THE GOLD CHRONICLES
with James Rickards and Alex Stanczyk
Golds role as an international alternative to the United States Dollar
How financial warfare between sovereigns works
Strategic view on changes to sovereign gold reserves
China is slowly shortening the maturity structure of its US Treasuries and letting them run off the books versus selling
Analysis of projected Trump policies; deep dive into some of the inconsistencies and potential scenarios
Trump may be able influence the appointment of as many as 4 or 5 members of the FOMC
Currency Wars are alive and well, new rounds of devaluation are starting
Helicopter money and price inflation
Are capital markets complex systems, and why it matters
Why traditional models such are VaR are old science that may no longer apply to markets
Specific criteria used in physics to identify a complex system
Triffin’s Dilemma and gold
Alex: Hello, Jon. It’s great to be here. I’m very excited about today’s podcast. This is a new format where we’re recording directly, so we’re going to dive right in.
Jim, you recently collaborated with some of the nation’s leading experts on economic security and contributed to a report published by the Center on Sanctions and Illicit Finance. Would you talk about gold’s role as an international money alternative to the United States dollar?
Jim: I’m happy to, Alex. The report you’re referring to was just released, and you’re right, it’s the Center on Sanctions and Illicit Finance – CSIF, we call it. It’s part of a larger Washington think tank called the Foundation for Defense of Democracies. It has quite a distinguished setup of scholars, advisors, boards of directors, and so forth.
They have a website, so everything we’ll be talking about here is publicly available. I encourage listeners who are interested to go to the Center on Sanctions and Illicit Finance at the Foundation for Defense of Democracies, FDD. You’ll find it easily.
Our release was a new report geared to the transition. I was one of the contributors out of a number of other contributors and editors involved. We started working on this last summer not knowing whether Hillary Clinton or Donald Trump would win the election. My own view was that Trump would win. It was proposed as a transition document to help whichever administration came in to understand these linkages.
To help our listeners understand it, just picture a simple Venn diagram – two big circles. Think of one circle as defense, intelligence, national security, diplomacy – all those aspects of national security broadly defined. The other circle is global capital markets that include stocks, bonds, commodities, derivatives, obviously gold, foreign exchange, etc.
Imagine these two circles intersecting so they converge and there’s some overlap. That overlap where national security issues and global economic issues come together I’ll call “geo-economics” for a word. That’s really my specialty and the area this group and I work in.
That area is getting larger and larger. It’s difficult to think of a national security issue today that is not also an economic issue. Going back to the Obama administration, there were a lot of confrontations with Russia, North Korea, and others. Going back even further through the Bush and Clinton administrations where for whatever reasons the United States did not want to use military force but did not want to be uninvolved or let countries do whatever they wanted, we used economic sanctions.
Nobody wanted to start a war in North Korea, but we wanted to put economic pressure on them to stop their nuclear program. Nobody wanted to start a war in Iran, but we wanted to put economic pressure on Iran, again with regard to their uranium enrichment program. Then there were kind of rogue states like Syria where we would use economic sanctions to try to make it more difficult for the regime in power.
This whole area of economic warfare, financial warfare, includes an even more specialized part called cyber financial warfare using cyber techniques, which can affect any part of critical infrastructures. It could affect dams, hydroelectric plants or the power grid, etc., but we would aim it specifically at banks, stock exchanges, financial message traffic systems like SWIFT, etc., in an effort to disrupt the economy.
Kinetic warfare involves bombs, tanks, and things that shoot or explode – physical force. The purpose of kinetic warfare is usually to degrade the economic power of your opponent. In World War II and wars, we bombed railroad depots, pipelines, and factories not only to attack military forces but also to degrade the economy.
If you can do that with sanctions and cyber financial warfare, you can skip the bombs and get the same effect using other 21st-century cyber financial techniques. That’s what our center does. We just released this report that will go to senior officials in the Trump administration, but it was really a bi-partisan approach calling attention to this.
My particular contribution was a section I wrote involving gold. I thought that’s where I could make the biggest contribution, because even though there were a lot of scholars, as you and our listeners know, I still regard gold as money. I regard gold as the foundation of the international monetary system, but that’s a bit of a minority view.
Most people – certainly mainstream economists, central bankers, and others you talk to in the economics profession and policymakers – think gold is kind of a joke. They’re like, “Yes, we have some, but as Ben Bernanke said, it’s a tradition,” or “We don’t think it plays any role,” or they’ll quote John Maynard Keynes saying it’s a “barbarous relic.”
We all know the rap on gold. I went through this in my book The New Case for Gold, where I took these objections one by one, deconstructed them, refuted them, and showed that they don’t hold up. We’ve talked about that on prior podcasts, so I don’t need to repeat that whole analysis. But it’s fair to say that most economists and analysts don’t like gold very much, and yet I think about it quite a bit not only in monetary terms but also in strategic terms.
Since this was for the new president, it will go to Trump’s cabinet members and others, so I thought it was a good opportunity to inject gold into the discussion.
Here’s the point I made, and this is all obviously factually based. There’s something I call the axis of gold. I presently include four countries, although I could include others perhaps over time. They are Russia, China, Iran, and Turkey. We probably need to include North Korea in some ways, but let’s just start with those four.
What do I mean by the axis of gold? Number one, they are all acquiring massive amounts of gold. We spent a lot of time in the past talking about the Russia/China story. Russia has tripled their gold reserves in the last ten years from around 600 tons to 1800 tons in round numbers. China has done likewise officially, but unofficially we estimate that they have even more gold than they admit. China has gone from about 600 tons to 800 tons that they acknowledge, but my estimate is they probably have 3000 or 4000 tons, perhaps more off the books in the State Administration of Foreign Exchange. So, the Russia/China story is pretty well known.
Less well known is the Iranian story. We have even less information on Iran than we do on China, because Iran is an outlier and a bit of a pariah in the international financial system. There’s not a lot of gold mining output in Iran. There is in China, by the way. China is the largest gold producer in the world from a mining perspective, producing – at least for the time being – about 450 tons a year. That’s more than twice as much as the next closest country.
Iran is not. Iran gets their gold from abroad. Where? A lot of it comes in from Turkey, trans-shipped through Turkey. Some of it is smuggled in from Dubai right across the Strait of Hormuz.
I’ve been to Dubai a number of times. The smuggling boats, called dhows, are down in the waterfront called the Baniyas Road, and they’re all lined up. You see boxes full of HP printers, Sony TVs, Apple iPhones, and all that, but who knows what’s inside the boxes? There is probably a fair amount of gold in there.
They fly it in from Turkey, they smuggle it by boat from Dubai, and they recently got billions of dollars of gold courtesy of the United States of America. Our listeners are familiar with President Obama’s efforts to induce Iran to sign a deal that would in theory defer their uranium enrichment program for ten years and slow down their effort to become a nuclear power. I don’t want to spend a lot of time on the deal itself, because there are enough critics out there, and our listeners can find out all they need to know about that.
Part of the deal is that the U.S. would release some funds we froze years ago that were owned by Iran and also provide other money that could look a little bit like a ransom for some hostages. Leaving that aside, the amount was well over $10 billion.
Over $1 billion was in the form of cash. When I say cash, I don’t mean a wire transfer; I mean physical bank notes. We couldn’t give them U.S. dollars, because Iran doesn’t want dollars. They’re pretty much out of the dollar system. We actually had to call the central bank of the Netherlands and do a swap with them. They sent large-denomination euro notes to Iran, because they’ll take euros and other forms of money, including gold.
Included with these ransom payments was billions of dollars of gold. We don’t know the exact amount as that’s never been disclosed, but you can think of it as several hundred tons, perhaps more. So, they’re all accumulating gold.
Why are they doing this? They’re doing it for a couple of reasons. One is to insulate or protect themselves from U.S. dollar inflation. The U.S. has an unmanageable, non-sustainable debt problem approaching $20 trillion of debt.
That wouldn’t be so bad if the economy was growing fast enough to pay it, but it’s not. Our annual deficits are over 3% of GDP and our growth is around 2%. If you grow your deficit faster than your economy is growing, you’re going broke. You may be going broke slowly, but you’re heading down the same path as Greece.
Also, the Trump administration is talking about $1 trillion of critical infrastructure spending over and above the existing deficit. All of this looks completely unsustainable, but there is one way to deal with it, which is inflation. If you can generate enough inflation, the real value of the debt goes down and you end up paying it with cheaper dollars. You just print the money and pay it off.
What single entity has the most dollars in the world? The answer is China. They have well over $1 trillion of U.S. treasury notes that are vulnerable to devaluation through inflation. China can’t dump those. The treasury market is big but it’s not that big, and China knows it. If they tried to do it in a malicious way, the president could stop them with one phone call.
What they’re doing is letting it run off little by little. They shorten the maturity structure. Every month that goes by, a certain number of these treasuries mature. China just gets the money, but they don’t have to sell anything. They don’t have to dump them; they just kind of run off. It begs the question, what do you do with the money? One of the things they’re doing is buying gold.
Some people have speculated that they’re trying to come up with a gold-backed yuan. I find that highly improbable. There are many reasons why the yuan is not ready for prime time or it’s not in a good position to be a global reserve currency even though the IMF says it is. I think the IMF bent the rules to do that for political reasons.
The yuan is not ready. They don’t have a bond market, they don’t have rule of law, they don’t have repos, futures, options, dealers, auctions – all that plumbing and infrastructure needed to run a bond market so that people who have your currency have something to invest in. It just doesn’t exist and won’t for at least ten years, perhaps longer.
They don’t have enough gold to back their currency. The People’s Bank of China has printed more money than the Fed. People like to beat up the Fed about printing money – and they should. They printed close to $4 trillion since 2008, but the People’s Bank of China has printed even more with less gold than the United States. So, they’re not ready for that.
What they are doing is creating a hedge. Let’s say that there is no inflation and the dollar is stable. I don’t expect that, but let’s just assume it’s true. The dollar price of that gold might not do very much, but China will be happy because they’ll get their treasury securities paid off in real dollars.
On the other hand – and I think this is far more likely – we inflate the currency. We say to China, “Hey, China, here’s your $1 trillion. Good luck buying a loaf of bread, because we printed all the money.” China could shrug and say, “Yes, maybe our treasuries are worth less because of inflation, but our gold is worth more.”
Without dumping a single treasury and while continuing to have a substantial investment in U.S. dollars, the physical gold acts as a hedge so that if we resort to inflation (which in my view, we will), the gold will be worth more and their wealth will be preserved.
By the way, that’s a reason for every investor to have an allocation of gold. I recommend 10%, but people can do more or less according to their personal preferences. If nothing else, gold is good if the monetary system collapses, it’s good in a panic, and it always preserves wealth in the long run.
There are many, many reasons to have gold in your portfolio, but one of the most obvious that people get is inflation insurance. I like to say if it’s good enough for China, it’s good enough for me. I do recommend savers and investors allocate some of their portfolio to physical gold for that reason. That’s exactly what China is doing.
Russia is doing something similar, but I think Russia is more aggressive. They’re actually looking for ways out of the dollar payment system, maybe create a ruble zone. The ruble is also not ready to be a global reserve currency, but it could be an effective regional reserve currency meaning something that trading partners would accept.
Those trading partners would include places like Kazakhstan, Belarus, Crimea is part of the Russian Federation now, and Turkey, which is a major trading partner of Russia. That could be an effective inflation hedge as I described in the Chinese situation, but it’s also a form of wealth.
Iran is not very plugged into the global payment system. They’ve been in and out of SWIFT, and some of the sanctions are starting to ease up, but now the Trump administration is slapping them back on again.
Obama put them on through the end of 2013 to get Iran to the bargaining table. Once Iran came to the bargaining table to talk about the uranium enrichment program, Obama started to alleviate the sanctions, which he did to a great extent although not completely. Now that Trump is in, he is slapping sanctions back on again, because Iran is violating the agreement with missile testing.
This switching back and forth between sanctions and gold and dollars and missiles I hope makes my point that the geopolitical and the economic are converging and are very closely related.
For Iran, it’s an alternate form of wealth. Gold is fungible, it’s non-digital, you can’t hack it, you can’t erase it. If you take it to a refinery, even if you receive bars with serial numbers on them and assay stamps on them, big deal. Melt them down and make your own bars with your own new serial numbers. It’s an element; it’s atomic number 79. It’s completely untraceable. You can turn gold in one form into gold in another form. It’s still gold, but in such a way that it can’t be traced.
Iran’s motives are a lot more nefarious, and I talked about Turkey also. Turkey has confronted NATO and the United States. They’re somewhere between Iran and Russia in terms of looking for alternate stores of wealth on the one hand, but also thinking about what happens if they get kicked out of the financial system. How can they conduct trade and suddenly bounce payments?
Now let’s introduce North Korea. North Korea might be the most dangerous spot in the world. We certainly hear about confrontations in eastern Ukraine, the South China Sea, and the Senkaku Islands off of Japan. There are enough hot spots to go around, but North Korea may be the most volatile, the most dangerous.
North Korea is obviously testing intercontinental ballistic missiles. They don’t have one that works consistently yet, but they’re getting better at it and are moving in that direction. When they fire a missile and it fails or blows up or falls into the sea, everyone says they failed, but in their minds, they didn’t fail; they learned something. They are a learning organization, so failures are not really failures; they point to something that can be improved, and then you do better the next time.
They’re weaponizing their uranium and plutonium, making it smaller. They’re increasing the distance of their missiles. They’re not there yet, but they’re getting closer to being able to fire a nuclear missile at Seattle and kill millions of Americans.
We’re not going to let that happen, which means that the U.S. is set up to attack North Korea with air power, bunker buster bombs, and maybe something even more powerful than that to degrade and destroy their weapon systems, their enrichment programs, and their missile testing systems.
In the meantime, North Korea is going down this path. Why are they doing that? Well, 98% of their people are practically eating bark off of trees. They’re starving and suppressed, but a very small elite live fairly well with a lot of luxury goods. That’s how Kim Jong-Un bribes his own military commanders, spy chiefs, elites, and others – with Western goods and money.
How do they get money? They’re not integrated with the international monetary system, so one of the ways is gold. Why are they developing these programs? Do they really want to attack Seattle? You can’t rule it out, but what they really want to do is sell it to Iran to use against Israel, and Iran pays for it with gold.
If you were to do a dollar-denominated wire transfer payment from Iran to North Korea, it would be frozen by the United States. It wouldn’t go through. All dollar payments have to go through a U.S. bank or a member of what’s called Fedwire, a wire transfer payment system the United States controls. We would see that payment, stop it, and freeze it.
But if I put gold on a plane and fly it from Tehran to Pyongyang and unload it to pay for my missiles, that’s completely untraceable. It’s non-digital, there’s no message traffic, there’s nothing. You don’t even know what’s in the plane. It could be tourists or it could be gold, or both. It probably is both, because you don’t want to shoot it down and kill the tourists.
These countries are now using gold to settle payments between themselves for weapon systems and other illicit transactions in ways that are non-traceable, cannot be interdicted, cannot be hacked, cannot be frozen, etc.
That was the point I was making in the CSIF report. If you are the incoming Secretary of State or Secretary of the Treasury – you’re Rex Tillerson or Steve Mnuchin – and you have to deal with this in addition to all of the normal sanctions relief you may or may not be familiar with, you certainly have to come up that learning curve pretty quickly. There’s a new kid in town which is gold, and this axis of gold as I describe it is using gold to preserve wealth, get out of the payment system, and actually settle transactions including illicit arms transactions between and among themselves.
That’s in the report. I hope the listeners will go find it online at Center on Sanctions and Illicit Finance, CSIF, Foundation for the Defense of Democracies.
Jon: Thanks, Jim. That’s a fascinating outline.
I’m wondering, Alex, if you have any thoughts about Jim’s insights here.
Alex: Jim, it’s interesting that you mention that gold is being used in these ways and that it’s a relatively new method of doing it. You’re a student of history just like I am, so you know that this is a repeat of what has happened in the past. Gold has been used for thousands of years as international money, and I think that’s what you’re getting at.
If you look at central bank managers or governors of central banks or former chairs of central banks among the elite financial crowd, many of them don’t look at it as money, or at least they don’t say that when they’re in office. I found it interesting that recently the former Governor of the Reserve Bank of India, after getting out of office, did say that gold was in fact the best international money, and former Federal Reserve Chairman Alan Greenspan said the same thing.
Jim: Yes, we’re seeing more and more comments like that. I’m always fascinated by central bankers, and Alan Greenspan is a classic case. Before Alan Greenspan became Chairman of the Federal Reserve, he had a lot of positive things to say about gold going all the way back to the 1960s including through the 1970s and early 1980s before he was appointed Fed Chairman.
After leaving the Fed, he has given a series of public speeches where he had positive things to say about gold. The only time he didn’t have anything nice to say about gold was when he was Chairman of the Federal Reserve.
It’s almost as if you take that job and automatically shut up about gold, which tells you something right there, that it probably is important but they just can’t talk about it. Greenspan is an interesting case of a guy who has spoken candidly and favorably about gold before and after he was Fed Chairman but not during.
Jon: Speaking of Greenspan, let’s turn our attention to the U.S. for a moment. The opening weeks of this new administration have hardly been uneventful, and I welcome your thoughts on the likely impact on the markets of the Trump White House.
We’re spoiled for choice. There are so many factors here – Trump against Janet Yellen, trade wars, banking deregulation. Perhaps you could pick the factor with the most immediate significance and take it from there.
Jim: That’s actually a very tough question. First of all, you’re right; there’s no shortage of information or proclamations that are coming out of the White House about economic policies, whether it’s an actual executive order, pending legislation, a speech, or a tweet. We all wake up and read the President’s tweets to find out what’s going on. There’s a lot of stuff out there, and a lot of it is very significant.
Donald Trump has given some interviews. He said, “I go to bed around midnight or 1:00 and I get up at 5:00.” It’s like, “Okay, that’s four hours of sleep,” and he’s full of energy. He’s working 20-hour days. You hear stories about him calling generals at 3:00 am.
I think he’s driving his staff crazy, but he seems to have more energy than any of the people around him, and they’re all struggling to keep up. This is one of the most hyperactive administrations ever. You probably have to go back to Franklin Delano Roosevelt in 1933, but even then, I’m not sure they got as much done in 20 days. You always hear about the first 100 days of FDR, but this has only been 20 or 21 days of Trump and they’ve already turned the world upside-down, so there’s plenty to say.
I’d like to step back from that for a second and make a higher-level observation. Look at Trump’s individual statements; not just the President, but some of his cabinet appointees, members of Congress, people he’s working with, people on his staff, etc. Taken individually, there’s a lot of merit in many of them. I don’t agree with all of them, but who cares, that’s just my opinion. But a lot of them have merit.
Most of us think that cutting taxes is good because it’ll free up money for consumption and private spending or building infrastructure. It’s a good idea because our bridges, tunnels, and airports are falling apart, reducing regulation is a good idea, and so forth.
Individually, they sound like good ideas, but when you look at all of them, they don’t add up. There are some big contradictions and inconsistencies, and that’s what I’m focused on. It’s not so much a matter of being right or wrong; it’s just that if two things contradict each other, then there’s going to be a train wreck somewhere along the way.
Let me be very specific about what I mean by that. During the campaign, Trump complained that Janet Yellen was holding interest rates too low for too long. That’s probably true. I said they should have raised interest rates in 2009. I didn’t get much agreement at the time, but with hindsight, they skipped an entire cycle.
They wouldn’t be so desperate to raise them now during a period of weak economic growth and the late stage of a business cycle (which is not when you’re supposed to raise interest rates) if they had done their jobs and raised them in 2009 or 2010. But they didn’t. They missed a whole cycle and now they’re playing catchup, probably at the worst possible time.
They think two wrongs make a right, but they don’t. It’s just two wrongs. They should have raised them and then didn’t. They should not raise them now and they will, so they’ll probably mess up both times. They’re desperate to do that, but they did hold them too low for too long.
They probably had a good opportunity to raise rates last September 2016, but they did not do so because they were trying to help Hillary’s chances in the election. Trump has been critical of that. At face value, Trump wants higher interest rates.
There are two vacancies on the Board of Governors right now. These seats were left unfilled by Obama to help Yellen because he thought Hillary would win and she could fill the seats.
Oops, they’ve made a mistake there, because they didn’t foresee that Trump would win, and now Trump gets to fill those two vacancies. He’s going to have two Fed governors right off the bat. I would expect those announcements. There are some behind-the-scenes discussions with a couple of names being floated that I’ve heard about. We’ll see what happens, but I would expect those sooner rather than later.
Beyond that, Yellen’s term as Chairman expires next January. He’s clearly not going to reappoint her, so he’s probably going to pick somebody by December. They have to be confirmed by the Senate and ready to go by the time Yellen actually leaves in January.
There’s another governor, Dan Tarullo, whose role is regulatory matters. He’s not a monetary thought-leader in the way some of the others are, but he’s pretty strong on regulation. Trump will clearly appoint someone else to do the regulatory role, so I would expect Tarullo would leave because why would he stay if someone else just took his job?
So, Trump may get four appointments: the two vacancies – Tarullo and Yellen – and there are others coming out. Trump may get four or five out of seven seats to fill by the end of this year. That’s extraordinary and means that Trump can remake the whole Board of Governors.
He complained that interest rates are too low. Is he going to fill those seats with hawks so they’re going to raise interest rates? Well, hold on a second. Trump has also complained that the dollar is too strong; he wants a weaker dollar.
He accuses China and Mexico of currency manipulation. He also accused Germany and Japan of currency manipulation. Germany doesn’t have its own currency, they use the euro, so you have to point the finger at the ECB. Be that as it may, Trump has painted with a very broad brush and said that Mexico, Germany, Japan, China, and others have cheap currencies and that’s how they promote exports and cost Americans jobs.
This is currency wars 101. It’s what I wrote about in my first book, Currency Wars, a few years ago. I said at the time that they would continue for a long period of time, meaning 15 or 20 years. That book came out in 2011, so I’m not the least bit surprised that here we are in 2017 and not only are we still talking about currency wars, but they’re actually more urgent than ever because Trump is the President and he’s making a point of it.
Take everything I said in the last five minutes. Trump complains that interest rates are too low and he might appoint hawks, but he thinks that the dollar is too strong and he wants a weaker dollar. What happens when you raise interest rates? It makes the dollar stronger. It pushes in the opposite direction from a weaker dollar, which is what Trump says he wants.
There’s a basic contradiction there. You can’t have it both ways. You can’t have hawks raising interest rates and a cheap dollar at the same time, because higher rates make the dollar more attractive, money comes in, and the dollar gets stronger. That’s one problem.
Let’s take another issue called the border transaction adjustment or border transaction tax. This is something designed to promote exports and reduce imports, which would in theory reduce the U.S. trade deficit, help growth, create U.S. jobs in our export industries, and perhaps make it more attractive to manufacture in the United States instead of Mexico and China. This has been pushed by Peter Navarro, Dan DiMicco, Robert Lighthizer who is the designated U.S. trade representative, and some of the other inner circle members of Trump’s team.
What does it mean when you put tariffs on? You would tax imports with something like a tariff, and the cost of imports would not be tax deductible. If you’re a U.S. manufacturer and import components, you can’t deduct whatever you spend on those imported components from your taxes. In effect, it increases the cost of imports to a U.S. taxpayer.
Likewise, if you export items, the revenue from the exports is not taxable income. You don’t have to pay any tax on that. So, you lose your tax deduction on the cost of imports, you get a tax exemption on the proceeds from exports, and the combination of the two promotes exports and hurts imports. It acts like a tariff on imports. In effect, that’s what it is.
There’s another identity in economics, which is that savings equals investment in the aggregate. What happens when U.S. domestic savings are less than our investment which they are right now?
The United States spends more on investment, whether it’s housing or capital goods or other forms of infrastructure or long-term goods, than we save. The U.S. doesn’t save enough. Where does the difference come from? It comes from abroad, from overseas.
Foreigners invest dollars in our economy, and that’s how we make up the shortfall between domestic savings and investment. Where do foreigners get the dollars? They get it from running a trade surplus with the United States. They sell us stuff, we give them dollars, they take the dollars, and invest it back here.
There’s an identity there which is the shortfall between domestic savings and investment, which is exactly equal to the trade surplus of foreigners with the United States. It just has to be, because that’s where the dollars come from. They don’t come from Mars.
When you increase the cost of imports – in other words, when you put a tariff on or you do something like this border tax adjustment we talked about – and you increase the cost of exports, if that were the only thing happening, it would reduce our trade deficit. But then where would the foreigners get the money to make up the investment gap in the United States? And they have to.
The way that works out is that is that the dollar gets stronger. The stronger dollar offsets the impact of the tariffs. My imported goods could be French wine, a nice German pair of skis, a Japanese car, Chinese textiles, clothes you buy at Costco from Thailand, whatever it is. If the price of that goes up because of tariffs, the dollar has to get stronger so that the real price doesn’t change at all. In other words, the stronger dollar offsets the impact of the tariff. That’s how you adjust this global savings versus trade surplus identity that I described.
I’ll skip the economics lecture, but the bottom line is that all things being equal, tariffs make the dollar stronger because that’s how you offset the impact of the tariffs and maintain the foreign trade surplus that gets invested in the United States.
Once again, there’s a contradiction. Trump says he wants a weaker dollar, but tariffs would actually make the dollar stronger. There are other solutions including a collapse of investment so that you close the savings/investment gap by shrinking investment, but that would just throw the U.S. economy into a recession and nobody wants that.
Once again, we have Trump calling for a policy of tariffs or border tax adjustments on imports that would make the dollar stronger, yet at the same time, he wants the dollar to be weaker.
The reason I’m going through this in a lot of detail is to make the point that taken individually, these policies may have something to offer or they may not if you disagree with them, but collectively they don’t add up. Something is going to break.
What I expect is that the solution to this tariff savings shortfall issue I just described is inflation. If the dollar just gets stronger, that is by itself deflationary, but what if you generate inflation through easier monetary policy, i.e., we run larger deficits? The Fed accommodates the deficits. Well, that is what helicopter money is.
We get inflation. Now you may find that the nominal value of imports is going up, but the real value isn’t, because a lot of it is just inflation. You’d have a stronger dollar from imports, but you’d have a weaker dollar from monetary policy, and on net, you’d probably get inflation through higher input prices that would feed through the supply chain, etc.
Once again, I come back to gold. I can describe all this and give an economics lecture on it, but I can’t predict exactly how it’s going to turn out. I can tell you that not all these things will happen, because they contradict each other. The tariff thing flies in the face of a weak dollar. The Fed hawks fly in the face of a weak dollar, so you’ll probably get Fed doves, weaker dollar. You’ll probably get tariffs too, but they’ll solve that with inflation, and all roads lead to gold.
This is why gold is going up. Gold has gone up 10% in the past seven weeks from the middle of December until now. This is because expert traders look at the issues I’m describing and say, “There’s only one way out of this. There’s only one way to get to debt sustainability. There’s only one way to have larger deficits if that’s what Trump wants, which is inflation.”
People are getting ahead of that. Smaller investors should understand that this move in gold is not a normal blip or volatility; it’s actually being driven by a very fundamental understanding of the contradictions in Trump’s economic policies.
A lot of people remember election night when the returns were coming in and it became more and more apparent that Trump was going to win. Initially, the price of gold was soaring up to about $1330 to $1340 an ounce. It was a huge surge, and then it just hit an air pocket and went all the way down to I think a low of $1150 in mid-December.
Why was that? One reason was because in a very public way, Stan Druckenmiller sold all of his gold. Prior to the election, Stan Druckenmiller was one of the biggest bulls on gold. He acquired a very large gold position, some paper and some physical. Duquesne Capital is his family office/hedge fund. It’s not an open hedge fund; it’s a family office at this point.
When Druckenmiller saw that Trump was going to win, he said, “I was buying gold because I was worried about Hillary. Now that Trump won, I dumped all my gold.” People found out about that and said, “If Stan’s out of gold, I’m getting out of gold.” People sold their ETFs, this whole thing got a momentum, and gold went all the way down to the $1150 range, as I said.
Well, guess who’s back? Stan Druckenmiller is now buying gold. Now that the Trump train and the Trump euphoria are over, he’s looking at these contradictions and saying, “Trump really does want a weak dollar, and he’s in a position to get it because of his Fed appointments. A weak dollar means a higher dollar price for gold, so it’s a great price to buy gold.” He’s back in the market. Other people are getting tuned into this, and that is why gold is rallying. I would expect the rally to continue.
Alex: One of the things I’m hearing you say, Jim, is that basically all roads right now are leading to inflation, which also means that all roads are leading to gold as well.
I’d like to turn for a moment and talk about some core concepts. When I say core concepts, I mean the type of thing that you and I have discussed for years now and many of the regular listeners of our podcast are aware of. For people who are new to this podcast and the things we talk about, I recommend you go back and take a look at Jim’s first book, Currency Wars, and bring yourself current.
One of the most interesting things we’ve discussed since I’ve known you, Jim, is your description of capital markets as complex systems, and this is a view I’ve come to agree with. Why are capital markets complex systems? Would you talk a little bit about why that is? And for analysts using measurements such as VAR and other traditional tools, why does this matter?
Jim: Let me give you a fairly succinct version of that, Alex. As a lot of topics, I could deliver a two- or three-hour lecture on that, and I have, but let me give you the short version.
The question is, are capital markets complex systems? I think that is the most important question in economics today, and here’s why: There’s a difference between complexity and complicated. People use those two words interchangeably, and that’s fine in terms of everyday conversation, but in scientific terms they mean very different things, and I’ll explain why.
The models in use today by central banks, Wall Street, risk managers, etc. fall into one of two categories. One is equilibrium models. These assume that you have efficient markets, good pricing information, people are rational, they’re wealth maximizers, they act rationally, so the economy really works like a well-tuned Swiss watch.
Just in case it gets out of tune, every now and then there’s something economists call hysteresis, but basically something comes along and disturbs the equilibrium. It’s like your watch needs to be wound up because it’s running slow or whatever.
All the central banks have to do is come along, put a little pressure in the opposite direction, tip it back into balance, and then it’s like winding a watch. All of a sudden, it’s running like a Swiss watch again and it’s keeping very good time. An equilibrium model more or less takes care of itself, everything balances out, but just in case it gets out of balance for whatever reason, you can tip it back into balance.
The other model of risk management concerns events in capital markets. When I say events, I mean price goes up, price goes down, normal fluctuation or extreme fluctuation, panics, etc. That what’s called the degree distribution, which is how you compare the frequency and severity. How often do really severe things happen? How often do really small, little things happen? What’s the extent of both of those things?
Just imagine an X- and a Y-axis, a normal grid, where the vertical Y-axis is the frequency of the event and the horizontal X-axis is the severity of the event. The assumption is that it looks like a bell curve. A bell curve kind of smoothly slopes downward from upper left to lower right where the small events happen all the time, so you have high frequency and low impact. Extreme events happen almost never or at all, so by the time you get way out to the right on the X-axis (the really extreme events), the curve has come down and made a nice soft landing on the axis itself. In other words, the frequency is close to zero.
Extreme events never happen or happen very, very rarely, and common events happen all the time. That’s what’s called a normal distribution also known as the bell curve, and that’s the assumption behind a lot of risk management modeling including value at risk, which is the major model.
You have these two assumptions: 1) equilibrium models, and 2) normally distributed risk. Both of those things are empirically wrong, meaning it’s not just my opinion. You can look at data and the degree distribution of shocks and events in capital markets. You can actually look behind the operation, the system dynamics (capital markets), and see that empirically and analytically, those two models the central banks and Wall Street use do not correspond to reality.
If you have the wrong model, that’s pretty bad. It’s like thinking the sun revolves around the Earth. We all know that the Earth revolves around the sun, but for a thousand years or longer, people thought the sun revolved around the Earth. Try flying to the moon if you think the sun revolves around the Earth; you’re going to fail.
If you have the wrong model, you’ll get bad results every time. This is why central banks, the IMF, BIS, and others never see recessions coming, they never see panics coming, they never see anything like 2008 coming. They never see it coming, because they have the wrong models.
What’s the correct model? This gets back to your question on complexity theory. Imagine we were enrolling in the physics department at the University of Michigan or MIT, some fine school with a professor who knew nothing about economics. We wanted to go into the physics department and study complexity theory, and we were being taught by someone who didn’t know anything about capital markets. What would they teach us? What would they say a complex system is?
They would say it has four main parts or characteristics in determining whether a system is complex or not. The four things are diversity, connectedness, interaction, and adaptive behavior, so DCIA.
Let’s take them one at a time. In any system, you have what are called agents. Agents are the individual actors. An agent could be, in effect, a molecule or an atom if you’re talking about a radioactive element. It could be a person if you’re talking about getting stuck in traffic or trading, buying, and selling stocks. Whether it’s subatomic or at the human level, individual actors in the system are the agents.
The first thing you need is diversity of agents. If everybody acts the same, thinks the same, and responds the same, it’s not a complex system because there’s no clashing, there’s no divergence of opinion. There’s nothing to create unexpected outcomes.
Imagine it’s just a bunch of cave people in a primitive society all living in caves. If every one of those cave people thought exactly the same thing about everything, that’s a really boring system. That’s not a complex system. But if you have different points of view, now you have the beginnings of a complex system.
The second thing is connectedness. We have agents, actors in the system, with different points of view, but are they connected somehow? Can they find each other? If not, then again, that’s really boring. Everyone just sits in their cave and thinks what they think, but there’s no action. But in fact, if you all come out of your cave, sit around a campfire, and get into a discussion at night, now you have connectedness.
The third thing is interaction. We’re diverse, we think differently, we’re connected. Are we doing anything? Are we transacting in any way?
The fourth thing is adaptive behavior, i.e., my behavior affects your behavior, your behavior affects my behavior. We change what we do based on what we observe other people doing.
Again, to go back to the caveman analogy, the diverse cavemen come sit around the fire, they’re communicating, they interact, they all decide to go out and hunt for mastodon the next day. But one caveman goes in a different direction. Everyone else gets food but he doesn’t, so he thinks, “You know what? I better adapt my behavior. I better go with these other guys tomorrow, because that way I’ll get some food for my family.” There’s my caveman example illustrating these four things.
We can take these four things and apply them to physical elements, earthquakes, sunspots, or forest fires. There are many, many examples of complex systems, but let’s take what I just described and apply it to capital markets.
Do we have diverse actors? Of course we do. We have bulls and bears, fear and greed, long and short, leveraged and non-leveraged. We can get ten opinions on every stock or bond or commodity you want to mention, so yes, we have very diverse actors.
Are they connected? Absolutely. We have Thomson Reuters, Dow Jones, Bloomberg, chat rooms, telephones, e-mail, CNBC, podcasts. We are probably overly connected, but we’re certainly connected.
Are we interacting? Big time. Trillions of dollars of stocks, bonds, currency, commodity, transactions taking place every single day, every single minute. We’re transacting and interacting at a massive scale.
Finally, the last question is, do we have adaptive behavior? Well, of course we do. I just gave an example of Stan Druckenmiller selling his gold on election night. As soon as people found out, they went and sold their gold. We have adaptive behavior.
We’re four for four. The four key pillars of complexity theory taught by someone who knew nothing about capital markets, when applied to capital markets, reveal that capital markets are complex systems. They’re not only complex systems, they’re one of the best examples of a complex system you can think of.
It’s an interesting lecture, but what is the significance; what does it mean? The significance is that risk or events in complex systems are not normally distributed. They’re distributed according to a different curve called a power curve, not a bell curve.
It’s not just an argument about the shape of two different curves; those two curves are simply manifestations of events in the real world that have a completely different characteristic, different reaction functions, different frequencies, different severities; everything about it is different.
The minute you go through the looking glass and say, “Capital markets are not complicated systems with normally distributed events; they’re actually complex systems with events distributed along a power curve,” you have entered a completely different risk profile, a completely different way of understanding the world.
That’s what I do in my own analysis. Those are the models I use. The point being that if you’re stuck in the failed, incorrect, obsolete view that risk is normally distributed and systems operate in a kind of complicated equilibrium, you are going to miss everything. You’re going to miss every turning point, every crisis. You’re going to lose money and get wiped out every seven or eight years.
On the other hand, if you can embrace complexity theory, understand it, apply it, and see that the risks are far greater than what Wall Street tells us and that the worst thing that can happen is exponentially greater than what Wall Street believes and that the frequency is a function of scale and the scale keeps getting bigger, which means the frequency of the severe events gets exponentially bigger, you’ll be scared to death. You’ll look at the system we have and say, “It may not break down tomorrow, but actually, it could, and we could get completely wiped out.”
This is another reason to have gold in your portfolio, because gold will withstand these extreme events much better than other kinds of financial assets.
Alex: Outstanding. I love the caveman analogy. That’s really great. As far as all these indicators most financial professionals are basing what they’re doing on but is really based upon false assumptions, to me it’s like being on an airplane. You have all these indicators, but they’re feeding you information off false data. As you mentioned, that is a pretty scary situation.
We have a little bit of time left and want to go to a question from one of our listeners. We like to do as much listener interaction as possible, so for those of you who want to ask questions for the podcast, you can always submit them by e-mail to us at our website or ask directly on Twitter. We get those, and when we can, we include them.
This is a Twitter question coming from a user by the name of Absolute Hokies. That’s an interesting handle there! In reference to Triffin’s dilemma as it relates to the border adjustment tax, repatriation of funds, and Fed hikes, his question is, “Doesn’t BAT repatriation counter Triffin’s dilemma forces regarding dollar movement? And if so, does a stronger dollar worsen the debt crisis?”
Jim: That’s a compound question. I spent a little bit of time talking about the impact of border adjustment tax, and what I said was that if you impose it, it’s a kind of tariff. The reaction function would either be a collapse of investment because there wouldn’t be enough of a foreign surplus to fund the investment deficit so investment would collapse which would put the U.S. economy into a recession and be deflationary, or the dollar would get stronger to offset the higher input prices so that the foreign surplus can be just as big and they could fund the investment shortfall.
Either way, you end up with deflation or a stronger dollar. The deflationary impact of a stronger dollar offsets the inflationary impact of the tariff, and so the combination of the two is net neutral. It doesn’t really go to Triffin’s dilemma.
For the benefit of our listeners, Triffin’s dilemma goes back to the 1960s. It was named after a Belgian economist named Robert Triffin who spoke about when a country issues the global reserve currency. That is the situation with the United States, it was then and it is today. Today, U.S. dollars are 80% of global payments and 60% of global reserves, so it’s the dominant global reserve currency.
The world needs dollars to conduct transactions, it needs dollars to pay each other, it needs dollars to hold its savings, etc. Where do they get them? They get them from the U.S. trade deficit. If the U.S. ran a trade surplus, we’d be sucking up all the dollars in the world.
It’s only by running a deficit that we spread dollars around the world. Other countries earn the dollars from us, and then they have dollars to buy oil or things in the United States or invest or whatever they need.
Triffin’s dilemma said if you run the global reserve currency, you also have to run persistent deficits. If you don’t, the world won’t have enough of your currency for commerce to grow. But if you run persistent deficits, eventually you’ll go broke. In other words, the dilemma was that the thing you need to do to supply the world with dollars will eventually cause you to go bankrupt because your deficits will catch up to you.
He said this in 1960, and it’s turning out to be true. It took 55 years to play out and there were a lot of strong dollar/weak dollar episodes along the way, but the bottom line is that what Triffin predicted 55 years ago is playing out today, which is that the U.S. is going broke. Our debt is not sustainable, and we’re getting closer and closer to a dollar crisis every day. That’s Triffin’s dilemma.
Now, the border adjustment tax doesn’t really affect that one way or the other. I don’t want to put words in anyone’s mouth, but I think what the listener was getting at is, if you have a border tax adjustment, doesn’t that reduce the trade deficit and solve Triffin’s dilemma?
The answer is, no. If you get a stronger dollar as a result, the higher price of imports is offset by the stronger dollar, meaning you get more for your buck, so the trade deficit for the U.S. and the external trade surplus in dollars is the same. The exchange rate adjusts to offset the impact of the tariff, so the net effect on the deficit or surplus is the same, and therefore there’s no impact on Triffin’s dilemma.
Having said that, the whole issue with Triffin’s dilemma is coming to a head. The solution to Triffin’s dilemma is not the U.S. trade deficit or surplus; it’s the SDR or special drawing rights. The SDR is a form of world money issued by the IMF, and the IMF is not a country. The IMF doesn’t have a trade deficit or a trade surplus because it’s not a country. It just pulls the money out of thin air.
For foreigners to get dollars from the U.S., they have to earn them by running a trade surplus with the United States. That means we have a deficit; that’s Triffin’s dilemma. But for foreigners to get SDRs, they don’t have to do anything. They just have to wait for a phone call from Christine Lagarde, and she says, “Here are your SDRs.”
The real solution to Triffin’s dilemma is the SDR, but the impact of that is certainly inflationary, which, in my view, is one more reason to own gold.
Alex: Very good. Jim, I want to thank you for your time. It’s been an excellent discussion. And thank you to all of our loyal listeners.
Jon: Yes, thank you, Jim Rickards. This is fascinating new material. And thank you, Alex. It’s always a pleasure and an education sharing this time with both of you. Most of all, thank you to our listeners for spending time with us today. Let me encourage you to follow Jim and Alex on Twitter. Jim’s handle is @JamesGRickards, and Alex’s handle is @AlexStanczyk.
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