Jim Rickards and Alex Stanczyk, The Gold Chronicles February 2018
*How BLS jobs data largely being mis-read by financial media
*Why all current narratives in the financial media are missing the true causes of early Feb US stock markets correction
*Why Atlanta Fed analysis is more of a nowcast than a forecast
*Why exploding sovereign debt and debt to GDP ratio are critical to market stability in the next few years
*How student loans are a $1.5T problem with a significant default rate
*What the two critical confidence boundaries are, and how they might be crossed
*3 Yr playbook – not a forecast but a potential scenario
*Why the idea that Central Banks dont need capital would be challenged in a collapse of confidence
Listen to the original audio of the podcast here
Physical Gold Fund presents The Gold Chronicles with Jim Rickards and Alex Stanczyk offering insights and analysis about economics, geopolitics, global finance, and gold.
Alex: Hello, this is Alex Stanczyk, and welcome to the February edition of The Gold Chronicles. I
have with me today Mr. Jim Rickards, the brilliant analyst and member of our advisory board.
Jim: It’s great to be with you, Alex.
Alex: Just briefly, let’s review some of the topics we covered in our last podcast, and then we’ll
dive into our topics for today. We discussed why we are potentially on the cusp of a new set of
rules for the international monetary system, why gold may be in the first stages of a new multi-
year secular bull market, and we talked a little bit about what the significance is of central
banks that had been buying gold – net buyers of gold. I think they started doing that around
2010, so this would be going on almost a decade now. You can find all our previous recordings
Our topic today is regarding a recent significant correction or meaningful movement in the U.S.
stock markets for the first time in almost two years. It’s been up for a very long time, and
starting at the end of January running into early February, we began seeing these corrections.
There are narratives all over the media as to the reasons this has occurred, but I’d like to get
your point of view, because I think you look at things a little differently.
Jim: You’re exactly right, Alex. A correction is conventionally defined as 10% down from any
high. That’s not an ironclad rule, but it’s the conventional wisdom on Wall Street and a good
rule of thumb. The last correction ran from January 1 st to February 10 th , 2016, in reaction to a
Chinese effort to devalue the Yuan. And they actually did devalue the Yuan.
What was interesting about that is it was the second correction in six months. There was
another correction that ran from August 10 th to mid-September, 2015, about four months
earlier than the 2016 correction, which was also in response to a Chinese shocked evaluation
on August 10 th .
For two years since these two corrections (August 2015 and January/early February 2016), not
only was there no correction, there was no significant drawdown. I don’t know the exact
percentages, but if you want to use a 2% benchmark, there were no 2% corrections. There were
no days for many days in a row where it was down more than 1%, then the number of days in a
row when it hit highs. These were all records and good reason for concern, because that’s not
how markets operate.
There’s a technical name for that, but basically it’s when things go up on a steady basis in more
or less even increments with no corrections, no down days, no volatility. When you see that
pattern, you know something is wrong, because it’s not normal or sustainable. That pattern is
what tipped off some analysts that Bernie Madoff was a crook, because those were the kinds of
results Bernie Madoff was producing. There’s no money manager in the world, no matter how
good – I don’t care if you’re Warren Buffet or Bruce Governor – who can produce returns like
That’s what the stock market was doing and very much cause for concern. All those chickens
came home to roost just a few weeks ago between February 2 nd and 8 th , 2018.
Wall Street loves a story, so when something like that happens, you need a story. You’ve got to
reassure people, you need something to talk about if you’re going on TV or writing or are an
analyst at Morgan Stanley or writing notes. The story went something like this: Friday, February
2 nd , was the first large down day when it was down about 500 points. The following Monday it
was down 1,000, and Thursday it was down 1,000 again.
It all started on that Friday, February 2 nd , at 8:30 in the morning when the Bureau of Labor
Statistics released the monthly employment report, nonfarm jobs, which in this case was the
January employment report released February 2 nd . There’s a lot of different data in that. The
economy created approximately 200,000 jobs which is normal and healthy growth. It’s been
that way for a long time, so there’s no real news there.
The news was that wages year over year had grown 2.9%. Everybody jumped out of their seats
and said, “Oh, my goodness. Look at that 2.9%. It looks like the Phillips curve is alive and well
and Janet Yellen’s notion that it was just a matter of time. Inflation was just around the corner
and all these headwinds were transitory and – boom – here we go. Here comes the inflation.
The Fed is going to tighten more than we expect and raise interest rates. A fixed income
competes with stocks, so dump your stocks, buy your bonds, etc.” That was the conventional
I’ve just recited the narrative, but I would poke holes in everything I just said. Let me point out a
number of flaws in that.
First, that 2.9% number is nominal, but people get used to seeing real numbers. When the
Commerce Department Bureau of Economic Analysis reports GDP, that’s the real number. The
wage number I just referred to is a nominal number, and you must subtract inflation to see
what the real wages were.
With inflation running, depending on your measure, if you use CPI, non-core, that’s about 2%.
Taking the 2.9% minus 2%, real growth was 0.9% year over year. That’s better than getting bit
by a dog, because up is up, but that’s not a big number. In strong recoveries, we’ve historically
seen real wage growth, not nominal, but real wage growth of 3%, 4%, and sometimes 5%.
That’s what a booming economy that’s pushing limits and maybe heading for inflation looks
Nine-tenths of 1% year over year is nothing. I acknowledge that it was bigger than it had been,
so it could be the beginning of a trend, but it was not a big, scary number.
Meanwhile in the same employment report, they also reported weekly wages. Weekly wages
went down. Year over year, wage growth went up as we just described, but weekly wages went
down. The amount that people were actually taking home in their paycheck went down,
because the hours went down. What good does it do me to get a raise if you cut my hours from
40 to 30? Maybe my hourly went up, but my weekly wages went down, because you cut my
hours or moved me from full-time to part-time, etc. So, that was weak.
The labor force participation was unchanged. It’s very close to 40-year lows, but in an economy
that was booming, drawing more people back, and creating more jobs, you might expect that
number to go up. It didn’t. There was a lot of weakness in that report that got overlooked by
the headline number.
There was another thing going on literally the same day. I happened to be on Fox Business that
day with Stuart Varney, a great guy and I enjoy doing that show. Stuart was pointing to this
2.9% number, but the other thing he and a lot of people were saying is that the Atlanta Fed,
which produces what they call the GDPNow cast (not a forecast, but a nowcast prediction of
the present) was estimating first quarter growth at 5.4%, which is huge. Maybe he had to go
back to the Reagan administration in 1983, probably not that far, but he had to go back pretty
far to find a 5.4% quarter. So, everyone said wages are growing 2.9%, economy is growing 5.4%,
and here comes the inflation.
I watch that Atlanta forecast very closely as one of the numbers I look at it, but a lot of people
don’t understand the methodology there. You have to read the technical papers behind it. A
typical Wall Street forecast looks like this because they’re estimating GDP for the quarter while
still in the quarter. The data comes in at different times, and some of it lags. They won’t tell us
their first estimate of first quarter growth until the end of April even though the quarter ends
March 31 st . That’s because some of the data is not in yet and doesn’t come in on a regular
schedule. Some is weekly, some is monthly, some is quarterly with a lag, etc.
A typical Wall Street forecast takes the data they have and estimates all the rest, the missing
pieces, based on extrapolations and their own estimates using whatever methodology they
have. That’s not what the Atlanta Fed does. The Atlanta Fed says go with what you’ve got; let’s
not guesstimate the rest. We’ll take what we’ve got and fill in the blanks with correlations and
regressions. In other words, we won’t look forward. We’ll look back, fill in the blanks, and then
update. This is Bayesian analysis, which I think it’s a good form of analysis, but you must know
what you’re looking at.
The point being, that time series is consistently high at the beginning of the quarter. Go to the
Atlanta Fed website (a very useful service) and look at the second, third, and fourth quarters of
2017 when they put all this data out there. Look at their quarterly estimates from the beginning
of the quarter to the end of the quarter. You’ll find that they always start up high and go down,
down, down, and at the end of the quarter, they converge pretty closely on a real number.
When the number was 5.4%, I said, “It’s only mid-February, so it’s going to come down.” Well,
it did, and guess where it is today? It’s closer to 3%, and I expect it to be lower by the end of the
quarter. The 2.9% was not what it was cracked up to be because it was nominal, not real.
Knowing Atlanta methodology, it was easy to say that the 5.4% was going to come down, and it
has, so it’s looking like the first quarter is not going to be particularly strong.
For all those reasons – inflation, real growth, higher interest rates, capacity constraints – I don’t
buy that story at all.
Let me tell you what I do think took the stock market down, because the stock market is smart.
It’s a lot of players out there, and not all of them are going on TV making up stories. The market
was shocked by what I call the debt bomb. This emerged very quickly. Remember, the Trump
tax bill did not pass until almost the end of the year. It was close to New Year’s Eve before the
President signed it, and it was so complicated that you couldn’t absorb it all overnight. I was a
tax lawyer earlier in my career, so I know how complicated these things are. It took people a
while to figure out the impact of that, and they were working on it in early January.
I remember the rap on the tax bill. Yes, we’re cutting taxes by close to $2 trillion if you do a
static analysis, but we want to do a dynamic analysis, because this is going to stimulate the
economy. We’re going to get so much growth out of these tax cuts that the extra taxes on the
growth will offset the statutory rate cuts and it won’t cost us very much at all. Free lunch, in
You heard this from Art Laffer, Larry Kudlow, Stephen Moore, and Steve Forbes. These are all
good guys, and I’m not disparaging anyone. I know Art Laffer really well. He’s a good friend, and
I’m a big admirer of his. This is their analysis, but it does not hold water for several reasons.
A tax cut – in other words, a larger deficit – can be stimulative in certain initial conditions, but
those initial conditions would be the following:
You’re either in a recession or the very early stages of a recovery
You have a lot of slack in labor and industrial capacity
Consumption is low
Velocity of money is low
Your debt burden is not too high (i.e., you don’t have a lot of debt, you want to take a
loan, and you’ll get your credit approved immediately)
All those conditions – in a recession or early stages of recovery, a lot of slack in the economy, a
pretty good debt-to- GDP ratio in the case of a country – make a case for some Keynesian
stimulus, but none of those conditions are true. Today, we’re not in a recession or the early
stages of recovery; we’re in the ninth year of a recovery. Capacity constraints are real,
unemployment is extremely low, and, most importantly, our debt-to- GDP ratio is 105%.
Kudlow, Kramer, and Steve Moore are veterans of the Reagan revolution. They were in the
White House in the OMB or the Council of Economic Advisors or on Capitol Hill. They were in
various official capacities in the early ‘80s when Reagan did this, and we did get strong growth
under Reagan. In 1982, we were in the worst recession since the Great Depression and our
debt-to- GDP ratio was 35%, so not in 1981 or 1982, but in 1983 to 1986, we had that incredible
run of growth where the economy grew 16% in three years.
Remember, those are the conditions under which a little fiscal boost works. It did work and
produced growth, so these guys are trying to run the same playbook. The problem is, in 1983 it
was like playing a D3 college team, and today they’re playing against the New England Patriots.
In other words, the headwinds are enormous. Our debt-to- GDP ratio is not 35% as it was under
Reagan; it’s 105%. We’re not in a recession; we’re in the ninth year of recovery. We don’t have
a lot of excess capacity; we have capacity constraints.
None of those conditions exist now, so what you’re going to get out of this tax cut is just
deficits. Number one, you’re not going to get the kind of growth you need to make up the
deficit. Number two, in 2011 during a prior government shutdown, the Republicans and
Democrats actually agreed on something, that they were going to put some caps on spending
to take the continual debt ceiling and resolution budget debates off the table.
In terms of the federal deficit, entitlements are on autopilot – they’re statutory, there’s a
formula. Congress just has to find them, because they are what they are. For example, interest
on the national debt must be paid. You can’t say, “We don’t feel like paying the interest this
month.” Entitlements and interest on the national debt are a big part of the total government
expenditure, so what’s left that they can mess around with? Discretionary domestic spending
and defense are the only two things they can play with, so in 2011 they put caps on both. This
was called the sequester.
Here we are six years later. The defense budget has been bled dry, training is down, the cruise
missiles have been used up (we need to replenish those), all these vessels sadly are crashing
into each other because people are working long shifts, and there’s an absence of training and
new systems. We’re stressing our military to the breaking point, and everyone agrees we need
to spend more there, but the Democrats have veto power. This is not one you can jump to with
51 votes; you need 60 votes to do this. The Democrats are saying, “Okay, Republicans, you want
more defense spending? Give us more discretionary domestic spending.” The Republicans
didn’t like it, but they went along because they wanted the defense spending.
Congress blew off the caps on both, so now there’s no more sequester. They say this is going to
add $300 billion, but my estimate is more like $400 billion because of additional defense
spending in the immediate future.
Bear in mind that everything we’re talking about – $1.5 or $2 trillion from the tax cut, $300 or
$400 billion from blowing off the caps – is in addition to the baseline deficit. We have a deficit
anyway of probably $400 billion, but we’re piling all this on top of it.
The third thing I’ll give you that no one is talking about are student loans. Right now, student
loans are about $1.5 trillion. That’s bigger than subprime mortgages going into the mortgage
crisis in 2007. If you count what’s called Alt-A (a kind of subprime mortgage with low-doc, low-
credit mortgage), subprime and Alt-A together in the middle of 2007 before the crisis were
about a trillion dollars. Today, student loans are about $1.5 trillion, so it’s a bigger monster to
wrestle to the ground.
Here’s the main difference. Even at the worst part of the 2008 meltdown, default rates on
those mortgages were 6% or 7% which is quite high for mortgages. Default rates on student
loans are 20%, so 20% of $1.5 trillion is $300 billion. Most of that has not hit the budget yet,
because the Treasury doesn’t make the loans. Private banks and companies make and service
the loans, and the Treasury guarantees it.
When the student first gets in arrears, they do some kind of work-out. They have grace periods,
consolidation refi loans, and certain kinds of public service to get a deferral. There are a lot of
ways to put off the debt reckoning, but those have all been used and now we’re getting to the
point where a bad loan is a bad loan. There’s no more grace period, extension or deferral, and
the banks are saying to the Treasury, “Here’s the loan file. Pay me.” The Treasury must pay
them, and that’s when it hits the deficit. It’s starting to come in right now like a tsunami, so add
that on top.
Using low round numbers, $1.5 trillion for the tax cuts, $300 or $400 billion for the sequester,
blowing off the caps, and another $300 billion for student loans brings us close to $2.5 trillion
on top of $400 billion-a- year baseline deficits. These are trillion-dollar deficits as far as the eye
can see. That’s what I mean by the debt bomb the market suddenly woke up to. That was the
shock. Interest rates were going up, but it wasn’t this inflation story you hear about. That’s a
red herring. It’s this debt bomb that I just described, and that’s what shook the markets.
By the way, rating agencies are talking about cutting the credit rating of the United States of
America. They already did once. I believe it was Fitch in 2011 if I’m not mistaken. The others,
S&P and Moody’s, didn’t, but now S&P is making noises about that.
Once the market goes down, it feeds on itself. I analogize this to a mine field where the mines
are all buried, but it looks like a very nicely groomed lawn you have to walk across. You don’t
have a map or minesweeper, and you’re just hoping you don’t step on a mine. That’s the way
the stock market operates. Once the meltdown begins, what are the mines? Derivatives,
leverage, triple leverage, and inverse ETNs. As the volatility goes up and credit Swiss bonds are
triple, inverse, exchange traded note on volatility, that thing went to zero pennies on the dollar.
They had to suspend redemptions or suspend trading and liquidate that.
People say, “What’s next?” The answer is, “We don’t know.” A distress point causes that
counter party to sell other good assets to raise cash to meet margin calls, and then those good
asset sales hit somebody else’s trigger causing cascading stops. This is a densely connected
system that feeds on itself.
That’s why we saw those big thousand days. Remember, they weren’t just thousand-point days
in terms of going down; they were down 1500, back up 500, and back down again. Enormous
The first question is, “Is it over?” To answer that question, I tell investors to ask two other
1) What caused it?
2) What has changed?
We just talked about the things that caused it – the debt bomb – and that hasn’t changed. The
derivatives are still there as well, so nothing has changed. The market is very vulnerable to this
happening again, and it could be tomorrow.
Alex: We’re obviously looking at multiple trillions of dollars of new debt. I’ve heard economists
talk about how the U.S. can run unlimited deficits and unlimited debt, but is that really true? At
some point, will the sovereign debt load ultimately lead to a failure of confidence either in the
U.S. government or possibly, as importantly or maybe even more importantly, the Fed’s ability
to control the economy? That’s the narrative that allows everybody to sleep well at night. If
confidence in the Fed’s ability to control the economy goes away and the narrative changes,
that changes the whole picture for the entire global economy, does it not?
Jim: It does, and that’s a very good point, Alex. There are two separate confidence boundaries.
You mentioned both, but I think it’s important to separate them, because one or the other
could be triggered first.
The first confidence boundary is the ability of the Fed to control the economy. People have this
blind faith in the Fed. I’ve talked to Fed governors, Fed chairs, and Fed staffers, and privately
they’ll say, “Yes, we can do a little bit with money supply by giving it a slight boost, but we can’t
really create jobs or steer the economy. The most we can do is try to create some conditions
under which job creation can thrive and inflation doesn’t knock it out of control.” The dual
mandate is to help with job creation and avoid inflation. They feel confident in their ability to
avoid inflation or at least squash it if it appears, but they have no confidence in their ability to
If you ask a central banker what keeps them up at night, they won’t say inflation. They’ll say,
“We hope inflation doesn’t happen, but if it does, we can squash it like a bug.” Paul Volcker
proved that in 1981. “What we worry about is deflation, because we don’t know how to turn
I know how to turn it around, which is devalue the dollar against gold. Take gold to $10,000,
and you’ll get all the inflation you want, but they’re not ready to go there yet. That’s what FDR
did in 1933. He didn’t devalue the dollar against gold because he wanted to enrich holders of
gold. In fact, he stole all the gold before he did it. It was the ultimate inside trade. He did it
because he wanted inflation, and it worked. The economy grew robustly from 1933 to 1937.
If you date the Depression from 1929 to 1940 – those are the conventional dates, and I think
that’s a pretty good frame – it wasn’t down every year. We had a severe tactical recession from
1929 to 1933, and we had very good growth from 1933 to 1937 off a very low base. Then, a
second severe recession occurred in 1937 to 1938, a weak recovery in 1939, and then in 1940
the war spending kicked in, and that worked. The economy started growing very strongly again,
because we had the second World War.
Looking at that pattern, the growth from 1933 to 1937 was because of the dollar devaluation.
That did create inflation and get the economy moving. 1933 was a great year for the stock
market in the middle of the Great Depression. Bear in mind, you had lost 80% of your money,
so if you were in stocks, you were down 80% from the 1929 high, but if you happened to come
in and buy at the 1933 low, you had a great ride in ’33, ’34, and ’35. Those were great years for
the stock market.
The point is, the Fed says they don’t know how to get out of deflation, but they do. It’s just that
they don’t want to go there, because that would mean going back to a gold standard. If gold is
$10,000 an ounce, there’s your inflation, and then you’d have $400 oil, $100 silver, and $20
copper. All those other things would fall into line.
Getting back to pure monetary policy, there’s no central bank in the world that’s ready for a
gold standard yet except maybe for Elvira Nabiullina, head of the Central Bank of Russia, so
they’re not going to do that. In terms of monetary policy, no, they cannot get out of deflation.
They feel that they can control inflation as part of the dual mandate. The other part is the Fed
doesn’t have a hiring desk saying, “Come here, sign up, and get a job.” They don’t create jobs in
that sense. They try to create monetary conditions under which confidence builds, employers
hire people, and it’s very inexpensive to invest. For example, you can buy a new plant and hire
some workers. That’s the best they can do.
Yet, look at what they had to do to get there. Once interest rates hit zero in 2008, how did they
continue to stimulate the economy when they couldn’t cut interest rates? The answer was QE1,
QE2, and QE3 beginning in 2008 running through the end of 2014. Six years of QE took the Fed
balance sheet from $800 billion to $4.2 trillion.
The empirical research is starting to come in, and there are people who are very skeptical that it
did much for growth. It didn’t seem to do much harm to growth, but it didn’t particularly do a
lot of good, because we had the weakest recovery in history. What it did do was inflate asset
values. The stock market tripled, no question about that, and real estate got off the floor and
has nearly doubled since then, so it did have that effect of inflating asset prices, but not very
much wealth effect, and velocity was still declining. It didn’t do nearly as much as they thought
it did, but it did get asset prices up; however, that was probably creating a danger in and of
Here’s the point. Is there an invisible confidence boundary in terms of the Fed balance sheet
that if they cross it, people could lose all confidence in their ability to help the economy? The
answer is undoubtedly yes. The problem is, you don’t know where it is. It’s not $4.2 trillion,
because they got there. Is it $5 trillion? Maybe. Is it $6 trillion? You’re getting warm. Is it $8
trillion? Almost certainly south of that.
That’s where I part ways with these modern monetary theorists, the MMT crowd. They’re nice
people. I met a lot of them – people like Paul McCulley from PIMCO, Professor Stephanie Kelton,
advisor to the Bernie Sanders campaign, and others. Again, they are smart people and good
analysts, but they say in effect that there’s no limit; all you really need to do is have larger
deficits, borrow the money, have the Fed monetize the debt, and you could just do that as far
as the eye can see to get the economy going. I don’t believe that for a minute.
Now you’re invoking both boundaries. I mentioned one boundary, which is the Fed balance
sheet. The other boundary is, how big can the deficit be? Deficits are annual concepts that
cumulatively add up to the national debt which you judge as manageable or not manageable by
using the debt-to- GDP ratio. $20 trillion of debt doesn’t mean anything unless you compare it
to GDP. $21 trillion of debt in a $20 trillion economy is 105% ratio, but $21 trillion of debt in a
$42 trillion economy is only a 50% ratio. If we had a $42 trillion economy, I wouldn’t fret over
the debt, because there’s enough growth to pay for that debt. But that’s not the ratio; the ratio
is over 100%.
How do we know there’s a limit? Look at Greece, Spain, Portugal, Ireland, and a lot of countries.
Look at Mexico in 1994, Argentina in 2000, and the southern tier of Europe in 2010-2011. All
these countries hit their limit.
Alex: The same economists who say that the U.S. can run unlimited debts and deficits are going
to point out that all those examples are not the world’s reserve currency.
Jim: Right, and I would point out that the world reserve currency status is not a gift from
heaven or a permanent state of affairs. World reserve currency can change. People have
alternatives and can vote with their feet. They can wake up one day and say, “You know what,
dollar? Nice job, nice run since 1914, but I’m out of here. Get me some art, some silver, some
gold, some land, or maybe some euros.” There can be what economists call repugnance to the
People say you can have unlimited amounts of debt, because you can print unlimited amounts
of money, and that’s actually true. The U.S. will never default on this debt for that reason, but
that doesn’t mean the dollar retains its value. The oldest joke in banking is, if I owe you a
million dollars, I have a problem; if I owe you a billion dollars, you have a problem, because you
have to collect it from me.
Looking at China versus the United States where China holds a trillion dollars of U.S. Treasury
debt, I would say China has a problem, not the U.S. We could just print the money, ship it over
there, and say, “Here’s your trillion dollars. Good luck buying a loaf of bread, because we
inflated the currency.”
The U.S. will always pay its debt, because it can print its money; the Fed can always monetize it.
All of that is true, mechanically speaking, but it does not mean that you maintain confidence in
the dollar or that you don’t have hyperinflation or that you don’t end up like former Germany
or Argentina in 2000, which you probably would. That’s all clear.
The more interesting question is: Where is that boundary? I’ve had Fed governors tell me,
“Central banks don’t need capital,” but that’s a quote I disagree with. In my view, it’s one of the
reasons the Fed has started balance sheet normalization and quantitative tightening, which is
the opposite of quantitative easing. They are on the record articulating that they know they’re
close to that boundary, but they don’t know where it is any more than I do. They’re thinking
maybe $5 trillion or $6 trillion.
What if they had a recession, a liquidity crisis or had to cut rates back down to zero before they
got them to 3.5%, and they were only starting at 1.5%? They’d hit zero in no time. History
shows that you must cut interest rates 3% – 4% to get the U.S. out of a recession. I’m not
forecasting that we’ll go into a recession tomorrow, but it could happen. We’ll go into one
sooner or later, because expansion is nine years old. In a recession, they have to cut interest
rates 3% – 4% to get out of it, but they’re only at 1.5%, so how do they cut 3%? They can’t.
They’d get to zero pretty quickly, and then what would they do? They’d go to QE4.
This is where the concern comes in. Starting QE4 at $4.2 trillion is pushing that invisible
confidence boundary. They’d be rolling the dice on a complete loss of confidence in the Fed,
the Treasury, and the U.S. dollar. They are desperate to get the balance sheet back down to $2
trillion so they can expand it to $4 trillion again under QE4 or QE5. They’ll say, “We’ve already
been to $4.2 trillion and the world didn’t come to an end, so that feels okay. If we can get it
down to $2 trillion, we can go back to $4 trillion without the end of the world.” If they’re sitting
at $4 trillion and try to go to $6 trillion, that may be the end of the world, so they have said we
need to normalize things so we can do this again.
The bigger question I ask is, will they get to $2 trillion on the Fed balance sheet and 3% – 3.25%
in terms of Fed funds target rate before the next recession. Or, will they go into a recession
with not enough dry powder – rates not high enough and balance sheet not low enough to run
that playbook again.
It’s very likely, in my view, that the Fed will not get to where they want to be before the next
recession. They’ll be hitting these boundaries, and that will be a very dangerous time. You just
never know, though. As I said, people may wake up. I just explained it and gave you a three-
year playbook. Now, if I can think of it, other people can think of it. They may look at that three-
year playbook and say, “Why would I wait three years for the end of the world? I’ll get ready
now and go buy some gold.”
Alex: Something that occurred to me when you mentioned central banks not needing capital is,
how much of this hubris? That statement alone says a great deal about perhaps the way they’re
thinking right now. If it is really true that central banks don’t need capital, why do they all hold
Jim: Well, they do, and they don’t. I think there’s a little bit of hubris in it. I talked about this in
chapter six of my last book, The Road to Ruin. Be that as it may, at dinner with a small group
around the table, I was seated next to a member of the Board of Governors. There’s no need to
mention names, but I said to her, “It looks like the Fed is insolvent on a mark-to- market basis.”
The key phrase there is “mark-to- market.” They had a lot of ten-year notes, and interest rates
were going up at the time. The balance sheet wasn’t quite at the $4 trillion level but was getting
there. If you were running a hedge fund instead of a central bank, the losses on your ten-year
notes on a mark-to- market basis would’ve wiped out your capital.
Bear in mind, the Fed runs a $4.2 trillion balance sheet with about $50 billion of capital. In
round numbers, that’s over 100 to 1 leverage ratio. 100 to 1 looks like the worst hedge fund
you ever saw. That sounds like my old firm Long-Term Capital if you count the derivatives.
When you have 100 to 1 leverage, which the Fed does, it only takes a 1% change in your asset
value to wipe out your capital. One percent of 100 is one, and if you have 100 capital, it’s gone.
The Fed doesn’t mark-to- market; they carry those assets – they use historic cost accounting. If
they were using generally accepted accounting principles and had to mark-to- market, they
couldn’t do it.
I said to the Governor, “It looks like you’re insolvent on a mark-to- market basis.” She said, “No,
we’re not.” I said, “I think so.” She said, “No one’s done that enough.” I said, “I’ve done it, and I
think others have done it.” She sort of harrumphed and said, “Well, maybe …”
I kind of stared her down a little bit. She looked at me and realized that I knew what I was
talking about. She was just putting up a good front, so then she said, “Central banks don’t need
capital.” That was her answer. I said to her, “Thank you, Governor,” and thought to myself, “I
bet they do when confidence is in play.”
Banks don’t need any capital when no one is questioning their solvency or confidence. It’s only
when confidence is called into question that people take a look. “Oh, you’re insolvent? Well,
I’m out of here.”
That’s when we get into phrases like “black swan” and “tipping point.” To me, they’re
metaphorical, because they don’t really tell the tale. The technical term for this is hyper-
synchronicity which is when people’s adaptive behavior is affected by other people’s behavior.
For instance, with a small run on the bank, people see the line and say, “Oh, there’s a line at the
bank. I’m getting in line, because I don’t want to be the last guy to get my money out.” Next
thing you know, the line is around the block, the bank closes its doors, and they’re insolvent. It
didn’t start out that way, but a couple of people lining up because of a loss of confidence very
quickly leads to a longer line and then a shut-down.
The technical name for it is “phase transitions.” It’s what a physicist would say or a
mathematician would call hyper-synchronicity, but it’s the same thing. It basically means that
everyone wakes up, and confidence is gone. That is definitely a threat.
The Fed has never said, “We’re doing this because we’re worried you’re going to lose
confidence in us.” A banker should never use the word “confidence.” He should always take it
for granted. But, they have said, “We want to normalize the balance sheet in case we have to
do this again,” which means that they were not comfortable doing it again from the old level.
This means there is a boundary, but we just don’t know what it is.
Alex: That wraps up our time for today, Jim. What a great discussion that I think we should
explore more. The entire two vectors of confidence thing, as far as whether it’s government or
the Fed, may be in future discussions. Thanks so much for being with me today.
Jim: Thank you, Alex.
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