TIP114: JIM RICKARDS AND THE ROAD TO RUIN

(PART II)

26 November 2016

This is our second part interview with world renown investment author, James Rickards.

Rickards is a veteran of Wall Street with 35 years of experience and has had his fair share of chaotic experiences.  For example, in 1998 he was the principal negotiator with the Federal Reserve Bank of New York for the bailout of Long-Term Capital Management (LTCM).  Jim takes those extreme experiences and unique vantage points to talk about how the global economy is positioned today and where cracks in the system are starting to appear.

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IN THIS EPISODE, YOU’LL LEARN:

  • What central bankers are missing when looking at monetary policy.
  • What’s going to happen with interest rates in December.
  • World Taxation and how it could happen.
  • World taxation and how it could happen.
  • What Ben Bernanke and William Dudley personally told Jim about raising rates.

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TRANSCRIPT

Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:28  

Hey, how’s everybody doing out there? This is Preston Pysh. I’m your host for The Investor’s Podcast, and as usual, I’m accompanied by my co-host Stig Brodersen out in Seoul, South Korea.

Stig Brodersen  0:39  

Today’s show is the second-part interview with world-renowned author Jim Rickards [and] about his new book, “The Road to Ruin.” We got to continue where he left in the previous episode talking about financial history, and Preston, you have the first question.

Preston Pysh  0:53  

I love your conversation in your book where you’re talking about the difference between the Fed’s blunder of raising rates back in 1928 and what’s happening today. I want to give you this opportunity on the show to talk about this difference between those two time periods.

Jim Rickards  1:09  

Well, the point I was making was that because the Fed was created in 1913, it didn’t really get off the ground until 1914. It took almost a year to make the appointments and get the institution up and running. They couldn’t do it overnight, so it kind of started then. And of course, here we are in 2016. The Fed just celebrated their 100th anniversary a couple years ago. You look at one financial cataclysm after another, and almost all of them can be attributed to the blunders in discretionary monetary policy. I mean you don’t want to point a finger at the Fed, but they do control the money, and these are monetary systems, so you have to hold them to account. 

In 1928, the US was having enormous inflows of gold, and at the time we were on a gold standard. Now, it didn’t mean that there wasn’t a discretionary monetary policy. There was and that’s something that’s not well understood. People think they have a hard and fast gold standard, a fixed money supply, and every dollar can be turned into a certain amount of gold at a fixed conversion ratio or vice versa. That’s what a gold standard is, then when you get to the monetary policy, we get to fiat money without a gold standard. It’s just the Federal Reserve. They print money and sometimes they reduce the money supply, and that’s that. They act as if those two things can’t coexist, but they can coexist, and they did coexist through most of the 20th century. 

In fact, most so-called gold standards are really just a ratio of paper money to gold, and you don’t walk around with big bags of gold coins. You walk around with paper currency or bank deposits, but what makes it a gold standard is that you know that you can convert it to gold at a fixed ratio. You don’t have to worry about the money devaluing and being worth less and less in terms of gold. You’ve got to fix the gold ratio behind it. The money’s always going to be worth a certain amount. 

Well, in order for that to work and have a discretionary monetary policy and a gold standard at the same time, which is what we had in the 1920s and 1930s, you need to pay attention to gold. You need to use gold as a market signal to tell you if your policy is too tight or too loose, and then you’re supposed to adjust the policy accordingly. 

What was happening in the late 1920s is the US was having gold inflows. That meant that the Fed could increase the money supply, and the law at the time actually was the law all the way through until 1968. It allowed money supply to be two and a half times the amount of gold, so you would take the amount of physical gold that the Fed had at a fixed price, then multiply it by 2.5. That result is how big the money supply could be. It could not be more than that. There was a ceiling on it, but in fact during the Great Depression, it never got above 100%. The ceiling was 250%. They never got close to that. 

However, in 1928, the Fed should have pursued an easier monetary policy with gold inflows. That meant you should engage in monetary ease, try to create money inflation, and make the US prices a little bit higher, which would improve the terms of trade for our trading partners. This will result in gold turning around. It would start to leave the United States and go back to our trading partners because their prices would be less expensive. 

Our prices would be higher, the gold would flow out, and it was plugged back in again. It was something more like an equilibrium system, almost like the way the tide flows in and flows out. Gold was just a signal telling you [something’s not right]. That’s how gold was supposed to flow in and flow out, and the monetary policy was supposed to be in sync with that. However, that’s not what the Fed did. The Fed tightened, and the reason they tightened was because they were worried about stock market bubbles. 

When we all heard about the Roaring Twenties, and the stock market was a bubble at the time, the Fed kind of ignored their prime mandate, which is to pay attention to what gold was saying. They took it upon themselves to pop a bubble, and in doing so, they popped it so hard that they caused the stock market panic in 1929, which led to the Great Depression. That was a blunder on the part of the Fed. 

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We’ll come all the way forward to 2007 and 2008. Also, in 2000 you had the same thing. Greenspan talked about this in the 1990s with his famous speech in 1996. He talked about “irrational exuberance” in the stock market. He said that the market more than doubled between ’96 and ’99 before it finally popped in 2000. And then, of course, it popped again in 2008. 

The point I make in the book is that not all these bubbles that popped are the same. There’s an important difference, which is, “Is the bubble created by enthusiasm and overvaluation of stock prices themselves, or is the bubble created by credit?” That’s a big difference because of what happened in 1928 and what happened in 2000, when the dot-com bubble burst. 

Remember in 2000, the NASDAQ dropped 80%. 80% went from the kind of 5000 level down to around the 2000 level. That was a massive stock market crash, but there was no panic. If you happen to buy pets.com at $200 a share, you probably got wiped out. That’s no fun for the individual, but it was not a market panic. It didn’t spread around the world. It didn’t spread to other markets the way things did in 2008. It was just a bubble popping. That’s an example of a bubble not driven by credit. 

It was just driven by irrational exuberance, overvaluation, and speculation. What happened in 2008 was driven by credit. It was easy money in the mortgage market. No money down. No documents. No background checks. No doc, low doc, subprime, and all-day mortgage loans. Anybody could get one. That was a credit bubble, and when that popped it, it did cause contagion. It did spread through the banking system. It did cause bank collapse. It did cause [a] liquidity crisis. It’s a very different dynamic [thing]. 

The problem is Janet Yellen doesn’t seem to get the difference. She doesn’t seem to understand the difference between credit-driven bubbles, and let’s call it, speculative bubbles. There was always a little speculation in the credit-driven bubbles, but that’s really the danger. And so, she’s afraid to pop the bubble we have right now. 

She’s looking at the Greenspan Model of 2000, and saying, “Greenspan was right. He let the thing go, and then it popped. But it wasn’t the end of the world, so I’m not going to worry about asset prices.” However, she’s missing the fact that the bubble going on now is credit-driven. It doesn’t look like the 2000 bubble. It looks like the 2008 bubble, and that blind spot on her part is extremely dangerous.

Preston Pysh  7:33  

When bond prices go up for 35 years straight, which we’re at now, how can people not see that bubble as it hits almost zero percent here in the US and over in Europe and over in Japan? It is zero percent. It’s negative percent in some cases. When you look at the decisions that these beneficials are making, it almost seems like they’re making decisions completely off of equity markets. They’re looking how stock prices are going up and down. They’re really trying to make decisions around that and not necessarily the larger bubble that they are all riding on, which is the fixed-income market. Do you agree with me on that, Jim?

Jim Rickards  8:15  

Well, I agree completely. There are huge asset bubbles out there, and I see them in stocks and real estate. Now, they might be in bonds. I’ll drop a footnote on the bond market, though. The reason prices are going up is because interest rates have gone down, and that’s how bond markets work. The prices and interest rates are reciprocal. Lower rates means higher prices and higher rates means lower prices, so that’s just Bond Math 101. Rates have come down and prices have gone up and have continued for 35 years, right? It started in the early 80s, and it’s still going strong. 

However, when you look at interest rates, you have to distinguish between nominal rates and real rates. Now, it is true that nominal rates are close to all-time lows. That’s absolutely the case. Your Fed funds’ target rate is 25 basis points, 2-year Treasury notes are well below 1%, and even the 10-year Treasury note is about 1.8% as we speak. These are extremely low, and in some cases record low nominally. They’re not that low in real terms, because inflation has come down so much. 

Now, I’ll give you an example. In 1980, I got my first mortgage on a condo in New York, and I paid 13%. My mother cried at me. Her first mortgage was like 3%, and here I am paying 13% on mortgage. My mother was upset. She thought that was a dumb decision. I said, “Mom, I’m paying 13% interest, but inflation is 15%, and taxes are 50%. So, my after tax cost of funding is 7%, inflation’s 15%, and my real interest rate is -8%. The bank is paying me to borrow because I get to pay them back in cheaper dollars, whereas today, even with say, a 4% mortgage, if inflation is only 1.5%, which it is, that’s a positive real rate of 2.5%. So, when I borrowed at 13%, the real rate was -5%. 

Today, when you borrow at 4.5%, the real rate is positive 2% or 2.5%. So, nominal rates are at an all time low, but real rates are very high. That’s what drives economic decision making, and that’s what drives the economy. One of the problems that economists and policymakers are wrestling with is, “How do you get real rates negative?” 

That’s what stimulates borrowing. If I think I can go borrow money and pay it back in cheaper dollars, so that the real cost is negative, I actually get free money from the bank or the bank pays me to borrow. That’s what a negative interest rate means. That’s supposed to be a prod or stimulus to more investment, more R&D, more consumption, more economic activity, and higher aggregate demand. 

The notion is how do we get real interest rates to be negative, but what that means is that the nominal rate has to be below the inflation. Right now, it’s not. I said, the 10-year note was 1.8%, but inflation’s running about 1.6%. That’s still a positive real rate after 10 years, and that’s for government debt. Then, when you get into consumer debt, mortgages to real rates are even higher. So what do you have to do? You have to get inflation higher than nominal rates, and when you do that you have a negative real rate, and then that will stimulate some of the activity. 

Well, I like to say it’s a sad day, when central banks want inflation and can’t get it. However, that’s exactly where we are. Central banks all have a 2% inflation target. All the banks such as Bank of Japan, Bank of England, Federal Reserve, other European central banks, they all have inflation targets at 2%. They can’t get there. 

We’re at about 1.6% using the Fed’s favorite measure year-over-year PC price deflator. There are other measures you can use, but none of these [are positive]. Rates are negative in Japan. They’re negative in Europe. None of the banks are anywhere near the 2% target, so we have positive real rates. That’s a drag on activity. 

You can say rates are low in nominal space. You can call the bond bubble and in nominal space it is, but in real space rates are still too high. They’re going to either have to somehow cause inflation, which they haven’t figured out how yet, or they’re going to have to get nominal rates to be negative. We can kind of go on and on about this, but this is what happens when you manipulate markets for eight years. 

When you have this much intervention, this much money printing, and when you distort price signals this much, you’re in a, what we call, the intelligence community, [a.k.a.] “the wilderness of mirrors,” so you just don’t know where you are. That’s kind of where the Central Bank is today.

Preston Pysh  12:33  

I saw a note. I think it was just on Friday with Larry Summers because I know he’s been the big boys on this war on bash and trying to make all accounts electronic, so you can create the situation you’re describing there. I saw that he just came out, I believe it was on Friday, saying that the Fed now needs to be managed and be brought under the government veil and not have this autonomy to act on their own. Pretty interesting discussion with all of that. 

Jim Rickards  13:01  

Sure. 

Preston Pysh  13:01  

We won’t even go down that path, but I found that to be a very interesting article, especially considering the reason that they wanted them to have autonomy. It’s the exact opposite reason of where they’re at today. It gets into a very ironic situation. 

Stig Brodersen  13:15  

For the next question, I would like to shift gears here a bit and talk about the concept of world taxation. I chose this because this was a really interesting concept that I read about in your book. As a European, when I hear about taxation on a grander scale, I often think about harmonization of taxes, which is something that we have discussed here in the single market for decades now. For economists, it often has a lot of good arguments why you have a similar tax in terms of creating a better environment for businesses. 

One of the things that you talked about, Jim, in your book is that we’re talking not about a European tax, but a global tax for all the big economists. You talked about the way to look at this is not just to ask, “Is it good for businesses?” No, you said, we should also ask, “How is this basically related to the global debt burden?” 

It seems to be a concept that very few regulators think about, whenever they’re talking about this, at least in the media. Could you elaborate on this idea of a global tax, and why you might think it would be a bad idea, and how the elites might be doing this to be working on the Ice Nine concept as you talked about before.

Jim Rickards  14:32  

When you throw out a phrase like world taxation, we talked a little bit earlier about world money, the SDR, and we can get in the world government for that matter, and again, the initial reaction on the part of some leaders is to roll their eyes and go, “Well, there goes Jim again with those crazy conspiracy theories,” but these are not conspiracy theories. 

Again, I make the point. This is very, very important. This is all documented. This is all happening. You can go to these websites. You can attend these meetings. You can look at these working papers. It’s always real. None of it is the kind that is made up or fantasized. 

Now, as far as world taxation is concerned, we said earlier they love these crazy acronyms that no one understands unless you’re an expert on all this, but the key phrase here is BEPS, B-E-P-S. That stands for base erosion and profit shifting. Base erosion and profit shifting are the bad things that corporations do to get out of paying taxes. The governments are going to lead an attack on BEPS. This is all being directed by the G20. The G20 is this world leadership [organization]. It’s basically the board of directors of the world. That’s the easiest way to describe it. 

The G20 kind of emerged in November 2008 at the height of the panic, when Nicolas Sarkozy, who was the head of the G7 that year and President Bush ought to convene the G20 because they formerly operated through the G7, which are all the big developed economies. They knew they were going to need help and cooperation from China and Brazil and India, which are some of these large emerging markets,  and that’s what the G20 is. It’s a blend of the developed economies and the major developing economies, so you get these other economies on board. 

The G20 operates like a board of directors, but they don’t have a big staff and director. There’s Obama now, and there’s Merkel, and Theresa May will be part of it. There was David Cameron at the time, and Francois Hollande of France, and so forth. What they do is they farm out these projects to different existing agencies. It could be the United Nations. It could be the IMF, but we have another group called the OECD, Organization of Economic Cooperation Development, based in Paris. This is a kind of the rich countries’ think tank, and the G20 have given the OECD the task of coordinating and implementing the BEPS Project. 

By the way, I started my career as an international tax counsel at Citibank. I did this for 10 years. In 10 years, my whole career was just moving money around the world, so we didn’t have to pay taxes. All perfectly legitimate, but we had a lot of tools at our disposal from offshore booking centers, NASA, Hong Kong at the time, the Cayman Islands, a treaty network that ran through Netherlands and the Netherlands Antilles. No need to go down in the weeds on that, but we had triple dip leasing. 

We owned the Alaska pipeline, and we could write that off. Also, we had bad debt reserves that were at our discretion. We just had lots and lots of tools at our disposal, and it wasn’t difficult, basically, not to pay any taxes. And today, we see Apple and Google and others doing the same thing.

I’ll give you one simple example. Let’s say you have an invention that you invented in the United States. Well, if you patent that invention and license it for royalties. All those royalties come to the United States, so you’re going to pay US tax on it. But what if you take the invention and contribute the intellectual property to an offshore company, and then that company does all the global licensing, and now all the licensing fees go into Dublin instead of Seattle? 

You’re not paying any tax there because you got a special deal with the Irish government. Well, that’s the kind of thing that’s going on. There are many, many more complicated examples than that, but that’s a simple one that makes the point. 

The other thing that’s done is you mess around with debt-equity ratio. For example, I’ve got an offshore subsidiary. They give me a capital. I borrow a gazillion dollars from it and pay them interest. Well, what’s happening with the interest? It’s a deduction in the US and its income in,  say the Bahamas, right? So, I get a nice fat tax deduction in the US. 

The money goes to a tax-free jurisdiction like the Bahamas. I’m just taking out from one pocket and putting it in the other because I own both companies. So, between the intercompany debt and licensing and royalties and depreciation, there’s a whole bag of tricks. 

However, the governments are at a disadvantage because each government is taxing what goes on in its jurisdiction. The US taxes are actually global taxation, so they try to see all over the world. Germany taxes what happens in Germany, and the UK taxes what happens in the UK. The corporations are moving this money around so fast that nobody can keep track. So, what the governments did is they joined forces, and they’re going to create this global tax network. 

They’re going to say to every major corporation, “You’re going to have a global tax ID, not just your social security number. It will be the corporate equivalent. You’re going to have a global tax ID, all of your subsidiaries are going to have IDs, and all of your transactions are going to have IDs. And all this information is going to be reported to a database to whatever country has jurisdiction, but then all the countries are going to share all the data using this unified ID system, and then put it into one giant supercomputer that everybody can access.” 

Now, all of a sudden, Germany is going to be able to see the other side of the trade. They may know that a German corporation is paying interest, but they’ll be able to learn that the interest is going to an affiliate and Hong Kong is not paying any taxes, etc. So, they’re going to have the complete picture. 

And then, once you have the picture, you can attack it. You can use it to avoid provisions. You can use special laws and Section 269 of the Internal Revenue Code. I mean, their equivalents all over the world. They have the tools, but what they don’t have is the information. 

One of the best projects, they’re going to get the information, and then they’re going to combine the information and the tools, and then they’re going to tax these corporations. They’ll be able to run, but they won’t be able to hire, and then they’re going to raise the rates. 

Then, a lot of people say, “Well, what’s wrong with that? You know, why should they pay their fair share?” And my answer is, you should pay your fair share. But what’s fair? So, this is a full scale assault on the ability of corporations to legally avoid taxes, but it’s going to segue into something that’s much more punitive and much more extractive.

Preston Pysh  20:42  

So, something that I have a deep interest in trying to understand, and that comes down to understanding when you’re reaching a top and a credit cycle. Let me just give you an example of what I’m talking about here. If I was going to look at credit expansion and credit contraction, trying to figure out where that top is occurring is really important because it’s going to help you reallocate your assets and mitigate a lot of the risks that’s occurring.

For me, when I’m looking where that topping is kind of happening in this credit cycle, I look at things like high yield bonds. Once those start to reverse, and you start to see the yields on those start to kind of go in the opposite direction. 

Another indicator that Jeff Gunlock had just recently said is that when he sees unemployment rate basically bottom, and you’re not seeing it decrease anymore for a 12 month period of time. That’s a huge indicator for him that credit might start to contract moving forward. I was curious if you have anything that you use in your own personal investing approach that gives you some of those indicators of, “Hey, it’s time for me to reallocate my portfolio. Maybe start moving out of equities and putting [capital] into different types of asset classes?”

Jim Rickards  21:52  

Well, I do pay attention to those kinds of indicators, Preston, and I follow Jeff Gunlock and quite a few others, so I’m familiar with what you’re saying. But I would drop a pretty important caveat to that, which is that there’s something called Goodhart’s Law named after an economist, Charles Goodhart. Just to paraphrase it in plain English, what he said is, “When a market indicator becomes the subject of policy, it loses its meaning as an indicator.”

In other words, you take economic data. You treat them as signals, whether the market prices or GDP or unemployment or inflation or any of the things that people look at, and you use them as information. You do exactly the kind of analysis you just described. 

When unemployment is low and is not getting lower is that a sign of a top ascent? Historically that may be perfectly valid and a good insight. The problem is that so many of these indicators have become the targets of policy, and they are manipulated that they’ve lost their value as information. 

A simple one would be Chinese GDP. Look at the Chinese GDP. It was 10-11%, and it kind of came down to 9% and 8%. Now, it’s below 7%, but the government is targeting 6.7%. They said, “We’re targeting 6.7%.” Well, you know what? If you target GDP, you can make it whatever you want. All you have to do is go out and build a $5 billion train station in a town with 100 people, right? 

Thus, that will entail glass and steel and architects’ fees and cement and engineering and worker salaries. If you build a $5 billion train station, that’s $5 billion of GDP. You can make your GDP whatever you want, but it’s a complete waste of money. If you put a $5 billion train station in a small town, more people are not going to take the train. They’re certainly not going to pay more for their tickets. You might as well just write it off.

Preston Pysh  23:41  

With respect to productivity, you’re saying? It’s a complete waste with respect to the productivity that it’s actually producing? 

Jim Rickards  23:47  

Correct. You can build it. You can do smart things. You can build a highway and put a toll booth on it, and people use the highway and collect tolls. I mean there is smart infrastructure. I’m not against all government spending, and I’m not against infrastructure. However, you do have to be smart about it. My point with regard to China is quite often, they’re not smart about it. They’re just hitting targets. 

And so, when I look at inflation, interest rates, unemployment, and GDP, I say to myself, “How many of these things are now subject to Goodhart’s Law? How many of them have become targets of policy pursued through manipulation and market intervention, so that they’ve now lost their meaning as valuable pieces of information?” 

This is a big problem for the Fed because they’re looking at interest rates and credit spreads and inflation and unemployment as guise to policy without seeming to reflect on the fact that they’re manipulating all those things. 

They’re manipulating interest rates. When you’re manipulating interest rates, you’re going to manipulate inflation, and you’re going to get particular results. You might be able to create some jobs by keeping interest rates artificially low, and you might be able to create some investments by doing the same thing. 

I guess I’m at the point where, again, do I pay attention to them? Yeah. I’m appreciative of all the good work that people do along the lines you described, but I don’t put that much weight on it, because I feel that so much of the information is the result of manipulation. It really is not very valuable as information. 

What I try to do is look at other metrics and use not equilibrium models or not regressions, but Complexity Model, Bayes Theorem, behavioral economics, and some of the other tools in my personal tool kit.

Preston Pysh  25:29  

I like your point because last December, the Fed raised the quarter percent on the federal funds rate. For me, I was really looking at that event saying, “This thing is going to start falling apart. This is absolutely going to fall apart at this point, because I just think they made a misstep.” Then, in January, we saw it. I mean, this thing was unraveling itself. And so, that just further confirmed my opinion that this thing is really starting to fall apart. 

Now, I didn’t know if it was going to be a complete meltdown or we were just going to start to see a pretty strong bear market. That’s when it was probably in February or something like that, and you had every central banker and their cousin coming out and saying, “Oh yeah, we’re just going to print full on.” They were able to bring this thing back online. It was like this aircraft that was going to nose dive into the ground, and they were able to bring it back online, and then the market kind of came back up. Finally, we saw what? 18-8 on the Dow or something crazy? 

For me, all those indicators were lined up as far as, in my opinion, where the credit cycle had really peaked, and then they raised rates. I said, “Oh, this thing’s going to fall apart.” That change in government policy or I should say, central banker policy, was a complete unknown. It wasn’t anything that I could have projected. I mean, they were saying that they’re going to raise rates four times at the end of last year. I have appreciation for what you just said because it really confirms what I’ve experienced over the last year.

Jim Rickards  26:57  

Boy, that’s the perfect example, Preston. I mean, they took the stock market down by raising rates, and then they took it back up again with forward guidance and happy talk. To me, the stock market is not a particularly valuable indicator because I can see it’s being manipulated by the Fed. I would draw a straight line between the Fed’s rate hike and the market drawdown, so what I see coming is an exact replay.

Preston Pysh  26:57  

Yeah.

Jim Rickards  26:57  

They’re going to raise rates in December to kind of sink the stock market. They say they don’t care. By the way, I had the same conversation with Bernanke a little bit earlier. He said a very interesting thing. He also said they don’t care if the stock market goes down, but he said, it was 15%. What he means is that 5-10%, maybe even 15%. They say, “Too bad, we told you we were going to do it. If you’re like leveraged up in stocks, that’s on you. It’s not our job to prop up the stock market.” That’s probably true to an extent. 

However, beyond a certain point, when it falls too far, too fast, it becomes what they call “disorderly.” Then, they worry about contagion. They worry about, “Oh, is this going to spread to banking? Is it going to spread to money markets, etc.? Is it going to be a replay of 2008?” Then, they do intervene. That’s what they were looking at last February, but from January 1st to February 10, 2016, it went down 11%. That was like a five-week period from start to finish.

Preston Pysh  28:14  

So, did he imply anything beyond the rate hike in December? Because I know last year, they said, “Hey, we’re going to do it another four times this year. Was he like, “Let’s just raise it in December and see what happens?”

Jim Rickards  28:25  

He didn’t go there, but I have some insights on that. I can tell you how to think about it. It’s not an exact forecast of every FOMC meeting, but here’s the way to think about it. The Fed is not neutral, when it comes to raising rates. They are biased in favor of raising rates, so when they start the case, when they wake up in the morning, they’re not asking themselves, “Do I want to raise rates? Do I not want to raise rates? What’s the data, data dependent, all this stuff?” They wake up and say, “I want to raise rates. Can I?”

Just because they want to raise rates doesn’t mean the coast is clear. I compare them with a little kid, who’s trying to steal money from mom’s wallet. If mom’s looking, they won’t take it. But if mom’s out in the backyard, they’ll go grab some money. The Fed will raise rates, whenever they think they can get away with it.

However, if market conditions are disorderly as we saw not just in February 2016, but also, remember August 2015? After August 10, 2015, there was a sharp Chinese Yuan devaluation. That took the market down 11% in three weeks through the end of August. Also, the Fed had never planned the liftoff for September 2015, and they bought. They went to the happy talk and didn’t do the liftoff until three months later in December 2015. 

So, they want to raise rates. They can’t always raise rates. If they think things are “iffy” or the markets don’t expect it or financial conditions are already too tight for other reasons, they won’t do it. However, if the coast is clear, they will. And so, then the question is, “What will the situation be in March?” My guess is that if they raise it in December, which they certainly will, and if the market reacts negatively, which I do expect, that might again put it off in March because they’ll be in the same place they were last year, which is they’d like to raise them, but they can’t. 

The bigger question is, “Why on earth is the Fed raising rates, when the US economy is on the brink of recession and when the US economy is hanging by a thread?” You don’t raise rates in a weak environment. You raise rates when the economy’s hot, unemployment’s lower than this, but inflation is taking off, things look speculative, and then you raise rates to cool it down a little bit. And then, when the market goes down, unemployment goes up, inflation falls, then you ease, and you cut rates. The Fed never leaves the markets. The Fed always follows the market. The Fed’s always working with a lag. 

So, why on earth are they raising rates in a difficult challenging economic environment? The answer is, they’re doing it for the wrong reasons. They’re desperately trying to raise rates, so they can cut them in the next recession. Yeah, the history is that you need to cut rates 300 or 400 basis points, 3% or 4% in other words, to get the US out of a recession. Typically, the way it works is you go into a recession at 6.5% interest rates. You cut them to 3% down to 3.5%, maybe a little more, and then that’s enough to get the economy out of the recession. 

Well, how do you cut 300 basis points, when you’re only at 25 basis points? We can’t obviously. The trend to raise rates, so they can cut them, I say, this is like hitting yourself in the head with a hammer because it feels good, when you stop. The Fed’s conundrum is, “How do you raise rates enough, so you can cut them in the next recession without causing the recession you’re trying to prevent?” That’s the conundrum. And I think the answer is you can’t do it. They’re going to cause the recession.

Preston Pysh  31:39  

Now, I totally agree with you. I heard a really interesting analogy, where a person was talking about building a campfire. You start off the fire real small, and in order to keep it going, you just have to keep adding the same amount of wood. However, if you grow that fire a little bit bigger the next time, now it’s going to require more wood in order to keep it going. 

Next thing you know, you got like one of these massive [fires]. The diameter and perimeter of this thing is so massive that you’re just having trucks deliver the amount of wood that it requires to keep this thing burning. And then, it starts to go out. Well, now, the size of the investment capital that has to be supplied because the system is so freaking massive, and when you’re literally in the zero interest rate environment or close to it, and when you do have that economic downturn, it’s going to require such an enormous amount of capital just to keep that thing flowing.

Stig Brodersen  32:34  

So, next question, let’s go back in history just here shortly. I would like to talk briefly about long term capital management, which is one of the most fascinating and scary events here in modern economic history. The fund collapsed in 1998, and it lost billions in a short period of time. Jim, you were heavily involved in this, and we touched upon this before because you were the principal negotiator on this bailout. I think it’s interesting to compare what happened back then to today, because it really fascinates me that many hedge funds that brand themselves as virtually being risk-free, yet the reality is very different. 

The reason why I bring this up is because it really resonates with your idea that we probably shouldn’t be looking at the conventional models anymore. You are very critical about the Value at Risk (VaR) Model that a lot of these hedge funds use, because basically traders can keep adding new layers to neutralize swap positions. And when you do that, it kind of seems like it has no risk, but it also means that they require very little capital to initiate these investments. Could you tell us how the structure of many modern hedge funds seems to be risk-free but in reality, they can be a ticking bomb?

Jim Rickards  33:55  

Well, you’re exactly right, Stig. And LTCM (Long-Term Capital Management) was an example of that, but there are many, many others. This goes to one of the key points I make, which is that most of Wall Street, it’s not just hedge funds, some of the hedge funds are on the wrong track. Not all of them. Some of them are. 

But more importantly, the Wall Street firms, the major banks such as JP Morgan and others, the regulators, the central banks, the Fed and ECB, etc. have all got these models wrong. They’re all using variations of VaR. There are some assumptions underlying VaR. When you test those assumptions, they assume efficient markets. The markets incorporate all information smoothly and that the price of any market represents all the information. 

No, you can’t beat the market because you don’t have more information than the market itself. Risk is normally distributed, which means it kind of falls in accordance with the bell curve, so that small impact events happen with great frequency and high impact events happen with extremely low frequency to the point that once you get out to extreme events, the probabilities in once every…pick a number 3 million years, 5 billion years, etc., depending on whether you’re 10 or 15 so-called standard deviations out the bell curve, rational expectations, etc., and when you actually look at the science, every one of those assumptions is wrong. 

Markets are not efficient. There are all kinds of inefficiencies. There are big ones right now. We saw it in [inaudible] around the US presidential election, wherein there were massive mispricings that are based on a kind of more analytic assessment of potential outcomes. Risk is not normally distributed. It’s distributed in accordance with what’s called a Power Curve or a Power Law, which is just a different degree distribution, but it’s reflective of an entirely different kind of underlying dynamic that people are not rational. 

Why do people cling to it? Why do they stick with it in the face of a lot of contradictory evidence? That is the real mystery, and there are two main reasons for that. One is simple academic inertia. You’re a 60-year old professor, and you’ve got a 28-year old PhD candidate, and that PhD candidate comes to you and says, “Professor can you be my thesis advisor on this complexity project I’m working on?” I mean, it’s completely at odds with everything you’ve been doing for the last years. Are you crazy? Get out of here! You’ll never get published. You’ll never get a faculty appointment. You’ll never be in any prominent journals because you’re challenging the orthodoxy. 

Likewise, on Wall Street, there’s a lot of bad motivation, because VaR for all its flaws does at least superficially allow you to take more leverage than you really should. It allows you to take a lot more risk because it tells you the risk isn’t there. Objectively, soberly based on better science and based on cases we’ve seen from Long-Term Capital Management in 2008 and many others. There’s enormous risk in these positions, but VaR says there isn’t. 

If the regulators are willing to accept it, which they do, you can use more leverage. You can get big profits. Pay yourself a big bonus even if the whole world collapses next year. “Who cares? I got my $10 million bonus this year. I can probably take the money and buy gold or land or something that’s going to last, and if the whole world collapses, well, too bad for them.” I mean, that, sadly, is the attitude of a lot of hedge fund people and Wall Street participants, particularly if they can trade with other people’s money, kind of a heads-I-win-tails-you-lose type of bet. 

Thus, between simple inertia, the inability or willingness of people to grasp new ideas, and self interest in terms of preferring a system that may be statistically invalid, but enriches you personally at the expense of others; these are all bad reasons why this stuff persists. I spent a lot of time on this in my new book, “The Road to Ruin,” particularly with regards to Long-Term Capital Management.

I say every lesson we needed to know and learn to avoid 2008 was right there in 1998 after Long-Term Capital [Management]. And not only did we not learn the lessons, we did the exact opposite. If you laid out here five things we should have done, we did the opposite of everyone. We repealed Glass–Steagall [legislation], so that commercial banks could get into investment banking and act like hedge funds. 

We repealed swaps regulations, so that everybody could use more hidden leverage and off-balance sheet leverage. We repealed certain aspects of the broker dealer capital rules, so broker dealers could effectively leverage 30 to 1 instead of 15 to 1, etc., etc. The list goes on.

Preston Pysh  38:14  

All right, Jim. I know I speak for not only myself, but our entire audience, when we say thank you for coming on our show and being a part of this and helping all of us learn more and become more educated in all the stuff that surrounds the economy today and where it might be going in the future. I want to give you a quick opportunity to give our audience a hand off to some of your books, your websites, and your Twitter account and things like that, so lay it on them, and let them know where they can find you.

Jim Rickards  38:39  

Thank you, Preston. I know with podcasts, people listen at different times. My new book, The Road to Ruin, is available if it’s after November 15, the book’s in the bookstores, but it’s also available on Amazon, Barnes & Noble, and independent bookstores. My Twitter handle is @JamesGRickards. I put a lot of commentary on the international monetary system, so I welcome people to join me on Twitter.

Preston Pysh  39:01  

All right, Jim! Thank you so much for your time. It’s been such a pleasure talking with you.

Jim Rickards  39:06  

Thank you.

Stig Brodersen  39:07  

At this point of time in the show, we would like to say thank you to a very special person in the TIP community, and his nickname on the forum is Ennis Amander. His real name is David. And with more than 3000 registered users on our forum, I just want to say that David, you stand out. In the last year, you have posted 232 times on our forum, and I just want to say they are just all top quality. So, thank you so much for your contribution, and thank you for continuing to be posting all these awesome comments and analysis on our forum. 

And David as a token of our gratitude, we would like to give you access to our chapter by chapter video course of The Intelligent Investor, and also our new course, How to Invest in ETFs, and we’ll reach out to you very shortly after this episode is out. 

Now, the two courses just mentioned there are paid courses. We actually also have a lot of free courses, and you can find all of them at TIP Academy, which you can find on our navigation bar on the website, and you can check everything out in there. But guys, that was all we had for this week’s episode. We’ll see each other again next week.

Outro  40:15  

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.

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