The Road to Ruin

by James Rickards

  Faust and I ended the evening at the aptly named Bull and Bear bar in the Waldorf Astoria hotel about a block from the restaurant. We sipped straight Scotch, an aged batch selected with care by our friend Dave “Davos” Nolan, the hedge fund billionaire, and shared with another dinner companion, world-class biologist Beverly Wendland. Davos, Beverly, and I toasted Jon’s recent return to academia—what I called his “escape from the Fed.”

  Unfortunately there is no escape for the global economy.

  The Power of Gold

  Simply seeing market collapse, even through a complexity theory lens, is unsatisfying to investors who don’t care why things end, but want to know when. Greed plays a part. Investors may concur that capital markets will crash, yet they’re along for the ride until they do. In effect, investors say, “I know stocks are a bubble, but the gains are too good to resist. Call me the day before the crash; I’ll sell everything, move to cash, buy gold, and keep my profits. Here’s my number.”

  The proper reply to this penchant is that no one will know the hour or the day. The lacuna is not from lack of analysis; it’s just good science. Complexity’s essence is that invisible changes in initial conditions produce radically different systemic outcomes. Market processes are nonlinear and practically nondeterministic. There may be a cause-and-effect relationship between catalyst and collapse. Still, it is too small to observe and the timing is difficult to forecast. Predicting market crashes is like predicting earthquakes. One may be certain the event will occur, and can estimate its magnitude, yet one will never know exactly when.

  Laboratory science, in particular sand pile experiments (similar to a snowflake-avalanche dynamic) and computer simulations using cellular automata, reveal degree distributions of extreme events. Still, a million experiments will not let you predict which particular grain of sand causes a certain sand pile to collapse.

  Systemic instability, not an individual catalyst, destroys your wealth. Anxious investors should not focus on snowflakes, they should stay alert for an avalanche. Nonetheless, the search for snowflakes is seductive.

  The most sensational snowflake may be a publicized failure to deliver physical gold by a prominent bank. This will shock markets the way mortgage fund defaults did in 2007. A gold-buying panic, super-spike in gold prices, and ripple effects in other markets are predictable outcomes of such a failure.

  Gold is the world’s least understood asset class. Confusion arises because gold is traded like a commodity, yet gold is not a commodity, it is money. Countries with tens of thousands of tons of gold in their vaults are happy to obscure this distinction. Central banks know gold is money; they just don’t want you to know.

  Still, the presence of 35,000 tons of gold in government vaults, about 15 percent of all the gold mined in history, testifies to gold’s monetary role despite official denials. Even the IMF, which officially demonetized gold in 1974, holds 2,800 tons. Switzerland’s Bank for International Settlements, known as the central bank for central banks, holds 108 tons for its own account. Central banks and finance ministries do not hold copper, aluminum, or steel supplies, yet they hold gold. The only explanation for central bank gold hoards is the obvious one—gold is money. Still, the central bank preference for fiat forms of money such as dollars and euros necessitates a pretense about gold. The reason is that central banks share a monopoly on fiat. There is no central bank monopoly on gold—yet.

  One result of the confusion on gold’s nature is schizophrenic trading. At times gold trades as a commodity and responds to inflation, deflation, and shifts in real interest rates like any other commodity. COMEX proprietary gold traders are happy to sell front-month futures contracts, and buy the back-month at a profit after adjusting for storage and carry costs, a condition called contango. Institutional gold buyers such as SAFE, a secretive Chinese sovereign wealth fund, like low prices because their gold acquisition programs are not complete. Some gold holders wait in vain for traders in gold futures to notify the COMEX that they are demanding physical delivery. There is not enough physical gold to satisfy that demand; the gold futures exchange would quickly break down if they did. Still, why should traders demand delivery? Banks and brokers make good money from current practices. There is no immediate reason for small traders or mega-institutions to break up these profitable gold price dynamics.

  Gold will break out toward its intrinsic monetary value of $10,000 per ounce, versus the current commodity value of $1,400 per ounce, not because traders revolt, but because the transmission mechanism between physical and derivatives gold markets will break. The divergence between the perceived commodity value of gold and gold’s real monetary value will reconcile in money’s favor. Signs of this are visible.

  One sign occurred in November 2014, when gold’s price diverged sharply from the Thomson Reuters Continuous Commodity Index. Gold is one index component and closely tracked the index for years. That’s not surprising; an index component should track the index of which it’s a part. Then in November 2014, the index accelerated to the downside, while gold broke out to the upside. This divergence persisted through 2016. November 2014 marks the point at which the perception of gold as money began to dominate the perception of gold as a commodity.

  Other signs are less visible, yet more intriguing. On July 18, 2014, I dined at an exclusive private club in New York with a friend, one of the most seasoned gold bullion dealers in the world. What my friend told me was shocking, yet not inconsistent with similar accounts I heard in Hong Kong and Zurich.

  Little is learned about gold sitting at screens watching quotations. Gold is physical, not ephemeral. The experts in physical gold include dealers, miners, refiners, and secure logistics operators of private vaults, armored cars, and chartered jets that move gold around the world. My custom is to meet with these physical gold mavens when I can.

  The club dining room was windowless and dimly lit, with typical old-school mahogany paneling and thick moldings. The walls were tightly packed with paintings, mostly nudes that gave it a bohemian feel. The club was the perfect place to discuss gold, true old-school money. We did so over oysters, soft-shelled crabs, and vintage Champagne.

  My dealer friend was eyewitness to a strange sequence in 2009 involving HSBC, a too-big-to-fail bank, and one of the largest gold dealers in the world. HSBC controls a gold vault on West Thirty-ninth Street in Manhattan, near the New York Public Library. The vault’s exterior is nondescript, scarcely noticed by thousands who walk by each day. There are three loading bays on Thirty-ninth Street where armored cars pull up to deposit or receive gold bullion. One bay has a double-axled armored car often standing by to shuttle gold to a larger Brink’s gold vault at JFK Airport in Queens. From JFK, the gold is shipped around the world to destinations like Switzerland and Shanghai.

  Behind the bay doors is a gold counting room. Dealers with small deliveries can arrive on foot with coins or bars in courier satchels. The counting room is draped in bulletproof glass. This allows dealers in one part of the counting room to observe activity around them. My friend was in the counting room to deposit 100 ounces of coins. He observed a much larger delivery of 400-ounce bullion bars being off-loaded in the adjacent bay. He quipped to the counting room clerk, “Hey, I’ll trade you these coins for those gold bars over there.” The clerk lowered his gaze and said, sotto voce, “You don’t want to do that; these coins are more valuable,” implying that the bars were “salted” or partly fake.

  Shortly after this strange incident, HSBC abruptly announced it was ending its gold storage business for all but the largest customers. Small and midsize accounts were asked to leave and take their coins with them. Many support staff were fired, including the clerk who warned my friend about the fake gold. The woman who headed the physical deposit operations for more than twenty years, Stephanie Schiffman, died prematurely in her sleep.

  The story didn’t stop there. Not much later, China identified a shipment of salted gold bar
s, fakes coated in gold, received from HSBC. The bank was an intermediary in the trade. The origin of the fake bars was not disclosed to China. The Chinese demanded a make-good delivery, which HSBC promptly provided. The entire sequence was covered up and soon forgotten. Since 2009, China vastly expanded its mining and refining capabilities and is now less dependent on Western supplies. China also protects itself from bank fakes by insisting that old 400-ounce bars purchased from Western sources be re-refined in Switzerland into new one-kilo bars of higher purity. There is no point in delivering fake bars to a refinery because the fraud is discovered immediately when the gold is melted. Fake 400-ounce bars are left in the West.

  Trading in gold derivatives is supported with a shrinking store of physical gold. The China fakes are just one symptom of stretched conditions on the physical side. My dealer friend said supplies are dangerously tight. Orders of ten tons or more are quite difficult to fill. U.S. law requires physical gold forward sales to be settled by delivery within twenty-eight days. Otherwise such sales are reclassified as futures contracts, which are illegal unless traded on regulated futures exchanges. In current tight market conditions, this law is routinely ignored as dealers find it difficult to complete deliveries within the twenty-eight-day requirement. The U.S. government has shown no interest in enforcing the law. These illegal forward sales should be added to the reported open interest on futures exchanges to understand the inverted pyramid of gold derivatives resting on a shrinking fulcrum of physical supply.

  Physical gold at the base of the inverted pyramid of paper gold trading is the floating supply. This is different from total supply. Floating supply consists of gold available for prompt delivery to support dealer activity. Total supply consists of all the physical gold in the world. Most gold is hoarded in private vaults or worn as jewelry. It is not readily available to support trading. This is an important distinction. The difference between floating supply and total supply bears directly on how a failure to deliver physical gold could cascade into a full-blown gold-buying panic.

  Gold in Western central bank, IMF, and BIS vaults is part of the floating supply available for lease to the market. Once title is obtained through leasing by a bullion bank, that gold is used to make forward sales on an unallocated basis. The term “unallocated” is a euphemism. It means the buyer has gold price exposure and a paper contract, but no gold. One ton of German gold, held on deposit at the Federal Reserve Bank of New York, and leased to Goldman Sachs in London through BIS intermediation, can be used to support ten tons of forward sales to the market. Each buyer of part of those ten tons believes she owns gold. Yet there is only one ton of physical gold to support ten tons of gold sales. Even that one ton of physical gold is leased and may be withdrawn from the market by the lessor.

  When central bank gold is sold to China’s government and shipped to Shanghai, that gold goes into semipermanent deep storage and is unavailable for leasing. Total supply is unchanged, yet the floating supply is diminished. The same is true when countries such as the Netherlands and Germany repatriate their physical gold from the Federal Reserve Bank of New York to vaults in Amsterdam and Frankfurt. Legally, this gold could be leased by Germany or the Netherlands, yet there is no well-developed leasing market in either location. Leasing is centered in New York and London, where commercial law is clear and legal precedent gives transacting parties a high degree of confidence in contract enforceability. So gold repatriation to Europe diminishes the floating supply.

  Floating supply is also diminished as investors demand that their gold be transshipped from bank vaults at UBS or Credit Suisse to private vaults at Loomis or Brink’s. Gold in a bank vault is available for leasing or multiple unallocated sales while gold in private vaults is not. Confirmation of transshipment from bank vaults to private vaults was offered to me directly from senior executives of the vault operators.

  Another failure in the physical gold market is illegal substitution of allocated bars. Some buyers own their gold on a fully allocated basis, which means they have title to specific bullion bars, not just a paper claim. Standard 400-ounce good delivery gold bars are stamped with the refiner’s name, the assayer’s name, a specific weight (which may be slightly more or less than 400 ounces), the date the bar was poured, the purity (which is between 99.50 and 99.99 percent pure), and a unique serial number. Based on those identifying stamps each gold bar is unique. Yet pure gold is fungible; that has always been one of gold’s attractions. I have heard countless stories of gold investors who demanded physical delivery only to receive bars with different dates or other markings than those on their manifests. This means the original bars were diverted and other bars delivered as substitutes. Receiving parties rarely object because gold is gold. This is true provided the substitutions are not fakes. Any substitution is evidence of scarcity.

  All of these trends—depletion of COMEX warehouses, repatriation of gold to Europe, outright gold purchases by China, private nonbank gold storage, illegal substitutions, and gold counterfeiting—are accelerating. The result is a larger inverted pyramid of gold derivatives resting on a smaller floating supply of physical gold. Shortages, delays, and fraud in gold deliveries are emerging. For now, these dysfunctions are ignored by market participants who are happy to get gold even if delays are encountered.

  As physical scarcity becomes more evident to insiders, a phase transition emerges. Those with title to gold, but without physical possession, start to demand possession. This trend is seen in recent gold repatriation efforts by Germany and the Netherlands. Demand for physical gold also appears in Federal Reserve Bank of New York reports on gold deposits. In 2014, gold on deposit at the Fed dropped by 177.64 tons; over half that decline occurred in a brief two-month period, October and November 2014. The movement was all one-way; there were no months when gold deposits increased. This precipitous draw-down of physical gold occurred at the same time the gold price diverged from the commodity price index. The coincident draw-down and price divergence are consistent with the view that gold is money, and is in short supply.

  These trends are known only to specialists and insiders. The general public and U.S. policymakers are not alert to the implications. The shortage of physical gold relative to contracts, and the nervousness of contracting parties about good delivery, have triggered a classic run on the bank—except it’s a run on gold.

  This dynamic resembles the state of the gold market from 1968 to 1971, when Europeans cashed in dollars for gold from Fort Knox, leading President Nixon to shut the gold window on August 15, 1971. Today there is no fixed price for gold, and the gold is not coming from Fort Knox, but rather from private custodians such as the Federal Reserve and ETF sponsors. Still, the dynamics are similar.

  The environment is ripe for a highly publicized failure to deliver. When this occurs, gold owners in paper forms will want physical gold all at once. The price will spike as intermediaries scramble to buy scarce physical gold to make good on promised deliveries. Institutions previously uninterested in gold will suddenly want gold as well for their portfolios, increasing the upward price momentum. The end result is ice-nine for gold. Gold exchanges will halt trading. Contracts will be terminated and settled in dollars at the last closing price. Counterparties will lose out on future price appreciation and access to physical gold. Those who don’t have gold will be unable to get it at any price.

  The financial system will be fortunate if a gold-buying panic is confined to gold and does not spill over into capital markets. That seems unlikely. Financial distress is contagious. Even if a gold panic is momentarily contained, this does not mean capital markets are stable. There are other snowflakes.

  The Dollar Shortage

  Gold is not the only money in short supply; there is a global dollar shortage also, and it grows worse by the day. An acute phase of the dollar shortage will manifest soon as defaults, deflation, and bank failures. The reflationary policy response will include money creation, debt monetization, a
nd ice-nine lockdowns of financial institutions and money market funds. The conflict between countervailing forces of deflation and reflation is vast, and will be highly destructive of accumulated wealth.

  The suggestion of a dollar shortage may seem strange. The Federal Reserve created more than $3.3 trillion of new money between 2008 and 2015. Other central banks created comparably large amounts relative to their economies. How is there a dollar shortage with that much new money sloshing around?

  The answer is that along with $3.3 trillion of new money created by the Fed, markets created more than $60 trillion of new debt, and hundreds of trillions of dollars in new derivatives. The newly created money has been leveraged over 50-to-1 through various channels. Not all the new debt and derivatives constitute “money” as the term is conventionally defined. Still, that debt represents a state in which a counterparty expects to receive her “money back” by contractual performance in the fullness of time. When such contracts default, or when the value of collateral behind such contracts is diminished, or when the prospects of contractual performance prove doubtful, a slow-motion liquidation begins. In small stages, short-term creditors decline to roll over financing facilities, banks refuse to lend to other banks, accountants require write-downs, and the global system tips into deleveraging. In the classic formulation, everyone wants her money back. Yet there isn’t enough true money to give everyone’s money back. That’s when liquidation accelerates and the dollar shortage shows its teeth.

  Evidence for this liquidation comes from several sources. A stronger dollar measured by major dollar indices from 2013 to 2016 is good evidence of global dollar demand. Acute eurodollar interbank funding problems at major Italian banks beginning in June 2016 are additional straws in the wind. Net sales of U.S. Treasury securities by China, Russia, and Saudi Arabia in the first half of 2016 were evidence of those nations’ need to obtain dollars to satisfy capital outflow demands or maintain nonsustainable currency pegs.