Aftermath

by James Rickards

  Still, the wealth gap is only part of the reason America remains in crisis. As weak as growth is, the United States purchased that paltry growth with nonsustainable debt. Since the global financial crisis, America’s national debt roughly doubled from $10 trillion to $20 trillion. That debt is set to grow another $5 trillion in the next five years due to the Trump tax cuts, repeal by Congress of spending caps, and a wave of student loan defaults. That projection assumes no recession. If a recession strikes, analysts add another $2 trillion of debt on top of the projected $5 trillion because of lower tax collections, higher benefits for unemployment and food stamps, higher student loan default rates, and higher disability payments.

  This phenomenon of slow growth, high debt, and a wealth gap is not confined to the United States. It’s a global phenomenon. The situation is worse in China, Japan, and Europe. There has been persistent growth in global debt for the past twenty years. This debt cancer began before the 2008 global financial crisis and continued afterward. The crisis itself had no lasting impact on the growth of debt. The idea that the world deleveraged or the banking system became stronger since the crisis is a myth.

  While there was a slight decline in the developed economy debt-to-GDP ratio between 2012 and 2017, from 387 percent to 382 percent, the absolute size of the debt still increased from $170 trillion to $174 trillion. The decline in the ratio was due to slightly improved growth in major economies, especially the United States, after 2012. Meanwhile, the increase in emerging-markets debt from $42 trillion in 2012 to $63 trillion in 2017 and the increase in the emerging-markets debt-to-GDP ratio from 171 percent to 210 percent over the same period more than offset the mild reduction in the developed economy ratio. Combining the developed economy and emerging-markets data results in an increase of total debt from $212 trillion to $237 trillion, and an increase in the debt-to-GDP ratio from 310 percent to 314 percent between 2012 and 2017. These levels are unsustainable; the trend is ominous for investors.

  Investment Secret #7: Allocate wealth to alternative assets.

  We’re all familiar with the so-called run on the bank. Runs begin quietly, with a few depositors getting nervous about the solvency of the bank. They line up to get their cash before the bank closes its doors. Soon word spreads and the line gets longer. The bank projects an air of confidence and gives cash to depositors who request it as long as they can, but soon the cash runs out. Today, a bank run is unfolding at the Federal Reserve Bank of New York. What’s different is that the run on the bank involves gold, not cash.

  The New York Fed will never run out of cash because it can print all it needs. Still, they could run out of gold. Until recently, the New York Fed had 6,000 tons of gold stored in its vaults on Liberty Street in Lower Manhattan. That gold does not belong to the United States. The Fed gold belongs to foreign countries and the International Monetary Fund. Beginning a few years ago, central banks demanded the return of their gold to their home countries. Germany was the most prominent example, yet there were others, including small holders such as Azerbaijan. One of the largest holders, Turkey, is asking for its gold back also. The process is difficult because the Fed bullion consists of old bars, some stacked up since the 1920s, that don’t meet today’s standard for purity and size. This doesn’t mean the gold is bad, just that the bars have to be melted down and re-refined to meet the new standards. The gold stash in New York is dwindling and global behavior is coming to resemble a run on the gold bank. The reason is an expectation that gold prices will surge due to U.S. inflation, combined with a view that the Fed may be unwilling to release the gold in a future financial panic.

  Before the run on the Fed hits a manic stage, what can investors do to decide if gold is at an attractive price? If gold is just another form of money (it is), then the dollar price of gold can be analyzed as if it were a currency cross rate. The all-time high for gold was $1,900 per ounce in early September 2011, and the low since then was $1,050 per ounce in December 2015.

  Volatility in the dollar-gold cross rate says more about the dollar than it does about gold. When gold is $1,050 per ounce, the message may be that the dollar is too strong. When gold rallies to $1,900 per ounce, the message may be that the dollar is excessively weak. In either case a simple cross rate is a useful way to consider dollars versus gold. Still, it’s not a particularly sophisticated way to understand gold’s role in the broader monetary system and the macroeconomy. What other metrics can we use?

  One metric is the market value of gold as a percentage of the monetary base for a given country. This alternative measure asks how much gold a country owns relative to its base paper money supply. Even the most ardent gold standard supporters don’t argue for more than 100 percent coverage of money with gold. As we’ve seen, some coverage ratio between 20 percent and 40 percent has been sufficient since it’s unlikely that all dollar holders will want their physical gold at the same time.

  The U.S. Treasury holds over 8,000 tons of gold and the U.S. Federal Reserve System holds gold certificates issued by the Treasury as assets in approximately the same amount. Neither dollars (Fed liabilities) nor the Fed’s gold certificates (Fed assets) are redeemable into gold, although citizens are free to buy gold with dollars at market prices. Gold’s existence in the system is officially ignored by all parties. Gold is not a day-to-day operating reality of the system. That said, the gold-to-paper-money ratio is a thermometer that reveals the monetary health of the U.S. economy. In 1936 and 1980, when the value of official gold exceeded the base money supply, the U.S. economy was unhealthy, in the former case because of depression and in the latter case because of borderline hyperinflation.

  How is the economy today? The short answer is not well. The gold-to-paper-money ratio is again at an extreme level that does not reflect an overvaluation of gold, but an undervaluation. The gold-to-paper-money ratio is around 10 percent, well below the 20 percent to 40 percent range historically considered adequate for a gold standard, let alone the 100 percent range deemed necessary by Austrian School economists and other hard-shell gold standard advocates.

  The U.S. money system has never had less backing by gold than today and has never been more vulnerable to a loss of confidence. If confidence in paper money were lost due to an extreme economic event or excessive debt creation, and authorities had to turn to gold to restore confidence, the ability to do so has never been more impaired. This suggests the United States should follow China and Russia in acquiring more physical gold. This prospect makes it attractive for individuals to do likewise.

  CHAPTER EIGHT

  Aftermath

  Reduced to essentials, history has known only two … modes of wealth acquisition: making and taking.1

  —Walter Scheidel, The Great Leveler (2017)

  Rosewood

  The Rosewood hotel on Sand Hill Road off Route 101 in Silicon Valley is home away from home for high-end visitors to the tech capital of the world. It’s a short drive from the Rosewood to Google and Apple headquarters and other castles of computation. The hotel is expensive, but worth it; amenities are excellent. Still, the scent of privilege is strong. Marc Andreessen of Netscape fame has his venture capital firm in an office suite adjacent to the hotel, connected by slate walkways lined with trimmed hedges and flowing fountains. The grounds are eerily quiet. The scene might be mistaken for a spa or meditation retreat but for the signage and security guards.

  The hotel design is enviro-modern with low-rise, flat-roofed, stylish parallel lines done in tan, wood, and slate with greenery. The rooms are like connected bungalows; the doors lead directly outside, no hallways, no long rows of numbered portals.

  The lobby lounge has the only signs of life. Low-backed sofas, lounge chairs, and ottomans in the ubiquitous earth tones are occupied by cosmetological blondes and fiftysomething men, tanned, lean, in jeans, expensive tees, Nike Dunk Low sneakers or Italian loafers, no socks, and the occasional hopsack jacket. The body language says, “I’m rich, I’m invested here, I belong, who are you?” Th
e habitués were tethered to devices, tapping away, sipping Sauvignon Blanc, and staring blankly at the fake fireplace.

  I arrived at the Rosewood early evening in late April 2018 for a one-night stay after a flight from JFK to San Francisco and a short drive down to the Valley. My two prior Valley trips were off the run. One was to lead a complexity science seminar at Singularity University, a pop-up college on the grounds of NASA’s Ames Research Center in Cupertino. Singularity’s educational role is a thin veil over what is really a speed-dating venue for big brains and billionaire backers of the next big thing.

  My second Valley visit was to address a larger audience at the Ritz-Carlton in Half Moon Bay. It was Silicon Valley with surf. The Ritz-Carlton was dripping with money like the Rosewood, yet more in your face, more boisterous, more Dallas than digital. There was a golf tournament going on with a tented Cadillac prize on display for the winning round. I thought the Half Moon Ritz-Carlton must be the go-to hotel for Valley visitors, but I was wrong. The Rosewood was the real deal. Despite its elitist aura, I liked the Rosewood; the quiet was built in, ideal for a writer. I could get some writing done before my business the next day.

  I was at the Rosewood for a conclave with the board of directors of Morgan Stanley, one of the most powerful banks in the world. The board was meeting off-site on a trip that included visits to tech giant clients. I was invited by Morgan Stanley’s head of technology investment banking, Drew Guevara, to engage in a colloquy with the board on capital markets and geopolitical risk. The board met privately during the day, took a break, and reconvened for drinks and dinner. I was the after-dinner event to round out the day.

  Drew was a bit nervous about his decision to invite me. On the one hand, he was intrigued by a scientific approach to risk and thought the board would benefit from the discussion. On the other hand, he was worried about my critique of “elites.” He said, “Jim, I just want you to understand, these people are the elites. I don’t want my directors throwing chairs at the stage.” I replied, “I get it, Drew, I do this all the time. I always respect the audience, especially this board. Their biggest problem is they live in a thought bubble. They need to hear voices like mine. They’ll thank you when we’re done.” I appreciated the fact that he had invited me. Still, it wasn’t a risk-free decision; I have made edgy remarks, including the time I told a Fed governor her central bank was broke on a mark-to-market basis. She demurred, then stalled, then finally agreed.

  I did my homework on the board members before the event. Their résumés were familiar, but I had met only one in person prior to this event. The directors all knew each other, so this wasn’t a name tag event. I would have to repeat the names under my breath. James Gorman, the CEO, was obviously the easiest.

  Twilight arrived. “Showtime,” I thought. The way from my room to the cocktail venue was outdoors until the end. The path consisted of a flight of steps and a promenade on an open-air mezzanine with a trimmed lawn on one side and a twenty-foot drop on the other. As I turned from the stairs onto the walkway, a jet-black raven alighted on the fence at the far end and perched stock-still like a sentinel. I flashed back to Poe’s classic poem, “The Raven,” and to The Raven of Zürich, an out-of-print work that inspired my book, The Road to Ruin. Ravens have symbolized prophecy since antiquity. This raven didn’t say “Nevermore,” but I heard it in my head as I walked past the avian specter. I didn’t look back.

  Drinks were served on a patio with a pit fire. Dress was business casual; no jeans, no ties either. It was the directors’ turn to relax even as I was getting ready to work. I grabbed a Diet Coke with a lime wedge from the bar and mingled among those with a Scotch or Chardonnay. Drew greeted me and began to introduce me to the board members. I shook hands with Gorman and thanked him for inviting me. He’s tall, fit, brilliant, with zero tolerance for drivel. Gorman was a successful lawyer from Melbourne before his transition to investment banking. His demeanor was relaxed. Aussies are always down to earth, even when they rise to the top. It spoke well of Morgan Stanley that a lawyer was in charge, not a trader or quant. Lawyers are trained to see both sides and be good listeners and good advocates. “This is good,” I thought. “Good idea to keep quants in their place.”

  Next came Colm Kelleher, Morgan Stanley’s president. He’s shorter than Gorman, but with a more powerful build. Without much ado he said, “I’m going to knock you down when we get inside.” I thought to myself, “Tough Irishman, typical Wall Streeter. Watch out for this one.” I wasn’t wrong.

  The person I went out of my way to meet was Jami Miscik. She had a long career at CIA and rose to the rank of deputy director of intelligence. She was in charge of the Directorate of Intelligence, the analytic branch that receives intelligence collections from all sources, responsible for integrating that into analyses and reports. It also undertakes strategic studies to look at future threats and new analytic techniques. The Directorate of Intelligence is one of the CIA’s two main pillars, alongside the Directorate of Operations, which runs the clandestine service. The Directorate of Operations consists of case officers who handle spies in the field as well as black ops and deceptions. Miscik was well informed on those operations to conduct her analytic role. She was the highest-ranking woman in CIA history prior to Gina Haspel’s appointment as director in May 2018.

  I knew her on sight and walked up to introduce myself. Miscik had been my big boss at CIA when I worked on Project Prophesy. Although she ran the group I worked for, we never met at the agency. That’s typical of the compartmentalization that is part of agency culture. Still, we knew many people in common, including intermediate officers between my project and her office. The conversation was relaxed until I brought up insider trading in advance of the 9/11 attack. She abruptly pivoted and walked away to join another conversation. Old habits die hard.

  Companies as powerful as Morgan Stanley have equally powerful directors, but not all boards have the same discernment. Some boards are so large that each director’s impact is diluted. Some big-name directors are just that, names, who float from board to board as figureheads. Morgan Stanley’s board was different. Each member was distinguished, the board was small enough to be effective, and every director seemed highly engaged. Morgan Stanley was fortunate to have two female superstars in Miscik and the brilliant Hutham Olayan, heir to a Saudi engineering dynasty. Gorman did an admirable job putting the group together.

  Now it was time for dinner and my presentation. The format was relaxed, round tables of eight with a small stage and two barstools, one for me and one for Drew, who would introduce me and moderate the discussion. I nibbled, waited, and then took the stage on cue. My intro consisted of a video clip on a wide-screen TV showing my last interview before the 2016 presidential election. It was an appearance on Bloomberg TV, recorded live at 4:00 A.M. New York time on Election Day, broadcast to a European audience. Michael McKee, the Bloomberg economics correspondent, said, “We’ll all be in bed by ten P.M. tonight, Hillary will win it that easily. She’ll do even better than her husband did in 1996, she’ll win it in the East.” The anchor, Francine Lacqua, turned to me and said, “Jim, what do you think?” I said we’d be up late, but Trump would win in a close race. Francine seemed momentarily flabbergasted. She’s brilliant, but it was hard even for her to process a Trump victory forecast. She asked me about polls and turnout and I dissected both to support my prediction. Then the clip ended. I thought, “Well, that’s a good start.”

  Most of my presentation consisted of points I’ve made many times in the past. Capital markets are not equilibrium systems; they’re complex systems. Risk is not normally distributed; it’s distributed along a power curve. Events are not random; they’re path dependent. The most catastrophic outcome is not a linear function of scale; it’s a superlinear function. I summarized by saying that capital markets and the banking system were vulnerable to a collapse of unprecedented proportions because of the scale of the system, the dense interconnectedness of megabanks, and flawed risk models. />
  The point was not that I was saying something new, it’s that I was speaking to an audience that (mostly) had never heard it before. One who had heard my statistical analysis was Keishi Hotsuki, the chief risk officer. Hotsuki was not a board member, but it’s typical to invite nonboard senior managers to attend board meetings to inform decisions or as grooming for further advancement. Hotsuki said, “Jim, your presentation is music to my ears; I’ve been saying the same thing for years.” He gushed, “I’m so glad you gave this analysis. I want to hug you!” Gorman, the tough Aussie, stood up and quipped, “Keishi, I’ve been paying you millions for a decade and you’ve never offered to hug me.” Soon there were man hugs all around. An old saying goes, “Science advances one funeral at a time.” Maybe the science of risk management can advance one hug at a time.

  Now it was question time.

  Gorman began, “I read your book,” a reference to The Road to Ruin. I knew he meant it. People pay lip service to authors by complimenting their books, but a writer knows within seconds whether they’ve read more than a few pages. It’s an instinct. Gorman’s gambit meant a critique was coming next.

  He pointed out that Morgan Stanley’s capital adequacy had grown significantly since the last crisis, that certain risky trading strategies were no longer allowed, and that compliance and risk management had been greatly strengthened. He strongly disagreed with my assessment that Morgan Stanley and other securities firms were more vulnerable than ever to a financial collapse.