Though we’ve heard rumblings of a crisis and possible recession on the horizon, markets continue to behave as though everything is all right. We’re in the midst of the longest economic expansion in U.S. history, unemployment remains low, and the Fed is easing again.
What could go wrong and is everything as good as it seems? Financial Sense Newshour spoke with James Rickards about his take on possible problems for the world economy and how investors can protect themselves.
Debt Levels Worse Than 2008
In his latest book, The Aftermath: Seven Secrets of Wealth Preservation in the Coming Chaos, Rickards argues we’re headed for an inevitable crisis based on excess debt.
Unlike current economic theory, he relies on well-founded scientific models based on complexity theory, behavioral economics, Bayesian statistics, and history, among other inputs, Rickards stated, to try to understand what is happening now.
His latest book’s title refers to both the aftermath of the 2008 financial crisis, which we are still in, he noted, and eventually the aftermath of a coming collapse following the current expansion, which has been going on since June 2009.
The crisis is long over in the minds of many, he noted, but the problems and conditions that precipitated the last crisis have not been dealt with and are still in place. Central banks took the pressure off with money printing, zero interest rates, currency swaps and other guarantees behind the scenes, but the underlying imbalances remain.
These problems will come back even larger than before, Rickards noted, and on an even more dangerous scale since debt levels have only grown worse in the past 10 years.
The Battle Against Deflation
Outside of asset prices—namely, stocks, real estate and bonds—we have seen inflation rates generally on the decline for commodity prices and consumer goods.
Some argue that we’ll likely stay in a deflationary or disinflationary mode, but they aren’t considering that the Fed and other central banks will not permit this for two very important reasons. For one, governments can’t tax the benefits the average consumer accrues from lower prices.
Also, and more importantly, deflation increases the real value of debt, by definition. In an inflationary environment, it hurts less to pay down debt because you are nominally paying back that debt with dollars that have less value than when you originally borrowed them.
The opposite is true in a deflationary environment. The value of money is increasing, not decreasing, and that makes it more painful to pay off debt.
“What happens is that initially at least creditors win and debtors lose,” Rickards said. “This is why debtors hate deflation. … However, pretty quickly the debtors default. What starts out as a problem for debtors quickly becomes a problem for creditors. … Where does the loss fall? It falls on the banks.”
Seeds of Financial Dislocation
This is essentially what happened in the financial crisis of 2008. The Fed stepped in to prop up the banking system. Many people trust the Fed when it says its mandate is to produce stable inflation and keep unemployment within its target.
But that is not what the Fed is really for, Rickards stated. The Fed's job is to ensure the soundness of the banking system. This is why the Fed was founded, he noted.
Because deflation puts stress on the banking system, the Fed’s goal is to fight deflation at all costs. This is what has led to all central bank intervention in markets since the crisis.
There are only so many ways to fight deflation, however. The natural cure is growth, but extremely high debt loads are likely to curtail growth, Rickards noted. With demographics producing a natural deflationary pressure, growing our way out of deflation suddenly becomes much more difficult.
The only remaining solution is for central banks to inflate the currency to reduce the real value of debt. They cannot tolerate deflation because it increases the real value of the debt.
“Because of the natural deflationary state of the world and the high debt-to-GDP ratio, growth has been snuffed out,” Rickards said. “The other way to deal with the debt is to default. But there's no reason for the U.S. to default because the debt is in dollars and we can print the dollars. The third way out—and the way that's going to happen—is inflation.”
History of Debt
Modern Monetary Theorists argue that debt no longer matters, and we can simply roll over debt forever. One of the many problems with this view, Rickards stated, is that it ignores the history and role of debt in monetary history.
The national debt of the United States has not been growing in linear fashion, he noted, as many assume. Rather, U.S. debt follows a sine wave pattern, and traditionally it balloons in times of war, and is paid off in times of peace.
This model works, as long as we continue growing. We reduced the debt-to-GDP ratio in times of peace, which allowed for more borrowing when another war broke out.
This dynamic remained in place from the founding of the country until around the year 2000 at the end of the Clinton Administration, Rickards noted.
The highest debt-to-GDP ratio in the U.S. came at the end of World War II. It was 120 percent debt-to-GDP, but the U.S. became the global military and economic hegemon in return for running that level of debt.
Over the 35-year period from 1945 to 1980, the U.S. reduced the debt-to-GDP ratio from 120 percent to 30 percent through bipartisan effort.
The shift came when Bill Clinton left office, and George Bush became president. The national debt was $5 trillion and the debt-to-GDP ratio was around 60 percent. From that point, Bush doubled it from $5 trillion to $10 trillion. Next, Obama doubled it again from $10 trillion to $20 trillion. And now Trump has piled on a couple of trillion on top of that.
“Debt is now at the highest levels since World War II, except we haven't won any wars,” Rickards said. “We’re nearly in the position on relative basis we were in 1945. And based on CBO projections, which I think are conservative—I expect it will be worse than what the CBO is saying—that the debt-to-GDP ratio is going to keep going up.”
Why Debt Matters
Reinhart and Rogoff were able to persuasively demonstrate that once debt surpasses 90 percent of GDP, it is impossible to grow our way out of the debt. Keynesian theory stated that for each dollar of borrowing, we gain an additional dollar or more in GDP. This is known as the Keynesian Multiplier.
But this only works under certain circumstances, Rickards noted. Once you surpass that 90 percent threshold, each additional dollar of borrowing produces less than a dollar’s worth of additional growth.
“You get 90 cents of growth,” Rickards said. “You don't even get a dollar. You're now getting negative returns. What does that mean? It means that your debt's growing faster than your economy. That debt-to-GDP ratio is getting worse, and there is no way out except inflation.”
Financial Conflicts on the Horizon
Debt and inflation in the U.S. both play into the currency wars and trade wars we are seeing break out around the world. Rickards was the co-creator and facilitator of the first ever financial war game and this was sponsored by the Pentagon, he noted, developed specifically to address how economic conflicts will play out.
For example, many have expected the current conflict with Iran to play out with a U.S. attack on Iran. Recently, Iran launched an attack on the largest oil processing facilities in Saudi Arabia, and took 5 percent of the global output offline overnight.
Many expected Trump to announce a joint U.S.-Saudi military strike, but that hasn’t materialized yet. This response does not mean we aren’t taking action, however. President Trump did order financial sanctions ratcheted up against Iran.
“What people don't understand is that we are in a full-scale war with Iran today and have been for 2 years,” Rickards said. “It's not a kinetic war, except on their side. On our side, it's a financial war. People need to stop thinking about financial sanctions as an extension of trade policy. This is warfare. It's just a different form.”
There are many other important forms that warfare can take, he added, including both cyber and financial war that can cause economic damage through capital markets and the banking system.
Actually, Iran’s reversion to physical conflict—including using drones and cruise missiles, but also against oil tankers in the Gulf—indicate to Rickards that they are feeling the pressure from U.S. financial warfare.
It is possible that we may see regime change in Iran without the need for traditional military intervention, Rickards stated. Financial conflict is apparent in other areas, he added, and he’s been working on these issues for some time.
When Rickards was working with the CIA, he became involved in helping the Committee on Foreign Investment in the United States (CFIUS), which vets sales of U.S. companies and assets to foreign buyers. The committee places potential buyers in a matrix, with hostile and friendly buyers on one axis, and compares this against a company that is either considered essential or non-essential on the other axis.
Russia or China would be considered a hostile buyer, for example, and the United Kingdom would be considered a friendly buyer. Rickards is highly critical of the Uranium One deal, involving the sale of U.S. uranium reserves to Russia, under Hilary Clinton’s watch, he noted.
On the other side, a foreign purchase of a company like Ben and Jerry’s would likely not raise eyebrows—ice cream is generally not considered strategically important—but the sale of a company like Verizon would be heavily scrutinized as it includes vital infrastructure.
It was during his time working with CFIUS that Rickards and his team predicted that the next area of conflict to emerge would be in financial services. Immediately after his group made this predication, he noted, the 2008 financial crisis unfolded.
“It's important to understand that financial war is not a sideshow,” Rickards said. “It may actually be the main event. … You as an investor trying to mind your own business or build wealth or expand your portfolio may get caught in the crossfire of a financial war. So you have to take that into account in your portfolio allocations and risk management.”
How Do We Deal With Debt?
The trouble with U.S. debt is, there is no easy or pain-free way to discharge it at this point, Rickards noted. What he expects to happen, he added, is easier to predict because the alternatives are so unpalatable to those in power, they are unlikely to be allowed to happen.
Based on Reinhart’s and Rogoff’s work, showing that a debt-to-GDP ratio above 90 percent hinders growth, we cannot grow our way out of the debt trap. In fact, their work demonstrates that, the more you borrow past 90 percent, the slower growth becomes, exacerbating the problem, even as it becomes necessary to grow the debt just to service the old debt.
It’s something like being stuck running in place. The alternative is to engage in severe austerity or raising taxes, but that is unpalatable politically, and the public is also unlikely to accept it.
Alternatively, the U.S. could default on its debt, but this doesn’t make sense when we control the issuance of our currency, Rickards noted. We can simply print the dollars needed to repay any debt.
This leaves inflation as the only viable path, Rickards stated. Through inflation, the overall value of debt is reduced.
The problem with this approach is, so far the Federal Reserve has been unable to produce the rate of inflation it would like. It’s important to remember Milton Friedman’s famous quotation, Rickards noted, that inflation is always and everywhere a monetary phenomenon.
This is not true, Rickards stated. Rather, inflation is a psychological phenomenon. It is produced by growth in the money supply, but is also influenced by the velocity of money, or the rate at which a given dollar moves through the economy.
For example, a central bank may print tons of excess reserves, but if the money ends up parked on a bank’s balance sheet and isn’t lent out, it has zero velocity, and thus will not impact inflation.
While the Fed has been injecting money into the economy since the financial crisis, velocity has been falling for 20 years, Rickards stated. Americans are not borrowing and spending money at a rate conducive to producing inflation. This is a psychological phenomenon, he added.
“How do you change expectations?” Rickards asked. “How do you get people into a mood or mode where they want to borrow and spend more? That's hard. This could be intergenerational. … We had the tech bubble crash and the 2008 mortgage crash followed by a stock market crash and the worst recession since the Great Depression.”
The only viable option right now that Rickards sees is informed by the U.S. history of gold devaluation. Both President Nixon and President Roosevelt before him accomplished gold devaluation, he noted, and it led to inflation.
This isn’t possible right now, as gold does not have a monetary role in the economy, but it could at some point become necessary to use gold in this way, Rickards argued. When that happens, the value of gold goes way up in dollar terms, essentially producing inflation on demand.
“It’s going to take something much more radical,” Rickards said. “There is an answer. There is a way to change psychology. There is a way to change expectations. … If you look at history and you understand the psychological aspects of this, how can we change inflation expectations of the entire country all at once? You can't do it by money printing, but you can do it by raising the value of gold by a factor of 2 or 5 or 10.”
Is a Financial Panic Possible?
Eventually, the problem with U.S. debt will become untenable, Rickards stated. The current trend is to think back not to the 2008 financial crisis, but the crisis 10 years earlier, in 1998, centered on a liquidity crisis precipitated by Long Term Capital Management.
Rickards was Long Term Capital Management’s general counsel and negotiated the bailout, he stated. Most people don’t realize that we came within hours of shutting down financial markets and exchanges in that crisis, he added. Though a bailout was achieved, the risk was very real.
Next, the tech bubble burst, followed by the real estate bubble, which saw risk shift further. Instead of private equity bailing out failed institutions, it became necessary for the Federal Reserve to step in and back the banks directly.
At this point, the Fed’s balance sheet is compromised. Its efforts to normalize its balance sheet have essentially failed, and now we’re back to seeing the Fed push for lower interest rates. In the next crisis, who has a clean balance sheet and can step in to bail out the Fed and other institutions? For individual investors, having at least some assets that are not reliant on liquidity to retain value will be the path to preserve wealth.
“They haven't solved the problem,” Rickards said. “They’ve just moved it upstairs. Well, now they're in the pent house. There's only one clean balance sheet left in the world, which is the IMF. … (and) that's not a solution you want to rely on. What happens when the next crisis comes? What are they going to do? Go to $5 trillion? Or $6 trillion? Or $7 trillion? The modern monetary theorists are saying there’s no problem, but they're wrong. It's not a legal issue. It's a confidence issue. There's an invisible psychological boundary and once you cross it, people lose confidence in the dollar itself. That's what we're facing.”
Article written by Ethan Mizer