International Selection 16:10 - Aug 19th 2014

«I’m expecting the next crisis rather sooner than later»

James Rickards, bestselling author and former general counsel for LTCM, warns that the international monetary system is about to collapse.

About James RickardsJames Rickards is the author of the bestseller «Currency Wars: The Making of the Next Global Crisis» (Penguin, 2011) and «The Death of Money: The Coming Collapse of the International Monetary System» (Penguin, 2014). He is a portfolio manager at West Shore Group and an advisor on capital markets to the U.S. intelligence community and the Office of the Secretary of Defense. He has held senior positions at Citibank, Long-Term Capital Management and Caxton Associates. Rickards is a visiting lecturer in globalization at Johns Hopkins University and the School of Advanced International Studies. He holds an LL.M. from the NYU School of Law; a J.D. from the University of Pennsylvania Law School; an M.A. in international economics from SAIS and a B.A. from Johns Hopkins. He lives in Connecticut.Listening to James Rickards ain’t healthy for your stomach. The American lawyer, economist, and investment banker predicts that the global economy is heading for a disaster which will be even worse than the financial crisis of 2008. At the center of this horrifying scenario is the end of the Dollar as the leading world reserve currency, says the author of «The Death of Money». He’s putting the blame on the massive money printing of the Federal Reserve and on overreliance on flawed models to manage risk. Rickards is no stranger to financial crises himself: In the fall of 1998, he was the principal negotiator of the rescue of the hedge fund Long-Term Capital Management (LTCM).

Jim, in those dark September days of 1998 you had a front row seat when the financial system approached the edge of the abyss. What kind of parallels do you see when you compare the collapse of LTCM with the recent financial crisis?
The parallels are almost exact with the exception, obviously, that the crisis of 2008 was larger. But the dynamics were very much the same. What the crisis of 1998 and the crisis of 2008 had in common and what the next crisis will have in common is that regulators and risk managers are using the wrong models to understand and measure risk. And if you have the wrong models you will get the wrong results every time. In others words: These value at risk models and stochastic equilibrium models are underestimating the amount of risk in the system and therefore they allow too much leverage and too much risk. So the system becomes very vulnerable to a rapid collapse. Unfortunately, I see the same dynamics happening now again. That’s why I’m expecting another financial crisis rather sooner than later.

When do you think this crisis will happen?
Who knows when? Perhaps in one year or two years, but we’re not going to make it six years before the next crisis. The financial crisis in 1997/98 spread from Thailand to Indonesia and Korea. There were financial riots, people were killed. Then it spread to Russia and everyone was expecting that the next place would be Brazil. So the IMF was building a firewall around Brazil but halfway between Russia and Brazil up popped Long-Term Capital Management. To solve the problem the Federal Reserve did organize a meeting at which it urged the banks to put together a rescue package.
It turned out we did it but it was very, very costly and we worked night and day for five straight days from Wednesday to Sunday. The people on the outside don’t realize how close the system came to a complete collapse. We were hours away from all markets in the world shutting down. That was the opinion from the government officials at the time and I have certainly shared that opinion.

Why are you so concerned with respect to today’s financial markets?
In 1998 Wall Street bailed out a hedge fund. But in 2008 the government bailed out Wall Street. This time it wasn’t a hedge fund that was in trouble, it was all the major banks. We all heard about «Too Big To Fail» – well, those banks that were too big to fail in 2008 are  even bigger today. They have a larger percentage of the total bank assets and far more derivatives. This is true around the world. The central banks are bigger, too. The whole system is bigger and more leveraged today than it was in 2008  which is setting us up for the next crisis.

But then again: Without the various rescue packages and the stimulus programs  of the central banks the economy probably would be worse off today.
Understanding the global macro economy today in terms of a normal business or credit cycle is not the right way to understand the economy. That is why analysts and observers and policy makers are so confused. They keep waiting for the expansion to become self-sustaining and to growth stronger. But it hasn’t happened and they’ve been wrong with their forecast. If you look at the Fed’s forecast for example, the Fed has been wrong five years in a row and not by a little bit but by orders of magnitude.

So what’s really going on?
We are in a structural depression that began in 2007 and will continue indefinitely. A lot of people don’t understand the definition of an economic depression. They believe that it means a continuous decline in GDP. Put differently: If two quarters of declining GDP mark a recession than a depression must be a long string of declining GDP.  But that’s not the definition. A depression does not mean that you have no growth.  You can have growth in a depression, it just means the growth is below trend. But all the policy makers think we’re in a normal expansion an they’re trying to improve the expansion with monetary policy. But the problem is not liquidity. The problem is structural and you cannot resolve a structural problem with a monetary solution. That’s like treating cancer with aspirin.

But now the Fed is tapering QE3 step by step and plans to end the program this fall.
The Fed will keep doing the same thing over and over again and they will never get it right. They’ve tapered into weakness and as a result the economy is growing weaker. We certainly saw that in the first quarter GDP numbers and even in the second quarter numbers. They were much higher in the second quarter, of course. But almost half of that was inventory building which you should back out because inventories – on net – contribute zero to long term GDP growth. So the depressed growth continues. The question is how long will this go on?

So you’re not convinced that the Fed chief Janet Yellen will succeed in making a smooth transition to a more traditional monetary policy?
Not at all. They will finish the taper in October or November. But what they will find between now and the end of the year is that the data will be very weak. Therefore, by early next year, perhaps march 2015, just when people think they’re going to be rising interest rates, they will actually have to start QE4. So the Fed is trying the same remedies: The money printing goes on and the banking system continues to inflate which is setting us up for an even bigger crisis.

On the other hand, the risks of this super easy monetary policy seem to be quite contained. For example, there’s no violent outbreak of inflation so far.
Of course, we haven’t seen that much inflation. A little bit in food and energy, but not that much. To have inflation you need two things: You need the money and that’s where the money supply comes in. A lot of analysts have looked at the expansion of the Fed’s balance sheet and the creation of money in the last five years and how this is going to create inflation. The reason those analysts are incorrect is that money supply alone does not determine inflation. People actually have to borrow the money and they have to use it. That shows up in something called the velocity of money or the turnover of money. I compare that to having a ham and cheese sandwich: You can’t just have the ham, you need the cheese also. If the money supply is the ham, you still need the cheese which is the velocity.

So why is there no cheese in this sandwich?
The problem with velocity is that it is a psychological phenomenon. It depends on how you feel. Keynes called it famously animal spirits. There might be newer ways to describe it, using behavioral economics or sociology. The Fed is trying to change behavior with various forms of manipulation and kind of lying to the public about what’s actually going on. But so far that behavior has proven to be very resistant to change. People don’t want to buy. Therefore, the Fed can print all the money it wants. If people won’t borrow it and won’t use it they’re not going to get inflation. They’re also not going to get the nominal growth that is needed to support the enormous amount of debt that we have.

What happens when the psychology changes?
If the behavior does change it can change very quickly and then it is just as hard to change it back. The Fed keeps saying «don’t worry about inflation because when it appears we can get rid of it.» But I think they’re wrong about that. Let’s say we would get 3 to 3.5% inflation. At that point the policy makers would say «now, we have to cool it down a little bit.» But they would find out that they can’t cool it down because the genie is let out of the battle. Once people change their expectations, those expectations will race ahead out of the ability of the policy makers to change them.
So just when policy makers think they can turn inflation back down again it could go up to 9%. That’s what we saw in the seventies. That means we’re in for a crisis either way: If the Fed keeps printing money and they’re not getting inflation, we’re not getting the nominal GDP growth and we’re heading for a debt crisis. But if they succeed in changing inflation expectations then we’re heading into an inflationary crisis. So there are no good exits for the Fed.

What are the final consequences of all that?
There are actually three different outcomes. I’m not categorical about which one it will be, but they’re all bad. One possible outcome is that the Fed actually does change psychology and change behavior and we will get inflation. But then it will very quickly morph into something more like hyperinflation. That means you’ll still have your Dollars but the value of the Dollar has been destroyed. Another possibility is that they keep printing money and then the collapse is very sudden and we have another financial crisis, worse than 2008/09.  The central banks themselves will not be able to bail out the system again at which point they will require the IMF.  The IMF will then have to print world money, so called Special Drawing Rights or SDRs. It will represent a massive money printing exercise which will be inflationary too, but from an entirely new source.

And what about the third outcome?
This includes a scenario where there will be essentially chaos when we have these collapses. And then riots begin because people see their savings wiped out. Broker firms fail, brokerage accounts are wiped out, inflation wipes out the value of savings, the stock market crashes 70 to 80%. This would be already the third time that this happens: People’s savings were wiped out in 2000 because of the dotcom bubble, they were wiped out again in 2008 because of the financial crisis and now they’re wiped out again, except even worse. That might be the last stray. That might lead to rioting. And that will provoke a neo-fascist response. They will try to use police, national guards, executive orders, mass arrests and so forth. Whichever of these scenarios will be happening, they all stem from the same source: Policy makers not understanding what they’re doing whereas banks are becoming too large.

What could be the trigger of the next crisis?
For that I use a metaphor which I call the «snowflake and the avalanche»: Snow builds up on a mountain and the situation up there gets very unstable. Any seasoned alpinist can look at it and knows it’s an avalanche danger and it’s going to collapse. But it can continue for a very long time. So a snowflake comes along and it lands the wrong way. It starts to disturb a few more snowflakes and it gathers momentum.
Then it becomes a larger slide and the whole thing comes lose and it crashes down and kills everything in its path. What will the snowflake be? Well, it could be a number of things: It could be a failure to deliver physical gold, the collapse of a bank, a prominent suicide, a geopolitical event or a natural disaster. There are a number of things. But my point is it does not matter because it will happen sooner or later. Meanwhile, I‘m looking at the mountain side, seeing the avalanche danger, seeing how unstable the monetary system is and that’s where the concern should lie.

How can investors protect themselves from such an event?
The best thing a small investor can do is to have about 10% of investable money in physical gold. When I say investable assets I would exclude your home equity and any equity in your business. Put that into a separate category and take everything else into the category of your investable assets: Money that you have available to buy stocks or bonds. Put 10% of that in physical gold. Don’t buy paper gold like an ETF because when they close the exchanges your ETF is just a share and the gold will be unavailable to you. Also (ALSN 79.45 0.7%), put it in a safe place. Not in a bank because the banks may be closed, too. That would be your insurance. So even if you’re losing 60 or 70% on your other investments, gold could be going up three, four or five hundred percent.

That sounds quite astonishing. How do you come up with such kind of numbers?
As long as people have confidence in paper money there is no particular reason for a linkage between paper money and gold. But if people lose confidence in paper money the central banks need to restore confidence. One way to do that would be to link the new paper money to gold. If you do that you have to take a non-deflationary gold price. In other words a price that’s high enough so that given the existing amount of gold would support the leverage in the backup system. That price is not too difficult to calculate because we have the inputs. And the answer is: at least 9000 $ an ounce – possibly even higher.