Lighthouse Investment Management

Conference Briefing

DCA - Darien Community Association Academic Lecture Series by Jim Rickards Darien, January 10, 2013

"The Global Economy and the future of the International Monetary System"

Contents
Jim Rickards, Tangent Capital - Bio ............................................................................................................... 2 Problem solving with incomplete information: Bayesian model.................................................................. 3 Currency Wars............................................................................................................................................... 4 The economy is a 4-cylinder car ................................................................................................................... 4 The "real story" behind the actions of the Fed............................................................................................. 5 The endgame: four alternatives.................................................................................................................... 6

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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Jim Rickards, Tangent Capital - Bio
Mr. Rickards' career spans the period since 1976 during which he was a firsthand participant in the formation and growth of globalized capital markets and complex derivative trading strategies. He has held senior executive positions at sell side firms (Citibank and RBS Greenwich Capital Markets) and buy side firms (Long-Term Capital Management and Caxton Associates) as well as technology firms (OptiMark and Omnis). Mr. Rickards was the principal negotiator of the 1998 rescue of hedge fund Long-Term Capital Management sponsored by the Federal Reserve Bank of New York. He was involved in the formation and successful launch of several hedge funds and fund-of-funds. His advisory clients include private investment funds, investment banks, law firms and government directorates. Since 2001, Mr. Rickards has applied his financial expertise to a variety of tasks for the benefit of the US national security community and the Department of Defense. Mr. Rickards is a frequent speaker at conferences sponsored by bar associations and industry groups in the fields of derivatives and hedge funds and is active in the International Bar Association. He has been the interviewed in The Wall Street Journal and on CNBC, Fox, CNN, NPR and C-SPAN and is an OpEd contributor to the Financial Times, New York Times and the Washington Post.

(text in black is verbatim Jim Rickards; text in red are my own words)

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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Problem solving with incomplete information: Bayesian model

The economy and financial markets are highly complex systems; we don't have all the information needed to solve them. But if you get one big thing right, you can solve for all the other hypothesis cells. It is used in engineering, medicine, the military and game theory, but, unfortunately, not on Wall Street. Example: If you get the intentions of monetary policy makers right, you get interest rates right. That, in turn, will help you get the bond market right. Bond market, in turn, helps you figure out the credit market. Credit market helps you determine total credit market debt growth, which drives economic growth. That, in turn, provides clues for the stock market, etc.

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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Currency Wars
Currency wars can last many years and can take a dynamic of their own Initial problem: too much debt, both personal (households) and sovereign (governments) Problem: how do you get GDP growth under these circumstances? You steal it from trading partners by weakening your currency, making exports cheaper and imports more expensive This should theoretically lead to an improvement in the trade balance. A positive trade balance allows, ceterus paribus, either the private or government sector (or both) to save more respective accumulate less debt, leading to an increase in wealth. However, trading partners retaliate, leading to competitive currency devaluation. Global inflation is all you get. If you put tariffs on imports, currency wars turn into trade wars, which can turn into shooting wars. We had three periods of currency wars over the last 100 years 1919/20: situation like today (no growth, too much debt, especially Germany after lost WWI, and UK & France who had borrowed money from the US to finance WWI and couldn't pay it back). 1922, Germany introduced a new currency backed by gold and had one of fastest growing economies in the world. Gold price can go up both in times of inflation and deflation (as governments desperately try to devalue currencies in a deflationary depression).

The economy is a 4-cylinder car

The four cylinders are: C, I, G and (X-M). GDP = C (consumption) + I (investments) + G (government net spending) + (X-M) (net exports) Consumption and investment are growing very slowly right now Government spending got us through 2009/10 via massive spending, but the deficit is currently not growing => a constant number => does not add to growth What's left is net exports. Obama, in his "State of the Union" address in 2010, announced an "export initiative" with a plan to "double exports over the next five years". Since we won't be twice as smart or twice as productive in five years the only way to achieve this is to trash the US dollar.

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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The "real story" behind the actions of the Fed
M (monetary base) * V (velocity of money) = P (price change) * Q (quantity of goods produced) Q = real GDP PQ = nominal GDP The Fed is trying to get people to spend more money, to increase GDP If you want to increase PQ, then you have to increase MV Initially Fed thought this could work by increasing "M" (printing money, or "QE") However, the more they printed (increased M), the more the velocity (V) declined If your velocity is zero, M times zero equal zero

The Fed has tried everything: Cutting interest rates to near zero (2007) Printing money ("Quantitative Easing", 2008) Trashing the dollar (2010) Depressing long-term interest rates (Operation Twist, 2011) N-GDP targeting (2012)

Everything so far has failed. Which means the Fed will just try harder.

The US has to get 5% nominal growth in order to ever be able to pay back the debt (if debt grows faster than nominal GDP bankruptcy is only a question of time). Two ways to get 5% nominal: a) 4% real growth + 1% inflation or b) 1% real growth + 4% inflation Since 4% real growth is not going to happen, the Fed needs to engineer 4% inflation.

What could go wrong? The Fed has been wrong about everything in the past The Fed uses linear models, like a thermostat: turn it up, heat increases; if it gets too hot, you dial it down

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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However, economy and capital markets are highly complex systems with critical states; once you reach critical state, you cannot dial back. Like a nuclear reactor: once it melts down, you cannot "un-melt" it. There are irreversible processes involved.

The endgame: four alternatives

1. Multiple reserve currencies co-exist peacefully The share of the USD of world currency reserves has already declined from 70% to 60% since 2000, and the share of the EUR has grown. In the future, balance could be 35:35 between USD and EUR. A possible, but unlikely solution (would be unstable, as world monetary system would be without an anchor). 2. SDR's (Special Drawing Rights, the IMF's currency) This is the preferred path by the power elites National currencies get replaced by SDR's over time; a 20-year plan to do so exists already. Advantage: no more competitive devaluations, no currency available as safe haven. Consequence would be uninhibited money printing by governments and eventually collapse of monetary system. In 2008, private debt wash pushed up one level to sovereigns; during next liquidity crisis this debt could be pushed up towards supra-national level (IMF). However, issuing SDR's is nothing but printing money. 3. Return to the Gold Standard Multiple questions: What is the proper measure of 'money'? M0, M1, M2, M3? What is the proper reserve ratio? (Gold Standard does not mean 100% gold-backed currency; you just need enough to be able to hand out gold to the few people who want to see it. The UK had a reserve ratio of 20% when they ran a Gold Standard; the US had 40%. Which nations will be included? If the US went on to the Gold Standard alone, all other currencies would become worthless, leading to collapse of US exports. Important to get every major nation to "join the club". The US has 8,000 tonnes of gold, Euro-system (17 nations) has 11,000 (so the Euro is fine) and together with IMF (controlled by US and Europe) the West has 21,000 tonnes. China has, officially, only 1,000 tonnes (unofficially 2,000-4,000; they are scrambling to get as much as they can via covert acquisition). If China has 4,000 tonnes they might be able to sit across the table from the US and have a word in the design of a future monetary system.

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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What is an appropriate price? Some critics say there is not enough gold around to back all paper money claims world-wide, but it is just a question of price. US M2 can be covered to 100% at $30,000 per ounce; global M1 can be covered at $7,000 per ounce. This is a price level that could be reasonable. When you think of gold as money, then the S&P 500 Index has lost 85% over the last decade in terms of gold.

4. Chaos Closure of banks for extended time Closure of stock exchanges for extended time, turning stock market investments into private equity investments. Which path are we going to go? You have to identify the milestones => see the path. Rickards thinks alternative 3 (Gold Standard) is the most desirable, but we will probably go through alternative 4 (chaos) first as power elites try to force alternative 2 (SDR's).

Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. You shouldn't be surprised that accounts managed by Lighthouse Investment Management or the author may have financial interests in any instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and we might not necessarily disclose updated information should we discover a fault with our analysis. The author has no obligation to update any information posted here. We reserve the right to make investment decisions inconsistent with the views expressed here. We can't make any representations or warranties as to the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions, misinterpretation or misuse of any information posted is excluded. +++++++++++++++++++++++++++++++++++++++ All clients have their own individual accounts held at an independent, well-known brokerage company (US) or bank (Europe). This institution executes trades, sends confirms and statements. Lighthouse Investment Management does not take custody of any client assets.

Conference Brief - Jim Rickards at the DCA - Darien, January 10, 2013

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