September 17th Interview with Jim Rickards Topics:
*Cease fire in Ukraine holding, Putin is getting what he wants
*What is driving the current drop in the gold price, entry points
*Proper portfolio allocation to gold
*Comprehensive review of gold price manipulation, techniques, and proofs
*Motives, Players, Tools
*The end game is in view, what is it
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Jim Rickards Interview: 9-17-2014
Jon Ward: Hello, I’m Jon Ward on behalf of Physical Gold Fund and Anglo Far-East. We’re delighted as always to have with us here Jim Rickards. Mr. Rickards is an investment banker, an investment advisor based in New York, and he also serves on the Investment Advisory Committee for the Physical Gold Fund. Jim is the author of the New York Times bestseller, Currency Wars: The Making of the Next Global Crisis. More recently, he’s the author of The Death of Money: The Coming Collapse of the International Monetary System, also a New York Times bestseller. Hello, Jim, and welcome.
Jim Rickards: Hi, Jon. How are you?
JW: I’m very good and looking forward to today’s discussion, especially because it’s about a question that I think is important for all investors in precious metals. That subject is price manipulation. But first, let’s do a quick roundup on the current situation. In our last podcast, you offered us a multifaceted analysis of the crisis in the Ukraine and the accompanying financial war between the U.S. and Russia. So let me ask you, Jim, has anything happened since we spoke to modify your picture of that crisis and its implications for the global economy?
JR: Nothing has really changed in terms of the long-term implications or what’s going on, on the ground. Of course, we do have what looks like a ceasefire between the Ukrainian rebels—obviously backed by Russia—and the government in Kiev. So that’s a good thing, certainly for people on the ground who are innocent victims in all this. The ceasefire seems to be holding, which is significant, but to me, the significance of the ceasefire is that Putin’s getting what he wants. In other words, this is not a case where Putin has backed off or backed away. I think the markets have interpreted it that way. They said the sanctions are working and Putin’s been punished so he is backing off. That’s nonsense; the sanctions are not working. Putin not only has not been punished, but he’s actually gaining a lot.
The reason there is a ceasefire is because the Ukrainian government forces had gone into pretty much full retreat. The Russian-backed forces, including Russians themselves, had gone on the offensive, and so it was in everyone’s interest. In other words, it was in the Kiev government’s interest to have a ceasefire, because they were in retreat. It was in Putin’s interest to have a ceasefire, because he was getting what he wanted, and also it’s good PR if you want to think of it that way. So again, the ceasefire is good from a humanitarian perspective, but I would not infer that it means that Putin has backed off at all. It just means that Putin is getting what he wants and therefore, looking into the future, nothing has really been resolved. I believe Putin is going to insist that these nascent republics in Eastern Ukraine become true republics and perhaps join the Russian Federation. Remember, the governance in Russia is a multiple-member federation called the Russian Federation.
It’s good news that there’s a ceasefire. Markets have calmed down, but this is far from over. If the West and Kiev and NATO are going to insist that Russia back off, and if Russia is going to insist that these republics break away, then it’s really not over. I look for it to flare up again, but at least for now we’re in a quiet period.
JW: Let’s turn now to our topic of the day. To give a little bit of framing for that, we’re going to be talking about the gold price. Let’s just briefly touch on the current story of the gold price. Actually, gold and silver have both been under some pressure recently. I recall from several of these conversations that you’ve advised us to not look too closely at the price of gold or fret about the ups and downs. It’s what we would expect and doesn’t alter the big picture. Nevertheless, I think some investors in gold are maybe a little anxious about a significant drop in the price over the last few weeks. Would you help us understand that, what’s driving that and how to think about that strategically?
JR: Absolutely, if you’re a large investor in gold, no one wants to see the price go down from an investment perspective, but I think it’s always important to do two things. Number 1) Keep your eye on the long term. That’s the reason you own gold to begin with. Don’t get too distracted by day-to-day movements. Number 2) Understand what’s going on behind it. In other words, why is the price of gold going down? I think understanding why in any market is a source of comfort. If you think it’s out of control or just going to go one way forever, that’s one thing. But if you can understand that it’s a blip and what’s driving it and see how that driver can reverse, then I think that’s a source of comfort.
I’ve always recommended maybe 20 percent gold for the aggressive investor, but in most of my writings and interviews, I recommend 10 percent gold for the conservative investor. When the price of gold goes down, you do face a certain amount of criticism. If you said to buy gold and it goes down, you do get some complaints, but it’s not as if anyone ever said to go 100 percent in gold. The fact is, if you’re 10 percent in gold and gold goes down 20 percent, that’s only a 2 percent decline in your portfolio. Presumably the other 90 percent is doing well. I’m an investor in gold but I also invest in fine art, stocks, and private equity which have all done well, so I don’t worry too much about the gold. It’s a slice of my portfolio but not the whole thing. I think the first thing for investors to understand is that you should never be all in. You shouldn’t even be 50 percent in. If you are 10 percent in and it goes down, it doesn’t have that big of an impact on your portfolio, because it’s 20 percent of 10 percent, which is only 2 percent.
Another thing for people who are watching it, this looks like a good entry point. I’m not saying it couldn’t go lower. It might, but gold has shown a lot of resilience. It’s had several drawdowns of late — this is the third drawdown in recent months — and has come back pretty strong each time. I’m impressed with the resiliency. We all know that gold is seasonally strong in the fourth quarter, and we’re coming up on the fourth quarter in a few weeks. There are obvious reasons for that including the wedding season in India and demand in China. Gold continues to be very strong, and the physical supply continues to be scarce.
I just returned from Australia where I met with one of the largest gold bullion dealers in the country. This individual said their best months were when the price of gold was going down the most. When we say the price, we’re really talking about the COMEX price, and that’s subject to a lot of manipulation. We’ll come back to that later in the interview, but people have common sense. When that price goes down, they see a bargain. The Australian dealer told me that their customers were lined up out the door around the block, so to speak, to buy gold. So if you don’t have any gold, this could actually be a very good entry point. If you have some gold but want more, again, it’s a good entry point. If you’re a buy-and-hold investor, which I think is a good posture to be in, it’s important to understand why the price of gold has gone down.
There’s a very simple explanation. The dollar price of gold is simply the inverse of the dollar. If you have a strong dollar, that means a weaker dollar gold price. If you have a weak dollar, that means a higher dollar gold price. It’s not that complicated. Right now we have an extremely strong dollar. The euro has come down from about 140 to 128, and the Chinese yuan and Japanese yen are down. The Reserve Bank of Australia just cut rates trying to cheapen the Australian dollar. Even the pound sterling, which has been a heavyweight among currencies, was down because of fears about the vote in Scotland.
Look around the world, and it’s “King Dollar” again, so you would expect the dollar price of gold to go down on a strong dollar. The question investors have to ask is, can that last? Is that the new state of the world? The answer is absolutely not. The reason is that the United States has allowed the dollar to appreciate and allowed these other currencies to go down because these countries desperately needed help. The Japanese economy fell off a cliff in the second quarter and is in terrible shape. The European economy is back in a second recession inside this depression, so they actually needed help. The U.S. allowed the dollar to go up, allowing the yen and the euro to go down, thereby throwing them a lifeline. The U.S. does not want the Chinese yuan to be weak, but it went down anyway because the Chinese government manipulates it, and sterling has stubbed its toe over the whole Scottish referendum.
In considering all that, we do have a strong dollar, but the United States is the one that’s ultimately going to need help. We have a very weak economy. As I’ve said before, the Fed has tapered into weakness, which is showing up in data revealing that we had a lousy August employment report. The most recent reports from CPI and PPI (Consumer Price Index and Producer Price Index) show that deflation is more of a concern than inflation. When you’re worried about deflation, you’ve cut interest rates to zero, you’ve printed trillions of dollars and done everything you can, the only way left to get inflation into your economy (which the Fed wants) is to cheapen your currency. I look for a cheaper dollar ahead, and that means a stronger gold price. The reason gold is going down is because the dollar is so strong. The reason the dollar is strong is because we’ve let the euro and yen cheapen. This is what currency wars are all about, but that cycle is nearing an end pretty soon. The dollar is going to get weaker because the Fed’s going to need some inflation here, and that means a stronger gold price ahead.
JW: Thanks for that clarification about the current price. Now let’s turn to the subject of price manipulation. You’ve said a number of times in these conversations that the gold price is manipulated. I want to ask you about the implications for investors, so let’s take this step by step. We’ll look at possible culprits, but first would you review with us how the manipulation works? What does it actually take to manipulate the price of gold?
JR: If your goal is to keep the price of gold from going up or at least going up in a disorderly way, you only have to manipulate when it’s going up a lot. If gold’s going down for other reasons – and we mentioned a strong dollar as one of them – you don’t actually have to manipulate it. If it’s going down, then if you’re a central bank who wants a weak price of gold, you’re getting what you want. Manipulation really kicks in when gold is strong and looks like it’s breaking out. We saw that in August 2011 when it was rapidly approaching $2,000. That was an important psychological barrier and could have gone up a lot higher from there, so the central banks really did have to pull out all the stops to drive the price down. When gold’s going up on its own, that’s when you look for the manipulation. If it’s weak for other reasons, then the central banks really don’t have to do very much.
Let’s look specifically at techniques. The first and most straightforward technique, and the most obvious, is to just dump physical gold. If you’re a central bank, sell gold. Well, that was done for decades. Going back to the 1970s after Nixon went off the gold standard, the price of gold began to skyrocket. It started the decade at $35 an ounce. After Nixon shut the gold window, it went up to about $42 an ounce. Then they abandoned the official price completely, currencies floated, and gold began its steady ascent all the way to $800 an ounce in January of 1980.
On that path from $42 an ounce to $800 an ounce, the United States tried desperately and secretly to suppress the price of gold with gold sales. This is all described in Chapters 9 and 11 of my book, The Death of Money. The United States sold about a thousand tons and prevailed upon the IMF to sell 700 tons, so together the U.S. and the IMF dumped 1,700 tons of physical gold. That’s a lot of gold. It didn’t work, so at the end of the day, they just gave up and let the price of gold go where it was going to go, and then we had that super spike up to $800 an ounce in January 1980. During the period of ’76 – ’78, I’ve found what were classified, private documents (they’ve since been declassified) between Arthur Burns, chairman of the Fed at the time, President Gerald Ford, and the Chancellor of Germany all describing this physical gold manipulation.
There was another type of manipulation all the way through to the late 1990s and the famous Brown’s Bottom, when Gordon Brown, then Chancellor of the British Exchequer, dumped about two-thirds of England’s gold on the market in 1999. Switzerland was also a major seller of gold in the early 2000s, so for a long time, the way they manipulated the price was by dumping physical gold. There’s a problem with that, which is you run out of gold. England doesn’t have much left, and Switzerland has a fair amount but a lot less than they used to. The U.S. decided it didn’t want to sell any more but was happy for others to sell. Central banks did dump gold through the 1990s and in the early 2000s. Now, the physical dumping has stopped because people realized it wasn’t working. There were ready buyers but they were running out of gold, so they had to resort to paper manipulation. Let’s talk about how that works.
The easiest way is through COMEX futures. COMEX future prices long ago replaced the London gold fix. That’s an interesting word for the old ring of dealers who sat around on the phones with their customers and fixed the price twice a day. Going back 75 – 80 years, even more recently perhaps, that was significant, but since the creation of gold futures, the COMEX gold has really been the benchmark. The London fix just tagged along with that, if you will, independent of its own manipulation. Rigging futures markets is child’s play. You just wait until a little bit before the close and put in a massive sell order: you scare the other side of the market and they back away. Then you get into the fact that a lot of hedge funds are in gold, which did not used to be true. Gold was not a traditional hedge fund activity, but today there are quite a few hedge funds in gold. To be candid, hedge funds don’t really know that much about gold. It’s just another commodity to them much like coffee beans or corn or stock futures or anything. So what do hedge funds do? They use leverage, they follow trends, and they have tight stops. ‘Tight stops’ means if the trade works against you, get out.
Let’s say you have a lot of hedge funds in gold that are leveraged with tight stops. You come in with a big sell order, slam the price, and these stops start getting triggered. The hedge fund sits there and says “Oh my goodness, it’s down 2 percent so I must sell.” They sell, and that drives the price down further. It builds on itself as one after another hits his stop and sells. It’s a whole cascade down. Between hedge fund leverage, tight stops and leveraged futures manipulation, that’s the easiest way to do it. We’ve seen this time and time again. I’m an expert in this myself and have spoken with other experts who have done documentary, long-term statistical studies of this showing the overwhelming evidence that the price is being manipulated in that way. So this is one way to do it and the most visible, but it’s not the only way.
Another way to manipulate the price is with gold leasing and what are called unallocated forwards. ‘Unallocated’ is one of those buzz words in the gold market. A lot of people want to buy physical gold, so they’ll call JPMorgan, HSBC, Citibank or one of the large gold dealers and say they want to buy $5 million worth of gold, however many kilos that is. The bank will say fine, send us your money for the gold. But if you read the contract, it says you own it on an unallocated basis. That’s just a euphemism for the fact that you don’t have designated bars. There’s no group of gold bars that have your name on it or specific serial numbers that are specifically traceable to you. What this means is that the bank sells perhaps 10 times as much gold as they have actual physical gold in a vault.
It’s no different from any other kind of fractional reserve banking. Banks never have as much cash as they do deposits. Every depositor in a bank thinks he or she can walk in and get cash whenever they want, but every banker knows that they don’t have that much cash. They put the money out on loan; they’re leveraged institutions. If everyone showed up for the cash at once, there’s no way the bank could pay it. That’s why you have a lender of last resort in the form of the Federal Reserve that can just print the money. Well, it’s no different with gold. Banks sell more gold than they have. If every holder of unallocated gold showed up all at once and said please give me my gold, there wouldn’t be nearly enough to go around. But people don’t want the gold. There are risks involved, storage costs, transportation costs, and insurance costs. They’re happy to leave it in the bank. What they may not realize is that the bank doesn’t actually have it.
The way it works now is that a central bank can lease gold to one of these London Bullion Market Association banks, the big banks I mentioned like HSBC. Let’s say you have the Federal Reserve as fiscal agent of people storing their gold in New York. By the way, it’s not United States gold: it’s German, Dutch, Japanese, IMF… “OPG” or other people’s gold. They can act as a fiscal agent and lease it, usually through the BIS (Bank for International Settlements) which involves Switzerland. The BIS can then lease it to commercial banks who are LBMA members. None of this is speculation. You can in fact go to the BIS annual report and look in the footnotes where they disclose the facts. They don’t mention names but do say in black and white that they act on behalf of central and commercial banks in the global leasing market. We know who the commercial banks are because they have to be LBMA members, and we know who the central banks are, so we don’t really have to speculate that this is going on. It is going on as revealed in the footnotes.
So, the central banks lease to commercial banks through the BIS. The commercial banks then have title to a certain amount of physical gold. They then sell 10 times as much to the marketplace on this so-called unallocated basis. So you can see the leverage at work there. They can sell as much gold as they want and they don’t need to have the gold. They can just keep selling it.
Between the COMEX manipulation, physical sales (which are less important because the central banks got spooked when they started realizing that the vaults were going to be empty), back-to-back leasing, and unallocated sales — this is the tool kit. So the tool kit is physical sales, leasing and selling unallocated gold (and a multiple of what you’ve actually leased), and COMEX futures manipulation. One more element in the tool kit is the ETF, in particular the GLD ETF, another source of physical supply. We can talk about that separately, because raiding the ETF warehouses is a distinct kind of manipulation. Putting it all together creates a pretty powerful tool kit that can be and is used very effectively to suppress the price of gold.
JW: Yes, I was going to ask you about ETFs, because I was curious to know the relative importance of ETFs and futures. They’re both paper relatives of gold. Which has more impact on the market and on the price of gold?
JR: From a manipulation perspective, the futures market has much more impact. There is a lot of leverage in futures, and not that much leverage in the GLD. With ETFs, there’s physical gold, and shares representing the gold, and an arbitrage that goes on, but the real bang for the buck comes in the form of the futures where you can get 20-to-1 leverage. If I have $10 million, I can get $200 million of leverage out of it, and for $10 million of cash margin, I can sell $200 million worth of paper gold. We know who the brokers on the floor and the clearing brokers are, but the market is non-transparent, because we don’t know who the players actually are — those doing the buying or selling at a point in time. We don’t know who the ultimate customer is. Only the brokers know that, so there is anonymity through the broker and you have high leverage. That’s the most effective way to do it.
Now GLD is interesting. You have to know how it works and actually read through the documents, but in the simplest terms, GLD is a trust and the trustee has physical gold in a vault. This is true of all ETFs, but I’m talking about GLD specifically—their vaults are in London. There are a set of authorized participants I call the usual suspects. These are the large LBMA members such as Goldman Sachs, JPMorgan, and others. The way it works is if you want to sell the ETF, you go buy physical gold. You then give the gold to the trustee who puts the gold in the warehouse and issues shares to you. You can then act as an underwriter and sell the shares into the market. When a small investor or retail investor or even an institution that’s not one of these big banks buys ETF, they are not buying gold. They are buying a share or unit in a trust that owns some gold. They don’t have the ability to get the physical gold unless they jump through a lot of hoops, and it’s a very large size, and by arrangement with the dealers. Very few investors do that, and for small investors, it’s impossible.
If you don’t like gold or the price action, all you can do is sell your shares. Now we’ve got physical gold trading one way and ETF shares trading another way. They should be closely aligned, but there’s an arbitrage. Here’s what happens. If I’m one of these big dealers and I see the physical price of gold trade at a premium to the shares, my share gets me a certain amount of gold. I look in the physical market and see the same amount of gold trading at the premium, so there’s almost a risk-free arbitrage. I short the physical gold and buy the share. In fact, I buy the share from somebody in the market who’s been spooked out of it, and I short the physical gold. Now I take the share from the trustee and cash it in to get the physical gold. I deliver the physical gold to cover my short, and I keep the difference. So it’s kind of a risk-free arbitrage, but what that does do is it takes the gold out of the warehouse.
You can combine these manipulations. Let’s say I’m one of these dealers, there’s demand for physical gold in China (which there is), and there’s gold in the GLD warehouse in London (which there is). Here’s what I do. I go into the futures market and slam the price of gold. This spooks the little guy who starts selling his shares. That drives down the shares. Meanwhile, the smart money is saying, aha, here’s a good entry point, so they’re buying the physical. The little guy is dumping his shares while the big guy is buying physical. A lot of that buying comes from China, so as the dealer, I sell physical gold that I don’t have to China. I don’t have the gold, but I sell it short to China. I then buy shares from the little guy who’s scared to death, cash in my shares, get the physical gold, deliver it to China, and pocket the difference. Again, it’s almost a risk-free arbitrage.
This scenario would mean that physical gold is going from the GLD warehouse to the vaults in China. Guess what? I was in Switzerland not too long ago, and that’s exactly what the refiners and secure logistics people told me. They said they are seeing 400-ounce bars—old ones—show up from London, they melt them down, turn them into nice shiny new 999.9 one-kilo bars, and ship those off to China. This closes the circle, if you will. The arbitrage between shares and physical works exactly the way I described: use the futures to spook the little guy, buy up his shares on the cheap, short the physical gold, cash in the shares, get the gold, cover the short, send it to China, and pocket the difference. You can create your own demand, create your own arbitrage, and then profit from it.
Here’s the significance of that which I think is a very big deal. When gold is in the GLD warehouse, it is part of the floating supply. In other words, it’s part of the supply that’s available to support the kind of leveraged trading we just discussed. When it goes to China, it’s no longer in the floating supply. It goes to either end-user demand or the People’s Bank of China. There are others, for example sovereign wealth fund safe, state administration, and foreign exchange who are the covert buyers. When the gold goes off the market, it’s a one-way trip. When that gold goes from London to Shanghai, it doesn’t go back again; it stays in China. You can play these games for a while, but little by little, you need some physical gold. You can get a lot of leverage, but you need some physical gold to do it, and they’re even starting to run out of that little sliver of gold.
This really explains the price action in 2013. Gold had been up 11 years in a row when in 2013 it was down for the first year in a 12-year span. The reason for this was that 500 tons of gold was disgorged by the GLD warehouse, through exactly the kind of manipulation arbitrage that I just described. The GLD still has some gold, but it’s down significantly from where it was at the beginning of 2013. Once the GLD warehouse gets depleted, you can’t do that twice. There comes a time when the amount of gold left is so small that the management fees don’t pay the cost. If you’re the sponsor of the trust, you just want to close up shop because you don’t want to operate at a loss.
So that worked in 2013, but it’s not working anymore because there’s not that much gold left. It’s very complicated and hard for everyday investors to understand. It’s even hard for a lot of gold experts to understand, but when you see through it all, you can see where the manipulation’s coming from. The only comfort I would give investors – and I think it’s an important one – is that manipulation can last for a long time, but it always fails in the end. It failed in the London gold pool of the 1960s, with the U.S. dumping in the late 1970s, and the central bank dumping in the ’90s and early 2000s. We have new forms of manipulation going on now, but ultimately they always fail, and the price of gold will go much, much higher.
JW: Let me just pick up on one small corner of this story. You mentioned the London fix and in a way put it in its place by saying this is no longer a very significant function in the market. There’s been a lot of hoo-ha in the news about the scandal of the London fix. There’s an investigation and, it seems, the fix is fixed. Could you explain how the fix works, what the scandal was about, and what significance, if any, it has for the price of gold?
JR: Let’s take a minute and talk about how the fix worked, then what the scandal was, and then where we’re going with it. The fix was basically a small number of about five major dealers who all had customers. The customers could have been refiners, large investors, the bullion banks, etc. ¬— everybody wants to buy and sell gold.
Gold is a funny market. On the one hand, it’s very liquid. When I say liquid, I mean you can always buy and sell gold and get your money’s worth, but it’s also a very thin market. Thin markets are usually not that liquid, while deep markets are liquid. In this case we have a market that’s not very deep but is very liquid. That actually says something interesting about the fact that there’s always a demand for gold.
Any market participant would be very concerned about market impact, meaning that if I want to be a big buyer—or for that matter a big seller—I’m worried that if word gets out, the price will go down a lot or vice versa. If I mean to buy a lot, I don’t want the price to run up in front of me. You like to operate anonymously so other people don’t know what you’re doing. The major buyers and sellers give their orders to this small number of dealers who make up the fix. They know what the book looks like and what the supply and demand looks like, but they’re trying to feel out the other side of the market, so they give indications. They say, “Well, I’ve got interest in buying a certain amount at this price,” and the other guy says, “Well, I’ve got interest in selling a certain amount at this price.” It’s bit like a striptease: they’re showing the goods a little bit at a time. Through this exploratory price discovery process, they would arrive at a price that would clear the markets. Suddenly there would be a price and one guy would say, “Yes, at that price, I can sell everything I’ve got to sell.” The other guy would say, “Yes, at that price, all my buyers are filled.” Then they would say, “OK, done, fixed.” That would set the price at which all transactions would take place. It was a way of maintaining anonymity of their customers and their buying and selling interest on the one hand, but still showing enough information and feeling each other out in such a way that they could arrive at a price.
This is just the way markets operate and actually the way the stock market operated under the old specialist system before it was taken over by robots, computers, and high-frequency trading. There’s nothing wrong with that if that’s all it is, but two problems came along. As I already mentioned, the COMEX became so dominant that these guys were simply piggybacking on the COMEX; it wasn’t real price discovery. More importantly, they found out they could front-run their own customers. Surprise, surprise — banks are always looking for ways to rip off their customers.
The scandal was not the fix in the pure sense that I described but the fact that participants in the fix were using information about their own customer books to front-run their customers, actually buying and selling in a physical market away from the fix to front-run the people who were trying to participate in the fix. This has come to light, there have been investigations (some ongoing), fines and penalties, and class-action lawsuits. Deutsche Bank is one of the major dealers that withdrew. Interestingly, one of the major Chinese banks has stepped up. We talked about the techniques and reasons for manipulation, but we haven’t talked about who’s ultimately behind it. I think we can guess that the Chinese have a hand in this as it’s no surprise that they would like to become a member.
Again, the scandal wasn’t as much about the fix as it was about front-running people who were trying to participate in the fix. Having said that, it’s quite an obsolete system. Maybe now it will be reinvigorated and done a little more cleanly going forward, but the world does look to COMEX as the benchmark. And COMEX is heavily manipulated, so we don’t really have good reference prices for gold. What we have is theater, and people need to understand how the play is going to end.
JW: Let’s get back to the center of our story. We’ve looked at how manipulation works, and you’ve explained how it used to be done in the physical market. Now it’s done primarily through COMEX or ETFs or through leasing of unallocated contracts. The question then becomes “who done it”? Who’s the culprit here? Who’s actually behind this manipulation? Let me reference here what I see as the prevailing narrative when I look around at commentators on the gold market. It seems to me the popular story is “it’s the Federal Reserve.” They have a motive to drive down the price of gold in order to shore up the dollar because of that very simple equation you began this conversation with: a strong dollar indicates a weaker gold price and vice versa. But I also recall you saying to us that the Fed doesn’t really want a collapse in the price of gold because this would herald deflation. I’m curious if you could unpack this paradox, and the conflicting interests the Federal Reserve has around the price of gold.
JR: First of all, the key word in your question there, Jon, was “motive.” For example, a detective finds a victim who’s been shot in the head, lying on the ground, and there are no witnesses. In order to solve the crime, the first thing the detective asks is: “Who has the motive?” Sometimes it’s a spouse or business partner or sometimes it’s difficult to discern, but these are the first people to be questioned. I feel that’s the right way to think about who’s doing the manipulation, i.e., who has the motive. There are two players in the world who have the motive to do this: One is the United States, and the other is China, but their motives are different.
Let’s take the Fed. A lot of people have a very naïve and, in my opinion, mistaken view of the Fed’s interest here. People say you’ve got to squash the price of gold to prop up the dollar when in reality the Fed wants a weaker dollar. They don’t want the dollar to go away or collapse, but they do want a weaker dollar, because they’re desperate to get inflation as they’ve said over and over for years. They have a target of 2 percent. In some of their guidance in December 2012 they said, well, it’s really 2.5 on a forward basis temporarily. There’s a lot of hemming and hawing, but 2.5 privately. One of the regional Federal Reserve Bank presidents told me he wants 3.5. That may be his personal view, but there’s no doubt the Fed wants inflation. Well, the most recent figures are negative. CPI (Consumer Price Index) and PPI (Producer Price Index) are coming in negative, so we’ve got deflation in this country.
With the Fed desperate to have inflation, one way to get it is with a cheaper dollar because imports cost more. You have to remember that the United States is a net importer. We buy more abroad than we sell, so a cheaper dollar means import prices go up, and that inflation feeds through the supply chain in the United States which is what the Fed wants. This means the Fed actually wants a cheaper dollar, which means they actually want a higher gold price. Now here’s the catch: they want this progress to be orderly, and this is another key word. It’s not whether they want it higher or lower, because they know that gold’s going up and they want the dollar to go down. What they fear is a disorderly process. Gold can go up a little bit at a time; it just can’t spike up $100 an ounce per day.
Going back to the period of July, August, and early September 2011, that’s what was happening — the price of gold was skyrocketing. It went up from $1,700 to $1,900 very quickly and was clearly headed for $2,000 an ounce. Again, as I mentioned, that’s a psychological barrier. Once you go to $2,000, the next stop is $3,000. It was getting out of control, so there’s a case where the Fed did manipulate the price lower not because they ultimately want a lower price, but because they were worried about a disorderly increase. The Fed is perfectly fine with an orderly increase as long as it doesn’t go up too far, too fast, and change inflationary expectations; therefore, the Fed will be in the market to manipulate when they have to. They know the price is going up in the long run, but they just want it to go up in a gradual way. This little bit of nuance is lost on a lot of people now.
Now let’s consider China. China definitely wants a lower price because they’re buying. It sounds like a paradox — wait a second, you own gold, you’re buying more, why would you want the price to go down? It’s precisely because they’re buying that they want the price to go down. Again, they know it’s going to go up a lot in the end, but they need to buy more because they want to look the United States eye to eye.
The United States has 8,000 tons. China’s economy is over half the size of the U.S. economy but remember that China is growing a lot faster than the United States, so it’s not too many years away before Chinese nominal GDP catches up with U.S. GDP. In that world, they want 8,000 tons. China officially says they have a little over a thousand tons, but we know that’s a lie. They actually have some larger number. It’s hard to know exactly how much but 3,000 or 4,000 tons seems like a reasonable estimate based on what we do know. This is not guesswork, by the way. We have information on Hong Kong imports, we know that China does not export, and we know Chinese mining output. We don’t know the exact split between private and government demand inside China, but we can estimate first approximation, say 50-50, and then tweak it from there. This is enough to go on, so we know that China actually has 3,000 or 4,000 tons, but I’ve just described why they need to get to 8,000. This is what the U.S. has, because they want a certain gold-to-GDP ratio. (I talk about this in my book The Death of Money.) This is why China is a huge buyer.
Remember that there are only about 35,000 tons of official gold in the world. When I say “official gold,” that’s the gold owned by central banks and sovereign wealth funds. I’m not including private gold jewelry and what people have in private stashes, but just official gold. If you’re out to buy a little over 3,000 tons as the Chinese are, that’s 10 percent of all the official gold in the world. That’s a huge number. If China were transparent about that and made their intentions widely known, the price would run up like crazy, so naturally they don’t want to show their hand. I wouldn’t either if I were the Chinese. Of course they have a motivation to manipulate it down because they’re still buying. It’s like if you’re out to buy real estate, you’d start rumors that there was a toxic waste site even if there wasn’t just to get the real estate on the cheap.
That’s the sort of thing China’s doing. Now, here’s where it gets really interesting. We spoke earlier about the Fed, but the Treasury to some extent has to accommodate Chinese wishes because China owns several trillion dollars of U.S. Treasury notes. If the Fed and the Treasury want inflation as we just discussed and you’re China saying the value of inflation erodes the value of Treasury holdings, then your incentive is to dump Treasuries which would raise interest rates in the United States and sink their stock market and housing market. The Treasury doesn’t want that, so China says, “If you don’t want us to dump Treasuries, you have to let us buy gold because that’s our insurance policy against inflation. If you want to inflate your currency and steal from us in the form of making our Treasuries worth less, that’s okay as long as we have enough gold, because we’ll make up on the gold side what we lose on the Treasury notes side.”
China’s buying gold not to launch a gold-backed currency, at least not in the short run, but to hedge their Treasury position. The Treasury has to accommodate that or else China will dump their Treasuries. So we have this strange condominium of interests where the Treasury and China are on the same side of the trade saying, we’ve got to let China get more gold. This is something I have discussed with senior officials at the IMF, and they’ve confirmed the understanding that this global rebalancing of gold from the West to East has got to take place; ergo, China has to be allowed to get the gold.
Now we have the Treasury letting China manipulate the market so they can buy gold more cheaply, and we have the Fed occasionally manipulating the market so that the price rise isn’t disorderly, but where does it all end? It ends when China has enough gold and they’re done buying, they reveal the amount they have, inflation kicks in, and then the price of gold skyrockets. At that time the Treasury and the Fed will be comfortable, because both China and the U.S. will have 8,000 tons. Both countries will be winning on the price of gold. The losers will be people who don’t have gold and go out to buy it only to discover it’s too late.
JW: I want to return to a point you touched on briefly but I feel is critical for those listening to this story about price manipulation, and that is the implication for investors. When we hear about the enormous forces brought to bear on the price—with the US on the one hand and China on the other—how does the investor stand up against such forces? There is a temptation to say I can’t win against these players, therefore it’s not worth the risk of being in this market when these national forces can manipulate the price.
JR: In the short run, it’s correct that you can’t beat them, but in the long run, you will always beat them, because these manipulations are finite and there is an end game in play. In terms of why it’s fine, firstly, just look at history. All the manipulations in the past have failed. Again, IMF, U.S. dumping, English dumping, Swiss dumping, the London Gold Pool of the 1960s – they all failed. The one that’s going on now will fail, so patience is a virtue, as they say.
We talked about all the paper forms of manipulation of gold, leasing, unallocated gold forwards, etc. These are very powerful, but the second thing to consider is that any manipulation requires some physical gold. It may not be a lot, maybe less than 10 percent of all the paper transactions, but some physical is needed. The physical is rapidly disappearing into Chinese vaults where it will not see the light of day for a very long time, so that puts a limit on it. And again, we mentioned that central banks have stopped selling.
The third thing to keep in mind is that there is an end game here. The end game is when China has enough gold so that their gold-to-GDP ratio equals the United States. They’re not there yet, but once they are, there would be no point in buying more. They could let the price of gold go wherever it wants, inflation could get out of control, and they wouldn’t lose. If inflation and the price of gold took off right now, China would be left in the dust. They don’t have enough gold to ensure the portfolio losses on the Treasury side. If the price of gold skyrocketed and their economy was growing faster than the U.S., they would never catch up. They’re buying as much gold as they can, but since they’re trying to maintain the gold-to-GDP ratio and have the fastest major economy GDP in the world, it’s a moving target. They have to keep buying more and more and more. In a world where they were trying to buy more and more but the price was going up and up, they would never get there.
The price has to be kept down until China is done. When they are done, in other words when they have approximately 8,000 tons, then the United States and China can shake hands and both say they’re covered. There’s an old saying, are you off the bus or on the bus? Right now, Europe and the U.S. are on the bus. China is not, but once they get to 8,000 tons, they’ll be on the bus and won’t be disadvantaged. Then the bus can take off and the price of gold can go anywhere as it did in the 1970s.
Always bear in mind that the Fed does want inflation. They think they can dial up inflation a little bit at a time and if it gets too hot, they can dial it back down again like a thermostat. What will happen is the Fed will find out that they’re playing with a nuclear reactor, the whole thing melts down, and inflation spins out of control. We’re not there yet. It could be another year or two, but there’s going to be a lot of volatility in the meantime. I’d be the last one to say the price couldn’t go lower. It might, but I have been impressed with the resilience. I think the lower price is a good entry point, and China certainly thinks so.
The advice I would give to investors is that you need to not just look at the tape or just listen to the talking heads. You need to understand the dynamic behind it. You need to understand how the manipulation works, what the end game is, what the physical supply-demand picture looks like, etc. Once you put all of that together— and I do this in my book The Death of Money — it’s pretty obvious that gold is going to go a lot higher.
JW: Thank you, Jim Rickards. In terms of understanding underlying dynamics, you’ve certainly been extraordinarily illuminating as always and it’s been great having you with us here today. Thank you also to our listeners.
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Goodbye for now to Jim and to all of you listening.
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