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Market Strategist Jim Rickards: Fed Is Still Using Long Term Capital Management's Financial Models

November 04, 2014

In the 1990s, Jim Rickards was the general counsel of Long Term Capital Management and was the lead negotiator for the famous hedge fund with the government as it shook the entire global financial system.

After a 35-year career on Wall Street, Rickards has become a much-followed author (Currency Wars; The Making Of the Next Global Crisis) and market strategist.

He recently sat down with Sprott Asset Management and provided some of his current observations on the markets:

Hi, Jim. You have recently published Currency Wars and now The Death of Money. Are you expecting a global collapse of every currency? And if so, a collapse relative to what?

I expect a collapse in the value of currencies relative to real goods, real assets and real services. This will happen to all currencies, not just the dollar. I don’t expect a world where people lose confidence in the dollar and the euro does really well. On a relative basis, I’ve been bullish on the euro for some time. In the end game, however, if people lose confidence in the dollar this will be inflationary in all countries around the world, and I don’t think that any currency will be able to withstand it. When I say "the death of money," what I really mean is the loss of confidence in the purchasing power of money. That’s very likely to be a global phenomenon not confined to any particular country.

Is a widespread loss of confidence in paper currencies the end result of a currency war that you see happening?

Currency wars are part of the picture because the way you fight a currency war is by cheapening the currency, cutting rates and quantitative easing. We saw that recently with the announcement of more quantitative easing from Japan, which took the markets by surprise and caused the Japanese yen to fall by over 2 percent in a single morning. That is a huge move in the currency markets.

Another big factor in currency wars is the question of paying sovereign debts. It’s the sovereign deficits that are really the problem, and the question is how to deal with them. One way to deal with them is through inflation, which, of course, is the goal in a currency war. The problem is that not everybody can devalue against everybody else all at once. You have to take turns. So it goes back and forth and back and forth. That’s what happened in the 1920s and 1930s, and it’s happening again today.

Is the purpose of the different factions in a "currency war" to destroy other currencies? Or is the "currency war" simply a byproduct of each country trying to get out from its debt obligations?

In a currency war, it’s not that you want to destroy the other currencies, it’s that you want to cheapen your own currency; that actually means you’re strengthening the other currencies. You want to import inflation through higher import prices. You’re right – it is a policy and not something that just happens randomly or because of other actions. Countries have policies with regards to interest rates and taxes, and they have policies with regards to exchange rates. It is very much a deliberate policy; it doesn’t just happen.

You have said that China may secretly be selling the dollar and buying gold. If they’re trying to devalue their own currency, why do this? Shouldn’t they buy the dollar and sell the yuan?

You’re confusing two different things. You’re mixing up currency war with financial war. I have discussed financial war, which is different from currency war. Currency war is an economic policy countries use to fight deflation and encourage inflation by cheapening the currency and creating inflation in the form of higher import prices. It’s a way of creating monetary easing. It’s an age-old economic policy, used most famously in the late 1920s and 1930s in what became known as "beggar they neighbor." Countries were stealing growth from each other by debasing their currencies, trying to import inflation and improve their trade balances by causing cheaper exports to foreign buyers and more expensive imports for domestic buyers. That combination was seen to bolster growth.

Financial war is different. Financial war involves countries that are traditional rivals or even enemies, for instance, the U.S., Russia, and China, with competing interests everywhere from Eastern Europe to the South China Sea. Countries have fought wars in the past using traditional kinetic methods – armies, navies, air forces, missiles, submarines and so forth. We now live in an age where, thinking about warfare, you have to look at asymmetric forms of warfare – not just traditional forms – like chemical, biological, radiological weapons, guerilla warfare, terrorism and financial warfare. So the scenario I was discussing that involves China buying gold and selling the dollar was not a currency war; it was a financial war. There you are trying to destroy the economy of your opponent, which is a very different situation.

Is it correct to say you were very involved with the bailout of Long Term Capital Management?

Yes. There is a book about it – When Genius Failed, by Roger Lowenstein – that discusses my role, along with others’, obviously. I was general counsel of Long Term Capital Management from start to finish, and I negotiated the bailout in 1998.

Alan Greenspan, the former chairman of the Federal Reserve, has blamed the financial models used by the Fed for his missing the financial crisis. Does this remind you of what happened at LTCM? Do you think the Fed has gotten any better at predicting crashes since then?

No. I think you’re exactly right. The models that LTCM was using the 1990s were the same models that Wall Street was still using in the early 2000s and, for that matter, the same models being used today. They are called "dynamic stochastic general equilibrium models" and also risk management models like "value at risk" or VaR models. They were the ones that we used in the '90s and have continued to use for the last 16 years. They’re still being used now. They do not correspond with how markets actually work or to actual human behavior. They have failed in the past and they will fail again. If you have the wrong model, you will get the wrong policy, and you will be negatively surprised by results every single time.

According to Greenspan, the Fed expanded its balance sheet not to boost the economy or to keep inflation moving higher. It was because the Federal government had such large expenditures that it would have "crowded out" private borrowers if the Fed had not increased the size of its balance sheet. Do you think that’s true? Is the Fed directing the economy? Or just reacting to the capital demands of the U.S. government?

I think both things are true. I think Greenspan is right that we are seeing monetization of debt. This is what Frederick Mishkin, the former member of the Federal Reserve board of governors, refers to as "fiscal dominance." Yes, I think Greenspan is right about that, but it’s also true that they’re trying to fulfill the dual mandate of price stability and creating jobs. As between the two, the Fed is willing to tolerate higher inflation if they can create more jobs. They don’t talk about "fiscal dominance," and they don’t explicitly say they’re monetizing the debt. In fact, they deny that they’re monetizing the debts.

Greenspan’s right. When the credit demands of the federal government are that great, you either have to accommodate the demands or somebody is going to be crowded out. I think that the result would be deflationary. Governments cannot tolerate deflation. So rather than choose between stimulus from monetary ease and monetization of debt, I think that they are doing both.

When you look at the bank bailouts or LTCM bailout, do you think the Fed achieves economic stability by bailing out these institutions? Or do you think that they end up with a more fragile system after the bailouts?

Both. I think that in the short run, they did in fact prevent a bigger collapse. If LTCM had not been bailed out there would have been a worse collapse in 1998. If Goldman Sachs had not been bailed out there would have been a worse collapse in 2008. In the short run, Fed policies did prevent a worse collapse and a worse economic downturn, but it came at a very high cost. Probably the long run costs will be greater than the short-term gains. A lot of the short-term disruption might have produced a more stable system on a going-forward basis, with more of an emphasis on organic growth as opposed to financial engineering.

I think that the bailout worked but only in the short-run to prevent worse events at the time. In the long run they’re just creating larger bubbles and large potential collapses that have not emerged yet but probably will in the next year or so.

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