By Graham Rapier and Sara Silverstein
- Jim Rickards has seen first hand the bailout of hedge funds and has testified before congress about the 2008 financial crisis.
- He says another recession could hit before the Federal Reserve is done unwinding the processes put in places to save us from the crisis a decade ago.
- Rickards expects gold to go to $10,000 an ounce as some central banks may have to resort to the gold standard to restore confidence in the markets.
Jim Rickards, the author of "Currency Wars," "The Death of Money," and "The New Case for Gold," and most recently "The Road to Ruin," is no stranger to financial meltdowns. As general counsel for the hedge fund Long-Term Capital Management (LTCM), he had a front row seat as dozens of Wall Street institutions worked to bailout the firm with a $3.6 billion recapitalization.
Instead of using traditional macroeconomic models, Rickards prefers to borrow one from physics: complexity theory. Using this framework, Rickards proposes a scenario in which the world shifts partially back to the gold standard, with an ounce of gold being valued at $10,000 per ounce.
Here's the full interview, courtesy of The Bottom Line with Henry Blodget, with more from Rickards about what to expect from the next financial crisis — which could be here before you know it, and before the Fed is prepared:
This transcript has been lightly edited for length and clarity.
Sara Silverstein: You have a $10,000 price target for gold. Can you tell me what your thesis is for that?
Jim Rickards: It's important to understand that this isn't a made up number or one I throw out there just to get attention. It's the implied, non-inflationary price of gold in a system where you have either a gold system or some reference to gold. Now, there's not a central bank in the world that wants the gold standard, but they may have to go to it — not because they want to, but because they have to — in order to restore confidence in some sort of future financial crisis. The problem right now is that central banks have not normalized their balance sheet since 2009. They're trying, but it's not even close. If we had another crisis tomorrow, and you had to do QE4 and QE5, how could you do that when you're already at $4 trillion? They might have to turn to the IMF or SDR or to Gold.
Then, if you go back to the gold standard, you have to get the price right. People say there's not enough gold to support a gold standard. That's nonsense. There's always enough gold, it's just a question of price. Take Japan, Europe, China and the US — the big four economies — their m1 is approximately $24 trillion. If you had 40% gold backing, that would be $9.6 trillion. There are about 33,000 tons of official gold in the world. So you just divide 9.6 trillion by 33,000 tons and what you get is about $10,000 an ounce. If you had a gold standard with a lower price, that would be deflationary. You'd have to reduce the money supply. That was the mistake that was made in 1925. It did contribute to the Great Depression, and it wasn't because of gold, it was because they got the price wrong. So to have a gold standard today and not cause another depression, you'd have to have a price around $10,000 an ounce.
Silverstein: So that would be a really big crisis, a disaster scenario?
Rickards: Sure, but we've had them with regularity. You know, 1987 — the stock market falls 22% in one day. That would be the equivalent of over 4,000 Dow points. If the Dow went down 400 points it would be all anyone would talk about. Imagine going down 4,000 points. In percentage terms, that's what happened in 1987. In 1994 you had the Mexican tequila crisis. 1997,98: Asia, Russia, and Long-Term Capital Management. 2000: the dot com bubble. 2007: mortgages. 2008: Lehman, AIG. These things happen with some regularity. I'm not saying it's going to happen tomorrow, but we shouldn't be surprised if it does.
What I was covering in my book "The Road to Ruin," is let's say it does happen sometime soon, what's the response function? Because again, central banks... In 1998, Wall Street bailed out a hedge fund. In 2008, the Central Banks bailed out Wall Street, in 2018 who's going to bail out the Central Banks?
Silverstein: What are you looking at? You look at a lot of predictive analysis, what factor do you think is the most worrisome right now that points to a crisis?
Rickards: The scale of the system. I used complexity theory. I pretty much discard all the standard models, they don't reflect reality. Just a classic general equilibrium models, efficient markets, smooth continuous price movements, the Phillips curve, Black-Scholes — I'm good friends with Myron Scholes, and he's taught me a lot, but there's a lot of flaws in that model. None of those things reflect reality.
What does reflect reality very well is complexity theory, which comes from physics. It's had success in a lot of fields, climatology, seismology, and many other dynamic systems. It has not been used in finance except by very few people. I didn't invent it, but I'm the one pioneering the idea of bringing it to capital markets. When you look at capital markets through the lens of complexity theory, you ask yourself "what's the scale of the system?" Scale is just a fancy word for size. What measures are you using? If you look at total debt, gross national value of derivatives, the concentration of assets in the five largest banks, what percentage of the total assets of the five largest banks are interconnected? What you see is a very densely connected, fragile system that could collapse at any moment.
Silverstein: Is that why we were so surprised by the 2008 crisis, because of the complexity and leverage that was built in to it?
Rickards: That's a great question. I was going around lecturing in 2005-2006, saying this crisis was coming up. I didn't say it was going to be mortgages on August 8, 2007, but we're seeing this happen again. I had a front row seat in the bailout of Long-Term Capital Management; I was general counsel, I negotiated the bailout. I was in the room with the Treasury and the Fed and the heads of all the 14 major banks, a bunch of lawyers, and we came this close to shutting every market in the world. It didn't happen and we got $4 billion cash, we propped up the balance sheet, Wall Street took over. The thing was unwound over the course of a year, but it was a really close run thing.
Having seen that, as we kind of tip-toed up to 2007, I could see all the same problems happening again. Then when it happened it was really not a surprise. In September 2007, I told them what to do. This was a year before Lehman. It had started — now, remember the crisis had started in August 2007. In September, Secretary Paulson came up with this "super SIV." He was going to roll up all these special purpose vehicles from all the banks, then that was abandoned. I went down to the Treasury and said "look, this crisis is going to get worse, here's what you need to do: call all the hedge funds, tell them to give you all their positions in machine readable form, put it into a matrix, hire IBM Global Services." I was completely ignored. You could really see this coming. I see it coming again. I'm not saying tomorrow, maybe not even next year, but sooner than later it should come as no surprise.
Silverstein: I know where the complexity was in 2008, it seems like a lot of it was cleaned up when everything fell apart. Where's the complexity now?
Rickards: It hasn't been cleaned up, it's been moved around. Household debt is much more manageable today. Debt to net worth of households looks very good. Part of that is because the stock market's gone up and houses have gone up so the denominator of the fractions expands. That's improved, but the balance sheets of the central banks are far far worse. The Fed is leveraged 115 to 1, with a maturity mismatch. It looks like the worst hedge fund you've ever seen.
I actually spoke to one of the members of the Board of Governors, it was a social occasion and I was kinda tweaking her a little bit and said "you guys are insolvent every now and then depending on the level of interest rates because you have all these 10-year notes," and she said "no we're not." I said "I think you are." She says "well, maybe, but it doesn't matter." So here's a governor of the Federal Reserve telling me that the insolvency of the Fed doesn't matter.
Silverstein: Does it?
Rickards: Well, I think it does. There are a lot of people that don't. Modern monetary theorists, they think it doesn't matter. They would see no problem taking the Fed balance sheet to $8 or $12 trillion. Why don't we want bigger deficits, monetize the debt, stow it away on the Fed balance sheet? Who cares, it's all good. It's all good up until the point when confidence breaks and people look around, it's sort of like waking up out of a dream, like "oh, you guys are leveraged 200 to 1, you're insolvent on a market to market basis?" You lose confidence in the dollar and you want to get out of the dollar, at which point you're like "okay you can pay me in dollars, but I'm going to buy land, fine art, gold, silver, that's when velocity accelerates almost of nowhere, and inflation takes off. By the way, this is exactly what happened in the 1970s. In 1977, the US had to issue bonds denominated in Swiss francs. There were Swiss franc denominated Treasury bonds, we called them Carter bonds, because people didn't want dollars. It can get that bad and it can happen almost overnight.
Silverstein: The Fed is in a tricky situation. Is there any way that they can get out this? Is there any good path for them?
Rickards: I don't see it. Here's what the Fed is trying to do: They need to normalize the balance sheet, meaning get the balance sheet down to maybe $2 trillion. Right now it's over four. It's coming down a bit, but there's a long way between $4 trillion and $2 trillion, bearing in mind that in 2008 it was $800 billion. It also needs to normalize interest rates, which means getting from 1% to 3-3.25%. The question is how do you get there? The Fed is trying to raise interest rates 25 basis points, four times a year every March, June, September, and December through 2019 to get to 3.5% or so and bring down the balance sheet. They're going to be reducing it by the end of next year by $50 billion a month, which is a lot.
There are some estimates that the impact of that is the equivalent of 1 percentage point rate hike, because it is a form of tightening — you're reducing the money supply. You're reducing base money. The question is why are they doing it? Why are they doing it in kind of a relatively weak economy? The answer is they're preparing for the next recession. They want to run the playbook again, which is cut rates and go to QE4 and QE5. How do you prepare for the next recession without causing the recession you're preparing to cure? That's the finesse, that's the problem, and I don't think they can do it.