparent as the buying power [decreases] so China might not ever got there. So dynamically they have to keep the lid on the price until the rebalancing is done. Then, at the point it doesn’t matter. So wherever the price goes, China’s on the bus. This is all about making sure China’s on the bus.

Q: What about all the paper gold? What role does that play?

Rickards: The leasing and the unallocated gold, and the paper gold and the gold futures and all that, those are the tools for price depression. By the way I don’t believe or I’ve certainly not seen any evidence that major banks are taking position risks to make this happen. They are just intermediaries. They are making spread. They are charging commissions. They are doing what the customer wants but the customer happens to be the BIS (Bank for International Settlements]. And it’s mentioned in the book and documented in the footnotes from BIS financial statements that they do transact with banks and central banks and commercial operations in gold leasing operations. So, if the customer happens to be the BIS, you are going to do what the customer wants.

So it’s coming from the central banks [who created the BIS and are its constituency]. So, that’s the price depression [of gold]. And, by the way there’s more and more statistical evidence coming out. And I’m sure you heard about the study at Stern School of Business at NYU [New York University]. [The authors of the draft research paper are Rosa Abrantes-Metz of New York University and Albert Metz, a managing director at Moody’s Investors Service.] I haven’t seen it because it’s not published yet, but I’ve seen some excerpts and synopsis that indicates that there’s powerful statistical evidence that gold is being manipulated.

I’ve also spoken to another guy,  a Ph.D. statistician for a major billion-dollar hedge fund and who is not a gold bug. He did the work and reached the same conclusion [the gold prices are being manipulated]. He did a 10-year price study of [changes in gold prices] on Comex [the Commodity Exchange, a division of the New York Mercantile Exchange] during trading hours versus after hours. When you’re talking about markets and statistics, those two accounts should be the same. But the answer was they weren’t anywhere near the same. The Comex [during working hours] actually performed dismally and the after hours account did multiples what actual gold did. There’s no explanation for that other than the manipulation of the Comex. And he agreed with me that is the right conclusion.

So the evidence is everywhere [of manipulation of gold prices] and it’s all designed to keep the price of gold low until China gets the gold they need to be on the bus and you kind of go from there. What has been surprising is that utter nonchalance of the U.S. government. Because I’ve gone down to senior officials in the Pentagon, the intelligence community and the Treasury and elsewhere and in Washington with a little bit of alarm saying, hey, do you know what the Chinese are doing? Do you see what’s going on here? The reaction is they are either completely non-plussed or they were unaware of it or they are aware of and they don’t see why it’s such a big deal.

But let me explain why it is a big deal – not for just geopolitical geostrategic reason I just mentioned, but in terms of the technical set up for where gold is going to go from here. If you think of stocks and flows in round numbers there are about 35,000 tonnes of official gold in the world and about 177,000 tonnes of total gold. And mining output is quite small. All the mining in the world increases the total stock by about a little over one percent a year. So, it’s a factor but it’s not a big factor.

So when 500 metric tonnes of gold moves from a GLD warehouse to China’s government vaults in Shanghai – which it did last year, by almost a straight line with a stop in Switzerland just to get re-refined. But, when gold does that, a lot of analysts look at that and say, well, so what? It was in a vault in London. Now it’s in a vault in Shanghai. They just turned it from a 400-ounce bar to a kilo bar. Whatever. It’s the same gold. It moved from one vault to another. Who cares? And that’s kind of where the national alarm comes from.

But here’s the difference. When gold moves from the GLD warehouse to the government vault in Shanghai, there is no change in the total supply, but there is a diminution in the floating supply. The floating supply is that portion of the total stock that’s available for trading. So, if I’m in GLD or I’m in a bullion bank and I’m a UBS, that gold is available for the kind of paper trading we just talked about. But if you put it in private storage, you put in a Chinese government vault, it’s not available for paper trading. It’s just gold being put away. Well, that’s exactly what’s going on.

If you think of the gold market as an inverted pyramid, and on the bottom there are a couple of bricks of gold. And then in the inverted pyramid on the top you have all the paper gold. So, it would be leasing, unallocated sales, Comex futures which totals up to 100 to 1 [paper claims against each a portion of physical gold]. That’s OK. That’s not unlike other derivatives markets. But if you start pulling the gold bricks, the gold out from the bottom you’re going to topple the pyramid. At least you’re going to force that pyramid to shrink.

And that’s what’s going on. Total gold supply is not changing. The floating supply is changing. And that means less gold to support the paper trading. And that means one of two things is going to happen. If you keep the paper trading just as big, you are going to destabilize it. If you shrink it, it’s going to increase the price of gold. Either way we’re in for some interesting times.

Q: Does Washington recognize that China is trying to assure its place in any future international monetary system by acquiring this gold? Do they at least recognize that?

Rickards: The only really top-level official I’m spoken to who does recognize that and thinks it’s fine is Min Zhu, deputy director at the IMF.  I’ve spoken with him and he says that just makes sense to him. By extension it makes sense to the IMF. Because he used a phrase – I was shocked to hear him say it – they make a distinction between what they call credit reserves and real reserves. That is exactly the right way to put it [meaning paper money is considered credit reserves, a claim on the central bank standing behind it]. But I was shocked to hear anyone say it; because who thinks that paper money is credit reserves? I do. But I’m not sure many other analysts do. Min Zhu said clearly China is, in effect – and these aren’t his exact worlds – is overweight paper and underweight gold. And so they ought to get some gold. So he could see it for what it was and he thought it made a lot of sense. Why does it matter – unless we’re somehow going rewrite rules of the game and gold plays a role? Because if we weren’t going to do that and gold didn’t play a role, then it wouldn’t matter. But Min Zhu clearly thinks it does.

Now, on the U.S. government side, people in the Pentagon are interested [in what’s happening with China’s accumulation of gold and what it might represent], but they feel constrained in what they can do because they don’t want to mess with Treasury. And that’s the other thing people don’t understand. The think of the U.S. government as a monolith with a single point of view and nothing could be further from the truth. The U.S. government is an octopus with eight legs and every leg is dancing to a different tune. And so, the Pentagon is kind of concerned but they feel they can’t really say anything because that’s the Treasury’s job. Over at the Treasury I’ve spoken to a number of people there. The risk people there, it doesn’t even factor in, that’s the kind of thing we were talking about earlier. Well, the Fed, it’s just not in their mental frame. [I am not sure where key current and former top Treasury officials stand,] people like Lael Brainard, [the former Under Secretary of the Treasury for International Affairs] or Secretary [Jack] Lew. [As for former Treasury] Secretary [Timothy] Geithner, well he is an IMF guy. His training, his experience, is all in the areas we’re talking about.  I haven’t spoken with him. I can’t read his mind, but I have some difficulty believing he doesn’t understand it and doesn’t somehow approve [China’s accumulation of significant gold reserves]. Certainly, the U.S. is in a position to stop it and we’re not stopping it. So, somehow, at least in principle he must think it’s OK.

Q: I guess the point of all of this is that if the dollar is in a crisis and some of the scenarios unfold that you talk about in Chapter 11 [“Maelstrom”], then China is going to have a say in the design of the next international monetary system that emerges and they don’t want the dollar as the world’s leading reserve currency.

Rickards: They will now [have a say]. I don’t think that was true four or five years ago. It’s definitely becoming true and I think that’s what’s going on. That’s exactly what’s going on. By the way, there was a secret meeting in Washington [Sunday, April 12] that was a dry run for Bretton Woods. [The town of Bretton Woods, New Hampshire, was the site for a July 1944 United Nations Monetary and Financial Conference of delegates from 44 nations. They met to jointly design and sign an agreement to establish a post-war international monetary system with the dollar, backed-by gold, as the centerpiece of the new order.] Friday and Saturday [April 10 and 11, 2014] was the IMF spring meeting. And these finance ministers and central bankers from all over the world were there. And when they get together they do all these things. They do G20 on the sideline. They do BRICS on the sidelines And there all these get-togethers.

Well, on Sunday [April 12, IMF Managing Director Christine] Lagarde hosted a meeting and the head of the Bank for International Settlement was there and the head of the Swiss National Bank was there. And of course senior IMF officials were there. And then, this is all in a press release [issued the next day by the IMF http://www.imf.org/external/np/sec/pr/2014/pr14170.htm that reports there were] a number of other prominent economists and officials were there. But, they didn’t disclose the names. But clearly a mix of senior national monetary officials and senior bankers and private economist and academics at a meeting behind closed doors to discuss the future of the international system.

The title of the seminar was “Monetary Policy in the New Normal.” What will the rules of the game be once we get into the post crisis period? Of course I’m the one saying we’re not going to get to the post-crisis period because we’ve got all the wrong policies. But, be that as it may, that’s what they were doing. So, it looks like it was a one-day practice round for a new Bretton Woods.



Strengthen the Dollar or Face the IMF as 'Central Banker to the World'


Q and A with James Rickards
Part 3 of 3
Part 1 here
Part 2 here

By Robert Stowe England

James G. Rickards is a lawyer, economist and investment banker with 35 years of experience in capital markets on Wall Street. His new book The Death of Money, published by the Penguin Group, is a New York Times bestseller. His first book, Currency Wars, published in 2011, and was also a Times bestseller. In his new book, he explores further the consequences of the weak dollar policy pursued by the Federal Reserve Bank, coupled with the huge run up in deficits and debt by the United States, and the failure of Congress and the Obama Administration to devise policies that would spur faster economic growth. Rickards is a portfolio manager at West Shore Group, LLC, Haddonfield, N.J., an investment fund set up in 2013, and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community. He gained first-hand experience on the front lines of a financial crisis as counsel for the hedge fund Long-Term Capital Management, when he was principal negotiator in the 1998 bailout of the fund by the Federal Reserve Bank of New York.


Q: Now, looking at the scenarios you point out in Chapter 11 [“Maelstrom”], it appears that most likely candidate to become the centerpiece and central reserve for a new international monetary system if the dollar collapses is something called Special Drawing Rights or SDRs issued by the International Monetary Fund is the. Would the SDR be backed by gold?

Rickards: I don’t think they want it to be backed by gold. I don’t think there’s a central banker in the world who wants gold-backed money. But, the point I make is that they may have to. They may have no choice. If people have lost confidence in paper money, such as the dollar, why should they have any more confidence in the paper SDRs?

[On the other hand,] they might [have confidence in SDR as a paper currency] for two reasons. Number one. No one understands it. I’ve spoken to international economists who don’t understand SDR. Certainly mainstream economists and market analysts certainly don’t understand it. Everyday Americans or citizens around the world don’t understand it. Why should they? It’s a very technical subject. I’ve met experts who don’t understand it. So you might be able to get away with it because nobody knows what it is. The inflation [in local currencies tied to the SDR] would show up the grocery store, at the gas pump, but nobody would know where it’s coming from. They would say oh, those guys at the IMF they’re crazy, you know. Good luck figuring out who they are – a bunch of Communists and dictators and kings. Its unaccountable, unelected super-elite who meet behind closed doors. No one knows what SDRs are. This is the stuff that infuriates me. This is world money but they don’t want to call it that. So they call it special drawing rights. Is there anything more anodyne and bureaucratic [a name for money] that you can think of? I can’t. They do this stuff on purpose for exactly the reason they don’t want people to understand it. So it might work in the short run on that basis. And, it might not.

Gold is sort of what I call Plan B. If you go to Plan B, the United States has enough gold. Europe has enough gold. China doesn’t. And so China has to get their gold in case we go to Plan B. And even if we don’t go to Plan B, just when you sit down at the table to come up with a new system, even if you don’t use the gold standard, your gold is going to be your chips [as you bargain and negotiate the design of a new system]. Think of it as a poker game, you want a big pile of chips. And the guys with a little chips -- they’re going to go to the little table. And the guys with a lot of chips are going to sit at the big table. And China of course, needs a seat at the big table because they’re the second largest economy in the world.

Q: One of the scenarios you lay out after the crash of the dollar and the international monetary system is that the dollar would survive the crash and again by the lead reserve currency because officials decided to back it with gold. If that happened, you estimate the dollar price of gold would be set at $9,000 an ounce.

Rickards: I quote the value of the dollar in a future international monetary system and by the way $9,000 is the right price. That has all kinds of consequences. How likely is that scenario? People say now wait a second, Jim. You said $7,000 in your first book Currency Wars. Now you’re saying $9,000. What happened? So, the answer is they printed another trillion dollars [since the first book.] I don’t make these numbers up. I use actual data. And it’s a very simple ratio of physical gold at market prices to paper money. It’s eighth grade math. It’s not difficult. So, if you change the inputs, you change the outputs. If you print more money you get a higher price.

Now, here’s what the number means. Again I’ll emphasize that there are analytics behind this. These are not just provocative numbers designed to get a headline. It actually comes from some place. Here’s what the number means. That’s the implied non-deflationary price. And what that means is that we don’t have to have a gold standard but if we do, you have to pick a price and you better get it right because if you get it wrong you can actually make things worse and create a super depression. This is what happened in the 1920s. From 1870 until 1914 the world had a very successful gold standard, the classic gold standard. In 1914 they abandoned that because they knew they had to print money and borrow money to fight World War I.

So when World War I was over there was actually a period of turmoil. In 1919 and 1920 you had deflation and hyperinflation going on side by side. There was extreme inflation in the United States in 1919 and then we had the depression in 1920. And then you had hyperinflation in Weimar Germany in 1922. This is a period of enormous turmoil in the international monetary system and of course there wasn’t a gold standard. So in 1922 there was an international monetary conference in Genoa, Italy, and the major powers agreed to go back to a gold standard. But, it was a very bastardized form of gold standard called the gold exchange standard.

Q: So, what was the problem with a gold exchange standard?

Rickards: Here’s the problem. Having abandoned [the gold standard] in 1914 at a certain parity and having printed enormous amounts of money to fight World War I, and now deciding in 1922 to go back to the gold standard, what would the new price of gold be measured in your currency? Well, you sort of had two choices. You could be candid about the fact you had printed all the money and go back to a new parity where your currency is divided by half. That is one choice. And that is what France and Belgium and some others did.

Or, you could back to the old parity. Because it’s always a ratio of paper money to gold. So the amount of gold is pretty much fixed, so if you doubled the amount of paper money and you want to go back to the old parity, you have to cut the money supply in half. And that’s what England did in 1925 when Winston Churchill was Chancellor of the Exchequer. Well, that meant cutting the money supply in half, which they did and which threw England into a depression three years ahead of the rest of the world. You know people kind of date the depression from 1929, but England was severely depressed in 1927 and 1928. Churchill later said that was the greatest blunder of his life because he was a good general and good statesman but not a very good economist and he understood the implications.

And now come all the way forward to 2016 and 2017 and we’re at the international monetary conference and we’re basically trying to do same thing, rewrite the rules of the game. I make the point that you don’t have to have a gold standard but if you do, you better not repeat Churchill’s blunder. You better not pick a price that is so low that the implied money supply cannot finance gold trade and world commerce without causing a depression. So, the question is what is the right price? And the answer is $9,000 an ounce.

Q: Now, if the United States wants to avoid losing its leading role in the world monetary system, you indicate it could do so by returning to a set of strict monetary policy rules like those put into place in the 1980s, when Paul Volcker was chairman of the Fed and the Reagan Administration pursued a King Dollar strategy. If such policies were put in place, you say that could preserve the role of the dollar.

Rickards: Correct. Those rules had to do with what is a sustainable budget deficit and what is a sustainable debt load. And when I say sustainable I mean based on your debt and deficits, your total debt-to-GDP ratio and your ongoing deficits, what set of conditions is the market will to go along with you? OK, you’ve got a lot of debt and you’re running deficits, but your economy is such that we believe you are now on a sustainable path and we will continue to buy your bonds. And what I talk about in Chapter 7 [“Debts, Deficits and the Dollars”] are the formulas for that. And the theory if you stay within those boundaries, you don’t need a gold standard and you’re not facing a sovereign debt crisis and you might not be facing a currency collapse. You can kind of keep going. So that’s what I really talked about and I outlined those metrics.

The problem for the United States is that despite all the happy talk from Washington, we are continuing to go down the path to Greece. Now in the last year, year and a half there’s a lot of self-congratulations in Washington because we’ve cut the budget deficit in half, which is true. The budget deficit in round numbers has gone from about $1.4 trillion to about $700 billion in two years. That is true. But the debt to GDP ratio is still going up. It is still going up because even if you bring the deficit down from 8 percent to 4 percent of GDP, if your GDP is only growing at 2 percent, you’re still making the debt-to-GDP ratio worse even though you cut the budget deficit.

So, the budget deficit cannot be thought of in isolation as an absolute number. You have to think of it relative to the economy. And since economic growth is weak, cutting the deficit isn’t enough. And I’m asked if that means you have to cut the deficit further and I say you have to either cut the deficit further or you have to figure out a way to grow your economy. That’s where the austerity structural change that Europe is going through comes in. Europe is doing everything right. It’s been painful but they’re restructuring things in ways that will be sustainable, all under the direction of Angela Merkel and that’s what I talked about in Chapter 5 (“The New German Reich”). But the U.S. is not doing that. So, we’re still driving the bus off the cliff. We’re just going a little bit slower.

Q: Seeing how well Europe has handled its crisis and the sustainable path they have chosen and the amount of gold they have – which is the highest gold to GDP ratio among regions of the world – why would Europe and the euro not become the leading reserve currency in a new monetary system?

Rickards: Well, it might and I can’t rule it out. And to put a finer point on that, there’s one big thing standing in the way right now and it may go away in a few years and then the euro might play that role. But here’s the impediment. This has to do with the difference between a reserve currency and a trade reserve currency. You hear a lot of talk about the Chinese yuan. They are doing bilateral deals with Brazil and they’re opening up a yuan bond market, doing all these things deals around the world, doing deals with us, opening the capital account in small stages, widening the trade deficit. All that has to do with making the yuan a trade currency. But being a reserve currency is different.

To be a reserve currency you have to have a very wide pool of investable assets. Because what are reserves? Reserves are just a savings account for countries. So, we make a certain amount of money and we spend some of it and we have some left over. Those are our savings. And we put them in the bank and maybe buy some stocks or whatever. It’s no different for a country. If you export and import and you export more than you import, and you have capital inflows, you end up with savings and that’s what your reserves are. You have to invest them in something. When they’re $4 trillion, as in the case of China, or a $1 trillion plus for a country like Taiwan, Korea and others, you need a really big pool of assets [in which to invest]. You can’t buy $4 trillion of Australian bonds. I don’t think all capital markets in Australia are close to that.

So you can’t buy stuff like that beyond a certain amount. So, what’s standing in the way of Europe? Well, the Eurozone as a whole is bigger than the United States in terms of population and I think the economy is slightly smaller but it’s on a par. But the sovereign bond market is chopped up. You’ve got Italian bonds, French bonds, German bonds, etc. Now, imagine all those countries had a bond market where every bond was backed by the full faith and credit of the entire Eurozone. That would be comparable to the U.S. Treasury market and that’s what they mean to do. And then at the point you’d want euros because then at the point the bond market would be big enough. Right now it’s not. I mean, the Italian bond market is the biggest of the bunch but even it is not big enough for the kind of capital flows we’re talking about. And, you’re concentrating risk. You’re taking concentrated Italian sovereign risk. Or Spanish sovereign risk – exactly what the whole European sovereign debt crisis was about from 2010 to 2012.

But if you unify and back it by the full faith and credit of the entire Eurozone, now you’re talking. Now they’re trying to do that. But Merkel won’t let that happen until all the fiscal costs have gone through. She doesn’t want to write a blank check. So she’s holding that as a carrot to the stick. The unified credit backed by the full faith and credit of the Eurozone, which is basically Germany, is the carrot. But the stick is get your fiscal house in order. But they’re doing that. They’ve signed a fiscal treaty. They’re monitoring it coming out of Brussels and the IMF. They now have unified banking regulation. They’re going to have unified deposit insurance. They’re doing a lot of things in steps. But they’re still a few years away. No one knows exactly. But my estimate is that they are at least three years away. They may be a little longer before they can have a unified European sovereign debt market. So that’s what’s standing in the way [of being able to have the euro as take a greater role as a reserve currency]. But if they got there, and the system doesn’t collapse in the next five years, and Europe goes to a unified sovereign bond market backed by the full faith and credit of the entire Eurozone, at the point you do have a viable alternative to the Treasury market. And I would expect the European component of the reserves to go up significantly and the dollar would go down.