THE GOLD CHRONICLES
with James Rickards and Alex Stanczyk
Gold allocations according to some of the worlds foremost professional money managers
North Korea Update
How Congress is deadlocked and why it may affect the debt ceiling and budget
Why “Wealth Management Products” in China pose a potential threat to global markets
How liquidity can be frozen by governments at any time
”The Myth of August”
Alex: This is Alex Stanczyk, and I have with me today my friend and one of the smartest men I know, Mr. Jim Rickards. Welcome, Jim.
Jim: Thank you for that introduction, Alex.
Alex: Jim, with everything going on lately, gold briefly punched through the $1300 USD per troy ounce ceiling at the London Open. Ray Dalio, one of the world’s most respected hedge fund managers who manages money for governments as well as some of the world’s largest sovereign wealth funds, recently recommended a 5% – 10% allocation to gold. Do you have any thoughts on gold before we dive into the rest of our topics?
Jim: Gee, 5% – 10% allocation, where have we heard that before? Ray is the most successful hedge fund and alternative fund manager in history, certainly in the Hall of Fame along with George Soros, Bruce Kovner, Stan Druckenmiller and a relatively small handful of others.
I had occasion to meet him since we live nearby, and I have a lot of respect for Ray, but he’s come around to exactly what we’ve been suggesting to listeners all along, 5% – 10%. I personally recommend 10%, but that’s kind of season to taste depending on your risk appetite.
People say gold is risky or doesn’t have a yield or they’re nervous having it in their portfolio. I just look at people and say I would be nervous not having it in my portfolio. I can’t imagine going to bed at night, waking up in the morning, and not having an allocation to gold.
People disparage it in a lot of different ways, and in fact, they always want to put words in your mouth. I’m out there a lot giving presentations, doing podcasts like this one, with my book, The New Case for Gold, and people make comments like, “Jim Rickards says the world is coming to an end. Sell everything, buy gold.”
I have never said that, and I don’t believe that. The world is not coming to an end. We may go through some tumultuous changes with some severe stress in the international monetary system, but we’ve seen that many times over the last 100 years. It’s nothing new. When that happens, you’re going to want gold.
I wouldn’t go 100% in anything, including gold, cash or any other asset, but if you do 10% in gold, that leaves 90% in everything else. I’m often asked, “What about the ‘everything else’?” There’s room for cash as a good asset in tumultuous times as well as land, real estate, and museum quality collectibles. I invest in private equity, and I’ve invested in some technology startups and some natural resource startups, particularly in the water space.
Diversification is obviously important, but if you don’t have 10% in gold (I’ll echo Ray Dalio and say 5% – 10%), you’re driving without insurance. If things get bad, that’s the first thing you’re going to want to get, and you’re going to find that you can’t get it.
Alex: Indeed. Now let’s get into some of our subjects. On our last podcast, we discussed disinflation, slowing of the U.S. economy, Fed tightening into weakness, Fed’s new pet theory, and North Korea. That’s our first topic today.
We first started covering North Korea back in our April podcast, and since then it’s gone from being on nobody’s radar to what one whitepaper described as the world’s biggest tinderbox. As a quick recap for those not familiar with the back-story, we first started talking about North Korea’s weapons capability in our April podcast. If you want to hear it, it’s available on our podcast page at Physical Gold Fund Podcast.
Jim, you had been on a major news station and said that the North Korea threat was escalating and the U.S. would be at war with North Korea in short order. This was met with huge skepticism. An hour later, North Korea launched an ICBM test missile. Next, North Korea conducted a series of ICBM tests. U.S. intelligence has confirmed they can fit a miniaturized nuclear warhead into a missile-sized payload. Intel estimates that they’re sitting on up to 60 warheads at this time.
On Tuesday, August 8th, President Trump made the comment that North Korea had best not make any more threats to the United States or they would be met with fire and fury like the world has never seen.
On August 9th, North Korea revealed its plans to strike Guam with four nuclear missiles, and the green light to do so would come from Kim Jong-un. Current estimates are that it would be a 14-minute flight time for a North Korean missile to reach Guam.
For those who are not familiar with Guam, it’s a U.S. island territory in Micronesia used as a forward staging area for projection of U.S. sea and air power. It’s home base to a number of U.S. nuclear attack submarines. These aren’t the ones that fire nuclear missiles vertically. They hunt other submarines as their primary role, but they can also launch Tomahawk land attack missiles and provide insertion options for U.S. Seal teams.
Also located on Guam is Andersen Air Force Base, home to the U.S. 36th Wing. It includes Intelligence aircraft, fighter interceptors, and importantly, acts as one of only two critical forward airbases for U.S. long-range bombers in the Pacific. So, it’s a pretty important installation.
On August 10th, the U.S. Air Force, in an unprecedented move, transferred all three main bomber types in the U.S. arsenal to Guam. That included B1 Lancers, B2 stealth bombers, and B512 Stratofortresses.
As of now, North Korea has backed down on the threat regarding Guam, but the fact remains that they’re continuing to develop capabilities in defiance of the world asking them to halt their nuclear weapons program.
Jim, let’s game theory a bit. Where does it go from here?
Jim: First, Alex, that was a fantastic summary. As you know, I’ve been to the Pentagon many times for briefings on different topics. Your summary feels like I just sat through a Pentagon briefing, because that was very thorough. I don’t have a lot to add to that in terms of logistics other than to say I’ve been to Guam and Saipan on the Northern Marianas in the area you described, and yes, it’s U.S. territory.
Even before the ICBM test there was the Hwasong-12 and other tests more in the intermediate range. Then they made a big breakthrough with this intercontinental ballistic missile which has a much further range.
I was very disturbed when newspapers were publishing maps showing concentric circles from Pyongyang showing the range of the missiles to give readers an idea of how far they can go. I saw one that said, “We’re not worried, because it can’t reach Los Angeles,” but I looked at the map and saw that it covered Guam and Alaska.
The last time I looked, Alaska was a state and Guam a U.S. territory. I don’t understand this view that if it’s not a densely populated city – which of course we should care about – it’s somehow not a threat to the United States. It certainly is, and you’re right, Guam is U.S. territory with a lot of Americans living there.
The point is, this escalation has continued. Now, this has been going on for 25 years. We may have been warning listeners about it ahead of the pack, so to speak, months ago, but this threat has been escalating since the mid-1990s with Kim Jong-un’s father.
Bill Clinton did a deal with him in which we released some sanctions in exchange for promises to discontinue the program. They immediately broke that deal. Then George Bush did a deal with them whereby he also gave some section relief, and they immediately broke that deal. So, their track record is that they lie, they buy time, they get concessions, and they keep building the missiles.
The Obama administration essentially did nothing for eight years, so this thing’s been kicking around since the mid-‘90s. I do think the Trump administration deserves credit for clarity, saying, “Okay, that’s it.” The best line I saw was, “We’re not going to negotiate our way to the negotiations. If you want to come to the table and talk to us, we’ll meet with you, and we’ll tell you right now that what you must do is verifiably discontinue your weapons programs. What do you get in exchange for that? Let’s talk.”
Obviously, there would be sanctions relief and maybe even integrate the North Korean economy into the global economy. They’re actually very rich in natural resources. It’s an interesting country. They could be a commodity-driven exporter and have a decent economy, but they’re completely cut off.
That’s the back-story. For the recent sequence of events, let’s go back to August 8th – 10th when the stock market went down about 1.2%. That’s when this rhetoric was dialing up exactly as you described, Alex. Kim Jong-un was talking about attacking Guam, Trump was saying this’ll be met with fire and fury, Kim Jong-un was saying, “I’m waiting for the battle plans, we’re launching at Guam,” etc.
The weekend of August 12th and 13th, a lot of national security officials went on television. General H. R. McMaster, who’s the National Security Advisor, Rex Tillerson, and others gave interviews, but they dialed it back by saying war is not imminent. By the way, you have to agree with it; war is not imminent. If there’s a high probability it’s coming in early 2018, is that imminent?
Not in the sense that someone’s going to launch an attack tomorrow, but that’s close enough for investors to start thinking about it if they cared, and I certainly think they should. Yes, I’ll buy the fact that it’s not imminent. They dialed down the rhetoric, and then Monday, Kim Jong-un seemed to respond in kind. He said, “I’ve got the battle plan but I’m not ready to launch yet.”
By his standards, that seemed a little bit conciliatory. And then Trump made a statement saying, “We welcome this progress, and maybe we can do some basis for talking.”
Suddenly, stocks take off, it looks like the threat’s over, and everyone is dialing down, but that is not how I read it at all. Kim Jong-un actually said, “I will not launch at Guam if the United States engages in acceptable behavior,” or stated in the negative, if they don’t engage in unacceptable behavior.
That was a very specific reference to a joint U.S./South Korean military exercise that is conducted periodically. These military exercises have very long engagement periods. There’s a big one they’re going to launch on Monday, August 21st that lasts for about a week, I think August 21st to 28th. It has a lot of moving parts involving all branches of the military.
What Kim Jong-un was saying is, “I won’t launch at Guam if you call off that exercise.” That’s what he meant by the U.S. not engaging in bad behavior. You don’t have to read between the lines very much to see that’s what he meant.
Well, we’re not going to call off the exercise, because the U.S. is not going to be bullied or threatened. This exercise is long planned, and we’re going to go ahead and do it. The minute we do, we have now broken the condition on which Kim Jong-un was reframing, so, my expectation is he will test one of these systems.
Here’s where it gets really interesting. You talked about the miniaturization, Alex, and there are a lot of technologies you have to master to be able to do this. You have to get your hands on some uranium or plutonium and enrich it which is very demanding technologically. You have to build missiles to have a certain range which is demanding technologically. Then you have to miniaturize the warhead so you can fit it on the missile.
A nuclear device that would just detonate, create a chain reaction, and be a nuclear explosion could be the size of a truck. That’s called a device. It’s not necessarily weaponized, because it’s hard to deliver unless you get it small enough. And then finally, you have to ruggedize it. ICBMs go to space and come back into the atmosphere under a lot of stress, heat, and vibration, and it must survive all that.
One by one, Jong-un mastered all these technologies, and it looks like he’s getting to the final two: miniaturization and ruggedization. That comes from testing. But there’s one more thing he’s doing where I think he gets very dangerous. He has a submarine, and there’s reason to believe he will release a submarine-launched ballistic missile.
That’s different from an ICBM, because you can move submarines around. The U.S. has been betting on Terminal High Altitude Defense (THAD) defense, where we can shoot down these missiles with some degree of accuracy. No one wants to rely on that because it’s not 100%, but it’s better than nothing.
However, you can move a submarine to create a trajectory where you’re evading the THAD missile batteries, number one. Secondly, you can move that submarine within range to where it would support an intermediate range ballistic missile attack instead of an ICBM.
It’s a total game changer and possible that that’s what he’s going to do. He also might detonate a nuclear device to perfect that technology. That’s not a missile launch, that’s a nuclear detonation. Any one of these things is highly provocative.
My expectation is that the U.S. will go ahead as planned with this war game. Kim Jong-un intended all along to do the test knowing the U.S. would do this, and he’d put this marker down to make him look like the good guy. But of course, he’s not a good guy, and he’ll do something extreme. If he doesn’t aim a missile in the vicinity of Guam – which would practically be an act of war – it could be the submarine launch test or a nuclear explosion. That’ll get Trump going again, and then we’ll be right back where we were on August 8th.
This threat is not going away. People dialed it back a little bit last weekend, but I think it’s coming back at us, and the stock market is extremely vulnerable. You don’t have to reach hard to find people who think it’s overvalued, so we don’t have to belabor that. I’m not the stock market guy, but go to anyone from Robert Shiller to Warren Buffet or any well-respected voice on that topic, and you’ll hear universally that the stock market is overvalued and headed for a fall.
The question is, when? The answer is, it could be any time. It takes a catalyst, and this could be the catalyst. On top of the terror attacks we’ve seen in Spain on Thursday and Finland on Friday, there seems to be no end to it. That was enough to get the stock market heading in the wrong direction in the course of Thursday and Friday. Let’s see what happens, but I think stocks are vulnerable to this kind of shock. The market has not priced it in, and I do think it’s coming, probably next week.
Alex: This reminds me of many conversations you and I have had regarding complex systems and critical states, and that really is just a shift of psychology. It’s simply human nature. After a while, people become apathetic towards things, and sometimes it takes unfortunate events to shake and wake people up. That’s what we’re looking at.
We will continue to monitor what’s going on with the North Korea situation, and if there are important updates, Jim and I will probably discuss it again in a future podcast.
Our next topic is the debt ceiling and so-called government shutdown.
This subject has been discussed many times. Personally, I’m kind of disgusted with the fact that we have to do this versus proper fiscal management at the government level, and I know I’m not alone in this. The United States is now sitting on $19.974 trillion in debt. That is $165,851 per taxpayer. It’s a reality we must deal with on a regular basis now.
Treasury Secretary Mnuchin has written a letter to Congress asking them to raise the debt limit no later than September 29th. Jim, what’s your take on all this?
Jim: Good luck with that. You’re absolutely right, Alex, in terms of the backdrop.
Let’s sort it out for the listeners. There are two big but separate deadlines converging on September 29th. The way the media reports it is by throwing words around that tend to get mashed together in a lot of readers’ or listeners’ minds; however, they’re separate and they’re converging like two meteors hitting earth at once.
One is something you mentioned, which is the debt ceiling. This has to do with the borrowing authority of the U.S. Treasury. Is the U.S. Treasury authorized to borrow money to pay the bills of the United States covering everything from Social Security, Medicare, Medicaid, operations of government, military, you name it. The whole budget is around $500 billion a year. That’s the deficit.
The budget is well over several trillion, but that must be authorized by Congress. Until it’s authorized, the Treasury is running on fumes. It sounds strange, but the Treasury has a bank account at the Fed and other banks that is no different from your bank account or mine.
If we have money in the bank and spend it with no income, that account goes to zero. Your checks then bounce and you can’t spend any more money. Believe it or not, that’s the situation the U.S. Treasury is facing. It is running out of cash. They have new cash coming in all the time from tax collections, but it’s going out in terms of payments. They can run negative cash flow and draw it down.
That’s the situation the Treasury is facing. They need Congress to authorize an increase in the debt ceiling so they can borrow more money so they can pay the bills. It’s that simple. The problem is that Congress is not really functional right now and is not inclined to do so. This is because the Republicans have a majority of the House and Senate but can’t agree among themselves.
By the way, this is a replay of Obamacare. I don’t want to get into the weeds in terms of the healthcare debate, but I think a lot of listeners know that the Republicans came into Washington with control of both houses of Congress and the White House and said they were going to repeal Obamacare. They didn’t do it and they’re not going to do it, because they couldn’t agree among themselves. They didn’t need Democratic votes, but they did need to agree, and they couldn’t do that.
The same thing is playing out with the debt ceiling. There are members of what’s called the House Freedom Caucus that say, “We’re not voting for the debt ceiling increase unless we get some conditions.” They want to defund Planned Parenthood, there’s an issue around sanctuary cities, and around money for the wall. The White House wants money for the wall, and there’s an Obamacare fix. It’s not the repeal of Obamacare, but Obamacare was running out of money, and that is a separate appropriation that has to get through.
So, there’s a bunch of stuff standing in the way of this vote. Now, you could say, “Okay, to heck with Republicans. Let’s just get moderate Republican votes and some Democrats.” Well, the Democrats are sitting there, notably Nancy Pelosi, who said, “Why should we help you guys? You’ve run us out of town, you’ve ridiculed us, you’ve called us every name in the book, you don’t want to work with us on anything else, you don’t like our agenda. Why should we give you any votes?”
Even though the Democrats in general favor raising the debt ceiling because they like all these programs and spending money, they’re not inclined to vote for two reasons: 1) Why should they help Republicans? 2) They don’t want all these riders attached that I mentioned. If you put defunding of Planned Parenthood in a debt ceiling vote, you will not get one Democratic vote, so, it’s not clear where the votes are coming from.
Let me shift gears for a second and talk about another event, which is the budget. The budget is different than the debt ceiling. The debt ceiling is borrowing to pay your bills, whereas the budget authorizes all government spending that gives rise to having to pay your bills in the first place.
The U.S. is on a fiscal year running from October 1st to midnight on September 30th. While most of us are December 31st, New Year’s Eve, the U.S. government celebrates New Year’s Eve on September 30th.
This year, September 30th happens to be a Saturday when banks are closed and the government is not working, so it’s really September 29th which is a Friday. September 29th is D-Day in terms of keeping the government open, and there are two ways to do it:
You could pass a real budget which is kind of what you were saying, Alex. Are we mature enough to actually do that? The answer is no.
The other thing you can do is called a CR or continuing resolution. It’s basically a vote by Congress that says, “We agree that all the agencies can keep spending whatever they were spending before. We’ll get back to you later about new spending, new programs, terminations, and all those things, but for now, keep spending.” That’s what a continuing resolution is.
Here’s the thing. That’s a hard stop on September 29th for the reason I mentioned. The debt ceiling doesn’t have to happen at the end of September; it can happen at any time. In years past, I’ve seen this happen in March or other times of year. It just so happens by coincidence that it looks like the Treasury is going to run out of cash on September 29th this time.
As I said, you’ve got yourself two asteroids striking the earth. One is the budget authorization in the form of a continuing resolution, and the other one is the debt ceiling increase in the form of authorizing the Treasury to borrow money. They don’t have to happen at the same time, but they are happening at the same time and are subject to the same dysfunctions. In other words, the issues I mentioned, e.g., the wall, Planned Parenthood, Obamacare fix, and sanctuary cities, pop up in the debt ceiling debate and also the continuing resolution budget debate. There is no consensus on any of them. Again, it’s not clear where the votes are coming from.
Just to add another layer of intrigue here (or dysfunction is probably a better word), it’s not clear if the White House is so afraid of a government shutdown. In a government shutdown, nonessential workers stay home, the military is still on duty, the TSA still works at airports, the Post Office is still open, but there are a lot of government functions that do shut down including popular ones like national parks and monuments. They’re the ones that are going to be most visible.
The White House might like that. Remember, the White House is not exactly Republican. They kind of are and they aren’t. Jared Kushner, Ivanka, and some others seem more like Democrats, but Trump is very hard to categorize. I wouldn’t call him a conservative Republican at all. He’s a nationalist, a Trumpist, a capitalist. He’s a lot of things, but I wouldn’t call him a conservative Republican.
Trump is just as eager to fight with the House Freedom Caucus and Mitch McConnell as he is with Nancy Pelosi and Chuck Schumer. He might say, “What we need is a good government shutdown. Let’s show the American people just how dysfunctional we are, just how immature we are,” etc. Again, I don’t want to take sides in that debate. My role is simply to warn listeners that these two things are coming together. I don’t see how they’ll get resolved.
On top of everything we just mentioned, it takes time to do these things. There’s something called the legislative calendar. Don’t think for a minute that Congress works seven days a week or even five days a week. They tend to show up Monday night and leave Thursday afternoon to go back to their districts on the weekends, so they probably work about three days a week, not to mention holidays. Their idea of the Labor Day weekend is a ten-day recess. Most of us are happy to get an extra day off, but they’ll take ten days for Labor Day.
The point is, the legislative calendar only shows 11 working days between now and what we’re talking about, the September 29th train wreck. It takes members of Congress 11 days to find their way to the bathroom.
They have a lot of other stuff on their plate. They have judicial appointments, they need to reconfirm the new FBI Director, there is some cat and dog legislation on Obamacare, and we have a national security crisis with Korea not to mention all the sound and fury about racism in Charlottesville. Again, I don’t want to get into the weeds here, but that’s obviously adding to the dysfunction.
Put this all together with the possibility that the White House might not mind a train wreck. The fact that there is probably a train wreck coming anyway due to the shortness of time, degree of difficulty, and the lack of consensus, we could have a government shutdown. I think we will have a government shutdown on October 1steffective midnight September 29th, and I think this debt ceiling crisis is going to go right up to the deadline.
That doesn’t have a date certain; September 29th is an estimate for that. Imagine you’re running a bond portfolio – a big one, like a pension fund or something – and you’re saying, “Is the United States going to pay me the interest due?”
By the way, there is a big outflow on October 1st because it’s the first day of the month. With Social Security, welfare programs, and benefit programs, that’s one of those days when the outflows are greatly and excessively inflows. People tend to pay their taxes in April, and by October, you’re running on empty.
This is a mess on top of all the other serious national security, terrorism, and other problems we described. It’s one more reason, in my view, why investors should be over-allocated to gold right now and also have some cash.
Alex: When you’re discussing the schedule of how these politicians work, I’m over here shaking my head thinking, “Ah, the good life.” Hopefully, someday we’ll be able to rein that situation in.
Moving on to our next topic, as you and I have talked about many times, the world economy is heavily interlinked, and many of our listeners are professional money managers, so oftentimes, we will discuss what is going on in other jurisdictions.
Today, I’d like to talk a little bit about China. There is this disturbing trend going on over there where the banks are slowly becoming the majority, or I should say, the larger share of the investor base plus these things called wealth management products or WMPs.
From our discussions and what I’ve looked at in the past, the entire scheme of the WMP structure seems questionable to me. What are the risks and the potential spillover effects for the global markets?
Jim: The risks and the spillover effects are huge. We’ve had a taste of this a couple times recently. Just about two years ago on August 10, 2015, China did a shocked evaluation of their currency, the Chinese Yuan. The markets didn’t see it coming, and even the elites, the IMF, the U.S. Treasury, and others did not see it coming. China had their own reasons for doing it.
That caused a shock in U.S. stock markets. Go back and look at a chart from August 10th to September 1stwhen U.S. stocks fell about 11%, and it was worse than that. It wasn’t just that they went down 11%, but it looked like there was no end in sight. It happened to be from peak to trough an 11% drawdown, but when it was down 10%, we didn’t know that it was going to turn around at 11%. It could have gone down 20%. Think about where you were on August 31, 2015, maybe taking the kids back to school, on vacation or getting ready for Labor Day weekend. Investors had a sick feeling in the pit of their stomach. It felt like there was no bottom.
Then the Fed rode to the rescue, and that was when we were going to have the liftoff in interest rates in September. They pushed the liftoff back to December, got involved in forward guidance happy talk, and the problem went away, but it was pretty bad there.
The second time was December 2015 when China did a stealth evaluation. They learned their lesson on the shocked evaluation, so they were doing it in baby steps, but again, the U.S. market reacted badly from January 1st to February 10th, 2016. It again fell 11%.
There you have two examples of what is called in-state contagion. That’s a good word. The IMF uses the word “spillovers” when one bucket spills over into another bucket. Pick your metaphor, but to say that the U.S. markets are isolated, immune or pristine relative to the Chinese evaluation or the natural market events is false. We have two examples of stocks almost spinning out of control based on Chinese actions, so let’s come back to the WMP.
I’ll take a minute to explain what a WMP is. It stands for wealth management product and is a simple concept. As a middle-class Johnny saver, you’re not a Princeton or an oligarch, but you and your spouse have a good job and have some savings.
You walk into the bank and the bank officer says, “We have two products. You can make a bank deposit and we’ll pay you 2% interest or you can buy a WMP and we’ll pay you 7%.” Most people think about that for two seconds and say, “I’ll take the 7%, thank you very much,” and they do.
What gets lost in translation, even in Chinese, is that these wealth management products are not bank products. They’re not liabilities of the banks. They’re off-balance sheet special products very much like CDOs.
Banks take the money people put into the WMPs, bundle it, and buy junk bonds or equity in real estate, state-owned enterprises, bankrupt companies, speculative land deals, ghost cities, and you name it. They’re out there buying all this garbage, so they look like these Lehman Brothers CEOs from the 2006, 2007, 2008 period, which of course, almost brought down the world.
They don’t really tell that to the customer. I’m sure there is some disclosure somewhere in the fine print that no one reads. I’ve seen interviews with everyday savers, people walking out of a bank, and a reporter says, “What did you do with your money?” “I bought a WMP.”
They’ll say to the person, “Don’t you know that’s not the equivalent FDIC insured, that’s not a bank liability, and it’s not guaranteed by anybody?” Some people don’t know that, but some people say, “I know that, but Beijing will bail us out.”
Alex: That is the attitude in China, absolutely.
Jim: I’ve been to China several times. I’ve been out in the boondocks of China, I’ve met with provincial Communist party officials, and I’m very frank with these guys. I was having tea in an office near one of these ghost cities, and I said to one these guys, “Can you build seven cities here?” As I’m looking at them, they’re all vacant. Every building I’m looking at it is vacant, and he did it all with debt.
I said, “How are you going to pay back the debt?” He replied, “We can’t pay back the debt. That’s impossible. Beijing is going to bail us out.” You hear this over and over from government officials to a man or woman on the street.
Be that as it may, these WMPs are Ponzis, and I don’t just throw that word out there lightly. Let’s say I bought a two-year WMP two years ago, I go back to the bank, and it’s maturing. They say, “Okay, Mr. Rickards, we can roll your WMP over into a new two-year WMP.” I might say, “Fine, I’m collecting my 7% interest,” but Bernie Madoff investors collected their interest also. They just didn’t know that their money was gone.
But what if I say, “My kid is going to college in the States so I need the money,” and I cash out my WMP? They have invested in these junk assets, so they can’t really cash out the WMP. What they do is sell a new WMP to the next person who walks in the door, take that money, and give it to me.
The new person is happy because she’s getting 7%. I’m happy because I got my money back. Meanwhile, the money isn’t there. You must sell the new ones to pay the old ones, and what you really hope is that the old ones roll over so your net inflows are positive and you don’t have net outflows. This is a Ponzi.
By the way, the Chairman of the Bank of China in an interview said, “It’s a Ponzi.” I quoted this in my book, The Death of Money. It happens to be my analysis, but it’s not just my analysis; we have it on record from China’s officials.
That’s where we are. We know that all Ponzis fail eventually. They collapse and cause a panic. That’s coming, but it doesn’t have to be tomorrow. This Ponzi can walk for a long time. Madoff ran his Ponzi for 20 years. The guy is spending the money on himself, losing it in other things, but convincing investors that it’s all good. As long as you pay the coupon, sheep will feel good about it.
I saw an article, a chart, and analysis last week showing that the amount of WMPs is going down. This was taken as a positive by the analysts who said, “This is great. China is finally stepping up to the plate. They’re finally getting things under control. It’s good that the leverage in the system is going down. Isn’t this wonderful that the WMPs are going down?”
I said, “No, that’s a nightmare. That’s like Bernie Madoff saying, ‘My assets under management are going down.’” If you don’t have the money and you get into negative cash flows or net outflows in a Ponzi… If it was a real product that was wisely invested and you saw it going down, you might say to yourself, “That’s good. There’s more liquidity in the system. They’re reducing leverage. They’re not acting as crazy on real estate.”
It would be a good thing if it wasn’t a Ponzi, but people forget that it is a Ponzi. When you see assets in a Ponzi going down, that means the run on the bank has started and this fire is about to spin out of control. To me, that’s one of the scariest indicators I’ve seen and one more reason to expect that China is about to implode.
Just to be clear, nothing is happening in China until either the end of this year or early 2018. The reason for that has nothing to do with economics and everything to do with politics. There is a national Communist party, Congress, that hasn’t set the exact date, but it’ll be late October or early November when President Gee is going to be anointed, if you will, as the big G, the big man, the most powerful Chinese leader since Mao Zedong. He doesn’t want to rock the boat ahead of this party Congress, so no crises are going to break out in China between now and November. They can back that up because they still use firing squads if they have to.
Once we get past the party Congress and Gee has achieved his power goals, we’re into 2018, and yet two plus two does not equal five. I think you’re going to see some of these chickens come home to roost.
If you asked me, “How does this play out? What do they do?” I would expect a maxi-devaluation of the currency, because devaluation of the currency solves the capital outflow problem. You can reopen the capital account, because people are not as anxious to get their money out. Once you steal their money, you can’t steal it twice, so they say, “I might as well sit here. I’m not sure how to get my money out.”
I would expect a maxi-devaluation to boost exports and export-related jobs and cure the capital outflow issue. For right now, they’re squashing everything, so don’t look for drama from China before the end of the year. I would look for a lot of drama in the next year.
Alex: You mentioned that they all believe the government is going to bail them out if there are problems. That reminded me of my many trips to China talking to money managers, government officials, and others.
Before 2015, I made a trip and talked to five of the largest fund managers in China. They all said the same thing – they weren’t concerned about the banks or the markets. Then in June of 2015, I’m sure you remember there was the Chinese stock market crash.
The government basically froze everything and told them, “You can no longer trade. You’re not allowed to sell.” They were even going so far as to making criminal investigations into fund managers who were selling positions during that time, and they locked down liquidity.
You’ve mentioned something like that in terms of Ice-Nine in your recent books. That’s a big deal right now. The prevalent question on the mind of every professional money manager I talk to nowadays is, “What’s the liquidity like?”
Adding to that, keep in mind that secondary markets, stock markets, etc. can get shut down by governments at any time. If things are going badly, it can happen, and if you’re frozen out of markets, be super careful.
Jim: I had a conversation with an investor just the other day and pointed out that on October 19, 1987, the major U.S. stock market indices, which is now referred to specifically as the Dow Jones Industrial Average, fell 22% in one day. Not a month or a week, but one day.
In today’s Dow points, a 22% drop would be 4,000 Dow points. Not 400, which would be a really bad day. The other day it was down 275 and everybody was all spun up. Four hundred would dominate every headline. Imagine 4,000 Dow points.
The person I was talking to said, “Yes, but they wouldn’t let that happen. They’d change the rules. They have circuit breakers and would close the Exchange.” I said, “You’re right. They would close the Exchange.”
You tell me. Which makes you feel better: a 4,000 point drop or a closed Exchange? At least with a 4,000-point drop, I can still trade or get out at a price. I might not like the price, but things are still transacting. If you shut the market, that’s Ice-Nine.
My thesis was that when you shut one market, the demand for liquidity moves to another market, probably money market funds, and you have to shut that down. Then it moves to another venue, which would probably be a run on the bank, and you must shut the banks down, etc. It spreads, so, I wouldn’t be too glib or sanguine about the fact that you can close the Exchange, which you can, because then you should say, “What’s the next move?”
As far as the Chinese bailout is concerned, the fact is, Beijing will bail them out. What drives me crazy about Wall Street analysis is they’ll say, “Yes, but Beijing will bail them out,” and I’ll say, “But what does that mean?” It’s going to cost $1 trillion to do this bailout we’ve been talking about.
Chinese has approximately $3 trillion in reserves. About $1 trillion of that is illiquid. It’s real money. I’m not saying it’s fake wealth, but it’s in the stock market, it’s in hedge funds, it’s in private equity. Try getting your money back from Henry Kravitz. He’s not going to give it to you, at least not until your seven years or whatever are up.
Take $1 trillion off the board because it’s there and it’s illiquid. Then there’s another trillion that has to be held in liquid form as a precautionary reserve to do this bailout. If you use that money, then you don’t have the money you need to do the bailout.
That means there is really only $1 trillion in reserves in China that is not already spoken for either in the form of illiquid assets or precautionary reserve. When the reserves were going in 2016 at a rate of $50 billion a month, you’re broke in a year.
China is in a much more precarious situation than people realize. You can’t just throw the $3 trillion number around without thinking about how much of that is already spoken for (the answer is $2 trillion). That’s why I expect the devaluation would be the answer, because that does solve the capital account problem.
Alex: If you’re the Chinese government, why would you blow your dry powder on trying to prop everybody up and bail everybody out? As they’ve already proven, you can just shut it down and threaten people with criminal investigation if they try to trade.
Jim: I think that’s right.
Alex: Obviously, you and I have been banging the table on why you need to take a hard look at physical gold for a long time. I think these are all reasons that you have some of the smartest money managers in the world, like Ray Dalio, talking about it.
Moving on to our last topic. Jim, in our private discussions, you’ve mentioned something to me called The Myth of August. For our listeners, would you elaborate on what that means?
Jim: The Myth of August started as kind of a fun thing with me, although it’s not fun in the sense of the specific events I use to illustrate it. Here we are two-thirds of the way through August, so there isn’t too much time left but plenty of time for fireworks.
The idea is, August is a very popular vacation month. As the last month before kids go back to school, it’s a great time at the beach or the mountains, etc. From Europe to North America to around the world, a lot of people take their vacations in August. Everyone, at least in my part of the world, are in the Hamptons, the Jersey Shore, Cape Cod, or wherever. Offices empty out, whole industries, publishing is almost practically shut down, and nothing happens. It’s just quiet. We all come back to work and are rocking and rolling on Labor Day. That’s the myth.
The myth persists, yet the reality is quite different. Look at the things that have happened in August. They’re not just newsworthy; they’re among the most momentous events in history and financial history. Most famous, tragically, is what Barbara Tuckman, a great writer and historian, called the guns of August, which was the outbreak of World War I.
Even in more recent times, on August 15, 1971, Richard Nixon ended the gold standard. It was August 7, 1990, when Saddam Hussein invaded Kuwait and George Bush, 41, said, “This will not stand.” We sent troops to Saudi Arabia, airlifted them in to the Land of the Two Holy Places, as the Muslims say, literally the next day, which gave rise to Al Qaida.
It was August 1998 when we had the double embassy bombings in Kenya and Tanzania, and Bill Clinton responded with cruise missiles. August 1998 was also the famous Russian default which led straight to the global financial crisis meltdown involving Long-Term Capital Management. As their General Counsel, that landed in my lap, and I negotiated that bailout.
August 1991 was the Solomon Brothers trading scandal when Solomon, the largest U.S. bond dealer in the world, almost went bankrupt which would have started another financial crisis. Warren Buffet came in as a white knight, bailed them out, and the Treasury backed off in the threats against Solomon. The crisis did not go further, but it certainly had the potential to do so.
August 1991 was also a Russian coup. Some crazy KGB guys kidnapped Mikhail Gorbachev. Remember that one? I think the coup was busted because they got drunk on vodka, so their situation awareness was not the best, but they did kidnap the General Secretary of the Communist Party in an attempted coup. And we had Hurricane Katrina in 2005.
I don’t need to belabor it, but I’m very wary in August. A lot of very nasty things have happened. We’re in the home stretch here, just about ten days left, so hopefully it’s quiet, but given everything we mentioned at the beginning of the podcast about North Korea, I’m not so sure it will be quiet.
If the U.S. goes ahead with this military exercise, which I expect, and Kim Jong-un responds with some kind of test, whether it’s a submarine-launched ballistic missile, nuclear device or an ICBM aimed at Guam, which I also expect, then we’re not going to make it out of August without a financial earthquake. Let’s see what happens, but I wouldn’t put my feet up quite yet.
Alex: I think these are all good reminders.
Revisiting the whole liquidity thing, many people are heavily invested in what you and I call paper products that require some kind of counter-party to perform. In a recent paper, the IMF said that gold is the only financial asset you can buy that does not require a counter-party for it to have and retain its value.
I wasn’t going to share this, but I’m going to mention that I had a conversation earlier this week with the head of a trading desk who has 15 people under him. They’re running a lot of money as one of the largest financial houses in the world. If I mentioned the name, everybody would immediately recognize it, so I’m not going to say who this person was.
In a candid moment of discussion, he mentioned to me that they are pretty nervous about this kind of stuff. They listen to our podcasts on a regular basis and don’t miss one, so thanks guys. We appreciate the support.
He mentioned that if it were up to him in regard to all the paper investments – in other words, the ones with the counter-party risk and the ones that rely on exchanges to trade, etc. – he’d sell it all right now.
Jim: Personally, thank you if you’re listening, and thank you and your team for joining us.
The one thing I would say, Alex, is there is a name for restorative value that does not have counter-party risk. It’s called money. People say, “I have money in the bank.” No, you don’t. You have a bank deposit which is an unsecured liability of an occasionally solvent financial institution. Even a Federal Reserve note, if you read it, says, “Federal Reserve note.” Where I went to law school, that means it’s a liability, which it is.
People don’t think hard about what money is. They take a lot of things for granted and assume it’s money when it’s not; it’s something else.
Again, to go back to where we started, people say, “I’m nervous about buying gold.” I say, “I’d be nervous if I didn’t have any.”
Alex: That wraps up today’s podcast. Jim, thank you for your time. The discussion has been invigorating. We covered some really great material, and I very much look forward to our next one.
Jim: Thank you.
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