Hera Research, LLC

7205 Martin Way East, Suite 72 Olympia, WA 98516 U.S.A. +1 (360) 339-8541 phone +1 (360) 339-8542 fax http://www.heraresearch.com/

Interview: Jim Rickards on Inflation and Currency Wars

By Ron Hera February 4, 2011 2011 Hera Research, LLC

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. Lets talk about the Federal Reserves 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

2010 Hera Research, LLC

been pointing to the price indices and saying that you cant find inflation under a rock, you cant 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 youve 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 doesnt mean that a lot of things arent 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 thats being offset by policy inflation. So the fact that the price indices are around zero doesnt mean that theyre well behaved, it just means that theyre 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, Ive wondered which way its going to tip. If Im right about those two forces, one of them is going to prevail at the end of the day and, on which one its 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 theyre 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: Its been known since the 1950s, as Milton Friedman pointed out, inflationary effects occur with the lag. The fact that you saw QE in 2009 and inflation didnt 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 were 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, its 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. Theres 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 doesnt 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, thats basically flooding China with yuan and so the Feds 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 2

2010 Hera Research, LLC

inflation was showing up in China and now its 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, lets 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 theres nothing we can do about it. Our choice is between control and lack of control and, of course, theyre control freaks, so theyre going to go with control, which means theyre 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 1970s, it may be our currency, but its 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. Were seeing capital controls in Brazil, for example. Brazil couldnt 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 wasnt much they could do about it from a currency point of view, so theyre 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. Were seeing a little bit of that in China with rare earth elements (REEs), although theres 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.?

2010 Hera Research, LLC

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, were looking at significant inflationary forces, for all of the reasons I just mentioned, and thats 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 theres a risk of trade wars? Jim Rickards: Correct. HRN: If the U.S. economy is recovering, why doesnt 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 theyre not, such as unemployment. That suggests to me that its not a self sustaining recovery, therefore, I conclude that its 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. Its the whole reason for the Fed. HRN: Isnt 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 its 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: Didnt the bailouts and the Federal Reserves purchases of mortgage-backed securities clean up the bad assets? Jim Rickards: The bad assets havent 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 Feds Board of Governors kept interest rates too low too long, so thats when the bad loans were made. They were identified as such in 2007 and then we had the panic of 2008, but whats important to understand is that the bad loans havent gone anywhere. Its not as if theyve been magically transformed into good loans, its not as if theyve been marked down, its not as if theyve moved from weak hands to strong hands. Whats happened is, theyve 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, theyre 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 youre a bank, you just want that nominal value so you dont have to take the loss and the hit to capital. Second, theyre hoping that, because of the 4

2010 Hera Research, LLC

steepness of the yield curve, the banks could eventually earn their way out of the problem and make provisions for the bad loans. Obviously, theyre 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: Wouldnt inflation also reduce the real value of the U.S. federal governments debt? Jim Rickards: The United States has well over $100 trillion in obligations. Now, thats 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, its 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? Thats very hard to see. HRN: So, the U.S. economy cant grow its way out of debt? Jim Rickards: I dont 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 its already too late. Weve already fallen into a hole where, mathematically, its 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 cant 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 wont pay you. The other one, of course, is the one that governments prefer which is inflation. You say, OK, heres your trillion dollars and good luck buying a loaf of bread with it; its just not going to be worth very much. So, thats what were doing and thats another reason why Bernanke wants inflation. Of course, he doesnt want hyperinflation, he doesnt want 10%, but he doesnt 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 thats 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 dont think its 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 were going to buy about $75 billion a month for the next 6 months. I dont 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 Reserves purchase of U.S. Treasuries in the open market monetize U.S. government debt?

2010 Hera Research, LLC

Jim Rickards: These things are pretty fungible. Dollars are totally fungible and Treasury securities are quasi fungible because its the same credit in the same currency. So, imagine youre an institutional investor and youre 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, lets say, and the insurance company replaces that in their portfolio by buying a new 5 year note. From the insurance companys point of view, they got rid of a 5 year treasury and they bought a 5 year treasury, so nothing happened. From the Feds point of view, they bought the 5 year treasury with newly printed money and so theres some intermediation and theres multiple parties involved, but the net effect is exactly as if the Fed was monetizing the new debt. HRN: Lets get back to inflation. Cant 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 dont get 2% or 3%, you go straight to 10% and thats what happened in the 1970s. If you look at the late 60s and early 70s, inflation was 1% or 2% and then one year it pumped up to 3% and they said, oh my goodness, its 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, thats how it accelerates and gets out of control. I think thats whats 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 hes going to find is that it goes very quickly to 8% or 9% or 10%, which is borderline hyperinflationary and thats going to be a huge problem. Its 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, dont worry about high inflation because we have the ways and means of controlling that. If you take Bernanke at his word, which I dont totally do, but if you do take Bernanke at his word and he says I want 2% and inflation goes to, lets say, 3% or 4%, hes 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 hes not actually, politically or economically, going to be able to do it because hell be raising interest rates in the face of the greatest sustained period of high unemployment since the Great Depression. So, its just not going to be politically possible. HRN: Couldnt the Federal Reserve remove liquidity from financial markets to counter inflation? Jim Rickards: Theres 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. Lets 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 youre going to have massive markto-market losses on those bonds. First of all, theres the Bear Sterns junk and, remember, QE1 was not treasury securities, it was mortgage backed securities. Theyre not going to be able to liquidate the bonds without going broke. HRN: How can the Federal Reserve go bankrupt? 6

2010 Hera Research, LLC

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, theyre leveraged 50 to 1. Thats worse than Long-Term Capital Management when they got in trouble in 1998. If youre 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 Reserves primary dealers sell Treasuries to remove liquidity from the market and help keep inflation in check? Jim Rickards: The primary dealers cant create money through auctions or open market operations. The primary dealers can buy and sell securities but theyre 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 cant create money the way that the Fed does or make money disappear the way the Fed does. HRN: So, theres nothing the Federal Reserve can do to control price inflation? Jim Rickards: Theyve 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, its all talk. The Fed wont actually be able to keep inflation under control and its going to very quickly fly out of control. HRN: Wont rising prices make most Americans poorer? Jim Rickards: The Fed doesnt care about that. The Fed doesnt care about people. They dont care about workers. They dont 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: Its 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 theyre going to do and then spend the vast majority of their time thinking about messaging and wordsmithing. Well, theres a name for that. Its called propaganda. HRN: Thank you for sharing so many of your insights with us today. Jim Rickards: Its my pleasure.

2010 Hera Research, LLC

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 Reserves monetary policies. The debasement of the U.S. dollarthe world reserve currencythrough 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 Reserves policies, could lead to trade wars or, in the worst case, to economic and political chaos as has been seen in Tunisia and Egypt. ### Hera Research, LLC, provides deeply researched analysis to help investors profit from changing economic and market conditions. Hera Research focuses on relationships between macroeconomics, government, banking, and financial markets in order to identify and analyze investment opportunities with extraordinary upside potential. Hera Research is currently researching mining and metals including precious metals, oil and energy including green energy, agriculture, and other natural resources. The Hera Research Newsletter covers key economic data, trends and analysis including reviews of companies with extraordinary value and upside potential. ###
Articles by Ron Hera, the Hera Research web site and the Hera Research Newsletter ("Hera Research publications") are published by Hera Research, LLC. Information contained in Hera Research publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in Hera Research publications is not intended to constitute individual investment advice and is not designed to meet individual financial situations. The opinions expressed in Hera Research publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and Hera Research, LLC has no obligation to update any such information. Ron Hera, Hera Research, LLC, and other entities in which Ron Hera has an interest, along with employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. The policies of Hera Research, LLC attempt to avoid potential conflicts of interest and to resolve conflicts of interest should any arise in a timely fashion. Unless otherwise specified, Hera Research publications including the Hera Research web site and its content and images, as well as all copyright, trademark and other rights therein, are owned by Hera Research, LLC. No portion of Hera Research publications or web site may be extracted or reproduced without permission of Hera Research, LLC. Nothing contained herein shall be construed as conferring any license or right under any copyright, trademark or other right of Hera Research, LLC. Unauthorized use, reproduction or rebroadcast of any content of Hera Research publications or web site, including communicating investment recommendations in such publication or web site to non-subscribers in any manner, is prohibited and shall be considered an infringement and/or misappropriation of the proprietary rights of Hera Research, LLC. Hera Research, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of Hera Research publications or website, any infringement or misappropriation of Hera Research, LLC's proprietary rights, or any other reason determined in the sole discretion of Hera Research, LLC. 2009--2011 Hera Research, LLC.