THE GOLD CHRONICLES
with James Rickards and Alex Stanczyk
Commentary on FOMC and Rate Hike
How VAT may enable a revenue neutral solution to allow Trumps fiscal and tax cuts plan
One of the dangers to VAT is that it is prone to a creeping rise in the tax rate
Scenarios for consumer reactions to VAT perceived as price inflation
How increasingly fragile markets combined with highly leveraged financial services institutions are leading to amplified risk levels for the entire financial system
Market fragility from Jim’s view is a function of system scale – if you double the size of the system the risk increases exponentially
The system has not deleveraged since 2008, but has increased leverage and concentrated in an even fewer number of banks
The derivatives market is approaching one quadrillion dollars in size, approximately ten times the size of global GDP
Nation debt levels, debt ceiling, comments on the math of servicing the increasing debt burden in consideration of the debt to GDP ratio
The first $20T of US Government debt is treasury debt, with a debt to GDP ratio of about 105%, and it does not include contingent liabilities such as social security and Medicare
If counting contingent liabilities, it brings the US debt number to more than $100T, and the debt to GDP ratio closer to 1000%
The most likely path out of the current debt for the US is inflation, which means inflation is ultimately required and likely
Alex: Hi, Jon. I’m excited to be here and looking forward to today’s conversation.
Jim, you just recently got back from South by Southwest. Before we jump into this, do you have any interesting insights you’d like to share from this event?
Jim: You’re right, I just flew in from Austin the other day. It was my first time at South by Southwest although it’s been going on for a long time and has a great following. It’s an interesting mixture. They have expanded the menu, so now they have a film festival for a few days, then they switch to tech and interactive for a few days, and then they finish up with music, which is the root of South by Southwest – that’s how it all began.
It’s a mixture of techno geeks, spring break partiers, music producers, and talent. They block off all the streets, so it’s a little like a street fair similar to New Orleans at Mardi Gras.
The highlight for me was being able to participate in the launch of a new media platform along with a number of other participants who were there. I actually got to play a few hands of Texas Hold’em with Phil Hellmuth. For listeners who may not know, Phil is the 14-time world champion of poker. It was like sparring in the ring with Muhammad Ali back in the day. People could not have been nicer, and we had a lot of fun, so I certainly enjoyed that and met a lot of other great folks.
Phil did have some interesting insights. As a world champion of poker, you’d obviously figure him to be a smart guy with great intuition and a very sharp, incisive mind. We talked a little bit at lunch before our poker game about efforts to create algorithms that could beat him or anybody at poker, basically poker-playing algorithms.
There’s a long history of that with IBM trying to beat Garry Kasparov, world champion at the time in chess. I had occasion to talk to Garry about it. He knew his days were numbered although he actually defeated a couple of IBM programs, and finally they came up with one called Blue Gene that was able to beat him.
I had lunch with him before that contest, and he said, “I’m going to beat them next time and they’re going to beat me the time after that, because I can sort of reverse engineer what their developers are doing.” Of course, there’s nothing random in chess. It’s a deep game, but it’s kind of a mechanical game in the sense that there is a “finite” number of moves and results, although I’d put that in quotation marks as it’s quite a large number.
Poker is different than chess because you have more of an element of luck. Phil said to me that he’s been playing some of these algorithms, and he beats them routinely. The reason is that nothing in artificial intelligence has been able to come close to a poker player’s intuition about fear, spotting a weak hand or understanding when the other guy is bluffing. These are things that no amount of automation is quite up to yet.
I found it an interesting insight, and you know me, I obviously carry that over to the gold and financial markets with all the high-frequency trading and automated trading. I think 90% or more of trading on the New York Stock Exchange these days is completely automated.
The ability to – as Phil put it – smell fear in markets and human nature’s herding instincts crowding in and then everyone trying to go for the exits at once, those are the things you can’t automate. Investors always need to bear that in mind. I think there are some lessons there for gold investors and investors in other assets as well.
Alex: I have to agree with that entire element of being able to spot what’s going on with the crowd and just sense that. I’m not sure we’ll be able to teach machines how to do that, but it’s definitely an interesting topic.
Let’s turn our attention now to markets and the recent FOMC meeting. Your track record of predicting U.S. Fed moves is one of the best there is. As you are aware, the Fed just hiked interest rates. It seems the FOMC is divided in its views, though. Members of the Fed such as the Atlanta Fed don’t really see eye to eye with Yellen’s narrative.
We know that the Fed does not have the best record for forecasting the economy. Talk to me a little bit about why this matters and what you think the Fed is going to end up doing moving forward for the rest of the year.
Jim: I have been able to call Fed moves with a lot of accuracy going all the way back to September 2013. That was not long after the famous taper talk by Ben Bernanke in May of 2013.
At the time, they were nowhere near raising interest rates, but he said, “We might begin to reduce our asset purchases.” In other words, reduce money printing. Although he didn’t do it in May, he just said, “We’re thinking about it.” Well, by September, the entire market was poised for that move, but I said it wouldn’t happen. It didn’t then and finally did a few months later.
The same thing happened in September 2015 with the market poised for what they called liftoff, which was the first interest rate hike. That was long after they had finished the taper, so there was no more money printing. They were still printing money to roll over maturing assets, but they weren’t expanding the balance sheet. That ended in late 2014 and took all the way until September 2015. There was a lot of expectation about liftoff; again, I said they’re not going to lift off. They didn’t, and that happened once more three months later. The first rate hike was in December 2015.
Then in late 2014, I was saying they would not be able to hike rates in all of 2015. Meanwhile, the markets were predicting March, June, September, and December for rate hikes. Through eight meetings, it was no, no, no, they didn’t hike rates. It was finally clear in December 2015 that they would.
About three months ago, in December 2016, I called for the most recent hike on March 15th and the market expectation in Fed funds futures contracts as implying a probability of a rate hike. That’s the wisdom of the crowds. The considered judgment of all market participants had it at 28% December and 30% through February. I was forecasting 75%, 80% and basically leaning clearly to a rate hike.
Suddenly, in the three trading days February 28th to March 2nd, the probability skyrocketed to 50%, then 80%, then 90%. By Fed day, March 15th, everybody was at 100%. That was easy, but there were two months there when the markets were 30% and I was 75% – 80% before we all converged at 100%.
Here’s what I would say about that: I don’t have a crystal ball. It’s not like I’m doing some mumbo jumbo to figure this out, and I’m absolutely not smarter than my peers or the other people doing this. I know a lot of the quants and PhDs and friends on Wall Street who are all pretty smart.
All I have is a better model that is unbelievably simple. It’s not like you need IBM’s Watson to do your processing for you. As I’ve said all along – and we have discussed this many times – if you have the wrong model, you’re going to get the wrong forecast every time. If you have the right model, you have a much better chance of getting the forecast right.
So it’s really just about the model. I’m always happy to explain that to our listeners, because the thing is, the model works. It is your best guide to what’s going to happen with the Fed moving forward.
Of course, that has implications for the price of gold. There’s some extent – not perfect by any means, but some extent – to which the price of gold is correlated to the value of the dollar, and that in turn, ties to interest rates. So if you can get the Fed forecast right, you can at least have some insights into what’s going to happen with the price of gold.
Alex: Let’s talk a little bit about Trump’s fiscal plan and how this is going to work in terms of tax cuts he wants to make, etc. We’ll keep in mind his fiscal plan as it’s already been outlined, as well as we’ve recently been reminded that the U.S. government is now dealing once again with the so-called debt ceiling. This is an issue that keeps coming up and doesn’t seem to be going away.
You’ve recently suggested that perhaps VAT may be a way for Trump to cut taxes and get the fiscal program he wants. VAT is an acronym for value-added tax and is pretty common in Europe.
Would you briefly explain what VAT is, and do you consider Trump’s plan doable if VAT is made into law?
Jim: I’d be happy to do that and also talk about the impact of it, but to properly address that question, it has to be put in a broader context of the global economy – or if not the global economy, at least the U.S. economy which is a big part of the global economy.
VAT or value-added tax is very common around the world. The United States is the only major economy that does not have a value-added tax. The Treasury has wanted one forever going through Republican and Democratic administrations for decades.
Part of my background before I started doing more economic work and writing was spending the first ten years of my career as international tax counsel for Citi Bank, one of the world’s largest financial institutions. I had experience as a tax lawyer, so I’m pretty familiar with the ins and outs of this.
You can think of value-added tax as kind of a sales tax, but there’s a little more to it than that because there’s a value chain. They start with raw materials and inputs, then they sell to a manufacturer, then they sell to a distributor, then they sell to wholesale, then they sell to retail, and then retail sells to you and me. You actually apply the VAT at every step in this whole chain only on the portion of the value that you added. That’s why they call it a value-added tax.
There’s a wholesale element to it, but it’s basically a sales tax. Every time you sell your goods, whether you’re in the intermediate stage of the value chain or the end stage, you charge the value-added tax for the increase in the value relative to what you paid. It’s kind of like a super sales tax.
The reason the Treasury loves it is that it generates a ton of revenue and it’s also easy to sneak up on people. Maybe it would start at 3% or 4% (I’ll make up a number), and the next thing you know, it’s 5%, then it’s 7%, then it’s 8% like state sales taxes. I think our listeners have experience with state sales taxes that seem to only go one way, up and never down. Be that as it may, it’s a great revenue raiser and a way to pick people’s pockets.
The reason this is important is that it plugs into Trump’s bigger-picture fiscal plan. Getting back to the stock market and ultimately to the gold market, his fiscal plan is to cut taxes and add $1 trillion of infrastructure spending. The third leg of the stool is regulatory reform, but let’s leave that to one side for a moment although I think that’s positive for the economy.
Basically, he wants to cut taxes and spend more money, which implies bigger deficits. Congress is saying, “Hold on. We’ll consider the tax cuts,” but they have to be what they call revenue neutral, which just means that if you’re going to cut them in one place, you have to raise them someplace else.
What kind of tax cuts does Trump want? As Trump would say, they’re huge or amazing. He wants to cut the individual tax rate from roughly 39% to 33%, the corporate tax rate from 35% to maybe 25%, and he wants to bring back offshore earnings at maybe some favorable rate, 15% let’s say. All of this would cost the Treasury money relative to what they think they would get in a static projection.
The question Congress is asking is, “If you’re cutting those taxes, where are you going to raise taxes to make up the difference so that we don’t have larger deficits?” Think about that for a second. If it’s revenue-neutral and doesn’t increase the deficit, where is the stimulus?
Consider the whole idea of John Maynard Keynes as an economist. I’m not a Keynesian in terms of deficits as far as the eyes can see, but if you believe in Keynesian stimulus, you’ll say, “When the economy is as weak as it is now, deficit spending might be a good thing,” but if your tax cut is revenue-neutral, then there’s no additional deficit spending, so it’s hard to see where the boost is coming from.
It’s actually a little worse than that, because you have this concept of the marginal propensity to consume, which varies depending on total income and wealth. The issue is if you get an extra dollar in your pocket, what are you going to do with it? Are you going to spend the whole dollar, are you going to spend nothing and stick it in the bank, or are you going to spend 50 cents?
When you cut income taxes from 39% to 33%, that benefit mostly goes to people making $250,000 all the way up to $1 billion a year. They’re the ones in that tax bracket. Throw on a value-added tax or even something else called the Border Adjustment Tax, which is the other one that’s in the running that is highly regressive, meaning you’re taxing people who can barely get by.
If you have to go to the store and buy food for your family or you have to go buy clothing at Costco or you have to do any kind of shopping at all and you’re paying the value-added tax, then you’re paying that tax even though you might be poor or you’re just marginally getting by.
Whereas let’s think about those making $1 million a year, a pretty rare category. For people in that category, if they get a tax cut, are they really going to spend much more? Probably not. The people making that kind of money probably have three cars, five TV sets, two houses, and they take nice vacations already. Are they going to buy another house or take another vacation? Maybe, but probably not. They’re probably going to invest the money or save it.
The point is, if you cut taxes on people with a low marginal propensity to consume, they’re not going to spend a lot more, and if you raise taxes on people with a high marginal propensity to consume, meaning it really comes out of their pockets so maybe they spend less, that’s a headwind for the economy. That actually hurts what’s called aggregate demand; it hurts the economy.
So now you have two things going on. One is you’re revenue-neutral, so there’s no Keynesian multiplier or Keynesian stimulus. There probably wouldn’t be much of one anyway, but now you’re going to get none if you’re revenue-neutral. Plus, it’s not neutral in terms of consumption; you’re actually hurting consumption.
Now, there are advocates for them long term, but short term, this is going to basically cause the economy to slam on the brakes. I don’t understand why the stock market is so euphoric over Trump’s plans, because when you look at them, it’s hard to see where the stimulus is coming from.
The stock market does look like a bubble to me. That doesn’t mean it can’t go on. One of the lessons of bubbles is that they go on a lot longer than you think, so I’m not predicting that the bubble is going to burst tomorrow, and I’m not saying people should run out and short stocks. What I’m saying is we’re well into bubble territory.
As a very simple example, in early November right after the election, the stock market (I’ll use Dow Jones) went up a thousand points based on the Trump fiscal plan and tax cuts. Then in December, they came out with some more detail about the timing, and it went up another thousand points on the tax cuts. And then in February, around the time of the President’s address to Congress and they had more details along with Secretary Mnuchin adamant about getting it done by August, the stock market went up another thousand points.
I’m looking at that and saying, “Hey, you just rallied three times on the same news.” There aren’t going to be three tax cuts; there’s only going to be one tax cut, but the market rallied three times on the same news. That’s bubbly behavior, and it looks like the market is way ahead of itself.
There’s a lot more to say, but I’ll wrap it up there. Some of this reality – meaning the stimulus is not going to be as great as expected, the impact of the tax cuts are not going to be as great as expected, and the whole thing is going to take longer than expected – is going to be a bit of a wakeup call for the stock market and could combine with other things to give us a serious correction, maybe down 10% or so by the summer.
Alex: I have a follow-up question to the VAT topic. Instead of consumers looking at it and thinking it is additional tax, is there a scenario where VAT could be perceived by consumers as prices of things going up? Could this be some sort of psychological trigger that could accelerate the velocity of money or an inflationary-inducing kind of effect?
Jim: It could be, and that’s a very good question. In fact, prices will go up. I’ll leave it to the people at the Commerce Department to sort out how they want to define inflation, but if you have something that’s $100 and you slap on 5% VAT, suddenly it’s $105.
The talking heads and people on financial television will tell you, “Oh, don’t worry about it. It’s not inflation; it’s only a tax,” but I’m not sure the average consumer would think of it that way. If they’re paying $105, that’s 5% inflation overnight.
There are other weird consequences such as we’ve seen in Japan, which is if they announce an effective date, you might actually get a short-term boost in consumption. That would be good short-term for the economy, because everyone will run out and buy stuff before the effective date. If they said “This is in the bill that’s going to pass Congress with an effective date of September 1st,” you might see everyone at the end of August shopping like crazy to beat the sales tax or value-added tax.
That did happen in Japan, but it’s only a Kool-Aid high. It’s a short-term boost, because the day the tax comes into effect, the economy falls off a cliff. All you did was bring the entire aggregate demand forward to get ahead of the deadline.
It’s still early days since this bill has to wind its way through Congress, but I know the value-added tax is getting a lot of consideration and always has.
I spoke to top people at the tax section of the American Bar Association. These people are career professionals, they’re lawyers who talk to the Treasury on a regular basis about policy. One of those top people said to me a couple of years ago during the Obama administration, “The Treasury has given up reforming the internal revenue code. It’s just too much of a mess. The only way they see that we can keep the U.S. from going broke and raise revenue is with a value-added tax, with a VAT.” That’s the default position.
With the Trump administration and Congress saying you have to be revenue neutral and Trump committed to income tax cuts, there’s no way to square that circle without a big revenue raiser, and VAT is the biggest thing out there. We have to keep an eye on it. It may be coming, but it can have these weird effects of bumping inflation.
There are offsetting forces, and that’s what makes it tricky. On the one hand, sticker shock at the counter might give you an inflationary mindset. On the other hand, if everyone is running around spending before the tax and then not spending after the tax, that can actually be deflationary if aggregate demand drops and the economy runs into a brick wall.
The problem with all this is it’s not difficult to define theoretical outcomes based on what we know, but because these things are behavioral and psychological – what I call emerging properties of complex dynamic systems – basically we’re manipulating behavior and shouldn’t be surprised if we get some very bad results.
Alex: I had a really interesting conversation with a friend of mine whom you also know named Ronnie Stöferle. He manages a fund out of Lichtenstein called Incrementum. Our conversation was around this idea of fragility in markets. It seems clear to me, and to observers like Ronnie and other people I consider to be very smart, that the markets are becoming increasingly fragile.
If we can pick up on a comment you made in a recent interview, you said that companies most vulnerable to financial turmoil are those that rely heavily on high leverage and financial engineering to produce returns. You included banks in that category, and you forecast some potentially dire outcomes and consequences to this.
For those of our listeners who are new to these concepts, touch on why these are legitimate concerns and more likely to play out than not.
Jim: You’re right; I do know Ronnie very well. He’s a great guy and very astute market analyst. I call him an Austrian for the 21st century, meaning he’s a follower of Austrian economics but he’s followed a lot of recent development in economics and theoretical approaches to it. He brings that Austrian mindset but with a lot of really good, up-to-date technology. I think he is one of the sharpest commentators and fund managers out there.
Let’s address the issue of fragility and the impact of leverage by starting with leverage. Leverage is a pretty simple thing to understand. It means borrowed money that could be derivatives, off-balance-sheet contracts, futures and options which have embedded leverage, or it could be outright borrowed money.
It means you get more of whatever you’re betting on. If I buy a stock for cash and it goes up 10%, I made 10% at least on a mark-to-market basis. But if I buy stock on margin, borrow half the money, and it goes up 10%, I don’t owe any more debt. I owe the original debt, so I actually made 20% because I only had 50% equity. My 10% return becomes a 20% return if I bought it with half borrowed money, because I’m making the same amount of profit on half the investment, so obviously that gets a higher return.
Naturally, it works in reverse. You can lose twice as much money. If you leverage ten to one, you can lose ten times as much money.
What leverage does in any form, whether it’s outright debt, a note, or a derivative contract of some kind, is just amplify your return. Depending on the amount of leverage, you’ll make twice as much or ten times as much or a hundred times as much, and you can also lose just as much.
If you’re on the losing side of a highly leveraged trade, a very bad thing happens, which is you go bankrupt. In other words, if I have $1 million and I leverage it ten to one so I have a $10 million bet with $1 million of equity and $9 million of borrowed money, if my $10 million bet goes down 10%, I’ve lost 100% of my equity because I’m leveraged ten to one in that example.
It only takes relatively small market moves to completely wipe out your equity and force a bankruptcy. This is what was happening in 1998 and 2008. It happens to individual firms along the way. You see people making these leveraged bets over and over. That’s the impact of leverage.
Now you get into something called contagion. The IMF likes to call it spillovers, but it’s the same thing. You make a big leveraged bet, and if you win, it’s nice because you make a lot more money – everyone likes that. But if you lose, you don’t just lose more money, you actually wipe out your equity and go bankrupt, so you walk away from the table.
Let’s presume you have trading partners. The thing about trading and capital markets (money markets, stocks, bonds, etc.) is that as Paul Simon once said in a song, one man’s ceiling is another man’s floor. One firm’s mark-to-market loss is somebody else’s mark-to-market gain.
If the loser goes bankrupt and the person on the other side of the trade who had the gain goes to collect his winnings and the guy is not there, it’s like he won at the casino, took his chips over, and somehow between the table and the cashier, the casino shut down and went bankrupt. He’s basically sitting there with a bunch of plastic or rubber chips and can’t get his money.
Now the guy on the right or winning side of the trade might find that he’s in financial distress, not because he made a bad trade, but because he had a bad credit by doing the trade with a person who’s no longer there.
This is exactly what happened with AIG in 2008. AIG had all the losing bets. Goldman and Citi Bank and many others had the winning bets, but when they turned to AIG to collect, AIG was practically bankrupt and couldn’t pay. The government had to bail out AIG, not because they loved AIG, but because they said, “If we don’t bail out AIG, all these other firms, starting with Goldman, are going to go bankrupt.”
That’s how the danger spills over or there’s contagion. Think of it as like a disease where one person infects another and it just gets worse. All of a sudden, we go from individual hedge funds, small institutions, and individuals to some dealers going bankrupt, then they have a clearing broker who goes bankrupt, and next thing you know, it’s threatening the solvency of the entire futures exchange or derivatives exchange or banking system as a whole. That’s how it spins out of control and fragility comes in.
That’s well understood, meaning people have observed that many times. Credit officers try to prevent it by not permitting that much leverage, but they never get it right. So much of it is hidden, so much of it is off balance sheet, so much of it migrates to new ways.
The regulators are always fighting the last fire. After 2008, they were very determined to make sure we didn’t have another housing credit crisis. I don’t think we’re going to have another housing credit crisis because it’s extremely difficult to get a housing loan right now. But how about dollar-denominated emerging markets debt? How about the high-yield market? How about various forms of derivatives? How about buyout loans that corporations take out to buy back their own stock or pay dividends?
There are a whole host of other areas where this problem could emerge. Just because regulators went around and cleaned up the mortgage market doesn’t mean they have a good handle on all those other things.
Let’s burrow down inside the off-balance-sheet commitments of a major bank where we get into things like asset swaps. An asset swap would be if I want to borrow money but the person I’m dealing with only takes high-quality collateral, let’s say treasury notes, and I have a bunch of garbage corporate bonds on my books. I go to a mutual fund or a pension fund and say, “I’ll swap you my corporate bonds for your treasury notes on agreement to swap back.” It could be one week, one month, an overnight trade or whatever, but I’d give a whole bunch of corporate stuff as collateral and they’d give me treasuries.
Then I turn around and pledge the treasuries to the first guy who didn’t want my corporate junk but he will take the treasuries. I’m swapping corporates for treasuries so I can do another deal where I post treasuries as collateral, get some other line of credit, and add some more leverage on top of that.
This asset swap is an off-balance-sheet transaction; it’s invisible unless you know where to look. What started out as a two-party trade between the bank and the counterparty turned into a three-party trade between the counterparty, the bank, and the pension fund in my example. Instead of two assets being swapped, you get three or four.
This goes on all the time. All these conversion futures, asset swap futures, and off balance sheets are expanding, and this is where we now segue into complexity theory and how I really think about markets.
To Ronnie’s point that markets are getting more fragile, I think that’s right, but I would say they’re always fragile to some extent. The question is, how do we think about the risk? How do we measure it?
The way I think about it is in terms of systemic scale. Scale is just a fancy, more technical word for the size of the system. The point is the risk of the system. I’ll define risk as the worst thing that can happen, so what’s the biggest meltdown, the biggest collapse, the most contagion, the 2008-type of event? What’s the biggest disaster that can happen in the system?
Intuition says if I double the size of the system, I probably double the risk. If I triple the size of the system, I probably triple the risk, although the value-at-risk jockeys, risk managers on Wall Street, wouldn’t even say that. They’d say no, you can double or triple the system and increase the risk not at all or very little, because it’s long-short, long-short, long-short. In other words, you’re pairing off all these trades that net out to a small number, and it’s only that small number that really reflects the risk.
This is complete nonsense for the reason I mentioned earlier. That way of thinking about risk is fine when nothing bad is happening, but the minute something bad happens, you don’t get to pair off, because there are two different counterparties, and now you’re worried about the counterparty of your winning trade.
You’re stuck with the losing trade. The winning trade that supposedly pairs off from a market risk perspective all of a sudden has the guy going bankrupt. The market risk converts into credit risk, so you still lose and go bankrupt yourself. That’s why value at risk has no capacity to deal with it at all.
Leaving that aside, the value-at-risk people would say risk is very little. The people using intuition would say you double the system and the risk. The fact is, if you double the system, you don’t double the risk; you increase it exponentially by perhaps a factor of ten or even more.
As we see these off-balance-sheet relationships, derivatives, outright leverage, and hidden asset swaps all grow, think to yourself, the system is not just getting riskier; it’s getting exponentially riskier.
We’re at a point now where the biggest banks are bigger than they were in 2008 with a higher percentage of total banking assets. The off-balance-sheet exposures are larger. The amount of debt in the world is significantly larger.
The notion that we deleveraged the system since 2008 is nonsense. We’ve not only increased the leverage – meaning the debt and the derivatives – but we’ve concentrated it in fewer and fewer hands. This makes it even more dangerous and more likely that one party in distress is going to take down the entire system.
What I expect based on very good science – not just my gut but you can actually see it unfortunately in front of your eyes – is a new collapse coming that is far worse than what happened in 2008. I think that’s Ronnie’s point, and I agree completely.
Alex: This reminds me of a quote I heard that went along the lines of financial services today consisting of the dark art of shuffling and reshuffling the same paper assets over and over again in order to generate larger and larger returns.
On a scale perspective, give people an idea of how big this has gotten, the derivatives market. How big is this in dollar terms, and how big is it compared to everything else?
Jim: It’s getting close to a funny number that is called $1 quadrillion at notional value. It’s a little bit lower than that, a little over $700 trillion, but is converging in on $1 quadrillion. $1 quadrillion is $1000 trillion, so take a second to get your mind around that.
That is approximately ten times larger than global GDP. Global GDP, the entire value of all the goods and services in the world, is approximately $70 trillion and the gross notional value of derivatives is approximately $700 trillion, so derivatives are ten times larger than global GDP.
Think of global GDP as the real economy, real stuff that we buy or make and sell, services we provide, etc. The derivatives are ten times that. Going back to what I said earlier, when you throw ten times leverage on something, it only takes a 10% drawdown to wipe you out.
A 10% drawdown on the gross notional value of derivatives would wipe out the entire global economy. Those losses would be larger than the total output of the world. That’s a pretty daunting thought.
Now take the second point I made, which is that it’s not linear, meaning when you scale up the system, the risk grows exponentially. This would be like an extinction-level event in archeology, geology, cosmology, and biology when all those sciences converge in different ways and have what is called an extinction-level event like when a comet or an asteroid hits the Earth and causes massive tsunamis, volcanic eruptions, black clouds, freezing temperatures or ice ages with a very high percentage of all life on Earth killed. There would be a few survivors, remnants, and then little by little, over millions of years, we would claw our way back to some kind of life. This is what happened to the dinosaurs and has happened more than once throughout history.
We could be looking at an extinction-level event in capital markets.
Alex: The thing that is really concerning to me – and I’m sure others have thought of this, too – is the people who are driving these airplanes, so to speak. All of these derivative books are managed by human beings. What comes to my mind is that human beings are not infallible, as you well know. My question is, do these people actually know what they’re doing?
You had a front-row seat to a situation where the smartest guys in the room were running big money, and they could do no wrong. What is your view on that? Do they know what they’re doing? What is the chance that they don’t know what they’re doing, and that could really lead to some bad results?
Jim: You’re right; I was Chief Counsel of Long-Term Capital Management. We had 16 PhDs in finance from Harvard, MIT, University of Chicago, Stanford, Yale, Colombia, and some others – what I call the usual suspects. Two of them won the Nobel prize. It’s an interesting mix. They were basically the biggest brains in finance.
We even had complaints from deans of some graduate schools of finance that we were depriving academia of the next generation of scholars because we were hiring so many top-flight PhDs to come work for us.
There was no shortage of brainpower, but they absolutely did not understand risk or any of the things we’ve been discussing on this call. I wasn’t particularly focused on it at the time I was there as a lawyer making sure the contracts got done, making sure compliance was good, and negotiating deals. I knew what was going on and saw all of the contract flow, but I was seeing it from a lawyer’s perspective instead of the financial risk management perspective.
It all blew up, and we brought the thing in for a soft landing in the sense that we got the Wall Street rescue money. Wall Street didn’t rescue us; they rescued themselves.
Going back to what I said earlier, we had $1.3 trillion of swaps on the books. This was one hedge fund in Greenwich, Connecticut. It wasn’t like JPMorgan Chase, but even our hedge fund had $1.3 trillion of swaps. If we had failed, if we had filed for bankruptcy, I would have just slept in the next day and caught up on my sleep after the whole bailout drama, but Wall Street would have been left with all the losses. They put in capital to keep us going so they could collect on their bets, so they bailed themselves out.
That group absolutely did not know what they were doing. Unfortunately, things aren’t much better. I look around at the central banks, the FOMC, monetary research staff at the Board of Governors in Washington or the Federal Reserve Bank in New York, and other central bankers around the world. What I discover is that these people got the same PhDs from the same schools as my former colleagues. In fact, they were associates.
I believe the PhD advisor on at least a couple of the partners at Long Term Capital was Stanley Fischer who today is the Vice Chairman of the Federal Reserve Board. It’s a club, they all know each other, they taught each other, they all believe the same thing. It seems impervious to new learning. They know what they know.
The short answer to the question is, no, these people do not know what they’re doing.
There’s no better example than around this time last year when Jamie Dimon had an annual letter to the shareholders of JPMorgan Chase. Around April or so, they come out with their annual report that always includes a letter from the CEO.
He was discussing events from the year before, from 2015. We were in the aftermath of the London Whale fiasco when they lost billions of dollars because of that derivatives trader. Based on what had happened, Dimon was saying this is like a 15-standard-deviation event (I forget the exact number), this is something that should only happen once every three billion years, it was so rare, etc. I read that and didn’t know whether to laugh or cry. It was certainly an embarrassment to Jamie Dimon.
All that jargon about three billion years comes from an understanding of risk management based on what’s called a normal distribution of risk. Sorry, but risk is not normally distributed. If you look at the time series of movements in any capital market be it stocks, bonds, commodities, and certainly gold, the degree of distribution is not normally distributed. It’s distributed in accordance with what’s called a power law or a power curve.
It’s not a dry academic argument about the shapes of two different curves. Those curves are just graphical representations of two completely different systems that function in totally different ways with different shocks and different outcomes to be expected.
That’s a scary example from the head of practically the biggest, most powerful bank in the world that shows they really don’t understand risk.
However, there are some people who do and are going along with this because they personally enrich themselves. In other words, if your understanding of a system is that you can pull the wool over someone’s eyes, this is anywhere from highly immoral and unethical at best to just outright illegal depending on who’s doing it and how.
I do believe there are people in capital markets who, even if they don’t comprehend exactly how risk works, recognize that the standard models understate the risk, which means they can go around selling garbage to their customers who won’t understand it.
It’s like signing up for fire insurance, they’re pouring gasoline in the basement getting ready to light a match, and then the insurance is no good when the fire burns the house down. That’s kind of how they operate.
There are also some people who do get it but they’re like me; they’re writing books, they’re doing commentary, they’re practically yelling that the system is ready to implode. If you’re not actually running the Federal Reserve, then you try to have impact, but it’s a challenge.
I think most of the policymakers have no idea what they’re doing, some do but they’re kind of in it for the money because they can enrich themselves, and others do but they’re not in a position to change policy except through influence such as writing and speaking.
Eventually things will get straight. The question is, how much more damage will we have in the meantime?
Alex: I can tell you from personal experience that I concur. I’ve seen a large number of former and current Wall Street traders and people who have run large companies in financial services go to gold and buy gold for the very reasons you’re talking about.
The financial media and a lot of people in positions of credibility in financial services may not talk a good game about gold – probably because they don’t make any money selling it – but at the same time, I have seen them go to it for the very things we’re discussing.
Let’s shift our attention now to the national debt and where that’s at, how it gets serviced, what are the outcomes, and what are the solutions. National debt is sitting right around $20 trillion, and the debt ceiling has been a big deliberation lately.
Depending on how you work the numbers, I’ve read that there’s as much as maybe $10 trillion of additional deficit that’s probably going to end up happening because of spending that’s basically already been approved and is on the books.
You recently said that real economic growth is simply a matter of how many people are working and the productivity of those workers. What is the productivity of those workers? Demographic trends are what they are; there’s not much we can do to change those forces.
In much of the developing world, we have an aging workforce that is not being replaced with the same number of younger workers. Combined with the fact that productivity has been stagnant and not really growing sufficiently to service the increasing debt burden, we have a math problem here that does not seem to have a plausible solution.
We’ve discussed over time that certain structural reforms could help with this, but there’s no political will to do so, and therefore one more reason for people to get their financial house in order.
The way I look at it is time is growing short, maybe too short for systemic changes to be made, so why do people need to be paying attention to this, and what should people be studying to better prepare?
Jim: One of the points you raised, Alex, is that this is a math problem. We are so spun up today in ideology, left versus right, elites versus everyday people, Republicans versus Democrats, progressives versus nationalists, take your pick. Everybody is yelling and screaming at each other, everybody is upset, and nobody is getting along, but the thing about math is that it has no ideology; it’s just numbers. You can look at this deficit problem very clinically. It doesn’t matter if you’re a Republican or a Democrat; these numbers are going to eat you alive if you don’t do something about it.
Let’s just look at a couple of relationships. Throwing out a number of $20 trillion in national debt is important, but a debt in isolation doesn’t tell you very much. You have to compare it to your ability to pay, meaning that I look at the debt-to-GDP ratio.
Here’s a very simple example: Let’s say you make $30,000 a year and have $100,000 on your credit card. You’re probably going to go bankrupt, because you can’t service $100,000 of debt at the exorbitant credit card interest rates with a $30,000 income. Now let’s say you make $5 million a year and have $100,000 on your credit card. No problem; you can probably just write a check and pay the whole thing off. The point is, you cannot look at the $100,000 of credit card debt and answer the question of whether that’s a bad thing or an okay thing without understanding how much income the person has to service it. The $30,000-a-year person is probably going broke while the $5-million-a-year person is probably just fine.
When you say $20 trillion of debt, I immediately look at it in terms of the GDP. Now that ends up being a scary number. I’ll go all the way back to when Ronald Reagan was sworn in as president in 1981 and our debt-to-GDP ratio was 35%. I can’t recite the numbers off the top of my head, but it doesn’t matter. The numbers are a lot smaller, and what matters is the ratio of 35% I just mentioned.
Reagan was actually a big spender contrary to his conservative credentials. He took the debt-to-GDP ratio up to 55%, which is a 60% increase. If you throw 20 percentage points on top of 35% to start and get up to 55%, that’s a 60% increase in the debt-to-GDP ratio in the eight years of Reagan.
Having said that, we got something for the money, which is we won the Cold War. Reagan spent it on a 600-ship navy and Strategic Defense Initiative – the so-called Star Wars. He at least spent the money on a lot of good things, and the Soviet Union collapsed, so we won the Cold War. I would say yes, he spent a lot of money, but we fought a war, won it, and got something for the money.
In the years of George H. W. Bush and Bill Clinton, the debt-to-GDP ratio did not go up a lot. It went up a little bit, 60%, 61%, and came back down again. Believe it or not, Clinton actually banged out a couple of surpluses at the end of his administration, but it remained pretty constant in that 60% level.
Now, 60% is a big deal, because that’s considered the outer limit of the danger zone. If you look at Europe and the Maastricht Treaty and what the members of the European Monetary Union (the so-called Eurozone) commit to, they say they’re going to keep the debt-to-GDP ratios below 60%. They haven’t all done it; Greece is off the charts at about 120%, but nevertheless, they’re held to that 60% standard, and that’s how Angela Merkel measures it.
Kenneth Rogoff of Harvard and Carmen Reinhart who was at University of Maryland and might be at Colombia now are two of the leading monetary scholars and economic historians. They have looked at this closely, done a ton of research, and they think the danger zone is 90%.
This would mean that 90% debt-to-GDP is the place where more debt doesn’t help you. More debt doesn’t give you any bang for the buck but actually retards growth, and it makes it more difficult to pay off the debt. You start to look more like the person with $100,000 credit card debt making $30,000 a year.
Guess where we are today? We’re at 105%. By any definition whether Angela Merkel’s definition or the Rogoff and Reinhart definition, we are way in the danger zone. This simply means that Trump does not have the degree of freedom Ronald Reagan had.
Trump wants to be a big spender. He wants to rebuild the military and do infrastructure – bridges, tunnels, airports and new roads. We all love all that stuff, don’t we, but he doesn’t have the fiscal space – the running room – that Ronald Reagan had. Not even close.
In fact, he’s highly constrained, and Congress is going to insist that tax cuts be revenue-neutral. Where are you going to get the stimulus for all this spending that everyone keeps talking about?
The $20 trillion is just the tip of the iceberg. That’s treasury debt. Those are bills, notes, and bonds where we owe you the money and you get some contractual right. That doesn’t count contingent liabilities or include Medicare, Medicaid, social security, veterans’ loans, federal home, farm loans, student loans, food stamps. These are all conditional and contingent liabilities the U.S. government has piled on.
If you do that, multiply it by ten, and we don’t have a 105% debt-to-GDP ratio; we have a 1000% debt-to-GDP ratio. There’s $103 trillion of these contingent liabilities.
I’ve heard mainstream economists say, “You don’t have to count that, because we could always change the law.” Really? You think you’re going to get rid of social security? Technically you can change the law, but that’s just wishful thinking and is absolutely not happening in the short run, because Trump says he’s not touching entitlements.
How do we get out of this? Notionally, there are four ways out. One is growth. You could grow your way out of it if you held the debt constant or it didn’t go up very much and you grew the economy faster than the debt was growing. That would lower the debt-to-GDP ratio and is exactly what the United States did from the end of World War II until around the time of Ronald Reagan as I just described.
But that gets back to what is the source of growth? It is simply expansion of the labor force times productivity. How many people are working? How productive are they? Like the old song by Peggy Lee, Is That All There Is?That’s all there is – working force times productivity.
The problem is, if your working force is growing about 1.5% a year and your productivity is about 1% a year or a little bit more, you multiply one by the other and get a number that’s less than 2%. But how much is the deficit going up?
Today we’re in a sweet spot where the deficit is going up around 3% to 3.5% of GDP, but projections that just came out of the CBOE show that we’re past the sweet spot. That number is going to start to go up to 4% and ultimately 5% and 6%.
Let’s be generous and say your economy is growing 2% and your debt is growing 3% or 4%. Your debt-to-GDP ratio isn’t going down; it’s going up. It’ll go up from 105 to 106 to 110. You’re on the path to bankruptcy just like Greece.
What can you do to increase the labor force? One of the big ways to do it is immigration. By the way, people are not having enough kids. I’m going to leave that debate to others, but the fact is demographically, indigenous population is not growing. We’ve been relying on immigration.
What’s Trump doing about immigration? He’s building a wall through Mexico. Again, I don’t want to jump into these policy debates. You could be pro-wall or anti-wall, knock yourself out. I’m just saying that this approach to immigration is not going to help the U.S. expand the workforce.
Then beyond that, you can say, “Let’s get people off the couch. Let them stop eating Doritos and watching Final Four basketball and get back in the workforce.” Really? Check out the opioid epidemic. There’s more to it than that, but this is devastating. There are a lot of reasons to think that we’re not going to be able to grow the workforce more than about 1% if we’re lucky.
Productivity is declining, and economists are not sure why. That’s an interesting debate for another day, but those are just the facts. So, it doesn’t look like we’re going to grow our way out of this. Growth is a good way out, but it’s not happening.
The other thing we can do is simply default on the debt and say, “Hey, we’re not paying you.” That’s not going to happen. Why should it? We can print the money, so why on earth would we default on debt denominated in a currency that we can print? You wouldn’t do it, so that’s not going to happen.
The only thing that’s left is inflation, and that’s what they’re trying to get. The irony is that we have a central bank that’s been trying for eight years to get inflation, and they can’t do it. It’s a pretty sad thing when the central bank wants inflation and can’t get it.
Inflation is the traditional way out, but we’re not getting the inflation. We look like Japan; we are Japan. I said that in my first book, Currency Wars, and even before that. In 2009/2010, I said we are Japan.
Ben Bernanke scurried around in the 1990s and early 2000s as a private economist and as a member of the Federal Reserve Board and later Chairman yelling at Japan, “You’re messing this up, you don’t understand how to use monetary policy,” really bashing the Japanese. Yet he went out and made every single mistake the Japanese made. We are Japan and will stay that way as far as the eye can see. It’s a slow-motion train wreck that sneaks up on people.
One of the reasons I own gold is because it’s kind of immune. If we have inflation, gold will do just fine. If we have a catastrophic collapse, again, gold will do just fine.
Maybe that’s a good place to wrap up. We’ll drill down on gold the next time, but gold is your insurance.
It’s been a pretty gloomy call, but it’s always a pleasure to talk with you, Alex and Jon, and our listeners. We’ve covered a lot of systemic risk and market risk, we’ve talked about leverage, derivatives, complexity theory, and the debt-to-GDP ratio. All of these things seem to be pointing in very bad directions, and they are. That’s not being a pessimist; that’s just being realistic and trying to do some good analysis.
The solution to all of them, at last for the individual, is to get some insurance through gold. I recommend a 10% allocation of physical gold. If you don’t have that much, start your allocation today and try to get there. Don’t use paper gold. Get either gold in storage – which is, of course, what Physical Gold Fund offers – or for smaller accounts, go get some coins and bars and put them in a safe place.
Alex: Very good. I want to thank you, Jim. It’s been a great discussion today, and I really appreciate it. As always, it’s very insightful, and I look forward to doing it again next time.
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