Hera : Ben Bernanke, Federal reserve, inflation

Financial Crime Is A Systemic Risk

Ron Hera — Tue, 23 Oct 2012 11:38:00 GMT

Famed Austrian economist Ludwig von Mises wrote in his seminal work, Human Action (originally published by the Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” The collapse of a historic credit bubble occurred in 2008. However, despite years of further credit expansion, “a final and total catastrophe” of the U.S. dollar system has yet to occur.

While an inflationary U.S. monetary policy has serious consequences, hyperinflation is not an immediate result. There are three general ways in which the U.S. dollar system could break down: (1) rejection of the U.S. dollar as the world reserve currency, or (2) as an eventual consequence of U.S. federal government insolvency and (3) a domestic failure of confidence. Of the three, U.S. federal government insolvency is the most serious because it would result in both the loss of the U.S. dollar’s world reserve currency status and also in a failure of domestic confidence. However, a new threat to the U.S. dollar has emerged which could trigger a hyperinflationary collapse before the U.S. federal government’s finances become unworkable, e.g., when debt service begins to crowd out military and Social Security spending. Specifically, the perceived legitimacy of the U.S. financial system has not merely been tarnished by recent scandals but is in danger of collapsing. The consequences of a domestic breakdown of confidence and trust in the U.S. financial system cannot be overstated.

World Reserve Currency Status

The most commonly cited challenge to the U.S. dollar system relates to its waning status as the world reserve currency. The BRIC countries (Brazil, Russia, India and China), along with South Africa, no longer use the U.S. dollar for trade settlement amongst one another. The Chinese have internationalized the renminbi (RMB), which is now used in trade settlement with the other BRIC countries, as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African countries under bilateral agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars in exchange for crude oil since 2009. While European countries utilize the euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready to settle international trade using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant.

At the global level, the implicit crude oil backing of the U.S. dollar by the Organization of the Petroleum Exporting Countries (OPEC) remains in place and the U.S. military remains dominant. As long as OPEC backs the U.S. dollar, and as long as there is no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example, is a troubled currency and its future is questionable. China’s economic ascent is likely to continue and the RMB can be redeemed for Chinese-manufactured goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency and China’s military is not ready to take on the role of a global superpower.

At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there is no consensus regarding its eventual replacement. However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against inflation.

OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were no longer viable, i.e., if the prices of global commodities, and especially the price of gold, were to rise at an accelerating rate measured in U.S. dollars. China and Russia, for example, are significant buyers of gold and crude oil can be purchased with gold instead of U.S. dollars pursuant to bilateral agreements, if not on world markets generally. An eventual return to the gold standard is possible but seems unlikely in the near term.

Governments, banks and corporations around the world hold trillions of U.S. dollars along with U.S. dollar denominated financial assets, such as U.S. stocks and U.S. Treasury bonds. Even countries hostile to the United States cannot benefit by refusing U.S. dollar transactions or by dumping U.S. Treasury bond holdings in the market. Ignoring the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support the U.S. dollar, retaining the majority of the value of U.S. dollar holdings is always a superior alternative in the short run, particularly if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s collapse, a 100% loss.

In other words, the tolerance of the world financial system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions, i.e., Operation Twist, and quantitative easing is far greater than is commonly believed. The U.S. dollar certainly will be replaced as the world reserve currency at some point in the future, but claims that the U.S. dollar is in danger of imminent collapse as a result of international rejection are exaggerated.

U.S. Federal Government Debt and Unfunded Liabilities

Setting aside the world reserve currency status of the U.S. dollar, the largest threat lies in the risk of U.S. federal government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases or government budget cuts will allow it to pay back its public debt and also meet its unfunded liabilities.

As a percentage of GDP, total U.S. federal government debt is larger than that of Spain and nearly as large as that of Portugal and Ireland.

The U.S. federal government’s budget deficit, which stands at approximately 8.7% of U.S. GDP, is as high as that of Greece and higher than those of Spain, Portugal and Italy.

Total U.S. government spending at all levels is approximately 40% of GDP and, unless economic conditions improve, will increase further. Unfunded liabilities of the U.S. federal government total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion) and obligations for Medicare ($24.8 trillion), Social Security ($21.4 trillion), military retirement and disability benefits ($3.6 trillion), federal employee retirement benefits ($2 trillion) as well as state and local government obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected U.S. federal government insolvency and, as a result, hyperinflation, as soon as 2014. Mr. Williams’ projections do not include the fact that numerous U.S. states, counties and cities are insolvent or at risk for bankruptcy.

The insolvency of a sovereign nation becomes inevitable once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency. The more unworkable U.S. federal government finances become, the more likely a hyperinflationary collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of the U.S. dollar is increasing at an accelerating rate.

An inevitable outcome is not necessarily an immediate one and U.S. policymakers are masters of “kicking the can down the road.” Another financial crisis or a further economic decline in the U.S. could accelerate the financial breakdown of the U.S. federal government, but a robust U.S. economic recovery, technological breakthroughs and other decelerating factors could delay it.

Despite the fact that Mr. Williams’ Hyperinflation Special Report 2012 is required reading, the timing of the predicted outcome assumes a low international tolerance for the monetization of U.S. federal government debt. Mr. Williams implicitly assumes that the market for U.S. treasuries is a free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse, but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate U.S. Treasury bond yields and the value of the U.S. dollar for an indefinite period of time. On one hand, according to Herbert Stein’s Law, “If something cannot go on forever, it will stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except for all the rest.’

Since the start of the Federal Reserve System, the U.S. dollar has passed one apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is imminent. The roots of the arguments generally date back to 1971 when Nixon closed the gold window. Severing the link to gold was a crucial point of no return, but, more than forty years later, a hyperinflationary collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead for the U.S. dollar.

Domestic Confidence in the U.S. Dollar

Within the United States, outside of Wall Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure. In other words, private sector debt levels remain high and money is relatively scarce in the ‘real economy’. Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young people.

A scarcity of physical notes or a race to shed currency in favor of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by the U.S. federal government and by the Federal Reserve has thus far proven sufficient to prevent a panic. U.S. households do not generally have cash and often rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered hyperinflation in recent history, U.S. citizens have no practical alternative currency. In the absence of runaway inflation, the impetus to flee the banking system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless of U.S. monetary policy.

An outlying but growing problem is the risk of a breakdown of confidence and trust in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement pose a serious threat to the U.S. dollar system.

Before the 2008 financial crisis, confidence in the U.S. financial system was shaken by fraudulent sub-prime mortgage lending and securitization practices. The collapse of the housing bubble and the 2008 financial crisis revealed profound systemic risks. In 2010, the so-called “Flash Crash” reopened questions about the stability of U.S. financial markets and, in 2011 “robo-signing” and other foreclosure frauds were reminiscent of sub-prime lending.

In late 2011 and 2012 perception of the U.S. financial system suffered a staccato of blows, including the failure of MF Global Holdings Ltd., with the loss of $1.6 billion in customer funds; JPMorgan Chase & Co.’s $6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest), with the loss of over $200 million in customer funds; money laundering by HSBC for drug cartels, including Mexico’s most violent criminal organization, Los Zetas, and for states that sponsor terrorist organizations; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440 million; as well as a growing number of civil and criminal cases linked to mortgage, foreclosure and securities fraud.

Scandals elsewhere in the world, such as the rigging of the London Interbank Offered Rate (LIBOR) by Barclays, in cooperation with other banks, including JPMorgan Chase & Co. and Citigroup, Inc. in the U.S., further undermine confidence in the U.S. financial system.

A Black Swan?

Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement could trigger a hyperinflationary collapse. The result of a domestic breakdown of confidence and trust in the U.S. financial system would not be a traditional run on banks or a rush into cash due to mistrust of banks (creating demand for physical notes) or a rush out of dollars into hard goods due to runaway inflation but rather a run on financial markets. If investors, pensioners, private institutions and fund managers withdraw from the markets in order to preserve their capital, it could potentially cause not merely a stock market decline but a crash. In the worst case, a domestic breakdown of confidence and trust could lead to a near total collapse of U.S. financial markets. The failure of financial firms, the accelerated disintegration of the U.S. dollar’s world reserve currency status and the final bust of the U.S. government’s finances would follow. Neither the federal government nor the Federal Reserve can fix the U.S. financial system if its perceived legitimacy were to fail. An inflationary policy response, at that point, would only exacerbate the problems of the U.S. dollar. History may record yet again that “there is no means of avoiding the final collapse of a boom brought about by credit expansion” because the escalating moral hazard engendered by limitless bailouts is itself a cause of collapse.

John Embry on Gold, Silver, Currencies and Commodities

Ron Hera — Sun, 01 Jul 2012 20:14:00 GMT

The Hera Research Newsletter is pleased to present the following insightful interview with John Embry, Chief Investment Strategist of Sprott Asset Management LP, where he plays an instrumental role in the corporate and investment policy of the firm. Mr. Embry, who is a world renowned expert on the gold market and on gold and precious metals mining shares, currently focuses on the Sprott Gold and Precious Minerals Fund. Mr. Embry has researched the gold sector since 1963 and has more than thirty years of industry experience as a portfolio management specialist.

After graduating from the University of Manitoba with a Bachelor of Commerce degree, Mr. Embry began his investment career as a stock selection analyst and Portfolio Manager at Great West Life, where he later became Vice President of Pension Investments for the entire firm. After 23 years with the company, he became a Partner in United Bond and Share, an investment counseling firm acquired by Royal Bank in 1987.

At Royal Bank, Mr. Embry was named Vice-President, Equities and Portfolio Manager at RBC Global Investment Management, a $33 billion organization where he oversaw $5 billion in assets, including the flagship $2.9 billion Royal Canadian Equity Fund and the $250 million Royal Precious Metals Fund, which was the #1 ranked fund in Canada for its 2002 net performance of 153%.

Hera Research Newsletter (HRN): Thank you for joining us today. Let's talk about gold stocks.

John Embry: Gold stocks represent a tremendous value in relation to the price of gold and to the fundamentals of the sector. There has been tremendous shorting activity by hedge funds and, as a result, dedicated gold funds have experienced redemptions. Retail investors, who are natural buyers of these stocks, have been annihilated by the price action. This has created one of the finest opportunities, if not the finest opportunity, that I have ever seen.

HRN: Do you have a short term price target?

John Embry: I don't look at short term price charts for gold. In a market as heavily interfered with as this one, charts can be made to look any way you want in the short run. As I see it, if you don't like gold at these prices, then you must like currencies. My partner Eric Sprott often says, the U.S. dollar is the best looking horse in the glue factory. If the U.S. dollar is the world's strongest currency, that's the best endorsement for gold that I can think of.

HRN: Do you believe that currencies are losing value?

John Embry: The fact is that economies are slowly melting down. The problem is excessive debt in almost every corner of the world. The only way to deal with the debt is through aggressive growth, but fabricating growth through more debt won't work. The idea that you can get the economy to move forward by creating even more debt just doesn't wash. We can't service the existing debt, even at artificially low interest rates. I don't see any easy way out. We have to get the excessive debt out of the financial system. Either policy makers are going to create mounting inflation or there will be a deflationary debt collapse.

HRN: Europe seems to be a case in point. Do you think the Euro will break up?

John Embry: The Eurocrats who constructed the currency aren't going to give it up easily. The key is how much the Germans are going to go along with. They realize that there's a huge loss for them if the Euro falls apart. I wouldn't want to be in German Chancellor Angela Merkel's shoes. Germany is trapped in the Euro because it relies on exports and German banks hold the debt of other European countries. Despite the bailouts and the inflationary policies of the European Central Bank (ECB), Germany doesn't have much choice.

HRN: How can European governments solve their debt problems?

John Embry: The problem is that it would take a horrific debt collapse to set the stage for future expansion. There is no politician on earth that wants that to happen on their watch. Consequently, policy makers will resist deflation and we're going down the opposite road, which means mounting inflation or possibly hyperinflation. I don't think politicians will change the system. I think the system will change the politicians.

HRN: Can the economy recover in a high inflation scenario?

John Embry: Creating even more debt is not going to work. To me, high inflation is the most corrosive thing that can happen to an economy or to a country. I'm really worried that neoclassical, Keynesian economists like Paul Krugman, who are prescribing even more debt, will bring about a collapse.

HRN: Are these problems the result of Keynesian economics?

John Embry: If you really applied Keynesianism as Keynes originally envisioned it, the government was supposed to run surpluses when the economy was growing to pay for the deficits that would be created during downturns. That's been conveniently forgotten. We've had an astounding build up of debt. I don't think people fully realize how serious this is. I'm amazed at how complacent people are. We've never been in a position like this in the entire history of the world.

HRN: Why do you think people are so complacent?

John Embry: I think it's cognitive dissonance. When confronted with something that's really unpleasant, and to which there's no easy solution, the average person will basically block it out and look for somebody to tell them that everything is fine. The mainstream news media and the government are doing that as we speak. Consequently, the average person doesn't have a chance of understanding what's going on. The man in the street doesn't have a clue what's coming.

HRN: What about investment professionals?

John Embry: I have a lot of close friends who have been in the investment business for 40 years and they don't want to hear it.

HRN: Won't the Federal Reserve and other central banks simply bail out the system?

John Embry: They think that printing money will buoy the markets and that that's good, but it won't solve any of the problems. Although you may get a momentary lift in the financial markets, when it plays itself out we'll be back in the same situation, but with money that's being systematically destroyed.

HRN: Does printing money work in the short term?

John Embry: There are nominal prices and real prices. Printing money is very deceptive and people are confused by its effects. I am only interested in real returns, not nominal returns. If you have a nominal return that's caused by inflation, you're losing money because governments tax nominal gains.

HRN: Can governments inflate their way out of debt?

John Embry: The U.S. federal government, for example, has reached a stage where forty cents of every dollar spent at the federal level is borrowed and a lot of that money has been printed. There has never been a case in history where that hasn't led to financial disaster. If you study any empirical evidence, they're in a hopeless position. They've only been able to get away with it so far because the U.S. dollar is the world reserve currency. If the United States wasn't able to print money and was trapped in the European Union, it would just be a massive Spain.

HRN: So, governments can't inflate away their debt?

John Embry: Inflation is the easier, more expedient route to take, but I would not rule out an accident. For example, if policy makers push austerity too far they could trigger a deflationary spiral that would be impossible to reverse. I subscribe to the Austrian theory of economics. In his book Human Action, Ludwig von Mises wrote that there is no way to avoid the collapse of a credit boom and that more credit expansion simply destroys the currency.

HRN: Don't inflationary policies help banks and support the financial system?

John Embry: The ECB could do another Long-Term Refinancing Operation (LTRO) or the Federal Reserve could buy more U.S. Treasuries in the open market but that's not really solving the problem. If you actually evaluated the banking system and marked all the assets to market, the system would be insolvent.

HRN: And the basic problem is too much debt and leverage?

John Embry: The over the counter (OTC) derivatives situation is so surreal I can't begin to express it. Correctly calculated, the notional value of all OTC derivatives is in excess of one quadrillion dollars globally. The vast majority are related to interest rates. Central banks have to keep creating liquidity to prevent these instruments from collapsing.

HRN: What can the Federal Reserve and other central banks do?

John Embry: They're lost either way. They're running a massive lab experiment with monetary policy and don't have a clue what the outcome is going to be.

HRN: Do you think the U.S. economy can grow its way out of debt?

John Embry: When I was a kid back in the 1950's, most women didn't work. Americans maintained their standard of living by putting a second person to work. When that was expended they made up the difference by going into debt and, eventually, they used their homes as cash machines. Now student loans total more than $1 trillion. I just don't see where the consumer demand is going to come from going forward. You can't get blood out of a stone.

HRN: What do you think the outcome is going be?

John Embry: I believe that before this is over we'll have a new currency system, probably backed by gold.

HRN: Do you support the gold standard?

John Embry: One of the greatest periods of wealth creation was when we had a gold standard in the second half of the 19th century. It's hard to believe that it's going to be 41 years since there has been gold backing for any of the major currencies in the world. That is what has allowed the massive build up of debt that we have today. If there had been a gold standard, we wouldn't be in the position we are in. Western governments don't want the gold standard because it restricts their ability to dole out favors.

HRN: But the gold standard doesn't prevent financial panics.

John Embry: There are always going to be financial panics, but, under the gold standard they tend to be short term. If we had had a gold standard, there would have been a number of cleansing periods where excess debt was eliminated. The Federal Reserve allowed the build up of debt that led to the stock market bubble and crash of 1929 and to the Great Depression, which was followed by World War II. It took about a decade to build up the debt and more than a decade to deal with the fallout. It's taken more than 40 years to build up the debt we have today and I don't know how long it's going to take to correct it.

HRN: What does this mean for the average person?

John Embry: I think living standards of most people in the world, particularly in the West are going to decline precipitously. The Federal Reserve recently reported that the net worth of the median American family has fallen nearly 40% since 2007 after adjusting for inflation. Before this all plays out, I think the percentages are going to be far larger.

HRN: Do you foresee any wider impact on society?

John Embry: When I was growing up in the United States after World War II, I didn't realize how remarkably fortunate we were as a society to have such a strong middle class. Seldom in history has there been a middle class to equal what transpired in the U.S. and Canada from the 1950s to the 1980s. We basically took it for granted because that's all we ever knew. The middle class in the United States is disappearing. What happens is that you have massive poverty and a small wealthy class. It's one of the worst things that can happen to a society and it can lead to civil unrest. If there's no reason to buy into the system, people will act up.

HRN: Do you view gold and silver as commodities?

John Embry: I view gold and silver as monetary metals. The mainstream news media conflates gold and silver with industrial commodities, but they're really a competitor to the currency system. Gold is the antithesis of paper money.

HRN: I've read that central banks are buying gold.

John Embry: Confidence in currencies is misplaced. There is a strong flow of gold from West to East. The Chinese, Indians, Russians and Vietnamese know perfectly well what's going on with the U.S. dollar and the Euro. They are buying physical gold and the West has been stupid enough to sell it to them.

HRN: What's your view on China?

John Embry: I'm not optimistic on China in the short run. The People's Bank of China (PBoC) recently cut bank reserve requirements by 150 basis points to stimulate 1.2 trillion yuan ($190 billion) of new lending because they don't want growth to fall from around 8% to 7%. As I see it, they've dined out on Western profligacy for 20 years and have become the most unbalanced economy in the world. An inordinate amount of China's economic activity is generated by exports and by all manner of capital spending on manufacturing, real estate, infrastructure and more. The slowdown in the world economy has revealed massive overcapacity in many sectors.

HRN: Can China develop a consumer-driven economy?

John Embry: The idea that China's economy can morph into a consumer-driven economy is preposterous. The very same consumers are employed in sectors like manufacturing where there is massive overcapacity. If the world slides into another global recession, which is not beyond the realm of possibility, I don't see how China stays out of it and if they don't then there's no engine of growth left in the world.

HRN: So, even with a rising middle class, China remains dependent on exports?

John Embry: The fact is that China has become the world's manufacturer but the ability of their two largest customers, Europe and the United States, to consume is being constrained. China is not going to be able to keep selling more year over year. The HSBC manufacturing index has fallen to recessionary levels.

HRN: It has been predicted that China will become the world's largest economy. Do you think that's true?

John Embry: I think China will probably dominate the 21st century. The U.S. dominated the 20th century but it went through some very tough times in the first half of the century.

HRN: With a slowdown in China, what's your view on commodities like copper or crude oil?

John Embry: In the short term, I'm worried about commodities. In a deep global recession, I expect there will be extreme monetary debasement, which will hold up the nominal prices of commodities more than supply and demand factors would suggest.

HRN: Do you foresee a bear market in commodities?

John Embry: We are in a short-term bear market that will be arrested by monetary debasement.

HRN: But there are value buying opportunities?

John Embry: Given my views on currencies, commodities that are already depressed could be decent repositories for wealth. I like agricultural products. As the global economy continues to develop, I think the supply of food is going to be a major issue.

HRN: How can investors protect their assets in a global recession?

John Embry: The only things I'm comfortable holding are precious metals and, because they are so cheap now, precious metals mining shares.

HRN: Where do you think the price of gold will end up?

John Embry: I'm more concerned with how many ounces I own than with how many U.S. dollars I can get for them at any given point in time. Gold and paper money are going in opposite directions.

HRN: Thank you for your valuable time.

John Embry: It was my pleasure.

After Words

John Embry doesn't mince words and his track record speaks for itself. A defender of the gold standard, John Embry sees gold and silver as currencies competing against the U.S. dollar and the Euro, which are losing value because of extreme debt levels, weak economic fundamentals and policy induced inflation. According to John Embry, abandoning the gold standard has led to unprecedented debt levels that could take decades to unwind. In the mean time, inflation seems likely to wipe out the middle class. While his outlook for commodities is bearish, John Embry believes that gold and silver and related mining shares remain the best way for investors to preserve their wealth.

Jim Sinclair: The Financial System Is Less Stable Today Than It Was in 2008

Ron Hera — Sat, 07 May 2011 11:35:00 GMT

The Hera Research Newsletter is pleased to present an in-depth interview with Jim Sinclair, Chairman and CEO of Tanzanian Royalty Exploration and founder of Jim Sinclair's MineSet, which hosts his gold commentary as a free service to the gold investment community.

Jim Sinclair is primarily a precious metals specialist and a commodities and foreign currency trader. He founded the Sinclair Group of Companies in 1977, which offered full brokerage services in stocks, bonds, and other investment vehicles. The companies, which operated branches in New York, Kansas City, Toronto, Chicago, London and Geneva, were sold in 1983.

From 1981 to 1984, Mr. Sinclair served as a Precious Metals Advisor to Hunt Oil and the Hunt family for the liquidation of their silver position as a prerequisite for the $1 billion loan arranged by the Chairman of the Federal Reserve, Paul Volcker.

He was also a General Partner and Member of the Executive Committee of two New York Stock Exchange firms and President of Sinclair Global Clearing Corporation (a commodity clearing firm) and Global Arbitrage (a derivative dealer in metals and currencies).

In April 2002, shareholders of Tanzanian Royalty Exploration (formerly Tan Range Exploration) approved the acquisition of a Sinclair managed private company, Tanzania American International, and its exploration assets in Tanzania. Subsequently, Mr. Sinclair became Chairman of Tanzanian Royalty and now leads its efforts to become a gold royalty and development company.

He has authored three books and numerous magazine articles dealing with a variety of investment subjects, including precious metals, trading strategies and geopolitical events and their relationship to world economics and the markets. He is a frequent and popular commentator on financial and market related issues in various news publications, and has been profiled in the New York Times.

In January 2003 Mr. Sinclair launched, Jim Sinclair's MineSet, which now hosts his gold commentary and is intended as a free service to the gold community.

Hera Research Newsletter (HRN): Thank you for speaking with us today. You are one of very few people who have tried to warn investors about OTC derivatives. Why are OTC derivatives a problem in your opinion?

Jim Sinclair: Over the counter (OTC) derivatives are the reason we are going through what we are going through now. An OTC derivative is a kind of wager on what something will do. Up until 2009, most of these wagers had very little, if any, money behind them and, if the direction you bet on didn't come to fruition, the amount of leverage resulted in extraordinary losses. There was a major rollover in derivatives tied to real estate in 2008, as well as in other types, such as those tied to sub-prime auto loans.

HRN: Did OTC derivatives destabilize the financial system in 2008?

Jim Sinclair: Absolutely.

HRN: Don't financial institutions use risk cancellation models to hedge risks using OTC derivatives?

Jim Sinclair: Before the failure of Lehman Brothers, OTC derivatives losses would have almost netted out to zero. You can consider derivatives like a string in a circle with various knots representing all the derivatives transactions. When Lehman went broke, the string broke. When Lehman couldn't meet its obligations on derivatives, they could no longer be netted out to zero. That's why the banks went down, and that's why you had the government bailouts and quantitative easing (QE).

HRN: OTC derivatives are the real reason for the bank bailouts?

Jim Sinclair: That is a fact which can in no way be argued away.

HRN: Hasn't the problem been cleaned up by the Dodd-Frank Wall Street Reform and Consumer Protection Act?

Jim Sinclair: The pile of OTC derivatives is over $1 quadrillion. After 2008, the International Monetary Fund (IMF) adopted a new method of valuing them called value to maturity. Value to maturity assumes all of them will function, which is a cartoon. The derivatives pile hasn't contracted. Basically, it has expanded, but value to maturity reduced the notional value from over $1 quadrillion to under $700 trillion. The amount outstanding is the same as it was in the first place.

The flavor of the present moment is credit default swaps against the solvency, or lack thereof, of sovereign nations. New derivatives have some margin behind them, but they only work if they are not called upon. If a nation's debt was in fact to default, it would happen very quickly without a great deal of run up before. Most people would expect a rescue to be coming. Let's say a rescue didn't come, those credit default swaps would simply not be able to function and down again would come the banking system.

HRN: Are you saying that the financial system is less stable today than it was in 2008?

Jim Sinclair: It appears more stable but that's only an appearance. The entire equity rally took place almost to the day from when the Financial Accounting Standards Board (FASB) relaxed the mark-to-market rule. It allowed financial institutions to make up whatever value they wanted for their worthless pieces of paper. If they used the real values, the banks would have come down.

HRN: Wasn't the FASB change a temporary measure to halt the decline in mortgage-backed securities?

Jim Sinclair: It wasn't just mortgage-backed securities. It was all the paper on bank balance sheets. The balance sheets of banks appear to be in good shape but they're not. In fact, they will need a lot more funds.

HRN: Then the financial system is still vulnerable?

Jim Sinclair: They've kicked the can down the road. The purpose of QE, in other words the printing of money, is to maintain some degree of integrity in the financial system. Bear in mind that the grease for the wheels of equity markets is liquidity, meaning that if you create a lot of money, it goes into the hands of banking institutions and international investment houses. So, the equity out of thin air market has been sustained by QE.

HRN: What can the government do to prevent another crisis?

Jim Sinclair: You can assume that what's been done already will be done again. There are no other tools in a practical sense. The idea that there won't be a continuation of QE is nonsense.

HRN: Can the government bail out the banks again?

Jim Sinclair: The central banks will buy the government debt. That's called quantitative easing.

HRN: Doesn't QE undermine the dollar?

Jim Sinclair: The dollar is an exercise in psychology. It's a piece of paper with a promise to pay but there's nothing in which it can be paid. It's legal settlement for debt but there's nothing that it's convertible into. To maintain confidence, it's necessary to maintain the stature of a currency. In an arithmetic sense, if you go into a market to sell a supply of apples, and if you're the only seller, you can get a nice price. If more sellers, meaning more apples, come into the market, there goes the price of apples. QE creates more dollars, which increases the supply.

HRN: If the dollar is losing value because of QE, what about the euro?

Jim Sinclair: If you look at the dollar or the euro or the yen, or even the Swiss franc, it's a race to the bottom amongst all currencies. All countries everywhere are creating more paper every day. It's a relative valuation, rather than a valuation based on an objective reference. What happens in the European Union immediately affects the dollar.

HRN: You mean the sovereign debt crisis?

Jim Sinclair: There's too much focus on the euro countries. There's no difference between the economic union of Europe and the union of the states in the United States. The states of europe have been revealed to be insolvent. How about the states of the United States? Out of New York, Illinois, California, etc., how many are solvent? The focus of the media has been on the euro. The U.S. should stand in front of a mirror. The states of the economic union of America are in no better shape.

HRN: The news media is ignoring the U.S. sovereign debt crisis?

Jim Sinclair: In George Orwell's Nineteen Eighty-Four, there were loud speakers constantly teaching the people what Big Brother wanted. The loudspeakers today are financial television. How much attention has financial TV put on the insolvency of U.S. states? It's been mentioned, but not like the solvency problems of Portugal, Greece, Spain and Ireland, which have gotten hours, days, weeks and months of constant coverage. The solvency of New York, Illinois and California has been brought up but fleetingly at best.

HRN: So, the solvency problems of U.S. states are like an elephant in the room that no one is talking about?

Jim Sinclair: How can you say that the euro is a disaster based on the financial condition of the states of the economic union of Europe, when the states of the economic union of the United States are in equally bad shape and in some cases worse? There's no difference. If you want to analyze the euro based on the weakness of its member states, how can the dollar be strong when the states of the United States are as weak or weaker?

HRN: So, the euro could rise against the U.S. dollar, despite the European sovereign debt crisis?

Jim Sinclair: Sure it can. The question is, can the dollar go lower? The euro could go to $1.50 or higher.

HRN: But the U.S. dollar is the world reserve currency. Doesn't that guarantee its value?

Jim Sinclair: Only by default. It remains so because central banks own dollars. If central banks could exchange them for gold or other currencies without a major dislocation, they would.

HRN: Then, as a practical matter, central banks can't get out of the dollar?

Jim Sinclair: The only one that's gotten out of it is China. They've made deals all around the world for metals, materials, energy and manufacturing. If you add it all up, China is no more stuck in the dollar than the man in the moon.

HRN: Doesn't the U.S. maintain a strong dollar policy?

Jim Sinclair: The strong dollar policy has only been a moderate, long-term downtrend that continues lower.

HRN: Don't central banks manage currency exchange rates to prevent disruptive changes, like the recent Japanese yen intervention?

Jim Sinclair: In the Japanese yen intervention, the central banks intervened but how long can they intervene? They have to create money to intervene, which comes back to QE.

HRN: Do you mean the overall affect of currency interventions is to create new money?

Jim Sinclair: Anything that happens around the world, for instance, the Bank of Japan's response to the horrible disaster in Japan, was to go straight to QE. Money is being created everywhere without any discipline but the problems of financial institutions remain because they have make-believe balance sheets with improper values for their OTC derivatives.

HRN: Doesn't the suspension of the FASB mark to market rule buy time for banks to repair their balance sheets?

Jim Sinclair: There are five million homes for sale in the United States if you include the off-market shadow inventory, which is a real inventory. There's no repair coming in the real estate market, therefore, there's no repair coming in the OTC derivatives based on that. That means there's no repair coming in the underlying paper that the banks now value at much higher levels than they could possibly sell them for, if they could sell them at all.

HRN: Will bank balance sheets eventually get better?

Jim Sinclair: As long as confidence remains in place, which depends on the equity market and that comes back to QE.

HRN: Are you saying that the U.S. stock market rally is driven by QE?

Jim Sinclair: There's an inability to stop QE without the whole house of cards coming down on itself. There's no other choice. It's the only tool left. The Federal Reserve can't take a hawkish position on monetary policy and interest rates without this whole thing rolling over. They can talk about it constantly and might have more back-door QE than front-door QE.

HRN: If QE doesn't stop soon, what will happen?

Jim Sinclair: The end game is a virtual reserve currency linked to gold. It will be based on an average of major currencies, which will slow down the movement in the index. The IMF is moving in that direction with Special Drawing Rights (SDRs). The dollar will be just another currency. The dollar's not going to zero. It could loose a significant part of its buying power, which it already has and could again.

HRN: How would a virtual currency work?

Jim Sinclair: There would have to be a broad measure of the money supply, such as M3 used to be for the U.S. dollar, but on an international basis. The price of gold would be related to that measure. Central banks would have to value their gold according to their contribution to or extraction of international liquidity, so the price of gold would rise or fall on its own.

HRN: Wouldn't that be a gold standard?

Jim Sinclair: There'll never be a return to a gold standard in my opinion. The end of all hyperinflations has been a commodity currency. That's exactly what happened in Germany, for example. Gold has the capacity to give confidence to people if there's some relationship between the currency and gold. The virtual currency will be linked to gold but not convertible into gold.

HRN: So, a gold component will restore confidence?

Jim Sinclair: The answer is a commodity currency. That's what happened every time there was this type of situation in monetary history. The rentenmark, which ended the German hyperinflation in 1923, was supposedly backed by all the real estate in Germany, but the government didn't own that real estate. The point is that it wasn't true. There was no great commodity backing for the rentenmark, but it was enough. It was a period when people were searching for anything to restore confidence in the currency.

HRN: Do you expect high inflation in U.S. dollar terms?

Jim Sinclair: The deed is done. Inflation is a pregnancy. The conception has already taken place. There's a delayed effect but if you do the crime, you do the time. The Federal Reserve could stop QE tomorrow and it wouldn't stop what's going to happen because of what they've already done.

HRN: Won't inflation reduce the real value of debt and help to repair bank balance sheets?

Jim Sinclair: Inflation is the way debt will be taken care of. The value of the currency will be so reduced as to reduce the debt load. It will also change the political scene. Whoever has power going into this will not have power coming out of it.

HRN: In other words, inflation is politically destabilizing?

Jim Sinclair: People really haven't seen the big picture. Currency induced cost push inflation is already here. Look at what's going on right now in the Middle East. We are moving from order to lack of order.

HRN: Would you say that inflation in food prices is indirectly driving oil prices higher?

Jim Sinclair: Oil goes right through from fertilizers to farm equipment to transportation and to food prices. The price of food is going to go even higher than we are seeing this year. The price of oil is headed decidedly higher. Peak Oil was a concept of the future. Now it's a concept of now. A car getting 25 miles per gallon will probably be too expensive for the average person to drive.

HRN: How will high oil prices affect the prices of other things?

Jim Sinclair: There will be dislocation in the means of delivery of products. There may be shortages of goods, not because there are no available goods but because the means of distribution breaks down. It's not that there won't be corn or wheat, but the fuel needed to deliver it will be too expensive and people who work in transportation will demand higher pay so they can live. That's where hyperinflation comes in.

HRN: And money to maintain the distribution of goods will be printed out of thin air?

Jim Sinclair: Every nation that has ever done this has turned into a banana republic. People can live in banana republics but there will be few wealthy people. There will be a few super wealthy people and an enormous amount of poverty. You can see it across the border in Nogales, Mexico, where people continue to live in extreme poverty.

HRN: America is becoming like Mexico?

Jim Sinclair: The standard of living is going much lower. People have to realize that the damage is already done. It's not a question of whether the U.S. can be pushed over the edge. We are over the edge. We are watching the consequences play out now.

HRN: What can people do to protect their wealth from inflation?

Jim Sinclair: People have to try to maintain their buying power. Each person can become their own central bank and, to the best of their abilities, focus on the assets that benefit from the disorder that's taking place and that will continue to take place.

HRN: Do you mean buying precious metals or commodities?

Jim Sinclair: I've spoken to people who, over the last ten years, have had this perspective. They have done very well. Even doing it now could protect your wealth.

HRN: What about gold? Do you see gold as a currency that can't be debased?

Jim Sinclair: What is real money? Gold is a currency that has no liability attached to it. It's a measure of value and a store of wealth that's universally acceptable.

HRN: So, gold is an alternative to dollars or euros?

Jim Sinclair: Physical gold is the answer. An individual who holds gold will have more time and ability to function.

HRN: How much higher do you think the price of gold could go?

Jim Sinclair: What's the exchange rate of a currency with no liability attached to it? Gold is going much higher. We could see shocking gold prices, maybe Alf Fields' target of $10,000 per ounce or Martin Armstrong's target of $12,000 per ounce. I think that my price target of $1,650 per ounce gold is going to be so low it will be considered silly.

HRN: Thank you for your time today.

Jim Sinclair: It was my pleasure.

Nicknamed "Mr. Gold" for his incredible timing of the gold market in the 1970's, when he called the top of the market in 1980 to the day, Jim Sinclair, is a legendary precious metals, commodities and currency trader. Mr. Sinclair was influenced by his father, Bert Seligman, who was the business partner of Jesse Livermore, "The Great Bear of Wall Street" famous for short selling in the stock market crashes of 1907 and 1929. Currently Chairman, President and CEO of Tanzanian Royalty Exploration Corporation, part of Mr. Sinclair's strategy to protect his interests from the effects of currency debasement, is to acquire as much gold in the ground as possible without rushing to production because, he believes, the price of gold will go much higher. Mr. Sinclair's famous 2001 gold price target of $1,650 per ounce in 2011-a prediction ten years into the future-fell within 22% of the gold price in January 2011 after a phenomenal 511% increase over a ten year period, from an average price of $265.49 in January 2001 to an average price of $1,356.40 in January 2011 (London p.m. Fix)-one of the most astonishing calls in the history of precious metals trading. As a commentator on precious metals, commodities and currencies, investors ignore Jim Sinclair at their peril.

Interview: Jim Rickards on Inflation and Currency Wars

Ron Hera — Fri, 04 Feb 2011 08:31:00 GMT

The Hera Research Newsletter (HRN) is pleased to present an eye opening interview with James G. Rickards, Senior Managing Director of Tangent Capital Partners, a merchant bank specializing in alternative asset management solutions, and also Chief Operating Officer of Oro Capital Advisors, LLC, a commercial real estate advisory firm and Tangent Capital affiliate. He is a counselor, economist and investment advisor with 35 years experience in global capital markets.

Mr. Rickards has held senior executive positions at Citibank, RBS, Long-Term Capital Management and Caxton Associates. In 1998, he was the principal negotiator of the rescue of LTCM sponsored by the Federal Reserve Bank of New York. His clients include private funds, investment banks and government directorates in national security and he is an advisor on global capital markets to the U.S. Office of the Director of National Intelligence. He is a frequent speaker at conferences on derivatives and hedge funds and is active in the International Bar Association. He has been interviewed in The Wall Street Journal and the Economist, has appeared on CNBC, Fox, CNN, BBC and NPR and is an Op-Ed contributor to the Financial Times, New York Times and the Washington Post.

Mr. Rickards, who is a visiting lecturer at the Kellogg School and the School of Advanced International Studies, has delivered papers on econophysics at the Applied Physics Laboratory and the Los Alamos National Laboratory and has written articles on cognitive diversity, network science and risk management. Mr. Rickards holds an LL.M. (Taxation) from the New York University School of Law; a J.D. from the University of Pennsylvania Law School; an M.A. in international economics from the School of Advanced International Studies and a B.A. (with honors) from The Johns Hopkins University.

Hera Research Newsletter (HRN): Thank you for taking the time to speak with us today. Let’s talk about the Federal Reserve’s quantitative easing program (QE2). Is there a risk of price inflation?

Jim Rickards: I think there is a definite and highly significant danger of inflation coming from QE and QE2 specifically. A lot of people have said, in fact, the Fed has said, that, if you look at the key price indices, the Producer Price Index (PPI), Consumer Price Index (CPI), and the Personal Consumption (PC) price deflator, they are very, they use the phrase, “well behaved”. For the past year and a half, the critics, and I would include myself, have been saying that this situation is dangerous and unstable. The Fed has been pointing to the price indices and saying that you can’t find inflation under a rock, you can’t find inflation with a microscope, so what are you worried about?

HRN: Why do you think the situation is unstable?

Jim Rickards: There is a lot of inflation, but it is being offset by deflation. I compare it to an arm wrestling match. If you’ve ever seen an arm wrestling match with two really powerful participants, nothing really happens for a long time. The two arms just kind of sit there, then all of a sudden it starts to tip, then one guy just breaks and his arm is slammed down on the table. Just because nothing is happening at the surface doesn’t mean that a lot of things aren’t happening below the surface. In a depression, such as the one that began in 2007, you have very, very strong deflationary forces. I call it a natural deflation that’s being offset by policy inflation. So the fact that the price indices are around zero doesn’t mean that they’re well behaved, it just means that they’re masking the two tectonic forces that are pushing against each other.

HRN: Do you think deflation will win, or will it be inflation?

Jim Rickards: For the past year and a half, I’ve wondered which way it’s going to tip. If I’m right about those two forces, one of them is going to prevail at the end of the day and, on which one it’s going to be, I really reserve judgment because I could argue it both ways. I am now coming down on the side of inflation because the inflation is becoming very, very apparent. So, the first thing is that the well behaved indices are masking more than they’re telling us because, below the surface, there are powerful deflationary and inflationary forces fighting each other.

HRN: Why do you think inflation will win?

Jim Rickards: It’s been known since the 1950’s, as Milton Friedman pointed out, inflationary effects occur with the lag. The fact that you saw QE in 2009 and inflation didn’t show up until the end of 2010 really should not give you a lot of comfort because an 18 to 24 month lag is normal and would be expected. Sure enough, right on schedule, 18 months after QE1 was announced in mid-2009 we’re starting to see the inflation.

HRN: What does inflation in foreign countries have to with QE2?

Jim Rickards: There are some new forces in play since Friedman did his seminal work and, of course, it’s the result of globalization. What has been happening is that what would otherwise have been U.S. inflation is showing up in China and Taiwan and Korea and places like that because of the exchange rate mechanism. I put this under the heading of currency wars. In effect, China has been importing all of our inflation through the peg between the dollar and the yuan.

HRN: How does the yuan-dollar currency peg cause inflation in China?

Jim Rickards: Just think about the mechanics of it. There’s a lot of deleveraging going on, which is where the deflation comes from, so the Fed goes out and prints a whole bunch of dollars and spreads them around. Americans take a lot of those newly printed dollars and buy foreign goods so the dollars go to China, but China doesn’t want the yuan to appreciate because they want to maintain the peg, or at least they have until very recently. So, what do they do? They have to buy up the dollars. Well, in order to buy up the dollars they have to print yuan and basically give the yuan to the exporters in exchange for the dollars. Well, that’s basically flooding China with yuan and so the Fed’s printing press was being sterilized in America by the Chinese who were flooding their own country with their own local currency. So, through the exchange rate mechanism, and through the peg between the dollar and the yuan, our inflation was showing up in China and now it’s showing up in Vietnam, South Korea, Taiwan and other places.

HRN: Can the U.S. keep exporting its inflation?

Jim Rickards: Like I said, inflation in the U.S. was being offset by natural deflation and there is a time lag before inflation shows up. It has taken a while for inflation to show up in China because they also had a lag. U.S. inflation was being exported through the currency exchange rate mechanism, but all good things come to an end. These things are now coming to an end for two specific reasons. Number one, the time lag just works its way through, and I think commodity prices, input prices, are where the inflation is really starting to show up and it will work its way through the supply chain and eventually show up in retail. Number two, the Chinese have now thrown in the towel on the appreciation or revaluation of the yuan and the reason for that is inflation.

HRN: So, the Chinese yuan will rise versus the U.S. dollar?

Jim Rickards: Inflation is just another form of revaluation. What do you do when you revalue your currency? Well, you increase your cost structure relative to other countries. You make your goods more expensive from the view of a U.S. purchaser, let’s say. Well, inflation does the same thing, inflation increases your cost structure. So, inflation and revaluation are the same thing economically with one very important difference; revaluation you can control, but inflation very quickly gets out of control. The Chinese, once they saw the inflation, said, well, look, this is going to happen anyway, our cost structure is going up and there’s nothing we can do about it. Our choice is between control and lack of control and, of course, they’re control freaks, so they’re going to go with control, which means they’re going to go with the revaluation and try to stay ahead of the inflation.

HRN: Do the Chinese have any other option?

Jim Rickards: They thought they had an ability to keep a lid on their domestic inflation through price controls. We all know that price controls always ultimately fail, but they can work in the short run, especially if you have a more coercive society and I would put China in that category. Whether there was going to be a black market or offshore money or the inability to enforce their rules at the local level, I think they quickly realized price controls were a losing battle.

HRN: What about other export nations, like Brazil?

Jim Rickards: The Fed is flooding the world with dollars and, as former U.S. Treasury Secretary John Connally famously said in the 1970’s, “it may be our currency, but it’s your problem”. Raising interest rates, currency debasement and capital controls are all tools in the toolbox that exporters can use to deal with Fed monetary policy and QE2. We’re seeing capital controls in Brazil, for example. Brazil couldn’t really control the appreciation of the real, there was just too much demand, too much hot money flowing into emerging markets, Brazil in particular. So there wasn’t much they could do about it from a currency point of view, so they’re putting in capital controls. The next step down that road, you pretty quickly go from currency wars to trade wars and trade wars lead to tariffs and then export quotas. We’re seeing a little bit of that in China with rare earth elements (REEs), although there’s another agenda with respect to REEs having to do with encouraging manufacturers to put their plants in China so they can get guaranteed access to the REEs.

HRN: Will the revaluation of the yuan and capital controls in other countries cause prices to rise in the U.S.?

Jim Rickards: The inflationary chickens are coming home to roost in the United States. Once the Chinese throw in the towel and revalue the yuan, all of that inflation that Bernanke has been trying to get, but which has been going to China, etc. will show up in the U.S. I think, we’re looking at significant inflationary forces, for all of the reasons I just mentioned, and that’s probably going to be the story of 2011.

HRN: So, the Federal Reserve caused inflation in Asia, South America and elsewhere resulting in currency wars and now there’s a risk of trade wars?

Jim Rickards: Correct.

HRN: If the U.S. economy is recovering, why doesn’t the Federal Reserve stop QE2?

Jim Rickards: When you see data that point in a positive direction, you have to take a step back and say, OK, objectively, the data points in a positive direction but how much of that is policy induced and how much of that is self sustaining? My view is that almost all of it is policy induced and very little of it is self sustaining. I reach that conclusion by looking at data where, if we were in a self sustaining recovery, other things would be getting better and they’re not, such as unemployment. That suggests to me that it’s not a self sustaining recovery, therefore, I conclude that it’s mostly policy induced, which means the Fed is going to have to keep going.

HRN: Can inflation help the U.S. economy to grow and help to reduce unemployment?

Jim Rickards: The main reason the Fed wants inflation has very little to do with growth and everything to do with the debt overhang and the fragility of the banking system. People forget that the Fed exists to help the banks. It’s the whole reason for the Fed.

HRN: Isn’t the purpose of the Federal Reserve to promote price stability and full employment?

Jim Rickards: The Fed was created by banks and it exists to prop up the banking system. The idea that it’s somehow a benign moderator of economic conditions, in my view, is nonsense. The Fed is first and foremost a device to prop up banks and, right now, the biggest problem in the banks is their bad assets.

HRN: Didn’t the bailouts and the Federal Reserve’s purchases of mortgage-backed securities clean up the bad assets?

Jim Rickards: The bad assets haven’t gone anywhere. They were identified in 2007, but they had been there all along. The bad loans were made in 2004, 2005 and 2006 because Greenspan and the Fed’s Board of Governors kept interest rates too low too long, so that’s when the bad loans were made. They were identified as such in 2007 and then we had the panic of 2008, but what’s important to understand is that the bad loans haven’t gone anywhere. It’s not as if they’ve been magically transformed into good loans, it’s not as if they’ve been marked down, it’s not as if they’ve moved from weak hands to strong hands. What’s happened is, they’ve basically been locked in amber, frozen on the balance sheets of the banks.

HRN: So, the Federal Reserve wants inflation to help banks that made bad loans?

Jim Rickards: The Fed is hoping for a couple of things. First of all, they’re hoping that inflation comes back so that, at least, the nominal values get back somewhere closer to where the loans were originated. Of course, the real value has all been eroded, but who cares? If you’re a bank, you just want that nominal value so you don’t have to take the loss and the hit to capital. Second, they’re hoping that, because of the steepness of the yield curve, the banks could eventually earn their way out of the problem and make provisions for the bad loans. Obviously, they’re going to the zero interest rate policy and so, with those two things in mind, the Fed wants the inflation to come and help the banks and give them time to recover.

HRN: Wouldn’t inflation also reduce the real value of the U.S. federal government’s debt?

Jim Rickards: The United States has well over $100 trillion in obligations. Now, that’s not all bonded debt, the actual debt is significantly less than that, but when you throw in contingent obligation arising from Social Security, Medicare, Medicaid, Fannie Mae, Freddie Mac, Federal Housing Authority (FHA), Federal Home Loan Bank, student loans, etc., etc. The point is, you can just go on and on with these obligations. The number is well north of $100 trillion. Now, it’s not all due and payable in the next couple of years, these are 20 year obligations, but then you have to say where are we going to get growth for the next 20 years to meet these obligations? That’s very hard to see.

HRN: So, the U.S. economy can’t grow its way out of debt?

Jim Rickards: I don’t see any feasible combination of growth and taxes that will generate enough income to pay off the debt. People warn about the debt trap, to me it’s already too late. We’ve already fallen into a hole where, mathematically, it’s impossible to earn enough to pay off the debt. The debt is compounding faster than growth is being generated and raising taxes is not a solution because that will kill growth, so you just can’t get there.

HRN: What can the U.S. federal government do about its debt?

Jim Rickards: There are two ways to deal with the debt. One is to just default; I just won’t pay you. The other one, of course, is the one that governments prefer which is inflation. You say, OK, here’s your trillion dollars and good luck buying a loaf of bread with it; it’s just not going to be worth very much. So, that’s what we’re doing and that’s another reason why Bernanke wants inflation. Of course, he doesn’t want hyperinflation, he doesn’t want 10%, but he doesn’t need 10%. If you do 4% a year for 17 years, you cut the value of the debt in half. So, that $100 trillion figure I referred to, in real terms, becomes something more like $50 trillion, which is still a big number, but much more manageable than $100 trillion. He says he wants 2% or slightly less. I think that’s disingenuous, I think what he would like is something more like 3% or 4% where, over a 15 to 20 year period, you could really reduce the value of the debt in real terms very significantly.

HRN: If the U.S. is debasing the dollar, why is there strong demand for U.S. Treasuries?

Jim Rickards: The reason the Treasury auctions are going well is because the Fed is buying. Think about what quantitative easing really is. The amount of quantitative easing over the 6 month period from November to June is approximately equal to the federal deficit. In other words, the federal deficit is running about $1.4 trillion a year, so half of it would be $700 billion and the Fed is out to buy $600 billion. By the way, I don’t think it’s going to end in June and they never said it was going to end in June. What they said was, we propose to buy $600 billion of treasury obligations between November and June, but they never said it was capped at $600 billion. They just said we’re going to buy about $75 billion a month for the next 6 months. I don’t think they will stop there. I view this as much more likely to be a trillion dollar plus program, not $600 billion.

HRN: How does the Federal Reserve’s purchase of U.S. Treasuries in the open market monetize U.S. government debt?

Jim Rickards: These things are pretty fungible. Dollars are totally fungible and Treasury securities are quasi fungible because it’s the same credit in the same currency. So, imagine you’re an institutional investor and you’re holding an off-the-run 7 year note with 5 years to maturity and the government is issuing a new 5 year note. Obviously, the primary dealers mediate this and are the interface between the Fed and the institutional investor. So, the Fed goes out and buys an off-the-run 7 year note from an insurance company, let’s say, and the insurance company replaces that in their portfolio by buying a new 5 year note. From the insurance company’s point of view, they got rid of a 5 year treasury and they bought a 5 year treasury, so nothing happened. From the Fed’s point of view, they bought the 5 year treasury with newly printed money and so there’s some intermediation and there’s multiple parties involved, but the net effect is exactly as if the Fed was monetizing the new debt.

HRN: Let’s get back to inflation. Can’t the Federal Reserve control inflation if prices start rising?

Jim Rickards: I think these processes are dynamically unstable and once you let the inflation genie out of the bottle, you don’t get 2% or 3%, you go straight to 10% and that’s what happened in the 1970’s. If you look at the late 60’s and early 70’s, inflation was 1% or 2% and then one year it pumped up to 3% and they said, oh my goodness, it’s 3%. After that, it went to 5%, then to 8%, then to 10% and then to 13%. In other words, between 1977 and 1981, in that five year period, cumulative inflation was 50%. The value of the dollar was cut in half over that very short 5-year period of time. So, that’s how it accelerates and gets out of control. I think that’s what’s going to happen again.

HRN: How much will prices go up in the U.S.?

Jim Rickards: Bernanke says 2%, but he actually wants something closer to 4%. I think what he’s going to find is that it goes very quickly to 8% or 9% or 10%, which is borderline hyperinflationary and that’s going to be a huge problem. It’s going to be a shock that the American people are not ready for.

HRN: What can the Federal Reserve do if price inflation starts to accelerate?

Jim Rickards: Well, Bernanke says, oh, don’t worry about high inflation because we have the ways and means of controlling that. If you take Bernanke at his word, which I don’t totally do, but if you do take Bernanke at his word and he says I want 2% and inflation goes to, let’s say, 3% or 4%, he’s saying, well, we can dial it back down to 2%. Well, how are you going to do that? One way is by raising interest rates, but are you really going to raise interest rates when unemployment is close to 10%? Bernanke says he can raise rates, and legally he can, but he’s not actually, politically or economically, going to be able to do it because he’ll be raising interest rates in the face of the greatest sustained period of high unemployment since the Great Depression. So, it’s just not going to be politically possible.

HRN: Couldn’t the Federal Reserve remove liquidity from financial markets to counter inflation?

Jim Rickards: There’s another problem with QE2, which is that the Fed is probably insolvent today if you applied some rigorous mark-to-market tests and that will become more apparent as this process goes forward. Let’s just say Bernanke gets what he wants, and, all of a sudden, inflation starts to creep up and he says; OK, now we have to put on the brakes. Well, how do you do that? The way you do it is by reversing QE. In other words, QE is creating money to buy bonds. The way to reverse that is to sell bonds into the market and take the money out. Well, the problem is you’re going to have massive mark-to-market losses on those bonds. First of all, there’s the Bear Sterns junk and, remember, QE1 was not treasury securities, it was mortgage backed securities. They’re not going to be able to liquidate the bonds without going broke.

HRN: How can the Federal Reserve go bankrupt?

Jim Rickards: The Fed is on its way to a $3 trillion balance sheet. Their capital, in round numbers, is about $60 billion. With $3 trillion on the balance sheet and $60 billion of capital, they’re leveraged 50 to 1. That’s worse than Long-Term Capital Management when they got in trouble in 1998. If you’re leveraged 50 to 1 and you have a 2% decline in assets, just 2%, and the stock market sometimes moves 2% in a single day, you just wiped out your capital. A 2% hair cut on $3 trillion is $60 billion and that takes your capital to zero and the Fed is broke.

HRN: Could the Federal Reserve’s primary dealers sell Treasuries to remove liquidity from the market and help keep inflation in check?

Jim Rickards: The primary dealers can’t create money through auctions or open market operations. The primary dealers can buy and sell securities but they’re doing it with money that already exists whereas when the Fed buys securities or sells securities they are creating or destroying money. The primary dealers can prop up the market in government securities, but they can’t create money the way that the Fed does or make money disappear the way the Fed does.

HRN: So, there’s nothing the Federal Reserve can do to control price inflation?

Jim Rickards: They’ve got to be looking down the road and saying, gee, we say we can get inflation under control, but the tools that we have to do that will basically be raising interest rates with 10% unemployment, which is not going to happen, or selling bonds and going broke, which is not going to happen. So, it’s all talk. The Fed won’t actually be able to keep inflation under control and it’s going to very quickly fly out of control.

HRN: Won’t rising prices make most Americans poorer?

Jim Rickards: The Fed doesn’t care about that. The Fed doesn’t care about people. They don’t care about workers. They don’t care about wages. They say they do, but the Fed only cares about banks.

HRN: Bernanke has been in the media, saying that inflation will stimulate the U.S. economy and help create jobs without causing prices to go up.

Jim Rickards: It’s propaganda. I had a discussion with former Fed governor, no reason to mention the name, who is a very well known economist, and what he said was that behind closed doors the Federal Open Market Committee spends about 10% of their time on policy and 90% of their time on communication. They very quickly arrive at what they’re going to do and then spend the vast majority of their time thinking about messaging and wordsmithing. Well, there’s a name for that. It’s called propaganda.

HRN: Thank you for sharing so many of your insights with us today.

Jim Rickards: It’s my pleasure.

After Words

Jim Rickards is one of the most astute intellectuals today in economics, financial markets and monetary systems, as well as an increasingly outspoken critic of the Federal Reserve’s monetary policies. The debasement of the U.S. dollar—the world reserve currency—through QE2, and due to monetary expansion resulting from low interest rates, is exporting U.S. inflation abroad, disrupting economies in Asia, South America and elsewhere. In addition to putting upward pressure on food prices globally, with potentially disastrous consequences, inflation is a hidden tax on savings and wages and, as prices rise, the living standards of most Americans will decline. Currency wars, caused by the Federal Reserve’s policies, could lead to trade wars or, in the worst case, to economic and political chaos as has been seen in Tunisia and Egypt.

QE2 and its Consequences (Part I)

Ron Hera — Tue, 18 Jan 2011 01:35:00 GMT

The Federal Open Market Committee (FOMC) announced on November 3, 2010 that it would purchase longer-term Treasury securities at a pace of $75 billion dollars per month through the Federal Reserve’s Permanent Open Market Operations (POMO) facility by the end of the second quarter 2011 and potentially beyond. The Quantitative Easing Two (“QE2”) program, championed by Ben Shalom Bernanke, Ph.D., Chairman of the US Federal Reserve, is expected to total at least $600 billion and the program may total more $600 billion, if Dr. Bernanke and the FOMC deem it to be necessary. Currently, QE2 is expected to continue until the end of 2011, i.e. up to $1.2 trillion, although there is ongoing policy debate within the Federal Reserve amidst growing fears that the policy may backfire.

Chart courtesy of Shadow Government Statistics

Monetary inflation is one result of QE2 because when the Federal Reserve buys US Treasuries it injects newly created money into the financial system, which, in turn, reduces the value of the US dollar (due to the increase in the quantity of dollars). A lower US dollar could stimulate US exports but could have unintended consequences, such as creating excess liquidity that could lead to asset price bubbles in the US. Low interest rates are already fueling a US dollar carry trade that seems likely to create asset price bubbles abroad. In 2010, borrowing in the US and investing abroad yielded significant returns, thus, there is a profitable carry trade in the world’s reserve currency, which has been called the mother of all carry trades by New York University economist Nouriel Roubini because of the US dollar’s increasingly tenuous status as the world reserve currency.

Global Outcry against QE2

The announcement of QE2 touched off an international firestorm of controversy. QE2 has been widely criticized by financial and political leaders representing US creditors, exporters and emerging economies. Nobel laureate Joseph Stiglitz has become an outspoken critic of QE2, warning that it poses a risk to emerging economies where asset price bubbles are already apparent. European Central Bank (ECB) President Jean-Claude Trichet expressed the same concern. The growing consensus on the part of emerging economies, such as Brazil, India, China, Argentina, Taiwan, Thailand, South Korea, Peru and Indonesia, is that capital controls are necessary to prevent excessive capital inflows, which can be highly inflationary. The International Monetary Fund (IMF), which bailed out a number of smaller countries in 2008, has supported capital controls since February 2010. The dilemma for exporters is that they must seek to control inflation, e.g., by raising interest rates, but must also debase their currencies to maintain their exports. The only other option is to institute capital controls. One of many critics, Brazil’s Finance Minister, Guido Mantega, warned that the US-led currency war “…is turning into a trade war.”

The growing consensus is that inflation in Asia will damage Asian economies before Western countries, which are debasing their currencies, fully recover from the recession that began in 2007. The trade relationship of the US and China is in the eye of the storm and fears of a trade war are growing. Debasing the US dollar reduces the value of China’s US Treasury holdings while China relies on exports to the US, totaling between $200 and $300 billion annually. For exporters, QE2 is a doubly destructive policy since capital inflows are inflationary while exports are reduced due to currency appreciation. The potential effects of a downturn in manufacturing resulting from falling exports, coincident with the bursting of an asset price bubble, is a formula for disaster. As more countries begin to conduct international trade without using US dollars, the world could be split into two camps. For example, talks are taking place between the US and Japan regarding the establishment of trans-Pacific free trade.

Interestingly, QE2 has the potential to “cash out” favored holders of US Treasuries in exchange for US dollars at their current value, i.e., before the US dollar declines further. China, Russia and Brazil are already reducing their US Treasury holdings and could be favored sellers of US Treasuries to the Federal Reserve (through its intermediaries). However, given the size of the US federal deficit, the simplest explanation is that the Federal Reserve is simply funding the US government.

Keeping the Wolfpack at Bay

While it may stimulate US exports and help to create conditions for renewed economic growth in the US (rather than relying mainly on the stimulation of consumer spending), QE2 represents a debasement of the US dollar and suggests that demand for US debt may be weakening. The current facts regarding the US economy do not justify the AAA rating of US sovereign debt. In February 2010, Moody’s publicly warned that it might have to cut the rating on US government debt. The warning was reiterated in December, while American politicians debated tax policy, and surfaced again in January. Until the US economy shows stronger growth, and until the US federal government gets its budget deficit under control, confidence in US sovereign debt and in the US dollar will continue to deteriorate.

US Treasury yields began to rise after the announcement of QE2 and, in December, US Treasuries experienced an unprecedented sell-off causing speculation that the US may become the next target of the so-called wolfpack, comprising short sellers of sovereign debt that are also OTC derivatives (credit default and interest rate swaps) traders. Artificial demand for US Treasuries created by QE2 could potentially head off the shorting of US Treasury bonds to generate credit default and interest rate swap related profits. Short sellers seeking to drive up yields run the risk that the Federal Reserve will step in and buy aggressively to drive yields back down, thus QE2 may preempt the wolfpack. The United States is not immune to such predatory practices might because the notional value of OTC derivatives is currently more than $605 trillion (approximately 10 times world GDP).

Chart courtesy of StockCharts.com

Artificial demand for US Treasuries could hold down bond yields thus supporting an inflationary monetary policy but the Federal Reserve’s own Primary Dealers forecast higher bond yields for 2011. The Federal Reserve’s control over US Treasury bond yields appears to be limited, ironically, as a consequence of currency debasement. Even if US Treasury bond yields rise, however, QE2 might still provide a means of keeping the wolfpack at bay.

Let them Eat Dollars

While QE2 has been generally positive for equities in the short term, the FOMC announcement in November 2010 triggered a sharp rise in commodity prices with gold closing over $1400 and silver closing over $30 at the end of 2010 and with the Commodity Channel Index (CCI) and global food prices at new highs. Rapidly rising global food prices pose an escalating risk of food shortages or worse, particularly in poorer countries, leading analysts to conclude that the world is one poor harvest away from chaos. President of the World Bank, Robert Zoellick, warned that rising food prices are “a threat to global growth and social stability.” Food riots, for example, have already begun to break out in Africa. In the US, consumers and businesses paid an additional $25 billion for gasoline between September 2010 and January 2011 and gasoline prices have continued higher.

Chart courtesy of StockCharts.com

Since the corrosive effects of expanding the money supply in excess of the rate of increase in sustainable economic activity, i.e., inflation, could not so quickly have resulted from QE2, QE2 seems to have damaged global confidence in the US dollar and in US Treasury debt. The January pullback in gold and silver showed that the sharp rise in prices after the announcement of QE2, in November 2010, was in part reactionary. Nonetheless, the strengthening of the US dollar can be largely attributed to the ongoing debt crisis in Europe and the ongoing bull market in commodities and precious metals points to a continuing influx of capital and to a reduced preference for the US dollar and US Treasuries. Had it not been for the revelation of Ireland’s economic troubles along with those of other European countries, the US dollar would certainly have fallen further compared to the Euro towards the end of 2010. What is more important is that the Euro, the US dollar and the Japanese yen have the same fundamental problem in common, which is a combination of high debt levels and economic fundamentals that, in the best case, do not inspire confidence.

Chart courtesy of StockCharts.com

All other things being equal, if the QE2 program were terminated, the US dollar would certainly rally and demand for US debt would certainly strengthen, lowering demand for commodities and precious metals. The termination of QE2 or an announcement of its impending termination is a potential short term risk for investors. Conversely, as QE2 continues indefinitely, the current commodities bull market, which has been amplified by the weakening US dollar, will continue And precious metals prices, which are currently consolidating, will move higher.

The emerging pattern since the announcement of QE2 is bullish for commodities and precious metals. Episodic flights to safety have tended to cause the US dollar to rally, despite poor economic conditions in the US, i.e., in response to economic instability in countries such as Dubai, Greece, Ireland or Spain. The pattern of US dollar-centric flights to safety has begun to break down, suggesting that investors may increasingly favor commodities and precious metals over US dollars and US Treasuries as hedges against inflation and sovereign debt risk.

Diminishing US Credibility

The credibility of the US government and the Federal Reserve is gradually deteriorating. In the worst case, a total collapse of confidence could trigger a race to divest of US Treasuries and to shed US dollars, i.e., a hyperinflationary currency event. The declining US dollar and the diminishing desirability of US debt and of the Federal Reserve bode well for commodities and precious metals while warning away any sane investor from US Treasuries.

In the face of indefinite QE2, it remains unclear (1) when the disintegration of the US dollar’s status as the world reserve currency might accelerate and a new reserve currency will be established, (2) if and when holders of US Treasuries seeking a way out might reach critical mass potentially triggering a proverbial rush to the exits (i.e., a collapse of US Treasuries despite the Federal Reserve’s artificial demand), or (3) if and when a race, whether global or domestic, to shed US dollars in favor of equities, hard assets, alternative currencies, precious metals or other real goods might begin. The first and second processes (removal of the US dollar’s world reserve status and the divestment of US Treasuries) are already under way and the Federal Reserve’s current policies are on track to eventually trigger the third.

Fundamentally, the Federal Reserve cannot prevent rising prices while the US dollar moves lower due to QE2 and due to the US’ deteriorating creditworthiness and credibility, nor can it control the flow of liquidity resulting from its actions or, therefore, resulting asset price bubbles, whether in the US or abroad. In light of the Federal Reserve’s current policies, it seems likely that, in the next 12 months, global economic volatility related to inflation, currency debasement and, potentially, developing currency and trade wars will increase while the financial stability of the US and of the Eurozone countries continues to decline and while commodity and precious metals prices continue to move higher.