Investment Strategies, Analysis & Intelligence for Seasoned Investors.

Skills, Education, and Employment

John Mauldin — Sun, 12 May 2013 06:16:00 GMT

David Rosenberg: A Bond Bull Turns Bearish
Wage Inflation?
Skills Versus Education
Kyle Bass and Japan
Tulsa, Atlanta, Nashville, and Brussels

"The large shortfall of employment relative to its maximum level has imposed huge burdens on all too many American households and represents a substantial social cost. In addition, prolonged economic weakness could harm the economy's productive potential for years to come. The long-term unemployed can see their skills erode, making these workers less attractive to employers. If these jobless workers were to become less employable, the natural rate of unemployment might rise or, to the extent that they leave the labor force, we could see a persistently lower rate of labor force participation."

- Janet L. Yellen, Vice-Chair, US Federal Reserve, March 4, 2013

It is graduation time, and this morning finds me swimming in a sea of fresh young faces as a young friend graduates, along with a thousand classmates. But to what? I concluded my final formal education efforts in late 1974, in the midst of a stagflationary recession, so it was not the best of times to be looking for work. It turned out that I had a far different future ahead of me than I envisioned then. But I would trade places with any of those kids who graduated today, as my vision of the next 40 years is actually very optimistic. With all the advances in healthcare, technology, and communications that have come and will come, they will get to embrace a world full of opportunity; and yet, this generation is starting out with more than just a minor economic handicap.

This week's letter will explore changes in the work marketplace, changes that generated quite a lot of discussion at last week's Strategic Investment Conference. At the end of the letter I will also provide a link for qualified investors to listen in on a webinar conversation between Kyle Bass and me on another of the main topics last week: Japan. This is one you'll want to tune in to. (Warning: this letter will read fast but print long, as there are more than the usual number of charts and graphs, though the word count is actually shorter than usual.)

And a quick note up front on Japan. As of the last two weeks, Japanese investors are now net buyers of foreign bonds, and the yen has broken through 100 to the dollar. I think what is happening in Japan is going to be the nexus of a global flow of cash that will be unlike any we have ever seen. Attention MUST be paid. It is windshield time.

David Rosenberg: A Bond Bull Turns Bearish

How do we get to full employment and improved national education from the launching point of David Rosenberg's very recent call (at the conference and elsewhere) that we will soon see inflation and the onset of a bond bear market? I must say that he surprised a few of us with his conversion from bond bull to bond bear. But the reason why he converted surprised us even more. I am not going to be able to do justice to his impeccably reasoned, highly detailed presentation in this short space, but let me hit some highlights.

Specifically, Rosie thinks that the Fed is going to be surprised by wage-push inflation. How could we see inflation in wages in such a soft labor market? That was the first question in my mind, and the following charts give me some reasons for my question.

The present unemployment rate is still higher than at any time in the last 60 years, except after recessions. The Great Recession ended four years ago, and unemployment is still stubbornly high. Indeed, this is the slowest "jobs recovery" we have ever experienced. The current level of unemployment has never been seen four years after the end of a recession.

And those who lose their jobs are staying unemployed longer. The fact is that the mean duration of unemployment is still almost double what it has ever been. Average length of unemployment is 37 weeks. When the recession ended, it stood at 23 weeks. This is structural, not frictional, unemployment. Ninety million American adults now subsist outside the official labor force –It could be there's an underground economy that we need to capture. The pool of available labor for the business sector is shrinking 2% per year.

Worse yet, the unemployment rate is still stubbornly high in spite of an unprecedented rise in the number of people who are no longer counted as being in the labor force. These are people who are no longer looking for jobs.We are back to workforce participation levels not seen since the 1970s. A good 5% of US citizens who are able to work are no longer are looking for work. Part of this trend is due to alternatives to employment becoming easier to pursue. Millions have been added to the disability rolls – some 4 million since the beginning of this century and almost 2 million since the beginning of the Great Recession (and still rising at an alarming rate!). Others have gone back to school, borrowing money in the form of student loans, which have topped over $1 trillion and are the only form of consumer credit that has been on the increase.

As a quick aside, we are also seeing skyrocketing rates of late payments as student loans overwhelm the ability of borrowers to pay. This is a true crisis brewing, as student loans are the only type of debt that cannot be discharged in bankruptcy. Student loans can make you an indentured servant for a very long time.

Some would-be workers find that in some states they can collect more on government assistance than they can earn by working lower-wage jobs, and thus they have no economic incentive to look for jobs that would actually lower their income. As I wrote in a recent letter, this is why we are seeing a large rise in non-reported incomes and jobs. And finally, there are those who are just discouraged. Jobs seemingly do not exist for their skill sets and in places where they can access them.

With so many people not participating in the labor market, isn't it reasonable to assume that if jobs again ever become available, these people will rejoin the official workforce? And wouldn't that create a shadow supply of workers that would keep wages suppressed for a long time?

Wage Inflation?

Maybe yes and maybe no. Rosie makes the case that there are numerous jobs available and that the numbers are rising, and there is data that supports his argument. I will reproduce here a few of his charts (out of the 59 he showed!). Job openings are on the rise and are back to levels last seen in the middle of the previous decade.

And what about all the businesses that have jobs on offer but can't find people to fill them? The following chart is from Rosie's and my mutual friend William Dunkelberg, chief economist for the National Federation of Independent Businesses. While job openings are not at all-time highs, the trend is encouraging.

The next chart shows the ratio of job openings to new hires. It is at a six-year high. As Rosie stated (inexact quotes, from my notes):

Looking for labor? Labor demand is not weak – JOLTS survey shows job openings up 10%, employers can't find qualified applicants. Firings plunge, layoffs 10% lower than in 2007. Number of job quitters rises – people leaving jobs to go to new ones, the 'take this job and shove it index.' 7.5% unemployment is actually the new 4.4%.

What are companies doing? More overtime, longer work week. Combination of rising wages, productivity growth heading lower. We've taken a lot of inventory out of the labor market. Keep your eye on unit labor costs. Correlation with inflation – unit labor costs are on the rise.

Employees are increasingly willing to leave a job and go to another one, yet productivity has recently begun to fall.

Yet young people are having increasing difficulty landing jobs. People aged 20-24 are still unemployed at levels not seen unless a recession is involved (see chart below). And research keeps coming in that more than 50% of college graduates are stuck in jobs for which a degree is not needed.

Even though the headline unemployment rate is falling, a large part of that drop is due to the precipitous plunge in the participation rate, as well as a rise in low-paying jobs. Curiously, it now seems a disproportionately high level of temporary jobs is no longer a precursor to economic recovery but is a new structural fixture.

Part of the responsibility for that increase in temporary employment can readily be laid at the feet of the Affordable Healthcare Act (Obamacare). Employers do not have to pay health insurance for temporary employees; that burden falls on the employee.

Healthcare for lower-wage employees can be a huge percentage of overall labor costs. While you may argue that employers should cover workers at all levels, the data coming in says that is not happening – thus the rise in temporary workers. Even an established employer like UPS is hiring new temporary employees in low-skill jobs at low wages without health insurance for their first year and cutting back on employees with major seniority (who cost more than double what new employees do), not giving them enough hours to survive and forcing them into the temporary market to meet their basic living needs.

We see evidence of this happening system-wide in the data showing lower hourly wages and a reduced number of hours in the work week. And those trends seem to be stabilizing. We are seeing the creation of a two-tier market, an upper tier for those with skills in demand and a lower one for those whose skills just do not command a premium in today's marketplace.

Rosie makes the argument that there is a shortage of skilled labor and that the price for those workers is going to rise, surprising the Federal Reserve, which still looks at historical data from a world that no longer exists. And he says this segment of the labor market is going to be large enough to create wage-push inflation.

It is an interesting argument, and contradicting David Rosenberg is generally not a good idea, although he did not convince Lacy Hunt or Gary Shilling, at least not at the conference. But at any turn there is always someone who has to lead the way. His arguments are something we must pay attention to.

In the panel discussion later in the day, I agreed that there are two labor markets, but the divide is between workers with skills that are in demand and workers whose jobs require no special experience or education.

Skills Versus Education

I am writing part of this week's letter in the rafters of a huge auditorium as I watch 1100 liberal art graduates at a major university receive their degrees. (I long ago made a promise to be here.) This was an expensive education, and the graduates are smart; yet when you ask them what their plans are, all too often you hear that they have not been able to find jobs or are opting to continue with school, often borrowing yet more money to do so, as they see no other viable options.

Recent research suggests that the cost/benefit ratio for education is not as good as it once was. See for example this article by Jeff Selingo.

Education – at least in the conventional sense – is not always necessary for job success. All too often it is the enemy of success. Yet the fallacy persists among the unemployed that "going back to school" will somehow solve their problems.

In most cases, it will not. The unemployed do not need more school; what they need are more skills. Why? Because what employers need are abilities. Workers are essentially a delivery mechanism for the ability to do whatever the employer happens to need done. This is not to say that formal education is unimportant; it is critically important – but not for the reason most people expect.

Degrees and diplomas are credentials. They do not, in and of themselves, guarantee that the holder possesses the skill an employer wants. They serve as screening tools, used to reduce a long list of applicants to a smaller number for closer review.

Employers want workers with the necessary skills. Workers want an employer who values their particular skills. When a match is made, everyone wins. Skills are the key to every match.

Skills can be acquired in school, of course. Indeed, it is impossible to spend thousands of hours in classrooms during one's formative years, while the brain is in peak learning mode, without acquiring at least some kind of skill. Children and adolescents are highly tuned skill-acquisition machines.

If schools produced the right number of students with the right sets of skills, the economy would be much closer to full employment. Something is wrong somewhere.

Yet those with college degrees are clearly able to find jobs of some kind. The unemployment level for college graduates is about half that of high school grads and almost three times better than for those with no high school degree. Education does matter.

Michael Ellsberg gives us one reason for that seeming advantage a degree delivers:

True, people with college degrees tend to earn more. But that could be because most ambitious people tend to go to college; there is little evidence to suggest that the same ambitious people would earn less without college degrees (particularly if they mastered true business and networking grit).

And while most people who end up starting businesses likely have college degrees, those degree-bearers should be well aware (as they learned in their freshman statistics classes) that correlation does not equal causation. Assuming that college was responsible for their success gives higher education more credit than it deserves. (New York Times: Will Dropouts Save America?)

America, as Ellsberg describes it, has yet another way to divide today's job market into two pieces: formal and informal. The "formal" job market is the old-fashioned one in which employers advertise and workers send resumes. It was never as effective as people thought. Successful professionals and business owners have long preferred the second, informal market.

When you need someone who can do X, you ask trusted friends and colleagues who they know. You will usually find a well-qualified candidate in short order. (And now you use LinkedIn and other social media.)

What role does your wall-decorating degree play in this process? A little – and a lot. If you can do what needs to be done, employers usually won't care where (or if) you went to college. But, since they turn to people they know when they search for candidates, and since our lifelong friendships are so often formed in college, being "in the circle" increases your odds of being known to the right people at the right time.

The old saying is then somewhat true: it isn't just what you know; it's who you know.

Further, if you advertise for a new employee today on one of the online job boards, you can get hundreds of resumes. Most are just people sending you a resume in hopes of attracting attention, but you can still get an overwhelming number of potential employees. How do you sort? One way is by education. That degree helps you sort, even when the job really does not require a degree.

But the skills advantage shows up in the next graph. Notice that the older you get, the lower your likelihood of being unemployed. As I have shown in previous letters, Boomers are not only working more than any other age cohort, they are taking market share from the 20-somethings. In fact, as of less than a year ago, 100% of the overall increase in jobs was going to those age 55 and up. Young people were actually losing ground in what was already a slow jobs recovery.

The reasons are trite but obvious. We Boomers have not saved enough to retire and must keep working. Given our fewer remaining work years, we'll work where we can and for what we can get. And then there are those of us who simply have no interest in anything that looks like traditional retirement. We are living longer and healthier lives than previous generations enjoyed, and there are simply more of us.

Even the youngest Boomer probably has 35-40 years of work experience and a lot of acquired skills. Young people may have more energy, but many jobs are not a function of simple energy and enthusiasm. Go into a Barnes and Noble or any number of other stores and notice the ages of those working. There are young people, sure, but I see my age peers as well. I didn't see that 20 years ago. And those "starter" jobs are where workers gain experience.

We have policies in place that encourage young people to load up on debt to get that degree. We need to create programs that match skills and jobs and that give employers incentives to hire and train those younger workers.

As Paul McCulley said at the conference last week,

Ages 22-27 are the years that really matter for your lifetime of financial security. We now have a job market that is the antithesis of what you and I graduated into.

That is a structural phenomenon, not cyclical. It will not heal itself with platitudes about more and better education. New businesses are being formed at the lowest rate in generations. Over the long term, the growth in the job market comes from new businesses. Want to create jobs? Stop increasing costs and regulations and making it harder for entrepreneurs to get started.

And get the SEC to issue the rules that Congress mandated they write over a year ago (the much-ballyhooed JOBS Act), which will make it possible for new ventures to publicly announce their need for capital on the internet without running afoul of the current regulations. The SEC is way behind the 90-day deadline specified in the act. The law as written by Congress is clear. Those groups lobbying for the status quo and standing in the way need to step aside. You are costing young people future jobs. Those are MY kids. And everyone else's.

(Just for the record, I am an equal opportunity employer. I have younger and older employees, all genders and races. Talent and a solid work ethic are the currency I look for.)

Kyle Bass and Japan

As you know, I am a firm believer that the state of the global economy is such that we as investors need to be diversified, flexible, and opportunistic. Consequently, I spend a great deal of time and effort looking into alternative investment strategies and managers. The Mauldin Circle program was created specifically to provide access to "best of breed" alternatives managers that I believe in. That's why I am particularly pleased to announce an upcoming Mauldin Circle webinar event featuring Kyle Bass of Hayman Capital Management, LP.

Many readers will recognize Kyle as one of the few investors who successfully predicted and profited from the subprime mortgage crisis in 2008, making significant gains for his investors. He has since continued to make well-defined predictions on the European sovereign-debt crisis and is a leading provocateur on the unsustainability of Japan's debt.

Please join my partners at Altegris Investments for this special webinar on May 29^th and learn more about how Kyle is globally positioned to leverage his investment thesis. This may be the most compelling discussion that you hear all year. I will be in Brussels talking with thought leaders and EU politicians, and Kyle will just be back from Asia and a deep dive into Japan, so we will be giving you the view from both sides.

If you are a qualified purchaser or a licensed investment adviser, qualified to make private placement recommendations, please join us for this exclusive Mauldin Circle webinar on Wednesday, May 29, at 12:00 EDT/9 PDT. Be sure to register here for this event – it will be one of the most interesting discussions of the year.

Upon qualification by my partners at Altegris, you will receive an email invitation. I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. I look forward to having you at this exclusive Mauldin Circle event. (In this regard, I am president and a registered representative of Millenium Wave Securities, LLC, member FINRA.)

Tulsa, Atlanta, Nashville, and Brussels

The conference last week was powerful and inspiring. But before we got started, I took time to visit with some of the team at International Stem Cell. We spent a good deal of time going over the exciting research they are doing on stem cells and Parkinson's disease. Even though I have not written about biotech in a long time, I still follow the industry closely. There is just so much promise of real breakthroughs everywhere I look.

Yes, ISCO is the company that launched the Lifeline Skin Care product that I have written about. Almost a dozen people at the conference came up and thanked me for recommending they try it. The skin crème is a follow-on of research they were doing on growing skin for burn victims. It is not a miracle, but it has made a difference to many, and the product helps support their far more important research on diseases such as Parkinson's. You can learn about Lifeline at http://bit.ly/0504md.

I believe we will see cures for many of the conditions that afflict us and have so far eluded treatment. I will be writing on my latest biotech findings in future letters.

I leave for Tulsa next weekend to "give away" my daughter Abbi to her fiancé, Stephen. Just Abbi, Stephen, and 200 of their closest friends. "Dad, we just can't cut the list any more!"

The following Wednesday I head for Atlanta for a board meeting of Galectin Therapeutics (another biotech I follow) and then move on the next day to Nashville for a presentation for my partners at Altegris Investments. Then it's back home for a day or so before I fly for Brussels for a speech. I might stop over in London before heading back, but one way or another I'll be spending extensive time with Jonathan Tepper, my Endgame co-author.

It is time to hit the send button and race to the airport. Dallas has a newly built terminal to replace the old one at Love Field. It is very nice and a true upgrade, but there the same old TSA drill and long lines await me. I know there is better technology available than what we are forced to endure. We pay for all this, and those workers are not cheap. Where is the new technology to make airport security faster and more efficient? But kudos to the head of the FCC telling the FAA to allow us to use our iPads as we take off. The FAA is so behind in so many small ways that add up to a bad overall customer experience.

Have a great week. And figure out how to hire an able young person!

Your started to work at the tender age of 10 analyst,

John Mauldin

subscribers@mauldineconomics.com

Is Abenomics Going to Put Japan Back on the Map?

John Mauldin — Thu, 09 May 2013 15:33:00 GMT

In a special Outside the Box today, Keith Fitz-Gerald, Chief Investment Strategist for Money Morning, dissects "Abenomics," the radical, not to say outlandish, fiscal moves that the newly installed government of Japan is making. And Keith has a ringside seat: he spends much of each year in Japan.

In an attempt to cut the Japanese a little slack, Keith comes up with four things that will have to happen for Abenomics to work – but when all is said and done, he says, Abenomics is a recipe for disaster. That does not mean, however, that there is not plenty of opportunity here for short-term profit, and Keith offers a play that is a potential money maker in this volatile Japanese environment.

For a limited time, Outside the Box readers can receive a 60% discount when they subscribe to Keith's Money Map Report. You can check it out here.

Our Strategic Investment Conference last week was over the top. It will take me several weeks to think through the presentations, and I will likely spend a few weeks writing about what I learned. But Japan was definitely a big topic, as was Europe. The focus on central banks is appropriate, if frustrating.

The consensus is that massive global QE will end in tears, but the final act may take quite some time to arrive in the US. Today, many central bankers are looking at the currency wars of the 1930s, and the lessons they are drawing from the Great Depression are clear. In a speech to the Economic Club of New York in early 2013, Fed Chairman Bernanke boasted, “In fact, the simultaneous use by several countries of accommodative policy can be mutually reinforcing to the benefit of all.” Bernanke argued that rather than call unconventional policies and devaluations “beggar-thy-neighbor” policies, they should be called “enrich-thy-neighbor” policies. That’s taking the lessons from the 1930s a step too far, but when it comes to unconventional policies and devaluations, Chairman Bernanke believes the more the merrier. And so do his fellow central bankers, apparently.

By the way, a theme is percolating in my mind, which I will develop at a later point. Briefly, the problems with “austerity” in Europe are not so much due to governments cutting back as they are to membership in the euro itself. In essence, the euro is a gold standard. In the '30s, when governments on a gold standard devalued they saw a boost to their economies. But since Eurozone members cannot devalue, they are left with deflation and depression. Then they blame others for not lending to them and forcing “austerity” upon them, when the primary culprit is their own inability to deal with their trade flows and labor costs. If the market cannot adjust currency values, the only choice left is a reduction in labor costs, which in the real world translates into higher unemployment.

But since the euro is a political and not an economic currency, you can’t address your national problem without leaving the euro, and that is not politically feasible. It is a conundrum.

I am really thinking about going to Cyprus in late June, and if any readers have suggestions for people to meet, I am interested.

I am learning more about marble and flooring than I ever thought I would know. We are getting closer to actually beginning construction, but I am ready to finish already, for a variety of reasons. Hotel internet is not always the best, and where I am here in Dallas it can really get slow. The weather here in Dallas is perfect, and I think I will walk to my next meeting. In a few short months, stepping outside will be like walking into an oven, but right now it couldn't be nicer out.

Have a great week.

Your up to my eyeballs in information analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Is Abenomics Going to Put Japan Back on the Map?

By Keith Fitz-Gerald

On the surface, Abenomics – the radical unlimited stimulus plan put in place by newly elected Japanese PM Shinzo Abe – appears to be working.

The Nikkei is up 68% since July, 2012, the yen has weakened by 26% over the same time frame, and Japanese consumer confidence is up sharply to the highest levels in six years.

The theory behind Abenomics is that the rising stock market will create capital, and the falling yen will make Japan’s export-based economy more competitive in global markets, while newly profitable companies will hire more workers.

Don’t hold your breath.

As I noted during a recent interview on NHK, Japan’s national public broadcasting network, the beleaguered island nation faces significant challenges:

Japanese debt is already nearly 500% of GDP when you add up public, private, and corporate obligations. That’s the highest on the planet and makes Europe’s spending look positively miserly. Mimicking Bernanke’s helicopter hijinks won’t help on anything more than a short-term basis.
More money does not equal greater innovation. Many Japanese companies are struggling to remain competitive in industries they once dominated. Examples include Sony, Matsushita, and Fujitsu.
Japanese utilities literally can’t produce enough power to fuel a Japanese recovery . Only three out of 54 nuclear reactors are running, and the national LNG import bill hit ¥621 billion in March. That’s more than double pre-quake limits, according to the Ministry of Finance. These costs will continue to rise as the yen weakens further. I doubt very seriously that any increase in export sales will be enough to offset rising energy costs, because margins are going to get pinched.
Formerly deep trade surpluses are now deficits.
Prices in Japan are rising faster than income at the same time that taxes are being raised. That’s a lethal combination that is serioiusly pinching consumers.
Japanese corporations, once keen to return profits home, are now expanding overseas and keeping money outside Japan.
Japan’s population is aging so fast that, effectively, there are no new workers, a problem that is compounded by the near complete lack of a workable immigration policy.

The bottom line?

Japan is making the same mistakes we’re making … or we’re making the same mistakes they’ve already made – it’s hard to tell.

Either way, the bottom line is pretty simple: You give me a trillion yen and I’ll give you a good time, too.

In order for Abenomics to work, four things have to happen:

Japanese banks cannot hoard money the way big banks have in the US. They have simply got to keep it moving right through to Japanese citizens and small local businesses.
Japanese bond market participants have to be willing to maintain bidding as the Bank of Japan conducts “market operations,” which is Fed-speak for interfering with normal pricing dynamics in an effort to maintain stability. If bidders walk away, the bond market will fail and the government will have to contend with offshore derivatives traders who are already lining up to play the same games they did in Italy, Spain, Greece, and the balance of the EU.
Japanese consumers have to engage. If wages fail to increase, living standards will decline and Abe will be up a creek without a paddle – and yes, I mean THAT creek.
The international banking community has to allow Japan to debase its currency without punitive repercussions. So far the G20 has acquiesced, but their tacit approval doesn’t really mean much. They have no choice but to go along with Japan's moves. Kuroda, who is Bernanke’s equivalent at the Bank of Japan and Abe’s sidekick, has made it clear he is fully committed to the program, no matter what the West thinks.

Longer-term, Abenomics is a recipe for disaster – have no illusions about that. Japan, as John Mauldin likes to say, is a bug in search of a windshield. No nation in the history of mankind has ever bailed itself out on anything more than a short-term basis by pursuing a course like Japan’s.

But short-term … that’s another matter entirely, and therein lies opportunity.

Historically, every 10% drop in the yen versus the dollar has translated to a 0.3% rise in Japanese GDP the following year, noted Kiichi Murashima, chief economist at Citi in an FT interview.

You cannot say the same thing about Japanese stocks.

Since the Japanese market’s initially collapse in 1991, the world has watched with bated breath as the Nikkei has risen … and plunged with alarming regularity.

If you’re going to buy and sell like a trader and you’re nimble, you can ride the Japanese equity bull – pun absolutely intended. Most investors aren’t so equipped, though, -and so the “buy and hope” approach they favor is far more likely to leave them disappointed than profitable.

Japanese bonds are probably of dubious value, too. So far they’ve been stable, because Japan has been able to issue mountains of debt to its own dutiful citizens. The cost of debt service has been negligible, because nearly all of it was held domestically.

Now, however, Japan has got a very different situation on its hands. Any rise in long-term rates, let alone a significant one like Kuroda is planning, is going to dramatically hike the cost of debt service to unsustainable levels. Factor in Japan’s rapidly aging population and dwindling workforce, and you’re looking at a far smaller pool of bond buyers.

My expectation is that Japan will be forced into international bond markets no later than 2015, which will effectively double their capital costs. Without meaningful social security reform and spending cuts, that’s going to really impact things.

That’s why I’d rather short the Japanese yen.

Stocks are fickle. Abe doesn’t care whether they go up or down. Bonds are a part of Kuroda’s repurchasing agenda, so those are covered, too. But the yen stands on its own.

In that sense, it’s the key to the proverbial castle.

In order to conduct any sort of serious financial reform, Abe is going to have to move the yen’s needle. Everything in corporate Japan depends on it.

Since I first brought this trade to everybody’s attention in Money Morning in February, 2012, the yen has dropped by 30%, and the investment vehicle I recommended, the ProShares UltraShort Yen Fund, is up more than 60% as it flirts with the psychologically important ¥100/$1USD level.

Now, having come close enough to that target for government work, I think the next stop is ¥125 to the dollar, which means that even if you missed the first part of this trade, it’s not too late to get on board.

And if you’re already holding Japanese equities?

Don’t look a gift horse in the mouth.

Hedge the snot out of them or sell into strength – equity markets are not as directly connected to central banking stimulus efforts. But they are absolutely linked to traders' expectations, which can and do change all too frequently on nothing more than a whim or an errant “tweet,” as we have recently seen.

You don’t want to be left holding the bag.

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About the Author: Keith Fitz-Gerald is a seasoned analyst, expert media contributor, and futurist with decades of experience in global markets. In his capacity as Chief Investment Strategist for Money Morning and Chairman of the Fitz-Gerald Group, he appears regularly on financial television programs around the world on the Fox Business Network, CNBC Asia, NHK, BNN, and more. He’s been called on for his extraordinary ability to see future trends in such publications as Wired UK and the Wall Street Journal. Forbes.com labeled him a “Business Visionary.” Even Mensa has called him to their stage. Mr. Fitz-Gerald splits his time between homes in Oregon and Japan, with his wife and two boys. He travels the world extensively in search of investment opportunities others don’t yet see or recognize.

The QE Sandpile

John Mauldin — Sun, 05 May 2013 05:49:00 GMT

Ubiquity, Complexity Theory, and Sandpiles
The Critical State
We Are Managing Uncertainty
Fingers of Instability
A Stable Disequilibrium
Tulsa, Brussels, NYC, and Monaco

Sell in May and go away? What about "risk off?" And ever more QE? Today's letter is a quick note and a reprise of a popular letter from yesteryear (with a bit of new slant), as I am at my conference in Carlsbad.

But first, I thought I would shoot you a few quick, interesting notes that crossed my desk in the last week. It is almost a ritual for me to mention at this time of year the old investment saw, "Sell in May and go away." It has been surprisingly good advice in most years. My good friend Art Cashin is a curator (and prodigious progenitor) of investment wisdom. He offers these two insights from his research:

Tomorrow is the beginning of May, so a "Sell in May" review is in order. To avoid reinventing the wheel, let me plagiarize the veteran Jim Brown's synopsis yesterday.

Sell in May? We are at that time of year when investors have to decide if they want to take profits and move to cash for the summer or risk losing those profits in the next correction. The Stock Trader's Almanac has made the "Sell in May and go away" trade one of the most visible trends in the market. Because the markets normally decline in the summer, they came up with the best six-month trading system. If you had invested $10,000 in the Dow in 1950 and only kept the money in stocks from November through April, you would have had $684,073 as of the end of 2011. If you reversed the strategy and invested for the May-October period, you would have lost $1,024 over the same 61-year period. That is a pretty telling statistic, and the cycle rarely fails to produce.

And Art followed up the next day with:

Mark Hulbert suggests it may be a much older multi-national phenomenon. The "sell in May" pattern also exists in other countries besides the US. Ben Jacobsen, a finance professor at Massey University in New Zealand, reached that conclusion after studying all available historical evidence from each of 108 separate stock markets around the world. For example, his statistical tests detected the seasonal pattern in the United Kingdom stock market as far back as 1694.

Jacobsen, in an interview, emphasized that the Halloween Indicator isn't merely the product of a shameless, after-the-fact data-mining exercise. He said that he found an article as long ago as 1935 – in the Financial Times – in which the "sell in May" pattern is referred to as something that was already well-known and followed.

Even though the pattern nearly 80 years ago already had a solid historical foundation, Jacobsen notes, since then the difference between the average returns in winter and summer has become even bigger.

This is a crucial point, he argues, since the all-too-usual tendency is for patterns to begin to evaporate once investors become aware of them and try to exploit them."

China's PMI came in this week at barely above 50 and has been clearly falling for the last year. Despite what you read, China's economic growth is slowing, which is NOT good for commodity metals and products (different from the "softs" like grains, cattle, etc.). GaveKal argues that the commodity price fall that we have been seeing of late is possibly structural in nature. Yet the bond market rises, gold is rising, stocks are rising. (Clearly, the market did not listen to my friend Nouriel Roubini this morning – Dr. Doom indeed! After his speech, no one at this conference can call me pessimistic. Although he prefers the term realistic.) Seemingly everything is levitating.

"Where is risk off?" I ask aloud back in the green room as I write this.

Paul McCulley quips to me, "Never get in a …… contest with a man who buys ink by the barrel." The clear implication is that this levitation is all central bank-induced. The Fed, Japan, and the ECB are all in full gear, and England is only waiting for Mark Carney to arrive from Canada with the North American printing technology employed so well by his friend Ben Bernanke.

The question I am asking at the conference is, "What will happen when quantitative easing has to end? What does that look like?" I will report next week on what I am learning here, but right now let's return to what has proven to be the most popular piece I have written over the last 13 years. And as you read it, think not just of sand piles but of the analogous pile of electrons of quantitative easing as it mounts up toward criticality.

Friedrich Nietzsche knew just how the troubling unknown grips our imaginations and compels us to look for answers:

"To trace something unknown back to something known is alleviating, soothing, gratifying, and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown – the first instinct is to eliminate these distressing states. First principle: any explanation is better than none…. The cause-creating drive is thus conditioned and excited by the feeling of fear…." –Friedrich Nietzsche

"Any explanation is better than none." And the simpler, it seems in the investment game, the better. "The markets went up because oil went down," we are told. Then the next day the opposite relationship occurs. Then there is another reason for the movement of the markets. But we all intuitively know that things are far more complicated than that. As Nietzsche notes, dealing with the unknown can be disturbing, so we look for the simple explanation.

"Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain that make us feel good. We literally become addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important to the chemical release. And so we look for reasons.

That is why some people get so angry when you challenge their beliefs. You are literally taking away the source of their good feeling, like drugs from a junkie or a boyfriend from a teenage girl.

Thus we may reason that the NASDAQ bubble happened because of Greenspan. Or was a collective mania. Or was due to any number of things – pick your favorite belief. My favorite: just as the proverbial butterfly flapping its wings in the Amazon triggers a storm in Europe, maybe a borrower in Las Vegas triggered the subprime crash.

Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, disasters, and the movements of markets. Then we'll look at how New Zealand, Fed policy, gold, oil, and an investor in St. Louis can all be tied together in a critical state. Of course, how critical and what state are the questions here.

Ubiquity, Complexity Theory, and Sandpiles

We are going to start our explorations with excerpts from a very important book by Mark Buchanan, called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory and critical states. It is written in a manner any layman can understand. There are no equations, just easy to grasp, well-written stories and analogies.

As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic buckets and making sand piles? Slowly pouring the sand into an ever bigger pile, until one side of the pile started an avalanche?

Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds on itself and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

The piles were indeed completely chaotic in their unpredictability. Now, let's read this next paragraph from Buchanan slowly. It is important, as it creates a mental image that may help us understand the organization of the financial markets and the world economy. (emphasis mine)

"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

The Critical State

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]… In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."

Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth's crust triggering earthquakes, or as wholesale changes in an ecosystem – or as a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third rate paper in Denmark could cause world-wide riots?

Buchanan concludes in his opening chapter: "There are many subtleties and twists in the story … but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before."

Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the probability of an avalanche becomes 2.14 times more likely. We find something similar in earthquakes. In terms of energy, the data indicate that earthquakes become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law," a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game? "…after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."

Now, let's couple this idea with a few other concepts. First, Hyman Minsky (who should have been a Nobel laureate) points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction. The problem with long term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."

We Are Managing Uncertainty

Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, giving a paradoxical rise to even more apparent stability. As the late Hunt Taylor wrote:

"Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters….

"I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it. This is something old.

"I think shocks will come, but they will be shallower, shorter. They will be harder to predict, because we are not really managing risk anymore. We are managing uncertainty – too many new variables, plus leverage on a scale we have never encountered (something borrowed). And, when the inevitable occurs, the buying opportunities that result will be won by the technologically enabled swift."

Another way to think about it is the way Didier Sornette, a French geophysicist, has described financial crashes in his wonderful book Why Stock Markets Crash (the math, though, was far beyond me!). He wrote, "[T]he specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. Think of a ruler held up vertically on your finger: this very unstable position will lead eventually to its collapse, as a result of a small (or an absence of adequate) motion of your hand or due to any tiny whiff of air. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary."

When things are unstable, it isn't the last grain of sand that causes the pile to collapse or the slight breeze that causes the ruler on your fingertip to fall. Those are the "proximate" causes. They're the closest reasons at hand for the collapse. The real reason, though, is the "remote" cause, the farthest reason. The farthest reason is the underlying instability of the system itself.

A fundamentally unstable system is exactly what we saw in the recent credit crisis. Consumers all through the world's largest economies borrowed money for all sorts of things, because times were good. Home prices would always go up and the stock market was back to its old trick of making 15% a year. And borrowing money was relatively cheap. You could get 2% short-term loans on homes, which seemingly rose in value 15% a year, so why not buy now and sell a few years down the road?

Greed took over. Those risky loans were sold to investors by the tens and hundreds of billions of dollars, all over the world. And as with all debt sandpiles, the fault lines started to appear. Maybe it was that one loan in Las Vegas that was the critical piece of sand; we don't know, but the avalanche was triggered.

You may not remember this, but I was writing about the problems with subprime debt way back in 2005 and 2006. But as the problem actually emerged, respected people like Ben Bernanke (the chairman of the Fed) said that the problem was not all that big and that the fallout would be "contained." (I bet he wishes he could have that statement back!)

But it wasn't contained. It caused banks to realize that what they thought was AAA credit was actually a total loss. And as banks looked at what was on their books, they wondered about their fellow banks. How bad were they? Who knew? Since no one did, they stopped lending to each other. Credit simply froze. They stopped taking each other's letters of credit, and that hurt world trade. Because banks were losing money, they stopped lending to smaller businesses. Commercial paper dried up. All those "safe" off-balance-sheet funds that banks created were now folding (what my friend Paul McCulley first labeled as the Shadow Banking System). Everyone sold what they could, not what they wanted to, to cover their debts. It was a true panic. Businesses started laying off people, who in turn stopped spending as much.

As I read through this again, I think I have an insight. It is one of the reasons we get "fat tails." In theory, returns on investment should look like a smooth bell curve, with the ends tapering off into nothing. According to the theoretical distribution, events that deviate from the mean by five or more standard deviations ("5-sigma events") are extremely rare, with 10 or more sigma being practically impossible – at least in theory. However, under certain circumstances, such events are more common than expected; 15-sigma or even rarer events have happened in the world of investments. Examples of such unlikely events include Long Term Capital in the late '90s and any of a dozen bubbles in history. Because the real-world commonality of high-sigma events is much greater than in theory, the distribution is "fatter" at the extremes ("tails") than a truly normal one.

Thus, the build-up of critical states, those fingers of instability, is perpetuated even as, and precisely because, we hedge risks. We try to "stabilize" the risks we see, shoring them up with derivatives, emergency plans, insurance, and all manner of risk-control procedures. And by doing so, the economic system can absorb body blows that would have been severe only a few decades ago. We distribute the risks and the effects of the risk throughout the system.

Yet as we reduce the known risks, we sow the seeds for the next 10-sigma event. It is the improbable risks that we do not yet see that will create the next real crisis. It is not that the fingers of instability have been removed from the equation, it is that they are in different places and are not yet visible.

A second related concept is from game theory. The Nash equilibrium (named after John Nash, he of The Beautiful Mind) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

A Stable Disequilibrium

So we end up in a critical state of what Paul McCulley calls a "stable disequilibrium." We have "players" of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their own personal outcome and to reduce their exposure to "fingers of instability."

But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. (Astounding. Was it less than ten years ago? Now Russian is awash in capital. Who could anticipate such a dramatic turn of events?) Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened: the historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.

The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

If it were not for the fact that we are coming to the closing innings of the Debt Supercycle, we would already be in a robust recovery. But we are not. And sadly, we have a long way to go with this deleveraging process. It will take years.

You can't borrow your way out of a debt crisis, whether you are a family or a nation. And, as too many families are finding out today, if you lose your job you can lose your home. People who were once very creditworthy are now filing for bankruptcy and walking away from homes. All those subprime loans going bad put huges numbers of homes back onto the market, which caused prices to fall on all homes, which caused an entire home-construction industry to collapse, which hurt all sorts of ancillary businesses, which caused more people to lose their jobs and give up their homes, and on and on. The connections in the housing part of the sandpile were long and deep.

It's all connected. We built a very unstable sand pile and it came crashing down, and now we have to dig out from the problem. And the problem was too much debt. It will take years, as banks write off home loans and commercial real estate and more, and we get down to a more reasonable level of debt as a country and as a world.

And, bringing this tale of instability up to date, we find that Ben Bernanke and his central bank colleagues worldwide have taken much of the burden of sovereign debt upon their mighty shoulders. But as they push their Sisyphean, quantitative easing boulders up the ever-steepening sandpile of the global economy, which side of the pile will collapse first? Will it be the European side, already dangerously unstable? Or the Japanese side, where the QE boulder is about to grow into a real whopper? Or could it happen over on the China slope, which is riddled with fiscal and financial crevasses?

And lest we be complacent here in the US, we only need Niall Ferguson to remind us, as he did here at the conference this morning, that the US may be in the grip of a profound structural malaise that neither easing nor austerity can relieve. I'll have much more to say about Niall's presentation and those of our other speakers in coming weeks. We were treated to some world-class thinking and synthesizing of views here today, with much more to come tomorrow! And I'll keep on asking everyone who comes to the stage, "But what about Japan?"

Our 10^th Annual Strategic Investment Conference is definitely shaping up as our best ever. And with intellects like Niall Ferguson, Lacy Hunt, and Nouriel Roubini, as well as premier investment managers that include the entire partner team from GaveKal (Louis and Charles Gave and Anatole Kaletsky), Jeffrey Gundlach, Kyle Bass, and Mohamed El-Erian, how could it not be the best? In his afternoon presentation, Mohamed did a beautiful job of tying together the themes we focused on today – and he was introduced by his best friend (and early-morning walking and debating partner), the irrepressible and incorrigible Paul McCulley, who was also our keynote speaker last night.

The conference is turning out to be everything that my co-host, Altegris, and I hoped and expected it would be. We are already working hard to get the conference videos ready, in order to send them to the attendees and all Mauldin Circle members over the coming weeks. In the meantime, here is a great montage from last year's conference for you to enjoy. If you are not yet a Mauldin Circle member, let this clip remind you of the unique benefits offered to those who .

Click here to initiate your membership in my exclusive Mauldin Circle Program for accredited investors and investment professionals. My partner Altegris and I have worked hard to enhance the program, which now includes access to webinars, conferences, special events, videos, accredited newsletters, and presentations featuring alternative-investment managers and other thought leaders and influencers.

The good news is that this program is completely free. The only restriction is that, because of securities regulations, you have to register and be vetted by one of my trusted partners, which in the United States is Altegris, before you can be added to the subscriber roster. This will be a quite painless process (I promise). I do not like limiting the letter to accredited investors, but those are the rules under which I work. This is not of my choosing, and I have worked in front of and behind the scenes to try to change what I think is a very unfair rule. (See important risk disclosures below. In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) Once you register, an Altegris representative will call you and establish access to the videos, presentations, and summaries from the speakers featured at our 2013 Strategic Investment Conference, as soon as they are ready.

Tulsa, Brussels, NYC, and Monaco

I am off to Tulsa in two weeks to "give away" my daughter Abigail Joy as she gets married on a Sunday. "Dad, do you have a tux?" came the call, as I think she might have noticed I am not wearing ties all that much these days. Actually, I had kind of planned to wear a tie at least one day here at the conference, but all my ties are still in storage, as are my shoes – I am down to one pair.

I was sitting outside during a break with Niall Ferguson and his wife, Ayaan Hirsi Ali, going over what she and I would cover when I did my Charlie Rose imitation and interviewed her at lunchtime. Mohamed came by and wished me well at the wedding. I paused for a second to think about which wedding he meant, and Niall gave me a hard time about not immediately getting the focus of his congratulations. "Aren't you involved?" he queried, and threw in a few other friendly jibes. I had to note my distraction over interviewing his wife in public (if you do not know the compelling story of Ayaan Hirsi Ali, Google her and then read her books, starting with her first one, Infidel. She is a powerful advocate for Muslim women, at great risk to her own life). While she is utterly charming and so gracious, she is also "formidable" (best said with a French accent), and I was intently focused on what we were going to discuss.

But trying to salvage my damaged reputation as a father, I immediately noted that Niall had clearly not gone through this process (though he and Ayaan do have a toddler at home). "The role of Dad," I said, "is to write a lot of checks and smile and show up at the wedding, walk down the aisle, smile, and hand off your precious jewel to some young kid – though you do get to dance with your daughter at the reception.” (And you have to resist the impulse to grab her by the hand and run off, as you remember her bouncing on your knee, running to the door to greet you, and sharing a thousand other treasured father-daughter moments.) Ayaan smiled and agreed. Niall just put on that fierce Scottish grin of his as he thought about his own kids and the costs of future weddings. (And congratulations to Ayaan, as she is now a US citizen. This country needs more people of her caliber to remind us of the "why" of who we are.)

The coming week starts another series of road trips – a day in Atlanta to attend the Galectin Therapeutics board meeting, followed by Nashville for Altegris, the weekend to Brussels and later the next week to Geneva, back to Dallas for a week, and then to Washington, DC, and New York.

It is not just time to hit the send button; as I close this, I also still need to finalize the PowerPoint of my brand-new presentation for tomorrow and host a reception on the lawn … and then do a series of meetings and video shots with guests (which will hopefully show up in this space one day soon)!

John Mauldin

subscribers@mauldineconomics.com

Debt, Growth, and the Austerity Debate

John Mauldin — Wed, 01 May 2013 23:09:00 GMT

Two weeks ago I wrote about the current debate over the 2010 paper by Ken Rogoff and Carmen Reinhart (hereinafter referred to as RR) on the correlation between debt and GDP growth. I said that the most important part of their work, which is the construction of an enormous database on debt and financial crises over the last few hundred years, was to be found in their book This Time Is Different and elsewhere. And their fundamental conclusion: debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment.

They did make an unfortunate error in a few cells of a massive Excel spreadsheet, which subsequent analysis has shown to not be a huge deal, though some have made it out to be. And the more I read of the issue, the more I believe that the bulk of the negative response has political overtones. There are those who wish to find reasons to abandon any move toward balanced budgets and reasonable fiscal policies. They see austerity as a punishment, some type of masochistic conservative Calvinist plot foisted on poor unsuspecting citizens who should not be held responsible for the governments they elect.

As I wrote two weeks ago, austerity is a consequence, not a punishment.

Last Thursday RR published an op-ed in the New York Times. Some were uncharitably dismissive of it, but if you take a careful look at the detailed online version, which is this week’s Outside the Box, I think you'll find their counterarguments thorough and reasonable.

An essay on Bloomberg notes:

The biggest howler is the least consequential. By highlighting the wrong cells in an Excel spreadsheet, Reinhart and Rogoff actually took an average over 15 countries, rather than the full sample of 20. Embarrassing? Yes. Important? No. Of the five missing countries, only one – Belgium – had ever experienced very high debt. Adding it barely changed the findings because Belgium’s economic growth during its high-debt episode was roughly similar to that in other highly indebted nations.
[emphasis mine]

While the media loves to focus on the simple (and regrettable) coding error (which RR acknowledge), the main body of their analysis still points strongly in the same direction, and that direction has been noted by other, independent researchers:

Researchers at the Bank of International Settlements and the International Monetary Fund have weighed in with their own independent work. The World Economic Outlook published last October by the International Monetary Fund devoted an entire chapter to debt and growth. The most recent update to that outlook, released in April, states: "Much of the empirical work on debt overhangs seeks to identify the 'overhang threshold' beyond which the correlation between debt and growth becomes negative. The results are broadly similar: above a threshold of about 95 percent of G.D.P., a 10 percent increase in the ratio of debt to G.D.P. is identified with a decline in annual growth of about 0.15 to 0.20 percent per year.” (NYT)

In fact, when you examine the paper and underlying research of the University of Massachusetts trio who discovered and wrote about the error, you find that there is not all that much difference in outcomes if you use their assumptions. The best analysis I have read is in this piece by F. F. Wiley (even if he misspells my name in his links <g>). For those wanting even more detail on this issue, I suggest you read the Wiley piece after you read RR’s response below.

Economics, at least in its predictive and prescriptive forms, is not a physical science, notwithstanding the physics envy of many economists. To try and suggest that major policy differences should be formed on the basis of numbers to the right of the decimal point is folly. It is enough at times to get the direction right. North rather than south. With regard to the present debate, it is clear that a point can be reached at which too much debt is a problem. Is there a bright, unchanging line? This far and no farther? There is not.

Water transmutes from solid to liquid to gas. In physics and mathematics, limits, and indeed singularities, occur; and we can measure and even predict them. With debt-to-GDP ratios, all we know for now is that the Bang! moment exists, but the precise point for any one given country is not something we can calculate. But wherever that line happens to fall, once it is crossed, Bang! Everything changes. And dear gods, that is a fate to be avoided.

This is far more than an academic tempest in a teapot. Understanding the relationship between debt and systemic financial problems is critical to how you construct your long-term portfolio positions. If there is not a relationship between debt and growth, then quantitative easing will have an entirely different effect on markets than if there is. It is really that simple. Can we point to exact figures and immutable relationships? Of course not. Nothing in life is that simple, and RR don’t even attempt to do so, although some of their critics (and to be fair, some of their supporters) try to see bright red lines around the 90% debt-to-GDP number.

I write this note from La Jolla, looking over the Pacific Ocean. I will have dinner with Jon Sundt and the partners at Altegris at George’s later this evening and then move on to Carlsbad, where I will meet tomorrow with my partners and team at Mauldin Economics. The bulk of the team will be in this week for a two-day planning fest before we celebrate our 10^th annual Strategic Investment Conference, starting Wednesday evening. I also have writing and reading and a brand-new speech to attend to. And I want to be there for all the speaking sessions. There will also be lots of late-night conversations with great friends on a very wide range of topics, from QE to biotech to geopolitics and all sorts of politically incorrect notions. Can it get any better?

It is about time to get to that next meeting. I hope your week is going well.

Your about as excited as I can get when I think about this week analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Debt, Growth, and the Austerity Debate

By CARMEN M. REINHART and KENNETH S. ROGOFF
The New York Times, April 25, 2013

In May 2010, we published an academic paper, “Growth in a Time of Debt.” Its main finding, drawing on data from 44 countries over 200 years, was that in both rich and developing countries, high levels of government debt – specifically, gross public debt equaling 90 percent or more of the nation’s annual economic output – was associated with notably lower rates of growth.

Given debates occurring across the industrialized world, from Washington to London to Brussels to Tokyo, about the best way to recover from the Great Recession, that paper, along with other research we have published, has frequently been cited – and, often, exaggerated or misrepresented – by politicians, commentators and activists across the political spectrum.

Last week, three economists at the University of Massachusetts, Amherst, released a paper criticizing our findings. They correctly identified a spreadsheet coding error that led us to miscalculate the growth rates of highly indebted countries since World War II. But they also accused us of “serious errors” stemming from “selective exclusion” of relevant data and “unconventional weighting” of statistics – charges that we vehemently dispute. (In an online-only appendix accompanying this essay, we explain the methodological and technical issues that are in dispute.)

Our research, and even our credentials and integrity, have been furiously attacked in newspapers and on television. Each of us has received hate-filled, even threatening, e-mail messages, some of them blaming us for layoffs of public employees, cutbacks in government services and tax increases. As career academic economists (our only senior public service has been in the research department at the International Monetary Fund) we find these attacks a sad commentary on the politicization of social science research. But our feelings are not what’s important here.

The authors of the paper released last week – Thomas Herndon, Michael Ash and Robert Pollin – say our “findings have served as an intellectual bulwark in support of austerity politics” and urge policy makers to “reassess the austerity agenda itself in both Europe and the United States.”

A sober reassessment of austerity is the responsible course for policy makers, but not for the reasons these authors suggest. Their conclusions are less dramatic than they would have you believe. Our 2010 paper found that, over the long term, growth is about 1 percentage point lower when debt is 90 percent or more of gross domestic product. The University of Massachusetts researchers do not overturn this fundamental finding, which several researchers have elaborated upon.

The academic literature on debt and growth has for some time been focused on identifying causality. Does high debt merely reflect weaker tax revenues and slower growth? Or does high debt undermine growth?

Our view has always been that causality runs in both directions, and that there is no rule that applies across all times and places. In a paper published last year with Vincent R. Reinhart, we looked at virtually all episodes of sustained high debt in the advanced economies since 1800. Nowhere did we assert that 90 percent was a magic threshold that transforms outcomes, as conservative politicians have suggested.

We did find that episodes of high debt (90 percent or more) were rare, long and costly. There were just 26 cases where the ratio of debt to G.D.P. exceeded 90 percent for five years or more; the average high-debt spell was 23 years. In 23 of the 26 cases, average growth was slower during the high-debt period than in periods of lower debt levels. Indeed, economies grew at an average annual rate of roughly 3.5 percent, when the ratio was under 90 percent, but at only a 2.3 percent rate, on average, at higher relative debt levels.

(In 2012, the ratio of debt to gross domestic product was 106 percent in the United States, 82 percent in Germany and 90 percent in Britain – in Japan, the figure is 238 percent, but Japan is somewhat exceptional because its debt is held almost entirely by domestic residents and it is a creditor to the rest of the world.)

The fact that high-debt episodes last so long suggests that they are not, as some liberal economists contend, simply a matter of downturns in the business cycle.

In “This Time Is Different,” our 2009 history of financial crises over eight centuries, we found that when sovereign debt reached unsustainable levels, so did the cost of borrowing, if it was even possible at all. The current situation confronting Italy and Greece, whose debts date from the early 1990s, long before the 2007-8 global financial crisis, support this view.

The politically charged discussion, especially sharp in the past week or so, has falsely equated our finding of a negative association between debt and growth with an unambiguous call for austerity.

We agree that growth is an elusive goal at times of high debt. We know that cutting spending and raising taxes is tough in a slow-growth economy with persistent unemployment. Austerity seldom works without structural reforms – for example, changes in taxes, regulations and labor market policies – and if poorly designed, can disproportionately hit the poor and middle class. Our consistent advice has been to avoid withdrawing fiscal stimulus too quickly, a position identical to that of most mainstream economists.

In some cases, we have favored more radical proposals, including debt restructuring (a polite term for partial default) of public and private debts. Such restructurings helped deal with the debt buildup during World War I and the Depression. We have long favored write-downs of sovereign debt and senior bank debt in the European periphery (Greece, Portugal, Ireland, Spain) to unlock growth.

In the United States, we support reducing mortgage principal on homes that are underwater (where the mortgage is higher than the value of the home). We have also written about plausible solutions that involve moderately higher inflation and “financial repression” – pushing down inflation-adjusted interest rates, which effectively amounts to a tax on bondholders. This strategy contributed to the significant debt reductions that followed World War II.

In short: many countries around the world have extraordinarily high public debts by historical standards, especially when medical and old-age support programs are taken into account. Resolving these debt burdens usually involves a transfer, often painful, from savers to borrowers. This time is no different, and the latest academic kerfuffle should not divert our attention from that fact.

Carmen M. Reinhart is a professor of the international financial system, and Kenneth S. Rogoff is a professor of public policy and economics, both at Harvard.

In an appendix to this op-ed essay, the authors further defend their findings that high public debt is associated with lower economic growth.

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The Cashless Society

John Mauldin — Sun, 28 Apr 2013 20:18:00 GMT

The Underground Recovery
The Cashless Society?
Welfare and Incentives
Carlsbad, Tulsa, Nashville, Brussels, and Homeless in Dallas

But Mousie, thou art [not alone],
In proving foresight may be vain:
The best-laid schemes o' mice an' men
Gang aft agley,
An' lea'e us nought but grief an' pain,
For promis'd joy!

Robert Burns, To a Mouse, on Turning Her Up in Her Nest with the Plough

It is a common trope in science fiction novels. Economic transactions are handled seamlessly with a wave of a card or a physically imbedded chip, and whatever the author imagines money to be is transferred, far removed from the archaic confines of ancient physical monies. If you Google "cashless society" you get about 600,000 references in under a second, and 20 pages into the references there are still articles on a future world where physical cash is no longer needed. Some see it as a sign of the "end times," some as a capitalist plot, some as a frightening vision of socialists and ever-bigger governments, and some as a logical step in the evolution of a technologically driven international commerce.

And some of the "cashless society" references are showcase articles for the latest innovation that turns your phone or smart card into a functional wallet. I can attest it is quite possible to go for days without needing actual cash (as long as there are no kids around). The Bitcoin phenomenon (28 million sources on Google!) is a libertarian enthusiast's dream of not just a cashless society but a society with no need for fiat money and central banks.

Today we'll look at research suggesting that cashless future might be farther off than we either fear or hope. Not only is a cashless society farther away than some think, we are actually seeing an increase in the use of cash all over the world (and this is not just a US phenomenon). We will look at some interesting factoids that in themselves make for thought-provoking discussions, but when we couple them with research on the rise of the unreported economy (aka the underground economy) and the number of people who get some form of government assistance, we may find problematic consequences resulting from hidden incentives that work in unintended ways.

The Underground Recovery

In a recent New Yorker article entitled, “The Underground Economy,” writer James Surowiecki explores the import of a study by University of Wisconsin economist and professor emeritus Edgar Feige, who for many years has done research on the amount of actual cash in the US. Feige has recently updated his work.

What prompted me to follow up and then finally to discuss his work personally with a remarkably accessible Feige was his rather well-documented refutation of a common assertion I have long believed: that at least 2/3 of physical, printed US cash circulates outside the borders of the country. Indeed, you can find research on this topic at the San Francisco Fed and in serious economic journals, so this was not just some anecdotal belief I held from observing the impressively large number of dollars in use wherever I travel in the world. But no, this factoid was something "everyone" simply "knew." Well, everyone but a few people like Feige and evidently some people at the New York Fed.

And we are not talking about a small difference between perception and reality here. Feige asserts convincingly that only 23% of physical US dollars are outside our borders. The difference is $400-500 billion, not a small sum. He vigorously (and I think conclusively) dissects the assumptions in the research that has generated and promoted the larger number. (You can read his 28-page paper here. Let’s look at some of the more interesting parts of his research. (Emphasis mine, of course. This is an academic paper, after all, and polite academics do not use boldface for emphasis.)

The rapid growth of substitutes for cash, particularly debit and credit cards, has led economists to predict the advent of the "cashless society". Yet cash holdings in most developed economies continue to grow and in the U.S., per capita currency holdings now amount to $3000. This paper revisits the long-standing controversy concerning the whereabouts of U.S. cash. Specifically, we employ a previously confidential data source on net shipments of U.S. currency abroad to re-estimate the fraction of U.S. currency held overseas. Contrary to the widely cited figure that 65 percent of U.S. currency is abroad, we now find that direct evidence supports the notion that overseas holdings amount to less than 25 percent. With domestic cash holdings amounting to roughly $2250 per capita, we are far from a "cashless society".

He goes on to note,

Currently, the official figure for the percent of U.S. currency held abroad as published by the Federal Reserve in their Flow of Funds Accounts and by the Bureau of Economic Analysis in the U.S. Balance of Payments Accounts is 39 percent….

To put these figures in perspective, they imply that the average American’s bulging wallet holds roughly 91 pieces of U.S. paper currency, consisting of: 31 one dollar bills; 7 fives; 5 tens; 21 twenties; 4 fifties and 23 one hundred dollar bills. Few of us will recognize ourselves as "average" citizens. Clearly, these amounts of currency are not normally necessary for those of us simply wishing to make payments when neither credit/debit cards nor checks are accepted or convenient to use. Yet as shown in Figure 2, these surprisingly high U.S. per capita currency values were exceeded by per capita currency values for Europe ($3274); Hong Kong ($3963), Switzerland ($6335) and Japan ($7562).

(Very odd factoids for those of us currently obsessed with all things Japanese. Not only do the Japanese have the largest per capita currency in circulation, but surveys tell us that the Japanese people only admit to holding about 10% of that cash. This is indeed, as Feige first noted in research in 1989(!), a "currency enigma." Sidebar question with no immediate answer: Cash is by definition deflationary, and Japan has problems with deflation … and now Kuroda-san is going to crank up the electronic printing presses? I will pose that one to Kyle Bass and Louis Gave, among others, next week. If the answer is interesting, I will report back.)

As Feige noted, on average we are each holding 23 $100 bills. Wondering where your Ben Franklins are? Here, just for fun, is the new $100 bill, coming on October 8:

Interestingly, much of the cash outside the US is in $100 bills, so that may explain where some of the missing C-notes are. Here’s Feige:

Even a cursory examination of the growth and magnitude of the U.S. currency supply in circulation with the public reveals that predictions of the advent of the "cashless society" are unfounded. Despite financial innovations giving rise to convenient substitutes for cash, per capita cash holdings continue to increase and by the end of 2011, amounted to $3000 for every man woman and child residing in the U.S. While this figure does not comport with our common sense notion of how many dollars the average person holds in her wallet, we show that Europeans and Japanese citizens hold even larger amounts of cash. Two explanations are offered for these large cash holdings. The first posits that a large fraction of U.S. currency is held abroad, the second that large amounts of cash are employed to undertake transactions that individuals and firms prefer to hide from the government either to avoid taxes, regulations or punishment for illegal activities.

The Cashless Society?

Professor Feige soundly refutes the first theory. The second one is what is interesting here: there is a rather large cash economy in the US.

The above-referenced article by Surowiecki in The New Yorker was actually about another piece of research by Feige on the "underground economy." (Feige is at least in his mid-70s and is clearly still quite active for one with "emeritus" in his title. He has one very impressive, yea, intimidating resumé, with 80 publications to his credit. His first book was published 50 years ago, and he has been called "the father of underground economy analysis.")

In my conversation with him, Feige made it clear that he thinks it should be called the "unreported" rather than the "underground" economy. By whatever name, that economy apparently totals about $2 trillion a year in the US. And the "lost" tax revenue is in the neighborhood of $400 billion a year. That amount is downright puzzling if the cash in US circulation is only $250 billion (as would be indicated if 65% of US dollars really were outside the country). That would be pretty high velocity (the number of times money moves from one hand to another). But if cash is actually $750 billion, then that velocity becomes not so remarkable at all.

Surowiecki writes:

The percentage of Americans who don’t use banks is surprisingly high, and on the rise. Off-the-books activity also helps explain a mystery about the current economy: even though the percentage of Americans officially working has dropped dramatically, and even though household income is still well below what it was in 2007, personal consumption is higher than it was before the recession, and retail sales have been growing briskly (despite a dip in March). Bernard Baumohl, an economist at the Economic Outlook Group, estimates that, based on historical patterns, current retail sales are actually what you’d expect if the unemployment rate were around five or six per cent, rather than the 7.6 per cent we’re stuck with. The difference, he argues, probably reflects workers migrating into the shadow economy. "It’s typical that during recessions people work on the side while collecting unemployment," Baumohl told me. "But the severity of the recession and the profound weakness of this recovery may mean that a lot more people have entered the underground economy, and have had to stay there longer."…

The U.S. is certainly a long way from, say, Greece, where tax evasion is a national sport and the shadow economy accounts for twenty-seven per cent of G.D.P. But the forces pushing people to work off the books are powerful. Feige points to the growing distrust of government as one important factor. The desire to avoid licensing regulations, which force people to jump through elaborate hoops just to get a job, is another. Most important, perhaps, are changes in the way we work. As Baumohl put it, "For businesses, the calculus of hiring has fundamentally changed." Companies have got used to bringing people on as needed and then dropping them when the job is over, and they save on benefits and payroll taxes by treating even full-time employees as independent contractors. Casual employment often becomes under-the-table work; the arrangement has become a way of life in the construction industry. In a recent California survey of three hundred thousand contractors, two-thirds said they had no direct employees, meaning that they did not need to pay workers’-compensation insurance or payroll taxes. In other words, for lots of people off-the-books work is the only job available.

J.D. Tuccille, over at Reason.com, responds to the New Yorker article with an interesting analysis pointing to tax rates as the issue, among other things:

Surowiecki bemoans the "damaging effects of this trend," but he should pay more attention to the damaging taxes and regulations that caused this trend by pushing people to work off the books. People aren't depriving themselves of legal recourse and traditional benefits because it's suddenly hip to do so – they're hiding in the shadows because red tape and taxes are strangling the legal economy.

These are concerns. People respond to personal incentives. If the incentive to make their life better in the short term is to work off the books – and that is the basic choice – then that is what they will do. But that is not where I want to go with this discussion today. Let’s focus on another incentive to move out of the reported economy.

Welfare and Incentives

I think almost everyone participates in the unreported economy in one way or another. Do you tip a waiter or waitress? Pay cash for taxis or tip the bellman at the hotel? The baggage guys at the airport? The guys who do your lawn? Even if you write checks for a service, does that mean that income is reported?

I and most other businesspeople try to pay for everything that is a business deduction with a credit card. That can be tricky during IRS audits, but it is just easier than keeping receipts and documenting expenses when you get homeand then trying to add up your cash payments. And you can use a credit card or cash card without problems almost everywhere.

(When I travel outside the US, I am sometimes frowned at if I try to use a credit card. Singapore? No problem. Across much of Europe a credit card is not an issue, but cash is clearly appreciated. Then again, there was the time I wrote about last January, when I tried to use a credit card at a taverna off the tourist paths in Greece, and they had to hunt for their credit card machine and it didn’t work after they found it. And gods forbid you try and use a credit card in Argentina. My point is that the unreported economy is hardly just a US phenomenon.)

But there is a part of US society where unreported income is a particular problem, due to unintended consequences of poorly designed incentives. That is the segment of the country on welfare.

Let me note up front that this is not an argument for or against welfare or helping the poor and needy. I am just noting the large cash economy and offering another reason why it might be as large as it is: misaligned incentives.

In the last few months, conservative news outlets cited a Republican Congressional survey that shows that welfare is about $1 trillion of the US budget, or $168 per day for those below the poverty line. When you dig into the data, you find that a very loose definition of "welfare" was employed, one that most Americans would not use for many of the programs the survey lists. It might argued that the money in question should not be spent, but the survey does not pass the smell test in identifying actual welfare.

According to the Center for Budget and Policy Priorities, even when one uses a very expansive definition of "welfare," only "13 percent of the federal budget in 2011, or $466 billion, went to support programs that provide aid (other than health insurance or Social Security benefits) to individuals and families facing hardship." (Informationclearinghouse.info)

The St. Louis Federal Reserve database shows an even smaller welfare number, at $273 billion (chart below), but you can add about $140 billion at the state level and that gets you closer to the $466 billion mentioned above. That is still a large number per day per family below the poverty line. But let me hasten to add that is NOT what an actual recipient gets; it is just the budgeted cost, which includes what it takes to run the government offices and pay welfare workers.

Let’s look at a few quick statistics, which taken out of context can be misleading, so don’t be misled or assume that I am. The total number of people on welfare is about 4,300,000. The total number of people getting food stamps (the SNAP program) is 46,700,000. We just saw a new high for the number of families on food stamps:

In Texas if, as a single mother of two or three kids, you can figure out how to qualify for every type of assistance available, you can amass get the princely sum of about $980 a month (plus some healthcare). Other states are more generous. The popular meme is that 40 states pay more than $8 an hour to those on welfare, with seven paying more than $12 an hour. But if you work and make more than $1,000 a month (more or less, depending on the state) you will not likely qualify for welfare. The more you make the less you can get, until at some point you do not qualify at all. The theory is that benefits should decrease as your work income increases. (Source for some data: http://www.statisticbrain.com/welfare-statistics/)

Of course, there is the earned income tax credit (EITC), which is phased out once income reaches certain levels. To qualify for that, of course, you need to actually earn income. And WIC, housing subsidies, Medicaid, and other programs exist. (And we will not even get into disability payments. We have recently seen the number of people on disability rise faster than the number of people going back to work. Can a child or other member of a family get disability and another get welfare? Yes, the system can be gamed. Different letter.)

The following chart is from the generally liberal Urban Institute. Note that the maximum amount of total benefits is received by those who have the lowest levels of income, which makes a certain sort of sense. This chart is for a single parent in Colorado, a state that is middle of the road as far as benefits go. Benefits are considerably lower in Mississippi and far higher in Massachusetts and Alaska.

I am not arguing either for or against the level of payments or costs or the rationale for any particular program here. Different issue, different day.

No matter where you live, with few exceptions, being on welfare is not a pleasant lifestyle. Neither is living on $10 an hour, much less on minimum wage.

The point is that people on welfare have a clear need for more money than they get from whatever government check they receive. For most people, welfare is a temporary assistance program to help them out between jobs. But in the last decade, and especially in the five years since the beginning of the Great Recession, the welfare and disability rolls have simply exploded.

The clear incentive, it seems to me, is to work for extra cash in the unreported economy. If as a single working parent you make $10 an hour in the reported economy, you are going to lose most if not all of your welfare benefits (depending on the state); while if you work in the unreported economy, you keep your benefits.

You can view this situation several ways. For instance, perhaps the EITC should be higher, as in, the more you make the more you keep.

If you have a skill that pays you $20-30 an hour (closer to the median family income pay level) you are better off keeping the job and staying off welfare. But if you are minimum-wage labor or not far above it, the equation works out better if you work off the books for that extra income.

Is everyone on welfare working in the unreported economy? I would not suggest that for a minute. Obviously, they aren't.

While acknowledging that correlation is not causation, the parallel growth of the underground economy and the welfare rolls seem to me to be not entirely unrelated. The natural incentives are clearly there. What worries me most is that we are creating a generation of people who are getting used to working off the books, whether or not they are on welfare. They are outside the system and will come to see themselves as not being part of it. It becomes something "other" – except when they want medical care, which, with the advent of Obamacare, will now be available them even if they work in the unreported economy.

None of our kids, yours or mine, believe Social Security will be there for them when they retire. No need to be in the system for that.

There is a lot of controversial work in the economics profession, but I think pretty much everyone agrees that people respond to incentives. I wonder what message we are sending?

Carlsbad, Tulsa, Nashville, Brussels, and Homeless in Dallas

Next Monday I leave for Carlsbad and my conference, which starts on Wednesday evening; but there are lots of meetings and other things to attend to beforehand. Monday I will go to the Altegris office, where there is a lot to discuss, and then I'll meet with Jon Sundt and the other partners that night. The next day will see my Mauldin Economics staff show up for a long day of planning, as we try to deal with our rapid expansion.

And then when the meetings are over and the conference starts up, I get to enjoy again one of my favorite times of the year, when I get to see so many friends and have so many awesome conversations. I personally wish I could make it last for a week or more, as there is just not enough time to spend with everyone. But we take what we can get and savor it.

After the conference I'll be home for a bit before I make my way to Tulsa, where my daughter Abigail will get married May 19. (Her twin sister Amanda is doing fine with one-month-old daughter Addison!)

Later that week I'll fly to Nashville for a night, to speak at a meeting for Altegris, before returning to Dallas to write my letter and then head for Brussels for a week.

I am working on so many writing projects, plus my speech for next week, that I am quite busy. And there are just so many interesting things I come across that seem to demand my attention, not the least of which is working on the new-apartment design and contracting. But of course, we actually have to close the loans and make the purchase first. It seems like it takes forever, which is exactly what everyone told me to expect.

I am still "Homeless in Dallas," living in an extended-stay hotel. I don’t want to rent a temporary apartment until the new place actually closes, so that I can finesse the timing of everything. Therefore, most of my worldly possessions are in storage. It is an interesting experience, as I am finding out that I need far less than I have, and I'm sure I could cut even more. The important things, it seems, are the phone and computer, which are my lifelines to my kids and other family and friends and work. Those two possessions go with me everywhere. And with the new technology in hand, I am finding it easier to enjoy myself wherever I am – and to anticipate the next moment as well. Yes, there are always issues. Kids come with issues galore, and there are always things in the businesses that need tending to. Expenses pile up to more than I like. As do writing deadlines. And now I have to put up with a lack of air traffic controllers and a balky FAA. There is no end of things I could dwell on and stress over, if I wanted to.

There are also a lot of Big Things to worry about in this world of ours, but with an abundance of family and friends, the Small Things seem to work out just fine. You have a great week!

Your living in the moment analyst,

John Mauldin

subscribers@mauldineconomics.com

Hoisington Investment Management-Quarterly Review and Outlook, First Quarter 2013

John Mauldin — Wed, 24 Apr 2013 20:52:00 GMT

Lacy Hunt and Van Hoisington launch into their first-quarter "Review and Outlook," this week's Outside the Box, with a statement that some may find eye-opening: "The Federal Reserve (Fed) is not, and has not been, 'printing money'…" But given the facts of life about how money is really created (and destroyed), they are of course right: it's all about the acceleration – or deceleration – in the M2 money supply.

But there are deeper currents here. For, as Van and Lacy say, "A review of post-war economic history would lead to a logical assumption that the money supply (M2) would respond upward to [the Fed's] massive infusion of reserves into the banking system. And yet, the Fed's 3.5x expansion of the monetary base over the past five years has only grown M2 by 35%, and year-over-year growth through March, 2013, was less than 7%. "In other words," say our authors, "there is no evidence that the massive security purchases by the Fed have resulted in a sustained acceleration in monetary growth; nor is there evidence that economic conditions have improved."

So what is wrong with this picture? Well, it turns out that not only can the Fed not control the money supply, it can't control the velocity of money either. And that means the Fed can't create rising aggregate demand. As in, Ben's shooting blanks.

To help us get our heads around this fundamental realization, Van and Lacy lead us deeper into the gooey cytoplasm of Federal Reserve genetics; but the bottom line, as Prof. Irving Fisher taught us, is that GDP = MV. That is, nominal GDP equals money times its turnover (velocity). And don't look now, but velocity is the lowest it's been in six decades.

The upshot (downshot?) is that the decade just past saw a growth rate worse than any in US history, except the 1930s. We already knew that, but it's good to have estimable gentlemen like Messrs. Hunt and Hoisington bring us the numbers and solid analysis to back up the surprising statements we find ourselves forced to make about this oh-so-Muddle Through Economy.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington U.S. Treasury Fund (WHOSX).

I am back in Dallas for a week and getting ready for my conference next week, preparing a brand-new presentation, working on books, looking through architectural plans, spending time with family, dealing with endless minutiae, and all the while trying to stay caught up with my reading. Life seems so much busier than a decade or so ago when I had seven kids at home and a growing business, was deeply involved in politics, and was limited to old-fashioned publications on paper as the sources for my research. I am not complaining, mind you, as I am having a marvelous time; I just wonder how I would have done back then what I do now.,

I am really looking forward to my conference next week. This will be our (Altegris and my) 10^th conference. From the beginning I have always invited speakers I wanted to hear and who would challenge my thinking. This is about our best line-up ever, and I really would put it up against the roster of any conference anywhere. Most conferences have a few “headliners” and then other speakers, many of whom pay to sponsor and speak. We have nothing but headliners. My only regret is that we could not go for a couple more days and bring in a few more names.

I know some people look at our line-up of speakers and see mostly bears, but I think the attendees are in for a surprise. I am looking at PowerPoints and letters from the presenters, and the large majority of them are finding places to put capital to work. This dynamic is going to make for some lively debates at the conference. You can learn more at www.altegris.com/sic .

Two final thoughts. Given how much I travel it may be self-serving, but I find it inexcusable that the FAA would blame “sequestration” on the cutback in air-traffic controllers, etc. In a federal budget that large, they could find a few dollars to keep things rolling. That Congress would allow this without requiring prioritization funds is just one example – out of thousands – of the executive branch saying, “See, if you don’t give us money we will just inconvenience you,” all the while funding programs that we could well do without They might also take a look at cutting and rearranging budgets, as any normal business would do, to make sure that the important work for their customers gets done.

And finally, I have to apologize to my British friends. I am appalled that the current administration did not send a few officials to the funeral of Dame Margaret Thatcher. So much has been written about her that there is little I can add. I understand that some in the current administration might not agree with her policies, but an official acknowledgement of the “special relationship” that exists between Britain and the US would have seemed to require the presence of a representative from our government. That none were dispatched causes me to feel great shame for our country. Is this the way we treat our friends? It speaks volumes.

Have a great week. And are you paying attention to Italy? It seems that whom the gods would drive mad they first send to Italy to study politics.

Your needing to go back to Tuscany analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

Hoisington Investment Management – Quarterly Review and Outlook, First Quarter 2013

Printing Money

“The Federal Reserve is printing money”. No statement could be less truthful. The Federal Reserve (Fed) is not, and has not been, “printing money” as defined as an acceleration in M2 or money supply. Just check the facts. For the first quarter of 2013 the Fed purchased $277.5 billion in securities (net) as their security portfolio expanded from $2.660 trillion to $2.937 trillion. A review of post-war economic history would lead to a logical assumption that the money supply (M2) would respond upward to this massive infusion of reserves into the banking system. The reality is just the opposite. The last week of December, 2012 showed M2 at $10.505 trillion, but at the end of March, 2013 it totaled only $10.450 trillion which was an unexpected decline of $55 billion. Printing money? No.

This broad misconception of the Fed’s ability to print money has been widely embraced since the Fed began its massive balance sheet expansion near the end of 2008. It was then that the Fed expanded the monetary base from $840 billion to $1.7 trillion in a matter of months. Further, from the initiation of this misguided program to the end of March 2013, the Fed has expanded the monetary base from $840 billion to $2.93 trillion. The money supply indeed went up (35%) but not in proportion to the increase in the monetary base (249%). Presently, the year- over- year expansion of M2 is only 6.8%, which is nearly identical to its year-over-year growth rate in March of 2008 before the Fed decided to “help out the economy” (Chart 1). In other words, there is no evidence that the massive security purchases by the Fed have resulted in a sustained acceleration in monetary growth; nor is there evidence that economic conditions have improved.

The Fed's Flaw

Not only does the Fed not control money, but it cannot determine velocity (V), the speed that money turns over, either. The great American economist, Irving Fisher, identified this connectivity between money and economic growth with a straightforward formula: Nominal GDP equals money (as defined by M2) times its turnover (GDP=MV). Two flaws exist in the belief that the Fed can create rising aggregate demand. First, they do not directly control M2. Second, velocity is almost entirely outside their control. In order to understand how these two variables prevent the Fed from increasing aggregate demand, it is necessary to become conversant with a few terms: monetary base, bank reserves, and money multiplier.

The monetary base, which is derived from a consolidated balance sheet of the Fed and Treasury, has an asset (source side), and a liability (use side). When the Fed purchases government securities, the asset side rises and the liability side, comprised of currency in circulation and bank reserves, increases commensurately. Bank reserves are funds that are held by banks on deposit at the Fed or in their own institution in the form of vault cash. These funds, or reserves, are available for lending. This process of lending reserves creates deposits and currency that constitute the definition of M2.

The monetary base is often referred to as “high-powered money” since the reserve component has the potential to expand deposits and therefore money. The operative word is potential, which may or may not be realized. The massive reserve injection since 2008 is therefore the primary reason why there has been an elevated fear of inflation since these funds could be loaned. However, the empirical evidence is clear that high- powered money is not causing an increase in M2. Why? A bank’s conversion of reserves into money is called the money multiplier (Chart 2, left scale). At the end of 2007, the money multiplier was 9.0. That meant that the monetary base of $825 billion (Chart 2, right scale) was multiplied nine times to create the level of M2 that stood at $7.4 trillion. At the end of March, 2013 the monetary base had exploded to $2.9 trillion, but the money multiplier had collapsed to only 3.6, creating an M2 balance of $10.4 trillion. The Central Bank has very little control over the movement of the money multiplier; the actions of the banks and their customers primarily control this variable. This lack of control was evident in the first quarter of 2013 when the monetary base rose by $264 billion and M2 fell because the money multiplier declined from 3.9 to 3.6. Therefore, the Fed’s balance sheet expansion was thwarted.

Velocity

Referring back to Fisher’s equation GDP=MV, the other constraint on the Fed's ability to increase aggregate demand is velocity. If M2 actually expands, then velocity must remain stable in order for nominal GDP to be lifted in proportion to the rise of M2. While stable velocity was assumed in most of the post war academic work on monetary theory, clear empirical evidence is that velocity is woefully unstable (Chart 3). A host of factors influence velocity, but arguably the most important one is the type of borrowing and lending that occurs. For velocity to rise, any increase in debt needs to create a productive income stream. For the past several years, most of the borrowing and lending activities have related to daily consumptive needs, including borrowing by the federal government as well as much of the recent upturn in consumer lending. Borrowing to finance consumption does not generate a productive income stream nor does it create the resources to repay the borrowed funds. Consequently, velocity has collapsed and now stands at a six decade low.

No Inflation

Inflation cannot ignite in such an environment. Incomes will languish and growth in aggregate demand, as measured by nominal GDP, will slow except for brief, intermittent periods. Some inflationists point to the vast pool of reserves and conclude that if borrowing and lending begin to accelerate, money will surge and so will nominal GDP, but this argument is invalid. First, the money multiplier could continue to contract, just as the most recent figures confirm. Even if, contrary to the latest data, the money multiplier were to stabilize, an extended period would still transpire before any meaningful change in economic conditions. Second, no sign suggests that credit creation is turning more productive. Hence, velocity will continue to fall. Research further indicates that there is a considerable lag between monetary change and altered economic conditions.

In the current setting, those historically long lags should be even longer. The intersection of the aggregate demand curve (AD) with the aggregate supply curve (AS) determines the price level and real GDP. In today’s highly globalized markets, with services coming on-stream from all parts of the world, the AS curve could be in the process of continually shifting outward. Thus, the price level could fall even if there are small outward shifts in the aggregate demand curve. Additionally, the extreme level of indebtedness is a force entirely independent of the Fed, and it is restraining aggregate demand and serving to neutralize what minimal influence the Fed has on the economy. Moreover, this year’s tax hike will serve to shift the aggregate demand curve inward, reducing demand, providing a second powerful counter-force to the Fed’s feeble actions.

Perspective

Our present economic situation is nearly unparalleled in American history (Chart 4). An examination of the real economic growth rate of each decade in the United States from 1790 to 2012 reveals the unprecedented sluggishness of our present economic environment. The 1.8% average rise in the thirteen years of this century is less than half of the 3.8% growth rate since 1790. The only decade that witnessed worse economic conditions was, of course, the 1930s.

Debt Constrains Growth

Bad things happen when government debt exceeds 100% of GDP. Four studies published in just the past three years document this conclusion. These studies are highly relevant since OECD figures indicate that gross government debt exceeds 100% in the U.S., Europe, Japan as well as in other OECD member countries. Three of these studies were conducted by foreign scholars and published outside the United States thus avoiding attachment to the unfortunate domestic political debate. Here are the studies, starting with the one with the broadest implications:

(1) In Government Size and Growth: A Survey and Interpretation of the Evidence, Swedish economists Andreas Bergh and Magnus Henrekson find a “significant negative correlation” between size of government and economic growth.

Specifically, “an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.” (Journal of Economic Surveys, April, 2011)

(2) In The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area, Cristina Checherita and Philipp Rother find that a government debt to GDP ratio above the turning point of 90-100% has a “deleterious” impact on long-term growth. Additionally, the impact of debt on growth is non-linear. This means that as the government debt rises to higher and higher levels, the adverse growth consequences accelerate. (European Central Bank, Working Paper 1237, August 2010)

(3) In The Real Effects of Debt, Stephen G. Cecchetti, M.S. Mohanty and Fabrizio Zampolli determine “beyond a certain level, debt is bad for growth. For government debt, the number is about 85% of GDP.” (Bank for International Settlements (BIS) in Basel, Switzerland, September, 2011)

(4) In Debt Overhangs: Past and Present - Post 1800 Episodes Characterized by Public Debt to GDP Levels Exceeding 90% for At Least Five Years, Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff confirm that public debt overhang episodes are associated with growth over one percent lower than during other periods, and such episodes lasted an average of 23 years. They write “the long duration also implies that cumulative shortfall in output from debt overhang is potentially massive”. (National Bureau of Economic Research, Working Paper 18015, August 2012)

When private debt to GDP rises above 160% to 175% of GDP, growth is also stunted. This argument is also operative since private debt to GDP in the U.S. was 260% of GDP as of the fourth quarter of 2012. The point on private debt is a serious matter since it strikes at one of the core purposes of central banking – to promote private credit growth. But this is only valid for normal considerations and not when private debt is excessively high. When private debt is excessive, efforts to promote more private debt are counterproductive, thus the Fed is destabilizing rather than facilitating economic growth. The two major studies on private debt, both completed in the past two years and published outside the United States, bear directly on this issue. The first is the 2011 United Nations Conference on Trade and Development (UNCTAD) study, Too Much Finance, authored by Jean Louis Arcand, Enrico Berkes and Ugo Panizza. They find a negative effect on output growth when credit to private sector reaches 104% to 110% of GDP. The strongest adverse effects are for credit over 160% of GDP. The second is the 2011 BIS study referenced above. It finds that these negative consequences, or what the BIS economic advisor Cecchetti refers to as the point at which debt levels turn “cancerous”, start at 175% just slightly more than the UNCTAD study.

Is Deflation a Continuing Risk?

In their pioneering work, This Time is Different, Carmen Reinhardt and Kenneth Rogoff (R&R) found that “In Depression-era defaults, deflation was the norm.” They, however, observed situations where extreme over indebtedness was followed by high inflation. For all its valuable contributions, R&R’s sample in this best selling 2009 book included both advanced and emerging economies. In later studies other researchers also separated advanced from emerging economies because the latter have options that the former do not. The emerging markets and very small economies in general can resort to currency devaluation when they become over-indebted which creates domestic inflation. Such adversarial action may succeed because the individual countries are too small and insignificant to harm others and thus would not evoke immediate retaliation. But inflation is optional for these smaller countries only. If advanced economies choose currency devaluation ("economic warfare") to deal with a debt overhang, this evokes retaliation and a “race to the bottom” that is globally deflationary (the 1927 to 1939 experience). As far as we know, all the debt studies of the past three years have confined statistical examination to the data on advanced economies, a procedure that is now widely supported.

Irrationality

Credible academic research indicates that economic growth deteriorates when debt to GDP reaches critical levels - a condition that has now been met in countries that represent 75% of global GDP. When this reality is coupled with the Fed’s inability to create money growth or inflation, the result will invariably be slow nominal GDP growth.

The financial and other markets do not seem to reflect this reality of subdued growth. Stock prices are high, or at least back to levels reached more than a decade ago, and bond yields contain a significant inflationary expectations premium. Stock and commodity prices have risen in concert with the announcement of QE1, QE2 and QE3. Theoretically, as well as from a long-term historical perspective, a mechanical link between an expansion of the Fed’s balance sheet and these markets is lacking. It is possible to conclude, therefore, that psychology typical of irrational market behavior is at play. This suggests that when expectations shift from inflation to deflation, irrational behavior might adjust risk asset prices significantly. Such signs that a shift is beginning can be viewed in the commodity markets. The CRB Commodity Index peaked about two years ago at 691, but now stands at 551, a 20% decline despite massive Fed balance sheet expansion. The ability of the Fed to arrest a downside irrational move in risk assets may be limited. Non-risk assets, such as long dated U.S. treasuries, should benefit from this shift in perception.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Austerity is a Consequence, not a Punishment

John Mauldin — Mon, 22 Apr 2013 21:45:00 GMT

The Bang! Moment
The Purpose of Debt
Austerity Is a Consequence, Not a Punishment
San Francisco, Carlsbad, Tulsa, Nashville, and Brussels

Two seemingly different questions and comments from readers and friends crossed my path the last few days, but I saw a definite connection between them. The first question was, Why do we pursue austerity when it seems not to work? And then many readers wrote to ask this week, What do I think about the real problems that are surfacing in the Rogoff and Reinhart assertion that debt above a ratio of 90% debt to GDP seems to slow economic growth by 1% (especially since I have quoted that data more than a few times)? We'll deal with each question separately and then see if we can connect the dots.

The first question comes from correspondence I have had with Ms. Aga Barberini, who works in the investment world in Milan, Italy. She came there from Poland some 20 years ago. The first part of her note contains the question on austerity, but I'll pass along more of her letter, as I think it will give us all some insight into the seeming chaos that voters are facing in choosing a path for Italy. (And I hope my editors leave some of the charming grammar in her letter. You can almost hear the musical tones of her Italian English.)

I am worried for Italy, too. When I came here 20 years ago Italy was beautiful and rich; it was very good for a girl from Eastern Europe. Nowadays a lot of Italians go to Poland and settle down.

I guess it's going to get worse, the austerity will be tighter. Please tell me why should we go ahead with austerity when IMF last month came out saying that for every point of tax lifting in Italy we lose 2.5 points of GDP? First they said that the tax lifting would produce only 0.5 points of GDP slip, now they say they were wrong.

The political chaos is lasting. My husband says, why don't we vote for the comedian in June (as it is almost sure we are going to vote again soon)? Sure, Grillo is right in a lot of things and would clean the politics a lot. (By the way, did you know that the oldest bank in the world, Monte dei Paschi di Siena's mess is reaching 20 billion euros? They took away the money doing ... the bank transfers ;-) The Banka d'Italia didn't see; CONSOB, the Italian SEC, didn't see...). But how can a serious person vote for the comedian?

But I say sometimes the one who is good for the revolution isn't necessarily good to rule the country. Do you remember the guy called Lech Walesa? Thanks to him the communism [in Poland] was fallen – we all agree. Polish people were so thankful to him that we appointed him for the first democratic president. Than we found that he didn't have enough background to rule the country and enough culture to represent us on the international stage.

I will vote Berlusconi again. I can't stand communists even if they call themselves "the left."

(Sidebar: I was in Siena last summer and visited the ancestral home of the bank mentioned above, the world's oldest, founded in 1472. I marveled that any bank could last so long. At the Palio last summer we met one of the senior managers of the bank. It turns out that it was local politicians who ran the board of the bank, and now the authorities are saying management hid the problems from them.)

So let me try to answer you, Aga.

Austerity has come to have a rather bad name of late. The complaint is that it just doesn't work. Which is somewhat like complaining that the roof is leaking because someone else hassn't fixed it. If by "working" we mean that austerity is supposed to produce growth, then of course it doesn't work. By definition, austerity means you are reducing a fiscal deficit, and doing so will reduce growth in the short term. That begs the question, why would you want to do that? Don't we want growth? Let's look at why a country might need to endure austerity.

"Austerity" is now the name we give to the situation where a government has to limit its spending during an economic downturn or recession. The governments of the developed world amassed huge sovereign debts in the course of what is known as the Debt Supercycle. As interest rates fell, borrowing to finance consumption and spending became easy. But now that decades-long supercycle has ended.

One way of looking at the problem of swollen sovereign debt is to tsay that it goes back to Keynes (although one cannot actually blame the current problems on his economic theory). Keynes argued (roughly) that when there is a normal business-cycle recession a government should spend money to counterbalance the private-economy slowdown. That means that the government should borrow money and run fiscal deficits to help boost spending and the economy. According to his theory, this would make the recession not as deep and help bring the economy back to recovery sooner.

This was tried after World War II in numerous countries in the developed world, and it seemed to work. "We are all Keynesians now" is a famous phrase uttered by Milton Friedman and attributed to US President Richard Nixon. It is popularly associated with the reluctant embrace of Keynesian economics in a time of financial crisis, by individuals such as Nixon, who had formerly favored less interventionist policies. (The phrase was first attributed to Milton Friedman in the December 31, 1965, edition of Time magazine. In the February 4, 1966, edition, Friedman wrote a letter clarifying that his original statement was, "In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.") (Wikipedia)

The problem that arose was that most countries rarely followed through on the second part of Keynes's prescription, which was to pay back the debt when times were good. Rather, the debt just continued to accumulate. But, because interest rates were dropping, the size and cost of the debt became less of an issue.

The Bang! Moment

And, as Rogoff and Reinhart showed through their massive data collection and work on sovereign debt crises, published in This Time Is Different and elsewhere, debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment.

I want to review some of their work, which will help us understand the reasons for austerity, but first let's deal with the controversy of the moment. There has been some considerable debate this week among economists about a paper Rogoff and Reinhart published after they wrote their book. Recent detailed work suggests the analysis in that paper is flawed and that there are actual programming errors in their spreadsheets. My inbox almost exploded the last two days as friends and colleagues sent me links to multiple sources talking about the problems with Rogoff and Reinhart's work and asked for my thoughts. Given that I find This Time Is Different one of the more important books of the last decade, let me provide some context.

In 2010, economists Carmen Reinhart and Kenneth Rogoff released a paper, "Growth in a Time of Debt." Their main result was that "… median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower." The work suggested that countries with debt-to-GDP ratios above 90 percent have a slightly negative average growth rate.

This has been one of the most cited stats in the public debate during the Great Recession. Paul Ryan's Path to Prosperity budget states that their study "… found conclusive empirical evidence that [debt] exceeding 90 percent of the economy has a significant negative effect on economic growth." The Washington Post editorial board takes the R&R conclusion as an economic consensus view, stating that "… debt-to-GDP could keep rising – and stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth." (from the Next New Deal site and many other links sent to me)

Next New Deal (nextnewdeal.net) had this analysis:

In a new paper, "Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff," Thomas Herndon, Michael Ash, and Robert Pollin of the University of Massachusetts, Amherst successfully replicate the results. After trying to replicate the Reinhart-Rogoff results and failing, they reached out to Reinhart and Rogoff, and they were willing to share their data spreadhseet. This allowed Herndon et al. to see how how Reinhart and Rogoff's data was constructed.

They find that three main issues stand out. First, Reinhart and Rogoff selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias in favor of their result, and without them you don't get their controversial result.

(You can get further details at http://www.nextnewdeal.net/rortybomb/researchers-finally-replicated-reinhart-rogoff-and-there-are-serious-problems. And there are other sources here and here.)

I and many others who are concerned about the growth of debt quoted that research. As we approach that 90% level in the US, it has become a prominent feature in certain circles. But I want to emphasize that The Rogoff and Reinhart paper mentioned above is a later work than their book. To my knowledge, no one is disputing the work in their book. Their book, This Time Is Different, is basically just an analysis of their very large and masterful accumulation of data about sovereign debt crises.

For the last two weeks I have talked about economists and their use of data. I pointed out that inflation as measured by the CPI is an average for the country and not reflective of any one person's actual experience.

Something similar can be said about the later work of Rogoff and Reinhart. Yes, there was an unfortunate formula in one cell of their rather complex spreadsheet; but more importantly, they made assumptions about what is important and what is not in creating their analysis, and the assumptions in their model gave one set of results. If you make different assumptions, you get other results that show that 90% is not all that bad. Just as economists argue about how we should compute inflation, there will now be arguments about what the debt-to-GDP numbers really mean. I am willing to bet that by this time next year we will see several studies, all arriving at different conclusions.

But in any case, whether in their original work or in the later paper, R&R describe a problem with excessive debt that is true on average. Actual experience shows that in some countries debt will create a problem at quite low levels, while Japan climbs toward 250% debt to GDP (and will get there all too soon) and hardly anyone blinks. Different pokes for different folks.

I'm going to toss in a quick note as I sit here in Hong Kong waiting for my next plane. I read the Financial Times while on the way up here from Singapore. There were several articles that seemed to rejoice in the fact that Rogoff and Reinhart's later paper has some flaws. They jumped on those errors to discredit the whole idea of austerity, the association between too much debt and a lack of growth, and the need to bring one's fiscal house into order. Why pursue austerity when it does not lead to growth, which everyone knows is the only real way to deal with debt?

You can almost hear the critics wanting to dismiss Rogoff and Reinhart's entire book, which clearly establishes the link between excessive debt and sovereign debt crises – a pattern that has played out some 266 times over the last few centuries, if I remember correctly. The point is that there is no magic number that says "This far and no farther." There is a mythical line where confidence and trust is lost, but no one knows where that line of demarcation is until it is crossed. And right up until the last minute, there are always those who look for ways to add more debt, who assure us, "This time is different." But it never is. A country can restore its fiscal house to order, pay back its debt, and grow its way out of the problem over time; there are numerous examples. But continuing to grow that debt-to-GDP number is to court a disaster that looms right in front of you.

If politicians want to keep the borrow-and-spend party going "just one more election cycle" and if no one takes away the punchbowl, the Bang! moment will most certainly arrive. That is the clear lesson of history. It is almost irrelevant whether that number is 90% or 120% or 80%. It will be a different number for each country, depending on the confidence that investors have in the ability of a country to pay back its debt. Investors in sovereign debt are almost by definition the most risk-averse investors there are. You do not invest in a country's debt to increase your risk exposure; you expect to get paid. There are other factors at play in determining the critical threshold, too: What was the purpose of the debt? How fast is the economy growing?

Can Italy, beset by recession, high unemployment, and a political crisis, grow its debt-to-GDP to Japan's 240% level? I think any serious observer would say no. Can it get to 130%? 140%? Maybe. We will not know until it's too late whether Italy or any other country (Spain, Japan, France, or the US) has more debt than the market is willing to absorb. But that is a line any politician should want to avoid crossing.

To cobble together an understanding of why Italy needs to deal with austerity – and to give Aga a good answer – we first need to revisit something I wrote in my own book, Endgame. One of the most important sections of Endgame is a chapter in which I review (and compare with other research) This Time is Different and include part of an interview I did with Rogoff and Reinhart. This chapter turned into a real economic epiphany for me, because the R&R data confirms other research about how things seem to go along swimmingly, and then the end comes all at once – the Bang! moment. Let's review a few paragraphs from my book, starting with a paragraph from the interview I did:

KENNETH ROGOFF: It's external debt that you owe to foreigners that is particularly an issue. Where the private debt so often, especially for emerging markets, but it could well happen in Europe today, where a lot of the private debt ends up getting assumed by the government, and you say, but the government doesn't guarantee private debts, well no they don't. We didn't guarantee all the financial debt either before it happened, yet we do see that. I remember when I was first working on the 1980' Latin Debt Crisis and piecing together the data there on what was happening to public debt and what was happening to private debt, and I said, gosh the private debt is just shrinking and shrinking, isn't that interesting. Then I found out that it was being "guaranteed" by the public sector, who were in fact assuming the debts to make it easier to default on.

Now back to the book [quoting Rogoff and Reinhart]:

If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.

Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short-term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget.

And the following is key. Read it twice (at least!):

Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.

Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained – or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.

How confident was the world in October of 2006? John was writing that there would be a recession, a subprime crisis, and a credit crisis in our future. He was on Larry Kudlow's show with Nouriel Roubini, and Larry and John Rutledge were giving him a hard time about his so-called "doom and gloom." "If there is going to be a recession you should get out of the stock market," was John's call. He was a tad early, as the market proceeded to go up another 20% over the next 8 months. And then the crash came.

But that's the point. There is no way to determine when the crisis comes.

As Reinhart and Rogoff wrote:

Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.

Bang! is the right word. It is the nature of human beings to assume that the current trend will work itself out, that things can't really be that bad. The trend is your friend … until it ends. Look at the bond markets only a year and then just a few months before World War I. There was no sign of an impending war. Everyone "knew" that cooler heads would prevail.

We can look back now and see where we have made mistakes in the current crisis. We actually believed that this time was different, that we had better financial instruments, smarter regulators, and were so, well, modern. Times were different. We knew how to deal with leverage. Borrowing against your home was a good thing. Housing values would always go up. Etc.

Until they didn't, and then it was too late. What were we thinking? Of course, we were thinking in accordance with our oh-so-human natures. It is all so predictable, except for the exact moment when the crisis hits. (And during the run-up we get all those wonderful quotes from market actors, which then come back to haunt them.)

The Purpose of Debt

Countries and governments, small and large, can go into debt for numerous reasons. As noted above, Keynes advocated going into debt during business contractions. But there are different types of debt.

There is debt that is used to build productive assets such as roads, airports, bridges, schools, and civic centers.

Then there is debt that is used for current consumption. When debt creates assets, future generations at least get some benefit when they have to participate in paying the loan back. In the case of current consumption, they get none. In essence, debt applied to consumption is spending today rather than spending in the future. You are borrowing money to spend on goods and services in the "now," with the promise to pay for that consumption later.

Next week, if all goes right, I am going to borrow money to buy two apartments in a high-rise in Dallas that will become, after we do a little remodeling, my future home. I will get an asset that I hope to pay off in about ten years. If I am lucky, that asset will then be worth more than I paid for it.

That is different from borrowing money to go on a vacation or to buy food or other goods that will have no future value.

Austerity Is a Consequence, Not a Punishment

But borrowing against the futureis what Italy has essentially done, Aga. Just like other countries all over the world, Italy borrowed for consumption and ran up a rather large debt. And then the crisis came, and lenders were not as willing to provide Italy money at low rates. That is the nature of investors who buy government bonds: if they perceive higher risk, they want higher rates.

The crisis arrived, and Italy lost cheap access to the bond market. The ECB had to step in and begin to buy bonds to lower their rates. But Italy had to promise to lower its deficits, and the way to do that is called austerity.

Italy is in a currency union called the Eurozone. A currency union cannot allow its members to run up debts beyond what the market is willing to finance, or the whole currency union will collapse. The central bank (in this case the ECB) can only print so much money before inflation and valuation becomes an issue. If the ECB allows Italy to run whatever debt it wants to, then it must allow everyone else the same privilege.

Eurozone officials may elect to help a smaller state like Greece paper over some of its problems, but at the end of the day countries must be able to handle their own debts you are going to keep your currency union up and running.

Italy must deal with austerity because if they don't they will lose access to the bond market. They ran up a huge debt and now must figure out how to pay it back. They borrowed money to spend, on the pledge that future generations would pay for it. Unfortunately, the future is now.

Yes, Germany and other countries could lend the Italians money, but they have their own problems. Egan Jones, the only truly independent rating agency, downgraded Germany this week. The Dutch too are having "issues," as my kids would say. Europe in general seems to be slipping into recession.

Some would argue that the ECB should just fire up the presses and print money, as Japan is going to do. Outright monetization. But that approach is highly problematic. Why should Finland want to see that happen if they are not also running large deficits? What about countries with lower debt ratios? The documents everyone signed when they joined the euro dictated that each country would be responsible for its own debt and that the ECB would not monetize debt.

It is one thing for a country to fall on hard times and for its fellow currency-union members to agree to help, but it is another thing to make that help open-ended. Italy has come a long way toward getting back to a sustainable fiscal situation in the last few years. I know it has been hard. I have always maintained that Italy has its own fate in its own hands. Aga, if you just cut the number of cars and drivers you provide to every small-time politician, you could eliminate about 20% of your deficit. Everyone in Italy knows there is a lot of waste and corruption. That is why a comedian like Grillo can get almost 25% of the vote!

The neo-Keynesians are right about this. In the short term, austerity will result in less growth. All but the mathematically challenged will agree with that. The scholarly literature seems to suggest that the short term is about 4-5 quarters, but that estimate is based on averages for a number of countries. Whether the actual interval is longer or shorter, it means that austerity will not produce growth in the short term. And if you have to cut 1-2% a year for several years, then that means little or no growth for those years. But the reason you have to do it is that you did not reduce your debt during the good times.

Austerity is a consequence, not a punishment. A country loses access to cheap borrowed money as a consequence of running up too much debt and losing the confidence of lenders that the debt can be repaid. Lenders don't sit around in clubs and discuss how to "punish" a country by requiring austerity; they simply decide not to lend. Austerity is a result of a country's trying to entice lenders into believing that the country will change and make an effort to restore confidence.

If Italy or any other country does not inspire confidence, then it must suffer the consequences when it loses access to the credit markets. Sure, the ECB or the IMF could lend you money, but their members are essentially investors as well. If there was unlimited money available, I can think of a country or two that might choose to run 10% and then 20% deficits. Why choose to tax when you can borrow and not repay? That is what politicians would all love to be able to promise.

Argentina has pursued such a policy for almost a century. After multiple devaluations, their currency is now a fraction of one billionth of a cent of what it was 100 years ago. It is rather hard to operate as an investor or businessperson in such an environment. One of the reasons why Italians wanted to get into the euro, Aga, was to take away from your politicians the opportunity to run up large debts and then devalue. The lira was a byword for fleeting value, not a currency for long-term investment.

You avoid austerity by not borrowing and consuming in the first place. After the market loses confidence, your choices are rather stark. If you default, then you are clearly out of the market for some time and suffer a very quick and deep recession as the government loses its ability to pay the salaries of government workers, provide healthcare, etc. If you elect to try to keep borrowing, you will have to implement a change in policy that will restore confidence – or find someone who will lend you money on better terms. Bluntly speaking, Germany and the EU might do that for Italy for a while but not unless they see the country actually controlling its deficit.

The problem Italy now faces is that any government that is elected will have to make hard choices. Trying to reverse the austerity already agreed to will almost certainly result in loss of access to the bond market. Is it possible to develop a plan to cut spending at a slower pace? Sure, if you can get the rest of the EU to agree, at the same time that Spain, Portugal, Greece (and soon France) all want the same policies.

If Italy were in control of its currency, might it make sense to print a little in the meantime, as the US, Great Britain, and Japan are doing? There is certainly a school of thought that says yes. But in a currency union of multiple countries that are all at different places on the economic journey, it is almost impossible to have a one-size-fits-all monetary policy. If the spigot is opened for Spain, Italy, et al., then Germany and others get inflation. That is a tough sell to German and Finnish voters (among others).

You cannot force the rest of Europe to fund your deficits. You can negotiate with them to try to lessen the severity of the crisis, but there is no pain-free path ahead from where Italy is today, Aga. Your debt to GDP is 126% and rising. Without ECB support, you would have already lost access to the bond market. If you want to stay in the euro, you just have to deal with it.

By the way, leaving the euro would be a VERY expensive option. The "new lira" would drop in value like a stone in Lake Como (Italy's deepest lake, for those not familiar with it, and one of the most beautiful lakes in the world). The cost of borrowing would skyrocket. The banks would be bankrupt overnight, requiring massive infusions of new currency that would further drive the lira down. You are frustrated with politicians now, Aga? What would it be like in the chaos of a depression? No one can manage well in such an environment. There would be no good choices, only a choice among disasters.

Tiny Cyprus might choose in the next few weeks to exit the euro. With bank accounts frozen and the economy shutting down, they might feel they have no choice. Pay close attention to what happens; it will not be pretty. (As an aside, I am seriously tempted to go to Cyprus in late June, just to see the country firsthand. I will be in Europe between speaking gigs and have not yet decided where to go.)

Italy must first of all choose a government. Cleaning up its political corruption and wasteful spending would be a good move, but even clean new politicians (if there is such a thing) will be faced with the same economic choices. Which, I should note, is roughly the same choice voters everywhere are faced with.

The US is also approaching an uncomfortably high debt level. It was less than ten years ago that I was writing about what the US investment market would look like with no government debt. Yes, that possibility now seems a distant memory, but we were paying down the US debt that fast. And then came the Iraq war and larger deficits and a Republican Congress that got drunk on spending increases. Cheney told them that deficits don't matter, and they took it to heart. They doubled down on debt.

If the US had entered the 2008 crisis with little or no debt, we could have spent that $1 trillion a year (or even several trillion and made Krugman and McCulley ecstatic), and no one would have really cared, from a total debt perspective. (We would have cared what the money was spent on). But we didn't. We squandered our surplus with new programs and spending. We borrowed and consumed. We wasted the good times by running up even more debt. And now we are close to paying a price.

So, Aga, I don't have any easy words for you, but I do think Italy will pull through. I will visit your country again and again in the future, because I love Tuscany. But if you can take comfort in the company of others in similar situations, then there are a host of countries in the developed world that are going to have to face austerity in one form or another. That is just what happens when you reach the end of the Debt Supercycle. You are no longer left with merely difficult choices; they are more like very tough, bad, and disastrous. The worst choice is not dealing with the problems as soon as possible. I only hope my own country can make the difficult choices soon, before we too are faced with a crisis.

San Francisco, Carlsbad, Tulsa, Nashville, and Brussels

I finish this letter in the Singapore airport before I begin the rather long journey back to San Francisco, where I will rest and recover from jet lag at the Fairmont, one of my favorite hotels over the years. I speak in SF Monday morning before heading back to Dallas and my "home hotel" for a week. As noted above, I am buying a property as my primary residence and had to move out of my leased home early, so I'm between places. As I have promised, when the deal for the new place gets done, I will write about my experience – the terms and negotiations and why I decided to buy now after all these years.

This is a bit of a first for me, as I fly to Hong Kong to catch a plane to San Francisco. I will leave very early Friday morning and arrive late on Thursday night, crossing the international date line and arriving the "day before" I left, getting back the day I lost coming here.

My Strategic Investment Conference is almost here. I am so looking forward to catching up with old friends. And I'm just as excited about the exchange of views we will have on how to navigate the coming economic transitions. It seems everyone is on the "short Japan" side of the boat, including me. Is the boat listing, or is there still room for others? The debate on whether there is a bubble in the US bond market will be intense. Europe will be a hot topic. China, too. Will the US see 3% growth this year or fall further behind?

And underlying our discussions will be an intense debate about the future of world growth and stability. I have purposely sought out thought leaders who steer independent courses. Kyle Bass, Niall Ferguson, Nouriel Roubini, Drs. Lacy Hunt and Gary Shilling, David Rosenberg, Charles and Louis Gave, Anatole Kaletsky, and Paul McCulley will all be there, among others. You can see the entire line-up for the May 1-3 conference (co-sponsored with Altegris Investments) right here, plus see highlights from last year's conference. There are still a few spots left, so I encourage you to register and join me and my friends as we think about our future. I think this is clearly the best investment conference of its kind this year, and I, along with Jon Sundt and his team at Altegris, am proud to be able to offer it to you.

I continue to be impressed with Singapore. This city/country just works. I was able to take a few hours and tour their magnificent Garden Domes. The entire place is a marvel of human engineering and vision. I want to return for an extended visit and explore the amazing variety of plants and trees they have assembled from the world's cloud forests. They built an indoor, 115-foot-high waterfall system and replicated a cloud forest that you can walk through.

Every time I come here there are new towering buildings and projects to reclaim land from the ocean. A sustainable future is a constant theme. Low taxes and a climate that is ideal for business have made this nation a center for commerce. Issues here and there? Sure, this is a human enterprise, and we come with built-in issues, but the problems are positive ones.

They are calling my flight, so it is time to hit the send button. Charley & Lisa Sweet, my long-suffering editors, will have extra work cleaning up this week's letter, but I don't think the plane will wait for me to go through it one more time.

Have a great week, and come see me in Carlsbad.

Your ready to read on the way home analyst,

John Mauldin

subscribers@mauldineconomics.com

Are Earnings Expectations Realistic?

John Mauldin — Thu, 18 Apr 2013 22:20:00 GMT

Outside the Box: Are Earnings Expectations Realistic?

In today’s Outside the Box, Sheraz Mian, Director of Research for Zacks Investment Research, gives us a thorough overview of corporate earnings trends for the past several quarters, along with consensus expectations for this year and next. Then he asks, “How realistic are these expectations?”

Not very, he says, and proceeds to tell us why. If we accept his analysis – and he admits right up front that it runs counter to the consensus – then we should be asking ourselves, how does a potential falloff in earnings vs. expectations matter, and why is it important at this particular juncture? I’ll let Sheraz answer those questions, too – he does so convincingly – but I’ll just add that his analysis is a significant piece in the puzzle we’re all putting together here in this tipping-point year of 2013.

Depending on what the politicians and bureaucrats do, or fail to do, in the US, Europe, and China (not to mention Japan), we could turn one of two corners this year: The left-hand turn – toward ever more QE, ballooning fiscal deficits, and an accelerating global currency war – would take us further up Inflation Hill, whose back side is a sheer cliff. The right-hand turn – toward deepening austerity and unemployment – spirals us down into the Morass of Negative Growth. It is only by forging straight ahead along the Main Street of innovative business and technological development, supported by balanced fiscal and financial policies and realistic market expectations (based on valid data and assumptions – something I have been driving at in my last couple Thoughts from the Frontline letters), that we will get through this challenging decade intact. But that is a difficult path to find between the siren calls of austerity and more printing.

Zacks Investment Research was founded in 1978 by Len Zacks, PhD. Many innovations have come from this firm over the years, including the creation of the Earnings Consensus that many investors now use to compare earnings estimates with actual earnings reports. Most notably, Len discovered the predictive power of earnings estimate revisions. He harnessed these benefits into the proprietary Zacks Rank stock rating system that has allowed Zacks Rank to compile an outstanding track record.

Zacks is offering OTB readers, at a very low rate, a one-month trial of all their products. You can learn more here.

As I write this, I find myself in Singapore, where it is early Wednesday morning, so I have lost a day – but I’ll get it back next Friday. I will meet Grant Williams in a few hours, and we will take a train to Malaysia for lunch and discuss the markets and business. Then it’s back to Singapore for a little work before enjoying the evening, when Simon Hunt and Steve Diggle will join us for dinner. The next day is meetings with event sponsors Saxo Bank and The Business Times, and then it is Writing Night – a day too early, but deadlines are deadlines, no matter which side of the international date line you are on.

Saturday night was rather amazing. I am used to more subdued fundraising events, but Dr. Mike Roizen is one of the senior guys in the Cleveland Clinic, and the Lou Ruvo Center for Brain Health in Vegas is part of the Cleveland Clinic system and is setting all sorts of records. If I or someone I knew had Alzheimer’s, I would check it out.

I guess if you are Michael Caine and Quincy Jones you can gather a lot of stars (it was their 80^th birthday). I was told they raised the second most ever for an event like this. The proceeds go toward research into Alzheimer’s and brain injuries/trauma. OK, so Bono walks out on stage unannounced and nails Frank Sinatra. Who knew Bono could do Sinatra? (The hook was, Q produced Sinatra). We were treated to Steve Wonder, Patti Austin, and Shaka Kahn – all of whom still have their chops and look great – Carlos Santana, and on and on. It was good to see people my age (ahem) still going strong on stage. You can watch the whole thing on various cable channels and donate a few dimes with your cell.

It really is time to hit the send button. Have a great week. And yes, I know gold went down. That just means I get more coins when I buy at the end of the month – if it will stay down.

Your needing to find a gym analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Are Earnings Expectations Realistic?

By Sheraz Mian, Director of Research, Zacks Investment Research

We all know that markets don’t always reflect the health of the economy. It is not unusual to experience stellar market returns in an otherwise mediocre economic backdrop – something that investors are currently experiencing. But future success in this investing climate is a greater challenge and requires a good hard look at how realistic earnings expectations are.

On March 28, the S&P 500 hit a new all-time closing high and is now on the cusp of surpassing the intraday high set in March 2000. The Dow Jones Industrial Average and a number of market indices comprising small- and mid-cap stocks are already at record levels – all in the midst of a struggling economy.

The first-quarter 2013 reporting season about to get into high gear will be the second earnings cycle of the current market rally. The rally got underway last November, but the first two months this year overlapped with the fourth-quarter 2012 earnings season. With corporate earnings generally considered to be the mother’s milk of stock prices, the market’s positive year-to-date momentum could be safely interpreted as investor satisfaction, if not happiness, with the earnings picture.

Past performance matters to the market, but it is far more concerned with what will happen in the future. After all, stock prices reflect expectations about the future. You can think of these future expectations built into the current stock prices as the collective wisdom of all investors. “Consensus” estimates of all the key variables that investors care about – like earnings, revenues, the economy, the Fed, etc. – reflect this “collective wisdom.”

So, where do current market expectations stand?

Earnings growth has been essentially flat over the last three quarters, a trend that current consensus expectations project into the first half of 2013. But the market’s “collective wisdom,” as reflected by consensus estimates, expects growth to come roaring back in the second half of the year and continue into 2014.

My experience leads me to disagree with the consensus. I don’t see a return to booming growth panning out this way, and would like to share the basis of my skepticism with you.

I am by no means suggesting that an earnings train wreck is on the horizon. Nor am I making a call to exit the market altogether. What I am suggesting instead is that current earnings expectations are vulnerable to significant downward revisions. An acceleration in that negative revisions process will most likely result in the market giving back some, if not all, of its recent gains.

You don’t have to agree with my conclusions, wholly or partly. In fact, many of my colleagues and I don’t see eye to eye on this issue. But nevertheless, it would pay to be a little skeptical of current earnings expectations being touted in the media, and maybe take another look at your portfolio to perhaps reposition it for a period of potential market weakness.

The discussion is particularly timely with the 2013 Q1 earnings season about to get underway. Expectations remain low, as they were ahead of the 2012 Q4 earnings season. The Q4 earnings season turned out to be better relative to preseason expectations, and we will likely see a repeat performance in the Q1 earnings season. But that shouldn’t lead to overly optimistic expectations for the coming quarters.

My goal in this write-up is to give you an update on how the Q4 earnings season turned out, and what recent estimate revisions trends tell us about the future of earnings growth.

Evaluating the Q4 Earnings Season

By most conventional measures, the Q4 earnings season turned out to be average. Not particularly good, but not bad either.

Total earnings for companies in the S&P 500 were up +2% year over, and 65.6% of companies beat earnings expectations with a median surprise of +3%. Total revenues were up +2.6%, with 62% of companies beating top-line expectations and median revenue surprising by +0.6%. Excluding the Finance sector, earnings were barely in the positive category.

The table below provides a summary picture of the actual results for 2012 Q4 and consensus expectations for 2013 Q1. Please be mindful of two factors as you read the table below and other earnings data here.

First, we have divided the S&P 500 into 16 sectors, compared to the Standard & Poor’s official 10 sectors. This gives us a more granular view of sectors like retail, construction, autos, transportation, aerospace, and business services. Second, the earnings data here accounts for employee stock options as a legitimate expense, rather than excluding them, as is the practice on Wall Street. As a result, the earnings numbers and growth rates are relatively lower.

Source: Zacks Data. Finance-sector revenue in the fourth quarter got a one-off boost from gains at Prudential Financial (Ticker: PRU). Excluding the Prudential revenue, total Finance-sector and S&P 500 revenue growth would be +11.9% and +2.6%, respectively. The margins column represents the net margins (total net income/total sales).

Despite Q4's average results, the stock market’s strong year-to-date performance shows that investors are overall quite happy with them. But why would this be? Simply, the reason is the extremely low levels to which expectations had fallen as the reporting season was getting underway in early January.

As you can see in the chart above, consensus expectations in early January were significantly below where they stood in early October. This tells us that the market’s favorable response to the Q4 earnings performance was largely a function of how low expectations had fallen between October and January.

But how does the Q4 earnings performance compare to other quarters?

The growth rates for earnings and revenues were better than in Q3, but significantly lower compared to the average for the preceding four quarters.

Note: The average is of the four quarters preceding 2012 Q4.

The “beat ratio,” the percentage of total companies coming out with positive surprises, reflects the same trend, particularly on the earnings side. There is an unusually high proportion of beats on the revenue side, but that’s likely a “payback” for the very low beat ratio in the third quarter. Expectations had come down to an exaggeratedly low level following the Q3 underperformance, which set us up for the unusually high level of positive revenue surprises.

Evaluating Expectations for the Coming Quarters

Earnings estimates from analysts are heavily influenced by guidance from management teams, particularly on the earnings calls. And while the tone of guidance in Q4 was somewhat less negative relative to what we heard from management teams in Q3, it was nevertheless predominantly weak and tentative. This prompted analysts to cut their estimates for the coming quarters, and particularly Q1.

The first table below provides the expected earnings growth rates for the coming quarters, while the second table looks at this year and next.

Note: The growth rates are year over year

To provide a context for the consensus growth expectations for the coming quarters, the next two tables show the absolute dollar levels of total quarterly and annual earnings (as against the YoY growth rates shown above).

Note: The quarterly data is for actual total earnings in the last four quarters and the consensus earnings expectations for the coming four quarters. The annual data shows the actual earnings for the five years through 2012 and the next two years. For example, companies in the S&P 500 earned $238.2 billion in the last quarter of 2012 and $965 billion for the full year 2012. Consensus expectations are for total earnings to come in at $242.3 billion in 2013 Q1 and $1.03 trillion in full-year 2013.

What we see from looking at the last few quarters is that total quarterly earnings have yet to get back to the 2012 Q1 peak of $248 billion. Total earnings have basically been trending down over the last three quarters, but consensus expectations are looking for earnings to start trending back up from 2013 Q1 onwards, with the growth pace materially picking up from Q2 onwards.

Another way to look at this data is by comparing the consensus expectations for the first half of 2013 with the actual results for the same period in 2012. Expectations are for flat earnings growth in the first half of the year, but a ramp-up in the back half of the year to a growth pace of +9.5%. This growth momentum is expected to carry into 2014, giving us earnings growth of +11.7% that year, after the +6.8% gain in 2013 and the +3.8% growth in 2012.

In absolute dollar terms, consensus expectations are for companies in the S&P 500 to earn $1.03 trillion (yes that is a trillion) in 2013 and $1.15 trillion in 2014. In terms of earnings per share, this approximates to $109.88 per “share” of the S&P 500 index in 2013 and $122.72 in 2014.

How Realistic Are These Expectations?

In my professional opinion, they are not realistic. I don’t think these expectations will pan out, and here is why.

Earnings increase through two ways: revenue growth and/or margin expansion (margins are basically earnings as a percentage of sales). The outlook on both fronts is problematic.

Margins have peaked already and at best can be expected to stabilize around current levels. And you can’t have significant revenue growth in the current growth-constrained environment.

Another avenue for growth, particularly at the individual company level, is through mergers and acquisitions. While many M&A deals don’t end up creating value for the acquiring company’s shareholders and don’t generate growth at the aggregate level, they do produce growth at the company level. The historical track record of corporate deal making, in terms of aggregate growth and returns, is spotty at best. But management teams are ever ready for a deal, particularly when elevated equity markets provide them with an easy-to-use currency and the credit markets are willing to fund anything, as is the case at present.

The expected strong earnings growth in the second half of 2013 and next year reflect a combination of revenue growth and margin gains. Revenue growth has a very strong correlation with (nominal or non-inflation-adjusted) global GDP growth. But economic growth has been very anemic lately, with the rich world’s slow-motion deleveraging process casting a dark shadow over the faster-growing emerging world.

The US economy is actually in better shape relative to the recession in Europe and Japan’s nascent efforts to inflate away its problems. But that’s only in relative terms – the reality is that the US economy is at best on a sub-2% growth trajectory. Even that growth pace may be at risk from unfolding fiscal austerity efforts such as the budget sequester and Fiscal Cliff-related tax hikes.

But consensus expectations are looking for a second-half 2013 GDP growth ramp-up that pushes the growth pace close to +3%, and even higher next year. With the US economy barely producing any growth in 2012 Q4, it is hard to envision the growth outlook improving to that extent. But current revenue-growth expectations reflect these optimistic assumptions.

As the chart below shows, margin gains play a big part in projected earnings growth in the coming quarters.

Note: These are net income margins, meaning total net income for the S&P 500 as a percentage of total sales. The data for the last four quarters and last seven years represents what companies actually reported. Net margins for the next four quarters and two years represent current consensus expectations.

Margins have already travelled quite some distance from the 2009 bottom and are essentially in line with the prior cyclical peak. One could argue that margins should move past the prior peak like the stock market; but before we buy into that argument, let’s not forget what gave us the 2006/2007 peak in the first place. Without even getting into the details of how the housing bubble back then pumped up everything, one could say with a lot of confidence that those were unusual times and cannot be expected to repeat. Total earnings, on the other hand, are already above the 2007 peak.

Margins follow a cyclical pattern. They expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. At that stage, margins start to contract again. Given the extent of unemployment and under-employment in the US economy, one could reasonably say that we haven’t reached those levels. That said, it is hard to envisage companies doing more with less forever.

So What Gives?

Not only are margins already at record levels, but corporate earnings as a share of GDP are also at multi-decade highs. Just as trees don’t grow to the skies, margins and the ratio of earnings to GDP don’t expand forever, either.

What all of this boils down to is that current earnings estimates are too high and they need to come down – and come down quite a bit. One could reasonably draw a scenario where earnings growth turns negative this year. But the most likely path appears to be for earnings growth to flatten out – with the absolute level earnings this year and next not much different from what we got in 2012.

Granted, negative earnings revisions would not be a new phenomenon, as estimates have been coming down for more than a year now. But the market has essentially shrugged off this weakening picture in the hope of an improving earnings outlook for the coming quarters. Importantly, investors have been heartened by the improving outlook for China, a less worrisome European picture, and resolution of some of the domestic macro issues.

But the level of calm in the market is bordering on complacence. After all, Europe remains in a recession; and recent Chinese data about PMI, industrial production, retail sales, and inflation show that we can’t take a rebound in that country for granted. Importantly, recent talk of changes to the Fed’s QE program from within the FOMC are offsetting its effectiveness, Bernanke’s assurances notwithstanding.

With global tailwinds dissipating, the earnings outlook question becomes far more significant for the market. Unless the domestic and international growth backdrop materially improves from current levels, it is hard to imagine current earnings growth expectations holding up. And as investors wake up to the significantly weaker corporate earnings backdrop over the coming months, it will become harder to justify the market’s recent gains, potentially leading to a broad-based pullback.

Investing in a Low Earnings Growth Environment

The bottom line is that actual earnings growth will be substantially lower than what is currently built into stock prices. This view is contrary to current consensus expectations and could potentially serve as a major headwind for the market once investors begin to share it in coming months.

The way to invest in such an environment is to look for stocks that don’t reflect aggressive growth expectations and that enjoy company-specific growth drivers not tied to broader macro trends. Companies that generate plenty of cash flows beyond their immediate capital needs and have track records of sharing excess cash with shareholders through dividends and buybacks are particularly well suited for a period of sub-par earnings growth.

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Assume a Perfect World

John Mauldin — Sat, 13 Apr 2013 18:32:00 GMT

Assume a Perfect World
Objects in the Rear-View Mirror Are Larger
An Imaginary Recession
Peace in Our Time?
Government Spending Per Household Exceeds Median Household Income
What Do You Want It to Be?
Las Vegas, Singapore, San Francisco, and Carlsbad

An engineer, a chemist, and an economist are stranded on a deserted island. They are starving, when miraculously they find a box filled with canned food. What to do? They consider the problem, bringing their collective lifetimes of study and discipline to the task.

Being the practical, straightforward sort, the engineer suggests that they simply find a rock and hit the cans until they break open. “No, no!” cry the chemist and economist, “we would spill too much food and the birds would get it!”

After a bit of thought, the chemist recommends that they start a fire and heat the cans. The pressure in the cans will force them open and the food will conveniently already be heated. But the engineer and economist object, pointing out correctly that the cans would likely explode and splatter the food all over the beach.

The economist, after carefully studying the cans and reading the labels, starts scrawling a series of equations in the sand, which eventually cover the entire beach. After much pondering, he excitedly announces, “I’ve got it! I’ve got it!” as he points to the final equation. They ask him to explain, with their visions of finally getting a meal causing them to regard the economist with a new sense of respect.

The economist clears his throat and begins, “First, assume a can opener …”

I am not sure how old that joke is, but it dates to about the time when economists discovered mathematics and models, which is to say, about the time when economists developed physics envy and decided they would like to be regarded as scientists rather than philosophers. This week we continue to look at the data and models developed by economists, with a view to understanding both their usefulness and their limitations. The specific data we will examine this week is inspired by the release of the President’s FY 2014 US budget proposal this week. While it and the House and Senate budget proposals may appear to be widely divergent, there are some underlying and quite disturbing similarities among them.

Specifically, all three proposals assume away the real world. It does not matter which version you prefer; they all lack the basic precautions and hedges that those of us involved with preparing family and business budgets make sure to include in our own forecasts. While whole books could be written about the underlying assumptions in these latest budget proposals, we will examine (hopefully briefly) just a few of the more glaringly problematic ones.

Assume a Perfect World

Like our castaways with their abundance of canned food but no can opener, a US budget forecaster is faced with the problem of predicting the fiscal future of a very large, very real economic system, but without a crystal ball. And as we saw last week, economists are not particularly good at telling us what happened in the year that just passed, let alone in the year to come. (And we often see national budgets that presume to extend out for ten years or more.)

The basic challenge is pretty simple. There is a need to forecast revenues and expenses. Expenses are the more straightforward of the two. Most government expenses are line items in a budget. “We project we will spend $5 billion a year fixing roads and bridges, $1 billion on our national parks, $925 billion on defense, etc.” Social Security, too, is straightforward. Healthcare involves a lot of guestimates, and unemployment costs go up and down with the economy.

Revenues are a bit trickier. Income tax revenues obviously go up and down with incomes, as do corporate taxes and Social Security and Medicare taxes. If there is a recession, revenues will fall. If you get an economic boom, then revenues could turn out better than projected. I think I remember some economists predicting in the mid-’90s that the rest of the decade would be flat or trend down – we had a boom. In the middle of the last decade I predicted a Muddle Through Economy, which to me meant 2% GDP growth, down from the average of 3% we had experienced for decades. Two percent turns out to have been slightly optimistic, although I remember more than a few people telling me I was just too bearish. I would be very happy if we could manage 2% average growth for the current decade. As I wrote a few months ago (here and here), there are several respected forecasters, including Jeremy Grantham and Robert Gordon, who think 1% (or less!) is more likely.

Last year we were at a real inflation-adjusted growth rate of 1.7%. Nominal growth of 3.5% for 2012 was the lowest since the end of WWII. So what do our intrepid budget forecasters predict for the next ten years? Not content to project that current trends will persist, they have whipped on their rose-colored glasses to deliver us bright promises of spectacular growth.

David Malpass writes Thursday in the Wall Street Journal that Obama’s 2013 budget projections make a prediction of 3.6% growth by 2016, with tax revenues up by 50%. But Obama may seem to be conservative if we look at the projections of the Congressional Budget Office.

The next chart is from work done by Veronique de Rugy. It shows that the CBO projects that growth in 2013 will slow to 1.4% and then TRIPLE to 4.2% over the next three years! In the years 2015-2017 they project the US to grow 4% annually on average. And that is real growth they’re foreseeing, not nominal growth.

I read that and went straight to the latest CBO report to check. But there on page 40 and following were the actual numbers.

The next chart is from page 41 of that 77-page report, which contains extensive details as to how they arrive at their various expense and revenue projections. I should note that they are consistent in that they do not project low interest rates during their predicted economic boom of the next several years. The Obama administration, on the other hand, assumes in their budget proposal that interest rates will be only 1.2% in 2106, to accompany their 3.6% growth (and inflation of only 2.2%). Now THAT would be a very accommodative Federal Reserve.

Either way, interest costs are projected to rise dramatically as the decade progresses, more than doubling in real terms. In nominal terms, interest-rate costs are expected to increase almost FOURFOLD, from a current $224 billion to a projected $857 billion! That means interest-rate costs are projected to grow to roughly 16% of the federal budget within this decade (back-of-the-napkin estimate).

The increase in debt (in dollar terms), along with an anticipated substantial rise in interest rates as the economy strengthens, is expected to sharply boost interest payments on the debt. CBO projects that, under current law, the government’s yearly net interest spending will double as a share of GDP—from 1.5 percent in 2014 to 3.3 percent in 2023, a percentage that has been exceeded only once in the past 50 years. (CBO)

I should note that both the CBO’s and the Obama administration’s assumptions are much more optimistic than those of Federal Reserve economists (to the extent that they make projections). And the track record of the Fed is that, on average, they have projected 2.1% more GDP growth than actually occurred, just one year out.

Philippa Dunne & Doug Henwood of The Liscio Report supplied that surprising figure, and continued in their piece this week:

What does this mean for the future? Since the timing of the withdrawal of ease is highly dependent on these major economic indicators, we should take the Fed’s forecasts of their future course skeptically. Given the demonstrated difficulties they have forecasting a year or less ahead, forecasts two years or more in the future seem especially questionable. (Corroborating a remark from a CBO official we relayed back in 2007 that forecasting out even 2 years is a waste of time.) Since so many forecasts tend to be extrapolations of the present and recent past, the timing of QE withdrawal is likely to be more dependent on the real-time trajectory of major economic indicators than on imagined futures.

Even though at least one CBO economist thought it was a waste of time to make even two-year projections, they do attempt a ten-year projection. How optimistic are they? Well, let’s go the FRED database at the St. Louis Fed (a marvelous tool and one of the more important free sources I use).

This is the percentage change in GDP year over year since 1940. Note that we have to go back to the 1960s to find a period where GDP grew by 4% for three years running. In fact, we have to go to 1969 to find even one year when it was 4%!

Objects in the Rear-View Mirror Are Larger …

Optimistic GDP projections mean that whatever revenue projections accompany them are also likely to be overly optimistic. Given the federal government’s lack of control over expenses, and its track record in forecasting expenses, it is likely that expenses will be underestimated, making actual deficits larger than they expect. One example: we have already seen Obamacare costs rise by over 40% from the projections just two years ago.

(That 40% does not even take into account what your private insurance costs have already risen and are going to continue to rise. Obamacare is going to be a giant economic debacle. That is not meant as an argument for or against universal coverage or coverage of pre-existing conditions. It is just noting that the economics of the way we are going about achieving our healthcare goals are turning our national program into a daunting fiscal disaster.)

An Imaginary Recession

Go back and look at the chart just above. Notice the shaded gray areas. Those are recessions. Now notice that there is not one decade without a recession, and most have two. Obama, the Senate, and the House all assume that we have vanquished the recession virus and will not experience that economic malady again in our near future.

Can I get any of my readers to make a wager with me that the US will somehow get through the rest of this decade without a recession? Buehler? Anyone? I thought not.

But that is exactly the wager that Congress and Obama are making with your tax dollars. Their budgets show expenses rising for the next ten years. And if we get a recession they will want to run even larger deficits. Their argument will be that we can’t possibly cut the fiscal deficit during a recession – that would make things even worse! Austerity doesn’t work; we all know that.

What happens if we do get a recession? Revenues go down, of course. Unemployment goes up, as do associated costs like unemployment checks.

Note the graph below. CBO forecasters assume that GDP will recover back to its former trend line, instead of simply growing from a lower base; and that is where they get their obscenely rosy back-to-back-to-back 4% increases.

What happens if we land in a recession instead? Not only do we not get back to that trend, we drift farther from it! Will the CBO then project 5% GDP growth for three years running to get us back to the original trend? That would be no more absurd than what they are doing now.

The reality is that no politician or government agency can forecast a recession (unless, as in 2012, they are arguing against a sequestration that is projected to actually cut spending). None of us really know when the next recession will happen. Theoretically, we could go another 10 years without one. It is also possible that the government will reveal that there really are aliens in Area 51. I leave it to you to decide which is more likely.

While acknowledging that forecasting a recession is impossible and politically a non-starter, it would be nice if forecasters and politicians were to admit the possibility of lower-than-estimated revenues and willingly contemplate what might happen if a recession did transpire. As the US approaches a truly debilitating debt level, I want to ask them, “Will you please tell us what the plan is if we experience recession rather than expansion?”

I can hear the answer now: “I don’t want to speculate about possible recessions. That is pointless.” But my rejoinder would be, “You are perfectly willing to speculate that we will have no recession and that we will grow at a rate not seen in over 40 years, not even during the Reagan and Clinton boom years. How speculative is that?” (Where is Nixon when we need him? Or was the growth during his reign a legacy from Kennedy and Johnson? Or was it just American productivity?)

Peace in Our Time?

The defense budget is projected to fall about 13% in actual dollars from 2011 to 2014 and to fall as a percentage of GDP every year. The liberal Brookings Institution argues that Obama’s budget is unrealistic in that it cuts spending too much. (In Obama’s defense, he is not cutting entitlements very much and cuts everything else to preserve them as much as possible, which from his point of view is the correct policy choice.)

The president’s spending projections are even less realistic. Between 2013 and 2023, defense spending is projected to fall by 40 percent as a share of GDP, from 4.0 percent to 2.4 percent, while non-defense discretionary programs fall by one third, from 3.7 percent to 2.5 percent. This is barely imaginable, but highly unlikely. During the past half-century, defense spending has never gone below 3 percent of GDP, not even in the years between the fall of the Soviet Union and September 11, 2001. Non-defense spending has never gone below 3.2 percent, a level it reached near the end of the Clinton administration. (During the Reagan era, it never went below 3.5 percent.) It is hard to believe Obama’s proposals would allow us either to meet our basic security needs or to afford the level of public investments that have helped sustain economic growth throughout our national history. It’s up to senior administration officials to make the case that their numbers are realistic, and they’ll face a heavy burden of proof.

In short, even with substantial increases in revenues, the swelling pressure of entitlements and debt is leading our country to shortchange its future. Is that the course we want, or are we backing into it because we aren’t willing to challenge the assumptions that are producing it? Before we get mired in technicalities, that’s the threshold argument we should be having. (Brookings Institution)

Government Spending Per Household Exceeds Median Household Income

In fiscal 2010, according to numbers published by the Census Bureau and the Office of Management and Budget (OMB), net spending by all levels of government in the United States was $5,942,988,401,000. That equaled $50,074 for each one of the 118,682,000 households in the country.

In that same year, according to the Census Bureau, the median household income was $49,445. That means total net government spending per household ($50,074) exceeded median household income (49,445) by $629... As recently as 2000, the relationship between government spending and household income was dramatically different. Data from the Census Bureau and the OMB show that in that year net spending by all levels of government was 3,239,913,876,000. That equaled $29,941 for each of the nation’s then 108,209,000 households. In 2000, the median household income was $41,990... (A very interesting e-book called Completely Predictable)

What Do You Want It to Be?

The next oldest economist joke goes like this: A businessman interviews a mathematician, an accountant, and an economist for a job. He asks them, “What is 2 + 2 ?” The mathematician answers, “Exactly 4.” The accountant replies, “Depending on what your interest, depreciation, and taxes are, approximately 2.”

The economist walks over to the door, shuts and locks it, closes the blinds on the window, and leans over and softly asks, “What do you want it to be?”

Budget forecasts are a lot like that. A politician wants to enact a certain deficit-reduction policy. He wants to make assumptions that work to his benefit. So he calls in his friendly local economist, who obligingly responds, “You need 4% growth to make this work? No problem. Here’s the data and math to back up those assumptions.”

The CBO is supposed to be politically neutral. And it is: those 4% projections it came up with are good for both parties. If they projected a 2% real GDP growth for the next eight years, the agency would be disbanded. And gods forbid they pull a Jeremy Grantham or (Northwestern University professor) Robert Gordon and project 1%. Or a Bill Gross, at 1.5%. With those low growth expectations, the CBO’s projected budget deficits get blown sky-high, projected new expenditures seem just a tad extreme, and those tax cuts they’re talking about will be much more difficult to budget.

Government economists would like to assume a perfect world: no recessions; extraordinary, never-before-seen growth; peace, with no need to worry about nagging little military problems or defense; falling unemployment; rising tax revenues, when government spending is already taking a huge chunk out of the economy; interest rates staying under control; deficits falling over time; and on and on.

It's not easy being an economist. How would you like to go through life pretending you could predict the future and even knew what M1 was all about? It is absolutely necessary that we make forecasts as part of a responsible approach to government spending, but we need to be more skeptical of those forecasts and use some common sense in our budgets in order to allow for a rainy day here and there.

Liberal-socialist Sweden allows its pensions to rise and fall with GDP, so as to keep from blowing out their budget process. They made that hard choice in the midst of a credit crisis. Perhaps we too should make a hard choice now, in order to make sure we don’t have a major crisis of our own.

Waiting for our forecasts to be wrong before we adopt a yet another “solution” based on a temporary fix of yet another forecast that turned out to be wrong is no way to run a railroad, unless you want your train running off a cliff. I applaud the recent attempts in DC to come to a solution on the deficits and budget, but where are the leaders who want to get real with those forecasts?

Las Vegas, Singapore, San Francisco, and Carlsbad

I will be in Las Vegas as you read this, joining my doctor, Mike Roizen, at a fundraising event to benefit the Cleveland Clinic Lou Ruvo Center for Brain Health. The event will have Sir Michael Caine and Quincy Jones celebrating their 80^th birthdays together. Born in the same year, same month, same hour, and within minutes of each other, their lives have touched multiple generations. Michael Caine is one of my favorite actors. (Dirty Rotten Scoundrels? And Secondhand Lions, with Robert Duvall, is a classic.) I have never done an event like this (with so many stars performing) where I will actually be close to the action. I have no business getting on another plane to stay at another hotel this week, but when will I ever get a chance like this again?

I get back Monday to pack for my trip to Singapore. I am told the conference, sponsored by Saxo Capital Markets and The Business Times, is sold out. I will get to be with old friends Grant Williams (You know him from Things That Make You Go Hmmm… and Bull’s Eye Investor), his partner Steve Diggle, and Simon Hunt, who is a go-to source on China. I hope to get to Malaysia with Grant for a side trip, just for fun, one of the days I am there.

As a quick aside, and apropos of our theme of distinguishing the real from the fake, I did a recent video conversation with Grant that I really want to show you. Our publisher, Ed D’Agostino, was there to ask us just the right questions, and we developed some themes that turned out to be a bit surprising, even to us. You can drop in on the conversation here.

I leave Singapore Friday evening, only to stop in San Francisco to do a speech on Monday for the National Association of Surety Bond Producers annual meeting, before heading back home to rest up.

The next week I go to Carlsbad for my 10^th annual Strategic Investment Conference (ably run and co-hosted by my partners at Altegris Investments), May 1-3. We have been doing a lot of planning for this one and have worked hard to make sure there will be a lot of interaction among the speakers on the stage and with the attendees. We managed to free up a few more spots this past week, so if you haven’t registered, this may be your last chance. It WILL sell out. To see the lineup that I think will make this the best investment conference this year, go to http://www.altegris.com/sic .

I have spent time recently on the phone or face to face with most of our speakers (I was with Nouriel on Wednesday). David Rosenberg has a completely new presentation and theme for this conference. Kyle Bass and Louis Gave will offer up ways to play Japan. Interest rates? Why not hear from the guys who have been right for decades? Managers who run billions and have done so successfully, across the entire gamut of market environments. Have questions about QE in the global environment? (Forget whether QE was right or wrong: what will they do about it now?) France? Italy? England? China? We’ll cover all that and much more.

I am making progress on getting the new apartment squared away. The home owners association of the building approved the plans today, so now we turn to the bankers to get the deal actually papered. It is time-consuming but rather fun. I have never designed a place for me before, but rather just took what was there. Getting the “new media” features right is a priority for my kids, and we are all excited about that. Blending the old and the new is a talent I am trying to cultivate. I am in a hotel only a few blocks from the high-rise where I will move later this year when construction is complete (late 3^rd quarter?). I walked by it tonight while thinking about this letter. I think the energy of seeing the downtown Dallas lights will be helpful in the creative process. And I will have my writing desk and chair where I am a lot more comfortable, with a great gym a short elevator ride below.

It is late and I need to hit the send button. Harking back to our story about the economist and the can opener, I can’t just assume sleep. And I have to actually get some before I get on that plane. Have a great week.

Your wanting to move in already analyst,

John Mauldin

subscribers@mauldineconomics.com

Taking Distortion at Face Value

John Mauldin — Wed, 10 Apr 2013 05:10:20 GMT

Last Friday I was in Sonoma, California, for Mike Shedlock’s investment conference. The weather was grey and gloomy, but the conversation was animated and bright. I was fully engaged the whole day and never more than when John Hussman was speaking, commenting, or asking tough questions. John and I have talked on the phone and corresponded for years but had never met. What a consummate gentleman and scholar. We felt like we had been old friends for years and committed to finding opportunities in the future to get together and compare notes in person.

John is no stranger to long-time readers of Outside the Box, as he has probably been the source of more OTBs than any other writer. John and I share a common foe that focuses our attention: a weekly deadline that we sometimes battle long into the night. This week John shares with us some of the insights he presented in Sonoma. One quick quote that I bet will spark your interest:

On the earnings front, my concern continues to be that investors don’t seem to recognize that profit margins are more than 70% above their historical norms, nor the extent to which this surplus is the direct result of a historic (and unsustainable) deficit in the sum of government and household savings. As a result, investors seem oblivious to the likelihood of earnings disappointments, not only in coming quarters but in the next several years. We continue to expect this disappointment to amount to a contraction in earnings over the next 4 years at a rate of roughly 12% annually.

Corporate profits are nothing if not mean-reverting. There are several explanations for this phenomenon; but whatever the cause, the current off-the-charts percentage of profits to GDP is highly unlikely to become an enduring feature of the New Normal. Especially not given the recent weakness across the rest of the data spectrum.

John manages the eponymous Hussman Funds, and you can learn more and read his additional work at www.hussmanfunds.com.

I am in the air, on my way to New York City at the moment, where I will enjoy a few dinners and two days of meetings and media before returning to Dallas. Tonight, Barry Ritholtz has called a dinner summit, and I notice that Maine fishing buddies Scott Frew and Jim Bianco are on the guest list. One of the topics, I am sure, will be the unintended consequences of central bank policy. I get what Japan, Europe, and the US want to try to achieve. But what uninvited and unwelcome guests will disrupt their efforts? We are in totally uncharted waters, with no historical precedent of QE on such a massive and global scale. And our political leaders, in Europe and elsewhere, pick this moment to screw around with the trust that depositors place in their banks? Is this really any way to run a railroad, barreling full speed down the track when there has been no slow-motion testing done? No stress tests on the bridges?

Do the politicians and central bankers actually think they can fully model the ramifications of their present actions? And if so, what model are they using? I get worried that they may be using a two- or three-level, variable-input model, when there may actually be a dozen or more major interconnecting nodes. Which is all the more reason to respect Hussman’s nervousness.

But tonight I will enjoy my dinner and friends. We have to take life’s pleasures as they come to us, and I am grateful that I get more than my share of such opportunities. I have to add, though, that looking over the latest analysis of the health insurance costs for my small company and family has certainly soured my stomach. Ouch. Good thing inflation is only 2%, right? If I couldn’t trust that government-derived number, I think healthcare cost increases might worry me.

But let’s all have a great week!

Your can’t afford to get sick analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Taking Distortion at Face Value

By John P. Hussman, Ph.D.

March U.S. Non-Farm Payrolls +88,000 (payroll survey, median expectation was 175,000)

March U.S. Civilian Employment -206,000 (household survey)

March Canadian Employment -54,500 (worst print in 4 years)

March German Unemployment +13,000 (surprise increase)

Companies issuing negative earnings preannouncements for Q1 2013: 78% (h/t Josh Brown)

One of the striking features of the recent market advance has been the nearly triumphant confidence that there is zero risk of a U.S. economic recession. Back in January, I observed:

The economic data are wrestling between two likely possibilities and a third less likely one. The first of the likely ones remains that the U.S. already entered a recession in the third quarter of 2012. While I expect the full third-quarter GDP figure of 3.1% to remain positive post-revision, it’s not at all clear that fourth-quarter GDP (estimated to come in about 1.5%) will survive those eventual revisions – ditto for the marginal bounce in industrial production. The second likely possibility is that the enthusiasm about QEternity (combined with a positive jolt to personal income from special dividends to front-run the fiscal cliff) represented another successful round of “kick-the-can” to push a weak economy from the verge of recession for another few months. When we look at the broad evidence from a variety of good leading and coincident indicators, that’s actually the possibility that I am starting to lean toward. The unlikely possibility, in my view, is that the economy has started to walk on its own. (see Puppet Show)

With a few months of additional data in hand, the evidence further supports the "kick-the-can" interpretation. Specifically, enthusiasm about QEternity, coupled with a positive jolt to personal income from special dividends, can probably be credited for another successful round of “kick-the-can,” pushing a weak economy from the verge of recession for another few months, but not durably so.

My impression is that we have once again arrived back at that can. While there is no shortage of smug observers who believe that recession risk does not exist and never did, the fact is that the strongest leading indicators, as well as the most timely coincident data, have deteriorated and danced along the border between economic expansion and economic recession for more than two years. Meanwhile, repeated rounds of QE have produced little but short-lived bounces to defer a recession that historically would have followed such deterioration more quickly. The chart below offers a good picture of this process.

Notice the successively lower levels, as each round of quantitative easing has smaller and smaller effects on real economic activity (speculative activity in the financial markets aside). The question at present is whether the recent bounce will prove to be temporary as well. This expectation is certainly consistent with the series of rapid-fire misses from the Chicago Purchasing Managers Index (particularly the new orders component), the national PMI reports for both manufacturing and services, and the unexpected weakness on both payroll and household employment surveys.

For my part, I continue to expect the U.S. economy to join a global recession that is already in progress in much of the developed world (assuming a U.S. recession has not already started, which we can’t rule out, but would require knowledge of eventual data revisions to confirm). Suffice it to say that the realistic case for a sustained economic expansion here remains terribly thin.

While some observers will reflexively point to the housing market as a sign of economic recovery, it is important to recognize that the millions of homeowners with underwater mortgages (home values below the amount of mortgage debt still owed) have no ability to sell their homes even if they wish to do so, unless they can come up with the difference out of pocket. As a result, the natural flow of demand from new household formation must be satisfied from an inventory of homes for sale that is much smaller than the actual “shadow inventory” that would be available if losses did not have to be taken in order to sell those homes. So the demand for homes resulting from household formation is satisfied from limited inventory plus new home building, even though there is an ocean of distressed and unsold homes already in existence. From this perspective, it should be clear that the bounce we’ve seen in housing is not a sign of economic recovery, but is instead a sign of misallocation of capital due to what economists would generally call a “market failure.”

Taking Distortion at Face Value

On the earnings front, my concern continues to be that investors don’t seem to recognize that profit margins are more than 70% above their historical norms, nor the extent to which this surplus is the direct result of a historic (and unsustainable) deficit in the sum of government and household savings (see Two Myths and A Legend for an analysis, including more than a half-century of data on this). As a result, investors seem oblivious to the likelihood of earnings disappointments not only in coming quarters, but in the next several years. We continue to expect this disappointment to amount to a contraction in earnings over the next 4 years at a rate of roughly 12% annually.

Despite the enormous weight of both accounting identity, historical data, and simple arithmetic, we continue to encounter persistent hostility to the idea that profit margins are the mirror image of extraordinary and unsustainable deficits in the government and household sector. The actual relationship was first detailed by the economist Michal Kalecki in the mid-1900’s. James Montier of GMO gives a nice derivation. The full relationship is:

Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

As I noted over a year ago, dividends exhibit very little volatility over time, and do not exert a material amount of volatility in the above relationship over the course of the economic cycle. It also happens that particularly in U.S. data, the difference between Investment and Foreign Savings (i.e. the inverse of the current account deficit) also fluctuates relatively little, because current account “improvement” is typically associated with deterioration in gross domestic investment, as shown below in data since the 1940's.

As a result, the Kalecki equation reduces, for all practical purposes, to a statement that corporate profits move opposite to the sum of household and government saving. Again, see Two Myths and A Legend. More than a half-century of data that demonstrates the tightness of this relationship.

The upshot is very simple, the U.S. stock market presently reflects two unstable features. One is that extraordinary monetary policy – specifically quantitative easing – has created an ocean of zero-interest money that someone has to hold at each point in time, and that provokes a speculative reach for yield. The other is that extraordinary fiscal policy, coupled with household savings near record lows, have joined to elevate profit margins more than 70% above their historical norm, as the deficit of one sector has to emerge as the surplus of another. The result is that investors quite erroneously accept the distorted “earnings yield” of stocks (and the associated “forward price/earnings multiple” of the S&P 500) at face value, without any adjustment for elevated profit margins or the historical tendency for such elevations to be eliminated over the course of the business cycle.

Put simply, stocks are not cheap, but are instead strenuously overvalued. The speculative reach for yield, encouraged by the Federal Reserve, has created another bubble – which is not recognized as a bubble only because distorted profit margins create the illusion that stocks are reasonably valued. We presently estimate a prospective 10-year nominal total return for the S&P 500 of less than 3.5% annually. The likelihood of even this return being achieved smoothly, without severe intervening volatility and steep market losses, is roughly zero. This does not imply or ensure immediate market losses, but it doesn’t need to. On any horizon of less than about 6-7 years, we expect that any intervening returns achieved by the S&P 500 will be wiped out, and then some. Speculate if you believe that your exit strategy will dominate that of millions of other speculators, despite market conditions that are already overvalued, overbought, overbullish. In my view, all of this will end badly.

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Cyprus Has Finally Killed Myth That EMU Is Benign

John Mauldin — Sat, 30 Mar 2013 04:03:00 GMT

This piece from Ambrose Evans-Pritchard is about as hard-hitting an analysis of Cyprus as I have read and really makes an interesting introduction to this week’s Outside the Box. No messing around:

Capital controls have shattered the monetary unity of EMU. A Cypriot euro is no longer a core euro….

The complicity of EU authorities in the original plan to violate insured bank savings – halted only by the revolt of the Cypriot parliament – leaves the suspicion that they will steal anybody’s money if leaders of the creditor states think it is in their immediate interest to do so.

The IMF doesn’t get off easy here, either:

The IMF’s Christine Lagarde has given her blessing to the Troika deal, claiming that the package will restore Cyprus to full health, with public debt below 100pc of GDP by 2020.

Yet the Fund has already been through this charade in Greece, and her own staff discredited the doctrine behind EMU crisis measures. It has shown that the “fiscal multiplier” is three times higher than thought for the Club Med bloc. Austerity beyond the therapeutic dose is self-defeating.

I want to amplify Ambrose’s comments by excerpting from another piece, by my über-liberal friend Yves Smith over at Naked Capitalist (although she might characterize herself as mainstream reasonable). But we share a healthy skepticism of large banks.

As we say in Texas, it ain’t over till the fat lady sings. And that would be Italy, as Ambrose points out. (Which given the original intent of that quote and that Darrel Royal of the University of Texas (way back in the day) was referring to Opera Italiana, it is appropriate – in fact, we said it first!)

I have been spending a few moments here and there the last few days with my new granddaughter, Addison (and her parents). I’m now officially in a hotel room in Dallas for the duration until we can get the new place actually bought and construction done, which at best will be late summer; but I will be traveling a lot anyway the next three months, so it’s just another hotel room. I am using it as an opportunity to learn minimalist living.

But I am having to become acquainted with a new knowledge domain, that of architecture and design. If I was just looking at another fund or investment manager, I would feel pretty comfortable doing it on my own, but I clearly need help here and no shame in admitting it.

Many of you may be in a similar boat when it comes to investing. You can leave it to the professionals entirely, but then you get the results that they design and not maybe what you really want. It works a lot better if you spend some time getting familiar with the rules and communicating your objectives.

Most of you would not think (or your wives would not!) of building a home without a great deal of input. Someone has to learn that language if you want to have something that really works for your situation and budget.

The same is true of investing. It is a knowledge domain that is unfamiliar to many, but it is critical to your future happiness. You really do need to get the basics down. The more you learn the better off you will be. And using professionals is important – unless you are going to spend a whole lot of time learning the rules and the tricks. In fact, it takes more than a minor investment of time and effort just to develop adequate skill to be able to pick the right professionals. Not all investment “designers” are the same level of expertise or appropriate for what you want and need.

I did a lot of construction as a young man and can understand the basics even today. But I was never skilled enough to do finish work or design. We will see if I can learn enough to pick the right team in short order! Thankfully, most of you have more time to choose investment professionals.

Have a great Easter weekend. I see more family coming my way and maybe Mavericks and Stars games in our future.

Your can’t believe what everything costs analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

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Cyprus Has Finally Killed Myth That EMU Is Benign

By Ambrose Evans-Pritchard, London Telegraph

The punishment regime imposed on Cyprus is a trick against everybody involved in this squalid saga, against the Cypriot people and the German people, against savers and creditors. All are being deceived.

It is not a bail-out. There is no debt relief for the state of Cyprus. The Diktat will push the island’s debt ratio to 120pc in short order, with a high risk of an economic death spiral, a la Grecque.

Capital controls have shattered the monetary unity of EMU. A Cypriot euro is no longer a core euro. We wait to hear the first stories of shops across Europe refusing to accept euro notes issued by Cyprus, with a G in the serial number.

The curbs are draconian. There will be a forced rollover of debt. Cheques may not be cashed. Basic cross-border trade is severely curtailed. Credit card use abroad will be limited to €5,000 (£4,200) a month. “We wonder how such capital controls could eventually be lifted with no obvious cure of the underlying problem,” said Credit Suisse.

One can only smile at the denunciations of Eurogroup chief Jeroen Dijsselbloem for letting slip that the Cypriot package is a template for future EMU rescues, with further haircuts for “uninsured deposit holders”.

That is not the script. Cyprus is supposed to be a special case. Yet the “Dijssel Bomb” merely confirms that the creditor powers – the people who run EMU at the moment – will impose just such a policy on the rest of Club Med if push ever comes to shove. At the same time, the German bloc is lying to its own people about the real costs of holding the euro together. The accord pretends to shield the taxpayers of EMU creditor states from future losses. By seizing €5.8bn from savings accounts, it has reduced the headline figure on the EU-IMF Troika rescue to €10bn.

This is legerdemain. They have simply switched the cost of the new credit line for Cyprus to the European Central Bank. The ECB will have to offset the slow-motion bank run in Cyprus with its Emergency Liquidity Assistance (ELA), and this is likely to be a big chunk of the remaining €68bn in deposits after what has happened over the past two weeks.

Much of this will show up on the balance sheet of the Bundesbank and its peers through the ECB’s Target2 payment nexus. The money will leak out of Cyprus unless the Troika tries to encircle the island with razor wire.

“In saving €5.8bn in bail-out money, the other euro area countries will likely be on the hook for four to five times more in contingent liabilities. But, of course, the former represents real money that gives politicians a headache; the latter is monopoly central bank money,” said Marchel Alexandrovich, from Jefferies.

Chancellor Angela Merkel will do anything before the elections in September to disguise the true cost of the EMU project. It has been clear since August 2012 that she is willing let the ECB carry out bail-outs by stealth, as the lesser of evils. Such action is invisible to the German public. It does not require a vote in the Bundestag. It circumvents democracy.

Mrs Merkel can get away with this, provided Cyprus does not leave EMU and default on the Bundesbank’s Target2 claims, yet that may well happen.

“I wouldn’t be surprised to see a 20pc fall in real GDP,” said Nobel economist Paul Krugman. “Cyprus should leave the euro. Staying in means an incredibly severe depression.”

“Nobody knows what is going to happen. The economy could go into a free fall,” said Dimitris Drakopoulos, from Nomura.

The country has just lost its core industry, a banking system with assets equal to eight times GDP, and has little to replace it with. Cyprus cannot hope to claw its way back to viability with a tourist boom because EMU membership has made it shockingly expensive. Turkey, Croatia or Egypt are all much cheaper. Manufacturing is just 7pc of GDP. The IMF says the labour cost index has risen even faster than in Greece, Spain or Italy since the late 1990s.

What saved Iceland from mass unemployment after its banks blew up – or saved Sweden and Finland in the early 1990s – was a currency devaluation that brought industries back from the dead. Iceland’s krona has fallen low enough to make it worthwhile growing tomatoes for sale in greenhouses near the Arctic Circle.

If Cyprus tries to claw back competitiveness with an “internal devaluation”, it will drive unemployment to Greek levels (27pc) and cause the economy to contract so fast that the debt ratio explodes.

The IMF’s Christine Lagarde has given her blessing to the Troika deal, claiming that the package will restore Cyprus to full health, with public debt below 100pc of GDP by 2020.

Some in Nicosia cling to the hope that Cyprus can carry on as a financial gateway for Russians and Kazakhs, as if nothing has happened. RBS says the Russians will pull what remains of their money out of Cyprus “as soon as the capital controls are lifted”.

The willingness of the Cypriot authorities last week to seize money from anybody in any bank in Cyprus – even healthy banks – was an act of state madness. We will find out over time whether this epic blunder has destroyed confidence in the country as a financial centre, or whether parts of the financial and legal services sector can rebound.

Yet surely there is no going back to the old model, even though the final package restricts the losses to the two banks that are actually in trouble. Savers above €100,000 at Laiki will lose 80pc of their money, if they get anything back. Those at the Bank of Cyprus will lose 40pc.

Thousands of small firms trying to hang on face seizure of their operating funds. One Cypriot told me that the €400,000 trading account of his father at Laiki had just been frozen, leaving him unable to pay an Egyptian firm for a consignment of shoes.

The Cyprus debacle has taught us yet again that EMU has gone off the rails, is a danger to stability, and should be dismantled before it destroys Europe’s post-War order.

Whether it marks a watershed moment in the crisis is another matter. Italy, Spain, France and Portugal have their own crises, moving to their own rhythm.

The denouement will arrive when the democracies of southern Europe conclude that recovery is a false promise and that the only way to end mass unemployment is to break free of EMU’s contractionary regime.

It will be decided by Italy, not Cyprus.

Will Cyprus Be Contained? (Updated)

By Yves Smith, Naked Capitalist

In March 2007, Fed chairman Ben Bernanke said that he thought the impact of losses on subprime mortgages was likely to be contained. It took five months for events to start proving him wrong.

August 2007 marked the onset of the first acute phase of the global financial crisis, when the asset-backed commercial paper market seized up.

Last week, in a press conference, Bernanke indicated that he thought the likelihood of the crisis in Cyprus having larger ramifications was limited, and avoided using the “c” word. But the message was similar to that of March 2007. So now that Cyprus has agreed to resolve its problem banks on its own, the island nation has secured a short-term sovereign cash fix. As MacroBusiness described it:

The restructure is enough for the IMF to agree to release a 10 billion euro bailout, which will do nothing whatsoever to address Cypriot public debt sustainability or the economy (other than hurt both).

And there also is a rather visible inconsistency between the Eurocrats’ insistence that Cyprus was too small to make any difference and the stock and currency market response to the news of a deal.

So are we likely to see the sort of delay between the assessment and the onset of trouble, as we did in 2007, or is Cyprus a nothingburger, as the Troika and many investors contend? I welcome reader input, but I’d say the odds of knock-on effects are greater than the cheery official assessments would lead you to believe.

As we’ve indicated before, the threat is that bank runs start in other periphery countries, based on a recognition that their bank is at risk plus a concern that they will be made to take losses, as large depositors were in Cyprus. We never thought the odds of a “hot” run, as in people lining up at banks to withdraw money, was all that high, and it’s been reduced even further by the fact that depositors under €100,000 were spared. However, we think the slow-motion departure of depositors from periphery banks is likely to resume….

First, confiscating bank deposits is now on the table in any future crisis. That’s toothpaste that’s not going back in the tube. Commerzbank chief economist Jörg Krämer has already suggested (Google translates) “a one-time property tax levy” for Italy and “a tax rate of 15 percent on financial assets.”

And adding fuel to the fire, the Leader of the UK Independence Party has urged expats in the periphery countries, in particular the 750,000 British in Spain to “Get your money out of there while you’ve still got a chance.”

Second, capital controls in Cyprus mean that there are now two Euros in effect: The Euro that you can use only in Cyprus, and the Euro you can use elsewhere in the so-called “monetary union.” So from the perspective of people in Cyprus, the results are in some ways worst that a breakup: rather than having depreciated dough, you have dough that has been impounded, particularly in terms of using it outside Cyprus.

In each case, why wouldn’t every business owner or wealthy Euro-holder in the periphery go into “First, they came for the Cypriots” mode, take economist Krämer at his word, and move their money to where they had some reason to believe it was safe?

Third, these concerns may be amplified by how rapidly and visibly the Cypriot economy craters. The “rapidly” is due to the fact, as discussed in greater detail in the post from Cyprus.com below, that the Cyprus economy will suffer a one-two punch: the loss of a big chunk of wealth, plus the disappearance of much of the financial services sector, which was 45% of GDP. The author estimates a 20% to 30% fall in output in two years; that could turn out to be conservative, given that the tender ministrations of the Troika will only make a bad situation worse. This is almost certain to be a more rapid and severe decay than in Latvia or Ireland.

But the “visibly” is just as important. The financial media has taken perilous little interest in the human suffering in Greece, Ireland, and Latvia (that should actually be no surprise given who their advertisers are). Oh, you’ll read the stories about how many medications aren’t being imported in Greece, sheets are being re-used in hospitals, suicides have skyrocketed, and trash collection is erratic at best, but these articles are few and far between. The dire conditions and the depopulation of Ireland and Latvia get even less press.

By contrast, the revolt by Cyprus’ parliament and the fraught negotiations have given this bailout negotiation far more profile than its predecessors. There is almost certain to be a fair amount of media coverage of the immediate impact of the bank restructurings and the capital controls. And we are also likely to get the BBC effect, which is ongoing coverage by the English press of conditions in Cyprus due to the number of expats living there (Richard Smith tells me that it was popular among RAF retirees, since their modest pensions and savings would not allow them to buy adequate housing in the pumped-up English market). That will probably produce some echo coverage in other English language press and possibly on the Continent. So the odd favor having ongoing media depictions of Cyprus’ distress, which in turn would increase anxiety levels in periphery countries.

You Can’t Be Serious

John Mauldin — Wed, 27 Mar 2013 22:21:00 GMT

You Can't Be Serious
The Serious Unintended Consequences
It Is Time to Break Up the Banks
New York, Singapore, and the SIC Conference in California

I admit to being surprised by Cyprus. Oh, not the banking crisis or the sovereign debt crisis or the fact that its banks were eight times larger than the country itself or even the fact that the banks were bloated with Greek debt that had been written down. I wrote about all that a long time ago. What surprised me was that all the above was apparently a surprise to European leaders.

While there is much to not like about what European leaders have done since the onset of their crisis some five years ago, they have demonstrated a prodigious ability to kick, poke, and massage the can down the road, to defuse crisis after crisis, and to indefinitely postpone the inevitable. They have demonstrated a remarkable ability to spend taxpayers' and others' money in order to keep Europe and the euro more or less in one piece. At every step they have been keenly intent on maintaining trust in the system. That they have been successful in keeping a majority of citizens in favor of the Eurozone and the euro, even in countries forced to endure serious austerity, must be recognized.

However, the shock in Cyprus reveals an absolute lack of preparedness in dealing with a problem that had festered for several years. By now it should be no surprise to anyone that sovereign nations can default, that banks can go bankrupt under the weight of defaulted sovereign debt, and that banks can be too large for some countries to bail out. That a clear and consistent response to Cyprus should have been worked out in the halls of Brussels and the ECB seems so, well, reasonable. Clearly, the large depositors in Cypriot banks, the majority of whom were Russian (according to Financial Times reports) thought the Eurozone had a plan. In fact, the apparent assumption, bordering on religious faith, that Eurozone leaders would not allow depositors in Cypriot banks to lose one euro, is almost touching. This snafu is going to have repercussions that spread far beyond this tiny island nation. Let's look at a few of the implications.

You Can't Be Serious

When we woke up to the Eurozone pronouncement that all depositors in Cypriot banks, no matter the size of their deposits, would take a loss my reaction was somewhat akin to John McEnroe shouting, "You can't be serious!" to a line judge whose call he infamously questioned.

While there was no official deposit guarantee in place in Europe, the implicit guarantee was €100,000, a number that had become all but sacred during the recent banking crisis. To wake up and find that European leaders not only did not consider this protection to be implicit but also planned to demand losses from all depositors, was quite the shock. I think this may have been the single worst "call" by European leaders since the beginning of the crisis in 2008.

Let's look first at what actually transpired. Cypriot banks held deposits of roughly €68 billion, four times the size of the total national GDP, while the total size of the banks was roughly eight times GDP. The "Troika" seemed to feel that Cyprus needed €17 billion in bailout money to be able to handle the crisis. But after finding hundreds of billions for Greece and Spain, they were only able to offer tiny Cyprus €10 billion (€10 billion is the equivalent of offering the US $8 trillion, give or take a few euros, just to keep it in perspective), and demanded that depositors in Cypriot banks be levied for most of the remaining €7 billion. They offered a formula by which small depositors would lose somewhat less than 10% and large depositors somewhat more (the actual number varied day by day).

The Cypriot parliament totally rejected the Eurozone proposal. Not one vote was cast for the deal. And when you look at the numbers, as any politician does, you can see why. This is an island of 1.1 million men, women, and children. There are (were) 370,000 bank accounts, with 360,000 of those containing fewer than 100,000 euros (per Dennis Gartman). In the recent presidential elections in Cyprus, there were 445,009 voters and a voter turn-out rate of 81%. Thus, a huge majority of voters had accounts with less than €100,000 in them. Call me cynical, but I think any politician could figure out which side of this fence to land on.

It now appears that "only" €5.8 billion is needed for the bailout, so the 10,000 or so accounts holding more than €100,000 will be docked an average of €580,000. "The tottering banks hold 68 billion euros ($88 billion) in deposits, including 38 billion ($49 billion) in accounts of more than 100,000 euros – enormous sums for an island of 1.1 million people, which could never sustain such a big financial system on its own." (NBC World News).

On the surface it looks like large depositors will lose about 15%. And if the Financial Times is right (and the betting line is heavily on their side), a significant majority of that money is Russian. Much of the remainder is tax-haven money (more on that later). "Not so bad," you might think; "things could be worse."

Well, actually they are worse. Some EZ officials suggest that the losses of large depositors could range up to 40%, and the Cypriots themselves suggest 30%. That is because if you are a Greek bank with a Cyprus branch your deposits are exempt from the levy. The logic behind that decision is just too arcane to explain in a brief letter that prides itself on rational explanations. Which is another way of saying that I actually couldn't understand it myself. But then, I'm just a country boy from West Texas, not a European financial wizard.

Things keep spiraling down in the Eurozone. One of the founding principles of the Eurozone was that a euro anywhere within the zone would be as good as one anywhere else. Euros would flow freely. All for one and one for all.

Except that now euros in Cypriot banks are no longer equal. Not only are they going to be "taxed" (or whatever euphemism they end up choosing – they're still debating that one – but if it were your account you might call it theft), but deposits will be subject to capital controls. Reports coming out of Europe this morning suggest that banks in Cyprus will stay closed until at least Thursday. It is not clear when you will actually be able to take your money and leave the sunny shores of Cyprus.

Cypriot banks will remain closed until Thursday, the government announced on Monday night, as President Nicos Anastasiades acknowledged that the country had come "a breath away from economic collapse" before its last-minute bailout. Speaking after he agreed a €10bn international rescue that includes the restructuring of the island's two biggest lenders with losses for bigger depositors, Mr Anastasiades also said capital controls would be imposed but as a "very temporary measure that will be gradually relaxed".

We will eventually learn what time frame a Cypriot politician has in mind when he says "temporary." And Mr. Anastasiades may have been speaking optimistically to the press. Other Cypriot politicians were rather less sanguine. From Dennis Gartman this morning:

They (bank depositors) knew for certain, however, that they were going toface massive losses when Mr. Averof Neofytou, the deputy president of the ruling Disy Party, said that those large depositors "Will [have to] wait for many years before they see what percentage they will get back from their savings – 30 percent, 40 percent, 50 percent, 60 percent, it will be seen…."

The Serious Unintended Consequences

Basel III standards require European banks to increase their deposit ratios. This European response to Cyprus is going to make that harder for banks in smaller European countries to accomplish. Very tiny Luxembourg has banking assets 13 times the country's GDP. Yes, I know that Luxembourg's banks are the very epitome of solid banking and that the majority of those assets are loans to central banks and other credit institutions, but there is no way on God's green earth that Luxembourg as a country could even begin to think about backing its banks. Of course, everyone knew that before this crisis, but if you are the treasurer of a large corporation, how soundly do you sleep at night after Cyprus? And God forbid you have an account in one of the peripheral countries. In the case of Ireland, the lesson was that the money would be found to back the banks, even if taxpayers suffered. But now? New rules for new times. And then you open The Financial Times this weekend and read (emphasis mine):

The chairman of the group of eurozone finance ministers warned that the bailout marked a watershed in how the eurozone dealt with failing banks, with European leaders now committed to "pushing back the risks" of paying for bank bailouts from taxpayers to private investors.

Jeroen Dijsselbloem, president of the eurogroup, was speaking after Cyprus reached its 11th-hour bailout deal with international lenders that avoids a controversial levy on bank accounts but will force large losses on big deposits in the island's top two lenders.

Evidently, Jeroen interprets the term private investors to mean depositors with over €100,000 in a bank. That has to be unsettling to anybody who has diligently saved for decades and is now retired and depending on those funds for sustenance. And for corporations that run a payroll account through a bank? The thought that you could see a lifetime of work building a business go down in an unelected bureaucrat's blink of an eye would keep me up at night. I do not think most corporate financial types see their deposits as an "investment" in the bank.

One of my favorite reads is Kiron Sarkar (who variously lives and writes daily in London, Ireland, and India). I talk and correspond frequently with Kiron. He is a retired but very senior investment banker with deep European political and business connections in many countries. As we say in Texas, he is "wired." (You can subscribe to his letter at http://sarkargm.com.) He shot out a special note on the rather incendiary comments of Mr. Dijsselbloem. I have seen other comments similar to these (but less well-said), expressing various levels of disbelief about the timing of Dijsselbloem's remarks, but here's what Kiron had to say:

Reuters quotes the Chairman of the EZ Finance Ministers, Mr Dijsselbloem, as having said:

"If there is a risk in a bank, our first question should be OK, what are you in the bank going to do about that? What can you do to recapitalise yourself? If you can't do it, then we will talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank and, if necessary, the uninsured deposit holders."

He is also reported as having said, "It will force all financial institutions, as well as investors, to think about the risks they are taking on because they will now have to realise that it may also hurt them. The risks might come towards them". These are very likely to be personal remarks, rather than an EZ finance minister's policy statement, but these comments suggest:

Uninsured depositors in EZ countries may well be bailed in in the future, ie Cyprus is a precedent;
EZ countries with large banking sectors will have to reduce their size and restructure;
EZ countries are seeking to shift risks away from the public sector and onto the banks; and
Bail-ins will reduce the need to use the ESM funds to recap banks, a policy which was proposed just under 1 year ago.

These are INCENDIARY remarks, especially given the timing and debacle over Cyprus. What happens to Malta? Slovenia is in trouble. Luxembourg has a massive banking sector, though it is an AAA-rated country. All 3 are in the EZ. I realize that Mr. Dijsselbloem is new to the job and has little to no experience of the financial services sector (why was he appointed, you may well ask), but to make such comments, especially at this time, is the height of irresponsibility. The comments Reuters reports seem accurate, as the FT carries similar quotes.

At the end of the day, Mr Dijsselbloem is, of course, right; but to say something like this, especially at this time, well …

[Now this is the key paragraph and takeaway. Read twice. – John]

Essentially, why will anyone keep more than E100k in any EZ bank – indeed, why deposit any amount in certain EZ banks, as the value of the EZ bank-deposit guarantee is worthless in a number of cases, as a number of the peripheral EZ countries can't afford to pay up. I repeat, the EZ bank deposit "guarantee" is not a joint and several responsibility across the EZ; it is the responsibility of individual EZ countries.

If these comments are not withdrawn/clarified, the weaker EZ banks in the troubled countries, in particular, are going to come under severe pressure. Even if withdrawn/clarified, this is yet another self-inflicted wound. The euro has declined materially since these statements by Mr Dijsselbloem were published by Reuters and the FT.

The euro has declined to US$1.2873 at present and continues to weaken. The European banking sector is being hit – no surprise. The peripheral countries (Spain and Italy) are also being hit, in particular. Bond yields of the safer countries are declining, unsurprisingly, whilst the yields in the EZ peripherals are rising. Italy and Spain look to be under pressure. A number of you may now understand why I am so negative on the EZ.

As I noted, Basel III makes it more necessary than ever for Eurozone banks to retain depositors, but this action on Cyprus will make getting large deposits more difficult for many banks. Note that less than 4% of depositors account for almost 60% of the deposits in Cypriot banks. Banks need those large depositors if they are going to grow their capital base to the required standards.

This unfortunate business underscores one of the most significant problems in the Eurozone, which is the lack of a collective deposit-insurance scheme. I wrote pessimistically about that topic over a year ago when European leaders promised they would create a Eurozone-wide deposit-insurance mechanism. That initiative has gone nowhere, primarily because the Germans have opposed it. (Ironically, so did Cyprus.)

Let me state this very clearly: if something as seemingly straightforward and necessary as deposit insurance cannot be achieved, then how can there be any hope for deeper fiscal union? And fiscal union will be necessary before all is said and done if the Eurozone is to survive.

It is not just tiny Cyprus or even Spanish banks that will be looked at with growing worry by large depositors. Let's examine this note from David Stockman on European banking, and in particular French banks:

BNP-Paribas is the classic example: $2.5 trillion of asset footings vs. $80 billion of tangible common equity (TCE) or 31X leverage; it has only $730 billion of deposits or just 29% of its asset footings compared to about 50% at big U.S. banks like JPM; is teetering on $500 billion of mostly unsecured long-term debt that will have to be rolled at higher and higher rates; and all the rest of its funding is from the wholesale money market , which is fast drying up, and from repo where it is obviously running out of collateral.

Looked at another way, the three big French banks have combined footings of about $6 trillion compared to France's GDP of $2.2 trillion. So the Big Three French banks are 3X their dirigisme-ridden GDP… By contrast, the top three U.S. banks which are no paragon of financial virtue – JPM, BAC, and C – have combined footings of $6 trillion or 40% of GDP. The French equivalent of that number would be $45 trillion for the U.S. banks. Can you say train wreck!

It is only a matter of time before these French and other European banks, which are stuffed with sovereign debt backed by no capital due to the zero risk weighting of the Basel lunacy, topple into the abyss of the shadow banking system where they have funded their elephantine balance sheets. And that includes Germany, too. The German banks are as bad or worse than the French. Did you know that Deutsche Bank is levered 60:1 on a TCE/assets basis, and that its Basel "risk-weighted" assets are only $450 billion, but actual balance sheet assets are $3 trillion? In other words, due to the Basel standards, which count sovereign and other AAA assets as risk free, DB has $2.5 trillion of assets with zero capital backing!

This is all a product of the deformation of central banking and monetary policy over the last four decades and the destruction of honest capital markets by the monetary central planners who run the printing presses. Furthermore, this has fostered monumental fiscal profligacy among politicians who have been told for years now that the carry cost of public debt is negligible and that there would always be a central bank bid for government paper. Perhaps we are now hearing the sound of some chickens coming home to roost.

Yes, yes, I know: "John, how can you even think that French debt could be at risk?" But if you look at France's income and balance-sheet statements, as if France were a stock rather than a country, you might not be so sure. Might I suggest that a good trade would be to be long German government debt, short French debt? Essentially, this is a bet that France will be worse off than Germany in the coming years, which seems like a good wager right now. And in a French debt crisis (well within the realm of possibility) that trade could work both ways! Just saying …

We will wrap up with this note that just hit my inbox from Louis Gave. (I am up late, as usual, and Louis writes from Hong Kong, where it is early). Remember that Louis is French as you read this.

So we now know that, in Europe, big depositors are the first in the line of fire to ensure that small depositors do not suffer losses. Needless to say, this raises the question of who wants to be a big depositor in a weak bank in a country undergoing a secondary depression?...

EU policymakers are probably not evil henchmen set on destroying the financial industry (even if it often looks that way from the City of London). The more likely explanation is that EU policymakers are simply ignorant of how financial markets work. For example, the fact that the two largest Cypriot banks' London branches have remained opened through the past week, allowing large depositors to take out millions of euros, hints that Europe's policymakers are simply clueless when it comes to how financial markets work. This also means that whatever pound of flesh the EU thinks it will be getting by wiping out the large depositors could turn out to be on the light side.

Or, for a second example of cluelessness, what could rival yesterday's declarations by the Dutch finance minister that the Cyprus bailout set a new "template" on how to deal with bust banks, namely make the rich depositors pay for the little depositors? What large depositor in a troubled bank in a country going through a secondary depression will want to stick around for that deal? We would venture that the next time that "solution" is applied, the eurocrats will find that the large depositors will not have waited around to get fleeced. In fact, as mentioned above, it might not even work this time (i.e., Cyprus), let alone the next one.

Going one step beyond the ignorance of how financial markets work, what seems profoundly shocking is the lack of recognition of this ignorance. Place yourself back in the fall of 2008. As the financial crisis was unfolding, the likes of John Mack, Jamie Dimon, John Thane and other banking heads were asked to meet at the New York Fed, the US Treasury or even the US Congress on a regular basis to explain what was unfolding (and what they planned to do about it). Meanwhile, how many times have the heads of Santander, Intesa, SocGen, Deutsche Bank, etc., been called in to explain what was going on, or for them to give their views on what should be done? If asked, perhaps these CEOs would have said that:

a) European banks are much more dependent on deposits than their US counterparts.

b) Owners of large deposits are likely to be more risk averse and much more active in moving their money than small retail savers (for whom moving money from one country to the next presents high costs and almost insurmountable hurdles). And this for obvious reasons: a 40% haircut on $1,000 is unpleasant but it's not going to change anyone's life. But a 40% haircut on a pensioner's life savings of $500,000 will have a huge impact—and a 40% haircut on any middle-sized company's $10mn payroll will be enough to bankrupt the business. In fact, this simple reality brings us back to Mark Twain's advice that it is always better to tax poor people as there are so much more of them—unfortunately, Europe keeps going the other way, with devastating consequences.

c) For these reasons, regulators and governments have never in living memory allowed big banks to default on their depositors, regardless of the wording of formal deposit insurance contracts. If this implicit guarantee is now removed in Europe (and it sure looks like it has been), then we should expect a big shift of large deposits out of the banks and into government bonds or credit market instruments.

d) This will prove very problematic, especially given the new Basel III regulations which encouraged a funding model whereby banks should rely more on deposits and less on bonds.

e) As savings shift out of banks and into credit markets, the "German bank" model based on bank-financing of industrial companies and long-term creditor-debtor relationships will inevitably erode, to be replaced by the Anglo-Saxon model credit-market financing along with the short-termism which it implies.

In other words, the law of unintended consequences is at work: the eurocrats will end up with exactly the opposite of the financial system they wanted. Either that, or the European banks will end up having to be nationalized in great numbers. These two possible outcomes seem to be the logical consequence of the EU's very unfriendly financial sector policies.

Louis is right. If you are a large depositor, you HAVE to be thinking about what country your deposits are in and how safe the actual bank is. Even if a bank is seemingly safe, is that any comfort? Is there any evidence that the depositors in Cyprus are better off being in one bank than another when the entire country's banking system has seemingly failed? Was every bank in Cyprus bankrupt at the same percentage rate? Who's to say, if BNP Paribas has problems, that a few finance ministers in Brussels would not demand that Societe Generale and Credit Agricole should be penalized, since they are in the same country? What is the logic here? Or is Cyprus a one-off because most of the losses are Russian and who really cares about those commies anyway? Except that the next time, comrade, it might be your bank account that is deemed expendable.

If you run a family office, large corporation, or just your own small pension account, you are not exercising reasonable prudence if you are not asking yourself, what are the risks as of today? You're calling European friends and trying to figure out what the new rules are. Who made these decisions and why?

After spending hundreds of billions and not flinching from potentially printing perhaps trillions of euros to shore up the periphery, the Eurozone leaders now balk at a mere €5.8 billion and raise questions about their whole enterprise? Over German politics? You can't be serious.

This may one day rank up there with "Let them eat cake" in the politically tone-deaf department. Merkel may have risked the entire euro experiment over local politics, after writing such large checks in prior situations. The Eurozone response to Cyprus indicates serious ignorance of how financial systems operate. Trust is an ephemeral thing. It is hard to build and maintain and can be so easily squandered. I suggest you go back and read (if you have not) the recent posting in Outside the Box of Dylan Grice's masterful essay on trust.

Last-second insert, which I haven't done in years, but this seems important:

As my editors and tech staff are literally ready to send this letter out, reports are starting to come across my desk that Russian depositors are finding ways to get money out of Cyprus, through branch banks in other countries. The ECB has supposedly told Latvia not to take Russian-flight money if they expect to join the Eurozone. Haircut estimates are ranging to 50%. If a lot of Russian money actually goes, it could be closer to 100%. I offer a few links, one from Reuters and one from ZeroHedge. I see some other reports and can't completely separate rumor from fact, but Reuters is usually reliable and has a policy of multiple sources.

No one knows exactly how much money has left Cyprus' banks, or where it has gone. The two banks at the centre of the crisis – Cyprus Popular Bank, also known as Laiki, and Bank of Cyprus – have units in London which remained open throughout the week and placed no limits on withdrawals. Bank of Cyprus also owns 80 percent of Russia's Uniastrum Bank, which put no restrictions on withdrawals in Russia. Russians were among Cypriot banks' largest depositors. (Reuters)

So, while one could not withdraw from Bank of Cyprus or Laiki, one could withdraw without limitation from subsidiary and OpCo banks, and other affiliates? Just brilliant. (Zero Hedge, citing the above Reuters quote)

If this is true (and Reuters makes it sound real), so much for sticking it to the Russians. This could escalate into something ugly. I rather think this weekend's Outside the Box will be on this still-brewing crisis. The Europeans are looking more and more like the Keystone Cops, in addition to being merely clueless. (And watching Jeroen Dijsselbloem trying to take back his words at this late moment is amusing. The Dutch are normally so disciplined. It just gets stranger, and if it was not so sad and scary it would be funny.)

It Is Time to Break Up the Banks

The problem we have been discussing is not just a problem in Europe. In a general sense, it is the problem of banks that are too big to be allowed to fail. It is time to rein in the size of large banks before the next crisis. BAC and C are not just too big to fail, they are too big to effectively manage. If banks want to get larger, they should pay more deposit insurance to offset the implicit guarantees they get from taxpayers to cover losses beyond the ability of an FDIC to underwrite. I would go so far as to increase the capital requirements of banks as they increase in size, giving an incentive for management to break them up into smaller (and more manageable) pieces. The number of top experts, economists, and bankers who agree with me is rising, as this recent post from my friend Barry Ritholtz over at The Big Picture demonstrates.

New York, Singapore, and the Strategic Investment Conference in California

In two weeks I will be in New York for a few nights. The following week I fly to Singapore (one of my favorite cities), where I will be featured at a conference sponsored by The Business Times and Saxo Capital Markets. I just now looked at the conference webpage and found I am in deep kimchee, as they have labeled me a guru. I have often noted that you get called a guru just before you make a major-league bad call. Full risk disclosure would suggest I tell you to ignore any of my upcoming prognostications until I really screw up bad. Then you can just ignore me at your usual discretion. You can read register to attend the BT Investment Dialogue at http://pbp.sph.com.sg/btinv2013/.

My Strategic Investment Conference, May 1-3 in Carlsbad, California, co-sponsored by my partners at Altegris (whose staff does the heavy lifting to make this one of the best-run conferences in the country) has almost sold out. Louis Gave (mentioned above) will be there. There will be a lot of discussion about Europe, and with Kyle Bass on hand you know we'll be talking about Japan. This is one you do not want to miss. In addition to the line-up I have mentioned past weeks, which I think is the best at any economic conference anywhere this year, Paul McCulley is going to come to kick off the conference on Wednesday evening. Paul has spoken at our conference nearly every year since we started, and I am grateful that he will come again. You can learn more and register at http://www.altegris.com/sic. Check out the speaker line-up. Even McEnroe would agree that this is a seriously world-class line-up.

As long-time readers know, I have written this letter from planes, trains, taxis, limos, and hotels all over the world, and from every continent except Antarctica (which is on my bucket list) and scores of countries. But this is the first time I have written to you from a hospital waiting room, as I wait to see my new granddaughter, Addison, who has arrived fashionably late. The old caricature, when I grew up, was of the useless father waiting nervously outside the delivery room. Times have changed, and it is now de rigueur for fathers to be at their wives' side. (It was something of a novelty when I was in there some 36 years ago.) Now the most useless thing in the waiting room is the grandfather, and I must confess to not being nervous (at least not that I will admit to). The clan gathered as the time wore on. I brought my computer to do a little work on this letter, assuming we were going late into the night; but after 14 hours of induced labor and not much going on, they elected to do a C-section, so it all happened rather quickly after I got here. I had an all-too-brief moment with mother and daughter and was then ushered out so the time could be shared with siblings and such. Amanda and Addison (6 pounds, 1 ounce, for those who might ask – I am just happy to see the requisite number of fingers and toes) are doing just fine. Son-in-law Allen has a huge Oklahoma grin on his face. It is one of those great nights to be alive.

And finally, for those who are nostalgic for a time when old warriors worked together when necessary for the good of the country, I offer this YouTube clip I ran across of President Ronald Reagan at a tribute dinner for his long-time political adversary and personal friend Speaker Tip O'Neill: http://www.youtube.com/Reagan&O'Neill. We need a little of that Irish magic now. Have a great week.

Your rather be a grandfather than a guru any day analyst,

John Mauldin

subscribers@mauldineconomics.com

Is The Government Lying To Us About Inflation? Yes!

John Mauldin — Sat, 23 Mar 2013 05:36:00 GMT

In today’s Outside the Box, Gary D. Halbert (my old and very dear friend and former business partner of many years) reminds us about a few significant facts concerning the Consumer Price Index (CPI) that mainstream economists and the media tend to ignore. The central question is whether the CPI is really indicative of the actual inflation rate. Not likely, says Gary, since the US Bureau of Labor Statistics (BLS), which compiles the CPI, has engaged in methodological shenanigans over the past couple decades (as has been well documented by John Williams of ShadowStats, among others). The upshot of all their monkeying with the numbers is that the official rate of inflation may be two to four times lower than the actual rate (which is rather convenient if you’re a government bureaucrat trying to hold down interest costs and Social Security payments).

These changes are hotly debated in academic circles. There are many economists who agree with the changes and can show with their models that inflation is low. That is the currently accepted wisdom, or what passes for it. The problem is that inflation only shows up, as one person put it, in the things we actually buy. If your main costs are food, energy, education, and healthcare (ring any bells?), then inflation is a great deal higher than 2%. Other items are actually falling in price. It comes down to the mix of items in the calculations and whether you buy into the concepts of substitution (if beef gets too expensive we buy hamburger rather than steak) and “hedonics,” which says that prices of products drop over time as quality and manufacturing efficiency improve, so the calculation of inflation should take this into account.

Which means you can have official inflation at a low level (or even falling for certain items), while the amount you actually spend out of your very real pocket is rising! And thus the debate.

Having refreshed us on the basic techniques of CPI massage, Gary turns to food and energy, which the BLS includes in “headline CPI” but omits from “core CPI.” He points out that while headline CPI jumped an unexpected 0.7% in February, core CPI rose only 0.2%. That is, food and energy price increases accounted for more than 70% of the rise. “Not good for the economy,” he notes.

And of course, this is all bad news for unwary investors, since

Those who believe that inflation is only 2%, when it may be 5-8%, may be making investment decisions that are almost guaranteed to erode the purchasing power of their money over time. This is especially true with low-yielding investments such as CDs, Treasuries, etc.

Gary wraps up by taking a look at “chained CPI,” which he explains as follows:

hained CPI assumes that when prices rise, consumers will resort to entirely different products, rather than just seeking a cheaper brand. For example, if beef prices rise, chained CPI would assume that consumers might opt for chicken to save money.

The chained CPI debate is raging as we speak: I got an email from the AARP this morning, urging me to tell my Senators to say no to chained CPI being used to calculate Social Security cost-of-living adjustments (COLA) – sounds like they may vote today (Friday) on a bill to do just that. But as Gary points out, we either calculate benefits using chained CPI – which, yes, is tough on those living on a fixed income – or we eliminate the cap on salary subject to Social Security taxation (that is, we raise taxes). As Gary says, “Either way, somebody’s got to pay, and it might end up being a little [of] both.”

Finally, a quick note: I am doing a webinar on Tuesday for Mauldin Circle members. The current state of the equity markets brings back memories of 2007. As the market continues to reach new highs, stock selection on both the long and short sides requires considerable expertise. That is why I decided that now is a good time to introduce you to one of the leading long-and-short investment managers, Jacob Gottlieb, CIO of Visium Asset Management. During our conversation on Tuesday, March 26 at 12:00 p.m. EDT (9:00 a.m. PDT), we will find out what’s on Jacob’s mind – his investment themes and where’s he seeing equity opportunities on both the long and short sides.

If you are not aware of Visium, they are a premier long/short multi-strategy manager with over $3.7 billion in assets. It’s a firm I have been watching for some time. Bloomberg cited Visium as one of “The 100 Top Performing Large Hedge Funds.” Take a look at this recent write-up on Visium: “The Quiet Ambition of Jacob Gottlieb.”

You will need to register for this exclusive webinar through The Mauldin Circle. If you are a Mauldin Circle member and a qualified purchaser or an investment advisor, a webinar invitation has been sent directly to you by email. A replay will also be available to qualified registrants. If you are unable to listen in to the live discussion, be sure to register so you can receive the replay information. If you are not a member of The Mauldin Circle and are a qualified purchaser, please join today. Upon qualification by my partners at Altegris, you will receive an email invitation . I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. I look forward to having you at this exclusive Mauldin Circle event. (In this regard, I am president and a registered representative of Millenium Wave Securities, LLC, member FINRA.)

Have a great week. I know mine will be eventful – daughter Amanda is due to give birth to granddaughter Addison on Monday!

Your thinking about the world Addison will discover analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

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Is The Government Lying To Us About Inflation? Yes!

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
March 19, 2013

Consumer Price Index Jumped in February

On Friday, the Labor Department reported that the Consumer Price Index (CPI) jumped an unexpected 0.7% in February. This was above pre-report estimates and was the highest monthly reading since 2009. We should be very concerned, right? Let’s take a closer look.

Upon further examination, we find that if we subtract food and energy from the CPI, the cost index rose only 0.2% last month. It turns out that most of the big increase in the CPI last month was due to the sharp rise in gasoline prices. The experts tell us that due to the volatile nature of oil and gasoline prices, we shouldn’t include energy in the CPI. Ditto for food prices which can also be quite volatile.

I have always argued to the contrary, that food and energy prices do indeed need to be considered in the CPI. Think pocketbook: if gas prices rise $1.00 per gallon, and you have to fill up once a week, and it takes 20 gallons to fill up your car, then you have $20 less to spend on something else that week, or $80 less per month. Not good for the economy.

Some others disagree with me, arguing that you spend the same amount each month, and that if you spend more on gas, then you spend less on other things, but the overall economy gets the same amount of money from you one way or the other. Both points are valid.

But if you are trying to measure the true inflation rate, I maintain that food and energy should be included. Apparently the government agrees with me since they continue to report the headline Index including food and energy, and secondarily report what the Index was without food and energy.

The real question is whether or not the Consumer Price Index is really indicative of the actual inflation rate. I will argue that it is not a very good indicator with, or without, food and energy. At the very least, the CPI is controversial.

Why the CPI is So Controversial

The Consumer Price Index (CPI) is produced by the US Department of Labor’s Bureau of Labor Statistics (BLS). It is the most widely watched and used measure of the US inflation rate. For years, there has been controversy about whether the CPI overstates or understates inflation, how it is measured and whether it is an appropriate proxy for inflation.

Originally, the CPI was determined by comparing price changes in a fixed basket of goods and services. Determined as such, the CPI was a cost of goods index (COGI). Over time, however, the US Congress embraced the view that the CPI should reflect changes in the cost to maintain a constant standard of living. Consequently, the CPI has been moving toward a cost of living index (COLI).

Over the years, the methodology used to calculate the CPI has also undergone numerous revisions. According to the BLS, the changes removed “biases” that caused the CPI to overstate the inflation rate. The new methodology takes into account changes in the quality of goods and “substitution.” Substitution is the change in purchases by consumers in response to price changes, and this alters the relative weighting of the goods in the basket. The overall result tends to be a lower CPI.

Critics view the methodological changes and the switch from a COGI to a COLI focus as a purposeful manipulation that allows the government to report a lower CPI. Most critics prefer that the CPI be calculated using the original methodology based on a basket of goods with fixed quantities and qualities. Doing so can result in a significantly higher inflation reading.

On Friday, the BLS reported that the CPI rose only 2.0% over the last 12 months. Economists using different methodologies (including the original methodologies) estimate that the real US inflation rate over that same period was anywhere between 5% and 8%. That’s a huge difference!

If Inflation is 2%, Why Are Prices Up So Much?

I read a good article last week from TIME Business & Money columnist Michael Sivy. He pointed out that his printer ran out of ink recently, and he was “shocked” to find that the same printer cartridge had gone up in price by 25% in less than a year.

While the government’s CPI has averaged only 2% since the end of the Great Recession in early 2009, many basic commodities have soared since then. Gold was $930 an ounce when the recession ended, and today it’s just over $1,600. That’s an increase of 70% in four years, or an annualized rate of over 14%.

Of course, that’s just one commodity. How about a broader measure? The Reuters CRB Commodity Index, which tracks the prices of energy, coffee, cocoa, copper, cotton, etc. is up 38% over four years, or 8.6% at a compound annual rate.

The price of gasoline has gone up from $2.60 a gallon when the recession ended to around $3.70 today nationally. That’s a 41% increase in four years, or an annualized rate of 9%. Taxes have gone up almost as much. Federal, state and local income taxes have risen 35% over four years, an annualized rate of 7.8%.

Then there’s the so-called “Big Mac Index” that was popularized by The Economist some years ago. McDonald’s hamburgers are available in many countries and their prices reflect the cost of food, fuel and basic labor. The price of a Big Mac, therefore, can be yet another indicator of inflation in a particular country. Since the recession ended, the cost of a Big Mac in the US has risen from an average of $3.57 to $4.37, or 5.2% a year.

As the main grocery shopper (and cook) in our family, I am reminded several times a week how food prices continue to go higher. Take a look at this chart from the St Louis Fed.

And while we’re on the subject of food, have you noticed how many manufacturers reduce the size of the containers and/or packages so as to reduce the enclosed amount – but still charge the same price as before? I know I’m not the only one!

Severe Drought Led to Higher Food Prices

Forecasters lay much of the blame for higher food prices on the drought that swept through much of the US last year, and is continuing this year. Last year’s severe weather put nearly 80% of the continental United States in drought conditions – the worst in 50 years. Particularly hard hit areas include the Midwest states of Illinois, Iowa, Minnesota, Nebraska, Kansas, as well as Oklahoma, Texas, Arkansas and many parts of Colorado and California.

The drought damaged key crops like corn, wheat and soybeans while driving up commodity prices and forcing farmers to scramble to find feed for livestock. Farmers and ranchers have had to cut back on the number of livestock and poultry in order to limit their own costs, which created a shortage of beef, chicken and pork.

Although conditions have improved in some areas, roughly 61% of the country still suffers from drought, which is remains at its worst levels in more than a decade, according to the US Drought Monitor.

On a personal note, we are fortunate to live on beautiful Lake Travis, just outside Austin. Lake Travis is a Corps of Engineers man-made lake, and it supplies water for hundreds of thousands of area residents and countless businesses in Central Texas. As such, the lake level varies significantly, depending on the amount of rainfall we receive each year.

The drought in Central Texas is in its third year. Lake Travis, which is 65 miles long and over 200 feet deep in places, is now only 40% full (or 60% empty). As the water level falls, we have to push our dock out further and further to keep it in the water. A trip down to the dock is over 125 steps (one way)!

So How Is the CPI at Only 2%? It’s Not.

As we’ve seen above, the prices of many things that consumers buy on a regular basis have risen much faster than the CPI. So how can the CPI be at only 2%? And how could it have averaged just 2% since the end of the Great Recession four years ago?

Some argue that it’s because wages are down, and with the economy so weak, workers can’t demand higher pay to make up for their increased cost of living. Indeed, that’s one of the factors causing the decline in real after-tax household income.

Real median annual household income in January of this year was $51,584 – or 92.7% of the level in January 2000. Incomes inched up early in 2012 but have been treading water since May, according to the Household Income Index. While household income ticked up slightly in the past year, it remains well below the $54,008 level seen at the start of the recovery roughly four years ago.

These are all factors influencing the economic recovery (or lack thereof) and thus the inflation rate. But they don’t explain why the headline Consumer Price Index has hovered around 2% for the last four years, or why other inflation measurements are in the 5%-8% range. How can this be?

Quite simply because it’s a government report that’s been frequently manipulated over the last 35 years. Whether by design (my bet) or coincidence, these revisions have served to reduce the official inflation rate.

Also, keep in mind that our government has a record $16.7 trillion in debt it is paying interest on. If interest rates rise, it costs Uncle Sam more money. If inflation rises, interest rates follow. Obviously, the government has incentives to manipulate the official inflation rate lower than it really is.

The bottom line is that there is no absolute and objective gauge of inflation. Any particular measure is simply one way of making the calculation, based on a host of assumptions. We do know with certainty that a number of the costs that American households face are going up considerably faster than the CPI.

Finally, the fact that real world inflation is higher than the CPI poses challenges for investors. Investors should calculate their total required return net of the effect of inflation. As the inflation rate increases, higher returns must be earned in order to obtain a desired real rate of return.

Obama’s Olive Branch – “Chained CPI”?

Before we leave the subject of CPI, I think it’s important to discuss something going on right now in the budget negotiations in Washington. Over the shrill opposition of liberal Democrats, Obama has verbally offered to change the way cost of living increases are calculated for Social Security and other entitlements. Instead of the CPI now used, he said he might consider using something called the “chained CPI.”

In a nutshell, chained CPI is a measure of inflation that seeks to account for substitution by consumers when prices rise. While the current CPI measure uses substitution to a small extent, chained CPI assumes that when prices rise, consumers will resort to entirely different products, rather than just seeking a cheaper brand. For example, if beef prices rise, chained CPI would assume that consumers might opt for chicken to save money.

The end result is that chained CPI is generally lower than the current CPI used for measuring inflation. As I noted above, the

CPI for the past 12 months was measured at 2.0%. The chained CPI for the same period was 1.8%.

If we switch to chained CPI for entitlement cost of living increases, which remains to be seen, it would mean that benefits would rise at a slower rate. Alan Greenspan recommended moving to chained CPI for Social Security back in his day at the Fed, but it went nowhere.

Liberal Democrats oppose the switch to chained CPI and demagogue it as a “war on seniors,” while Republicans feel it’s a way to save Social Security as we know it. Democrats prefer eliminating the cap on salary subject to Social Security taxation (read: increase taxes) to using chained CPI, which they view as a cut in benefits. It seems that only in a politician’s mind can a slower rate of increasing benefits be called a “cut.”

It’s still too early to tell how the current chained CPI debate will play out. This is one of those issues that hits both old and young. If chained CPI is used, then entitlement benefit increases will be lower. If it is not, then future Social Security taxes may well have to be higher. Either way, somebody’s got to pay, and it might end up being a little from both.

Hoping you stay ahead of inflation,

Gary D. Halbert

Will the Real Unemployed Please Raise Your Hands?

John Mauldin — Wed, 20 Mar 2013 21:41:00 GMT

Can Someone Figure Out Cyprus?
Data, Information, and Opinion
Will the Real Unemployed Please Raise Your Hands?
BLS: Everyone’s Favorite (Whipping Boy) Agency
The Household Survey
Home(less) Again, California, New York, and Singapore

This week’s letter will be a very short part of a book I am writing with Bill Dunkelberg (the Chief Economist of the National Federation of Independent Businesses) on the future of employment. It has taken longer to write than I initially anticipated, for a host of reasons, chief among which is that the future is not as obvious as I originally thought. Diving into the data has brought a few surprises. It doesn’t help that I have (probably to the frustration of Dunk, although he is way too polite to say it) changed the focus from “merely” what we need to do to create jobs (which is still an important part of the book) to what kinds of jobs will the future bring and who will get them.

But to understand the future of employment, we have to be able to measure what we mean when we say employment. And the data that we all too often think of as hard and fast is anything but. Is unemployment in the eye of the beholder? We know what we mean when we say our brother-in-law is unemployed. But does the government data mean the same thing? The answer is “maybe, sometimes, and it depends.”

I selected this part of the book not only because it is toward the beginning but also as a result of a conversation I had this week that got me to thinking about data and its usefulness. It is in this context that we will look at unemployment data.

But first, a quick comment on why this letter is not about Cyprus, which seems to be the topic du jour. I wrote four weeks ago, after my visit to Athens, that Cyprus would be a problem and to pay attention.

Can Someone Figure Out Cyprus?

The story changes every few hours. It is not clear what the Cypriot parliament will do. They could quite possibly simply say no, or change any number of things. The whole thing is patently ham-handed. It illustrates what I mean when I keep saying that the EU is making up the rules as they go along. Why take money from widows and then exempt the branches of Greek banks? (I hear the reasoning, but I don’t understand it.) It is all about protecting banks and institutions and not the defenseless. I find the whole thing rather outrageous in the way that it looks through the wrong end of the telescope.

And dear gods, why risk creating a situation that encourages depositors in banks to question the ownership of their money? If the deposits of the citizens of a member country of the EU are not safe from bureaucrats, at least up to €100,000, then why should they trust any bank? And why in Hades is the IMF appearing to dictate that depositors will lose money? And why do Turkish depositors in non-Greek banks lose when Greek depositors in Greek banks don’t? Cyprus is complicated enough without poking that nationalistic anthill.

Cyprus is also a problem in itself. It is the size of a small city, not a country. My friend Frank Trotter of Everbank noted today that the agricultural subsidies Texas gets from the US government total more than the entire GDP of Cyprus. Would anyone blink if the banks in San Bernadino County went bankrupt? Cyprus’s banking system is around 8 times the size of the country’s GDP, so asking the country to back the deposits of its banks is ludicrous. Perhaps as much as half the deposit total is from outside the country (encouraged by the banking system and regulators), and it is widely assumed that Cyprus launders a great deal of Russian-oligarch and Russian-mafia money. Which of course does not sit well with Germany, especially in advance of its upcoming election. Try telling the good burghers of Bavaria that they should pay to bail out Russian oligarchs. Frau Merkel has made it clear she will not.

The EU contends that Greece was a one-off situation and no one else will get bailed out, at least not on sovereign debt. We will see.

While the bailout money needed is about the size of the entire economy (€17 billion), that is chump change to maintain the system. The banks are in large part bankrupt because they bought too much Greek debt and were forced to take haircuts on that debt. If the ECB bailed out Greek banks and depositors (which they did), then why is Cyprus a special case, demanding that some small depositors and not others lose money? Then again, if the banks go down, which they could easily do without a bailout, depositors stand to lose a great deal more, as Cyprus as a country can no longer access the bond market.

Does Europe want Russia to step in at the price of Russia’s getting a Mediterranean port? Is saddling one set of people with a tax and letting others off the hook even legal in Europe? There seems to be some debate.

This mess occurred because there is no clear eurozone banking policy or general deposit insurance, both of which were promised in the wake of the last such crisis and then soundly rejected by Germany (Merkel), which does not want to pay for the banking sins of other countries.

I fear that whatever I write will be both obsolete and wrong before I can even hit the send button, so I will forbear. We will revisit Cyprus when we can make some informed observations. But let me point out that I wrote a few weeks ago that the real challenge to the euro is, first, France (another country whose banks are far too large to be bailed out in a crisis) and, second, that the voters of more than one country are simply getting fed up. The way European leaders are handling the Cyprus situation does not inspire confidence.

Data, Information, and Opinion

As I wrote in last week’s Outside the Box, I visited Bill Bonner’s rather isolated hacienda in the Andes, where he lives two months of the year. (His ranch has expanded to some 500,000 acres, by the way.) Bill is the founder of Agora, now the largest investment-letter publisher in the world, but he started from scratch some 30 years ago in Baltimore. As the rest of the group was out riding horses, Bill and I stayed back, waiting for our turn; and we began to reminisce about old times. The first time I met Bill was back in 1982, when I went to Baltimore. The city had sold him two buildings for $100, and he had paid too much. To say it was a dangerous neighborhood back then is an understatement. As a rather naive young Texan, I was scared to get out of my car and walk a half block. (For good reason, I later found out.) But the price was right and the low overhead was an advantage to a young entrepreneur in an industry that was still just a hope and a dream in some of our eyes. We had lots of hard work and hard-won knowledge ahead of us!

We talked about the evolution of the newsletter business. We both started in the days of printed letters and large promotional mailings (remember those?) And we were both lucky enough to transition to what was to us a very new and unknown thing called the internet early enough to get some advantage. But some things stay the same. We are still dealers in information, trying to help readers understand what is going on and helping them with their investments.

There is a hierarchy to what is offered in publications these days. The first and lowest level is data, the raw numbers. On top of that come the levels of information, news, analysis, opinion, and actual actionable advice. Each adds to our depth and breadth of understanding. Yet, even as they add to our store of knowledge, we find ourselves drowning in information and knowledge. All too much of it is random noise, serving only to drown out clarity and wisdom .

The highest form of writing, I said to Bill, is storytelling, and he agreed. (Bill is the master of the story in our business.) Both of us, with our Irish ancestry and proximity to the Blarney Stone, come naturally to the storytelling medium. In an earlier time, we might have been fixtures at the local pub, spinning our tales for a pint of Guinness. But the fates have been kind to us, and we get to earn more than a few pints here and there.

Our goal (and that of many of our friends) is not to be the teller of old tales, but to seek to find the analogy, the resemblance of what is happening in the world to what we can readily understand. If the reader can come away with a fresh insight into the mysteries of life and markets, of our larger social contracts and how they impact our financial future, then we have done our work.

Our craft is part of the human heritage, harking back to when our ancestors sat around the fire at night relating the events of the day to the larger picture. (I once had a very-late-night discussion with Anatole Kaletsky about whether economists were not in fact modern-day shamans; but rather than discerning the future in the entrails of sheep, we deduced certainty from government data. I mused that some economists might be better off peering at intestines.)

Scientists have found that we humans actually get an endorphin rush when we arrive at an understanding of an event that that has perplexed us. Sadly, that understanding does not have to be true, but merely believed, to release that ancient chemical rush.

The problem is that we writers often have to challenge accepted wisdom. The “facts” are often slippery things, and it is our job to corral them carefully, lest we and our readers be led on a horseback ride into the high Andes of faulty assumptions.

And thus we come to employment. Each month in the US, on the first Friday of the month, we breathlessly await the release of the employment numbers. Markets move on the whisper of a trend, only to reverse when that whisper turns out to be just one more bit of random noise. It is said that one should not want to know how sausages or laws are made. I would add government statistics based on surveys to that list. But let’s now turn to the book Dunk and I are writing on employment, and take a look at our first draft of the chapter on government employment data.

Will the Real Unemployed Please Raise Your Hands?

The old saying about liars, damn liars, and statistics contains more than a grain of truth. Statistics are especially hard to swallow when we don’t like what they tell us. How many times do we question the validity of some statistic when it disagrees with our preconceived notions? (Statistical surveys say, a lot!) And unemployment numbers for the last few years haven’t given us reason to celebrate.

Let’s start with what you already know: millions of people are unemployed. How do you know this? The same way you know how many Americans believe UFOs are real, or how many watch the Super Bowl or own a foreign car. Almost all such data comes from surveys.

Surveys can be wonderful tools, giving us insights into data our minds can’t otherwise process. What we have to remember is that every survey is based on a sample. There is no name-by-name database (as far as we are aware) containing information on all our UFO beliefs. If there were it would be outdated almost instantly, as every minute thousands of people are born, die, enter the country, leave the country, change their minds, or get abducted and leave the planet.

Most national surveys use a sample of, at most, a few thousand people. From this, we extrapolate conclusions about a country of 300 million people. Real-world experience indicates this is usually sufficient, too – or at least close enough for most purposes.

Survey respondents can only answer the questions they are asked, however, so it’s important to ask the right thing in the right way. Otherwise the results won’t reveal the information you want to know.

BLS: Everyone’s Favorite (Whipping Boy) Agency

“Official” information about jobs, or lack thereof, comes from the Bureau of Labor Statistics, which is part of the US Department of Labor. BLS gathers, analyzes, and publishes a staggering amount of labor-related data. The bls.gov website is a treasure trove for people who are interested in employment trends.

For the purposes of trying to understand what the BLS does, let’s look at their “Employment Situation” report. The one we will consider emerged from the BLS womb on Friday, January 4, 2013, at precisely 8:30 in the morning, Washington time. The 41-page news release summarizes the survey data BLS gathered the prior month. A new report is born each month, typically on the first non-holiday Friday. It is the source of the “unemployment rate” reported in the media and closely scrutinized by economists.

The report began with the two key numbers:

The monthly change in nonfarm payroll employment, and
The unemployment rate

This particular month those numbers were 155,000 and 7.8 percent, respectively. The first number is supposed to reveal how many new jobs the economy generated that month. The second is the percentage of the workforce that was unemployed during the same month.

Figure 1: BLS News Release

How does BLS know? The numbers come out of not one but two different surveys the agency conducts every month.

The Establishment Survey asks a sample of employers how many people work for them. BLS adds up their answers and extrapolates the results to the whole economy. In other words, US employers collectively had 155,000 more people working for them in December than they did in November. Or so BLS believes.
A separate Household Survey calls on people – not businesses – to determine their employment status. The result this time is that 7.8 percent of respondents who “wanted” to be “employed” were not “employed,” as BLS defines those words.

Now, why does it take the BLS 41 pages to convey what we just said in a single paragraph? Details, details. Let’s consider a few before we move on.

Seasonal Adjustments: Unlike people, all months are not created equal. Some of the events that affect employment are unpredictable, like earthquakes. Others are semi-predictable, like hurricanes and blizzards, but don’t happen every year. And some are very reliable.

We know, for instance, that in the summer students are out of school and families tend to go on vacation. We know people do more shopping in December. We know car makers introduce new models in September, and that they order parts months before then. All these events happen every year, more or less.

BLS statisticians consider these factors and make “seasonal adjustments” to their numbers. This helps make each month’s report comparable with other months. However, since not everyone wants these adjustments, or may disagree with the methodology behind them, BLS publishes the unadjusted numbers, too.

Other, less frequent adjustments, such as new census data compiled every ten years or demographic changes like the Baby Boom help account for longer-term changes. These adjustments are not an exact science, but without them the data would eventually stop telling us anything useful.

Labor Force: An unemployment rate of 7.8 percent begs the question: 7.8 percent of what? You might think the answer is “everyone.” Not quite. Not everyone is able to work. Not everyone wants to work, either. The unemployment rate is a percentage of a subset of the population BLS calls the “labor force.”

In fact, the labor force is a subset of a subset. Unlike the US Census, which counts every human being it can find, BLS is interested only in the “civilian noninstitutional population.” People in prison may be chipping rocks or making license plates, but BLS doesn’t care. They are “institutional” and not competing for jobs (unless you are a license plate maker or a rock chipper, perhaps). People in hospitals, nursing homes, and various other categories are also excluded.

Figure 2: Household Survey, December 2012

As we see in Figure 2, in December 2012 the civilian noninstitutional population was 244,350,000. The civilian labor force was 155,211,000.

Now, how does BLS determine how many Americans are in the labor force? They call us, or at least enough of us to provide a statistically valid sample.

The Household Survey

Formally known as the “Current Population Survey,” the BLS Household Survey is a monthly sampling of about 60,000 households. It is actually conducted by the US Census Bureau, which then gives the raw data to BLS for further analysis.

The 60,000 households are called during a “reference week,” normally around the 12^th of the month. Whoever answers the phone is asked a series of questions about their work status. From their answers, BLS classifies each person age 16 or over in the sampled household into one of three categories:

Employed
Unemployed
Not in the labor force.

Every person who lives in a sampled household goes in one of these three groups. The only escape is to be in the “institutionalized” category, as we discussed earlier, or to be under age 16.

BLS considers a person to be “employed” if they were a paid employee at any point during the reference week. If you started a new job the day before, worked fifteen minutes, and then got fired, BLS still calls you employed.

People also count as employed if they worked in their own business or farm, or if they worked without pay at least 15 hours in a family business or farm. This is important. Suppose you were laid off last month, and instead of looking for a new job you decided to start your own business. This is a fairly common scenario during a recession. Even if no one has hired you, your start-up work means you are “employed.”

Also counted as employed are people who have a job but who were temporarily absent during the reference week because of illness, bad weather, vacation, a labor-management dispute, or for other personal reasons.

The BLS sample, when extrapolated to the entire nation, tells us the US had 143,305,000 “employed” people in mid-December 2012. To be classified as “unemployed,” on the other hand, people in the sampled households must meet all of the following criteria:

Had no employment during the reference week,
Were available for work the entire week, and
Made specific efforts to find employment sometime in the last four weeks.

(Note that the BLS unemployment data has nothing to do with unemployment benefits. That’s an important piece of information, too, but it’s not part of the BLS report.)

Under these definitions, BLS believed there to be 12,206,000 unemployed people in the US in December 2012. Add this to the 143,305,000 who were “employed,” and we get 155,511,000 either working or who want to work. This is the “civilian labor force.”

From here the math leads straight to the unemployment rate: 12,206,000 divided by 155,511,000 equals 7.8 percent. A year earlier it was 8.5 percent, so maybe we’re making progress – but don’t be too sure.

The “civilian noninstitutional population” is 244,350,000 people. Subtract the labor force, and we have a third category that BLS calls “not in the labor force.” At 88,839,000, it is a big group, all of whom are neither “employed” nor “unemployed”; they simply don’t “participate” in the labor market.

BLS tracks this group with a statistic called “participation rate.” They found that 63.6% of the population was either working or looking for work in December 2012.

The participation rate has been drifting downward for a long time, and the reasons are a big subject of debate. Most analysts agree that at least some nonparticipants could be in the labor force if they would only … participate.

Recall that you are not “unemployed” unless you looked for a job in the last four weeks. You can be physically able to work, and even willing to work if someone offered you a job, but you must still have made “specific efforts” to find a job in the last four weeks. If you didn’t, then BLS does not consider you unemployed.

Nonparticipants aren’t necessarily watching TV all day. At any given time, many people are in various kinds of in-between conditions. For example, someone might leave a job (or be fired) and spend a few weeks or months traveling, or caring for a sick relative, or engaged in volunteer projects. Obviously, they would need to live on savings or find some other means of support, but many people do so.

A more ominous example of a nonparticipant is the “discouraged worker.” Such people had a job, lost it, could not find another one, and are not making the “specific efforts” to find employment that BLS wants to see. They tend to start looking again when they think more jobs have become available. This leads to a seeming paradox in which the economy improves, enticing discouraged workers to look for jobs, which expands the workforce but makes the unemployment rate worse instead of better.

Say what? Yes, the unemployment rate can change sharply, even if no one is hired or fired, based simply on changes in the participation rate. In the December 2012 example above, we saw that 88,839,000 people were “not in labor force.” Suppose 1% of this number had instead been looking for work that month. Not finding work, just looking. That would be 888,390 people now counted as officially unemployed.

Look what happens. The number of unemployed people goes up from 12,206,000 to 13,094,390. The labor force is now 156,399,390 instead of 155,511,000. The unemployment rate isn’t 7.8 percent, it’s 8.4 percent. And what if not just 1% but 5% of those “not in labor force” start making “specific efforts” to find a job? Unemployment rises to almost 11%! Other surveys have suggested that 5% is not at all an unreasonable assumption as to how many “nonparticipants” are actually seeking employment, and that number might even be way too low.

This kind of massive change is entirely possible with the BLS methodology. Does it mean they are doing it wrong? No, it simply means they are trying to distill a complex situation into a comprehensible set of numbers. Distortions are inevitable.

What it really tells us is to take all the numbers with a pinch of salt. Political spin and media reporting are not much help, either. When the unemployment rate goes from 7.8 to 7.6, they all exclaim, it’s a huge improvement, we’re on the right course, we’re making progress! And a move the same size in the other direction is a sure sign of recession and the loss of hope. (Even including a number after the decimal point in the unemployment rate demonstrates that economists have a sense of humor, if somewhat distorted.)

The BLS, ever-helpful, also gives us other ways to measure employment, but they are largely ignored by the mainstream media because they paint a much bleaker picture. (The following note is from my friend Grant Williams, in his brilliant Things That Make You Go Hmmm...)

The fact that there are multiple unemployment rates, including one that is labeled as the 'official' rate (U3), should be enough to raise a red flag as to how easy manipulation of those figures can be — particularly as the most comprehensive unemployment rate (U6) is almost double the official unemployment rate. It includes

• part-time workers who want to work full-time but cannot due to economic reasons

• 'discouraged workers', or those who have stopped looking for work because current economic conditions make them believe that no work is available for them and,

• other 'marginally attached workers', or 'loosely attached workers', and those who 'would like to' and are able to work but have not looked for work recently.

And, as can be clearly seen from the tables below, this has been the case for a long, long time.

Source: Portalseven

Instead of fixating on any one month, we should all look at long-term trends. The various statistical anomalies tend to sort themselves out, given enough time. The unemployment numbers are repeatedly revised for several months, then revised annually, and even larger adjustments are made every few years, based on new and more accurate data. For instance, two months later, we find that the number of new jobs in December 2012 has risen to 219,000. That is almost 40% more than the original estimate. But the January 2013 number has been revised down by 38,000. Such large revisions are typical.

Remember the jobless recovery of the Bush years? Revisions made years later tell us that it was not a jobless recovery after all. The seasonal adjustment factors are based in large part on recent trends. If the trend has been down, the seasonal adjustment is likely to understate the number of jobs created. Likewise, the unemployment numbers in the recent credit crisis have been revised downward, as the employment trend prior to the crisis had been upward.

The BLS has to have some mechanism by which to make its estimates. They really do try to get it right, but they are working with imperfect data. The formulas they use are quite public, if a bit arcane. Contrary to the belief of some, there is no “spin” in their data. It is what it is. But the formulas they use can be quite controversial to those who care about such things and are be hotly debated (although hotly might be a bit over the top as a descriptor of econometric disputes).

Further, the BLS has to simply guess each month as to the number of new businesses that have been created and the number of businesses that have failed. The ratio of the two is known as the “birth/death ratio,” and it can make a big difference. The “real” birth/death number may not be really known for years after the initial report, until other sources of information (tax data, etc.) can be collected and analyzed.

This brings up two points to always keep in mind. First, it is generally the trend of the BLS revisions that is more important than just the revealed numbers. In general, the trend can actually give us a lot more useful information than the fresh monthly data. If you add the trend data to the information from other surveys and sources, it can give a hint as to the direction of the economy and the markets.

Second, anyone actually trading on the monthly employment data when it is released deserves whatever revenge the markets take. (If your investment advisor is prone to such nonsense, you might consider what else he or she is up to, and question whether the relationship is really contributing to your well-being. Just saying.)

With those caveats, let’s answer the question posed as we began this chapter. How bad is the jobs crisis? BLS data gives us at least a rough idea. For comparison, we’ll go back five years, to December 2007. We now know that the recession was already unfolding, but at the time economic confidence was still generally high.

	December 2007	December 2012
Monthly Change	+18,000	+155,000
Unemployment Rate	5.0%	7.8%
Civilian Noninst. Population	233,156,000	244,350,000
Civilian Labor Force	153,866,000	155,511,000
Employed	146,211,000	143,305,000
Unemployed	7,655,000	12,206,000
Not in Labor Force	79,290,000	88,839,000
Participation Rate	66.0%	63.6%

We could write an entire book exploring just the numbers in this one table. A few highlights and anomalies:

The unemployment rate was much better in 2007 – better, in fact, than the 5.5% some economists now consider “full employment.”
The civilian noninstitutional population grew approximately 11 million in five years, yet the civilian labor force rose by only 1.6 million.
The number of employed was actually 1.9 million lower in 2012 than in 2007.
The “not in labor force” category gained 8.5 million people in five years.

Anyone who grumbled at the December 2007 BLS report would probably be glad to have it back. The situation now is much, much worse. It is also worse for some than others. But therein lies a book, and it is time to draw this letter to a close.

Home(less) Again, California, New York, and Singapore

As this letter hits your inbox, I will be making my way back to Dallas. Three planes should just about get me there, in just under 24 hours. I see it as just another day at the office and a chance to catch up on my reading.

Speaking of which, if you’re having trouble keeping up with yours, I may be able to take the load off a bit with our new Thoughts from the Frontline audio service, which delivers my weekly letter to your cellphone, iPod, MP3 player, or computer, whenever and wherever you choose. You can check it out right here.

I will be speaking at a special one-day event in Sonoma, California, on April 5. My friend Mike Shedlock is holding a charity fundraiser to support research into ALS (Lou Gehrig’s disease.

You can find out more at Mish's Conference.

My own conference (co-sponsored with Altegris Investments) is May 1-3. It is filling up rapidly. The line-up of speakers is the best I have seen anywhere this year. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. I hope to see you there.

I will be in Singapore for a speech April 18-19. I then hop back to San Francisco for a speech for the National Association of Surety Bond Producers (NASBP) on April 22.

I got a text this morning from daughter Amanda: “Dad, when are you coming back on Thursday? My blood pressure is high and they might induce the baby a little early.” A quick call gave Dad some assurance that things are all right. It is a good thing I was scheduled to come home anyway, as I would have left friends and meetings in the lurch to get back to be with Amanda. There are few days as important as this one, and I intend to be there. Not that I am necessary to the happenings. I will probably be my usual useless self, trying not to get in the way but feeling the need to be around just in case. I am not sure what that case might actually be, but being there makes me feel better.

I will return to Dallas to a hotel, as my worldly possessions are in storage somewhere. I am between residences, and it is unclear when things will sort themselves out. Rather than making any sort of commitment, I will just find a room and live and work from there. It is not as if I am not used to hotel living. And this does offer the opportunity to do an acid test of the new virtual office we have been working on. We have been practically there for a long time. For all intents and purposes, I carry my office with me – but I will miss my Health Chair.

Have a great week. Learn to ignore the noise, unless it is the gentle cry of a new granddaughter. And then just enjoy it.

Your wondering what my grandkids will do when they grow up analyst,

John Mauldin

subscribers@mauldineconomics.com

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Would the Real Peter and Paul Please Stand Up?

John Mauldin — Sat, 16 Mar 2013 05:59:00 GMT

As I sit here in Cafayate, surrounded by sumptuous beauty and enjoying a slower pace, I find myself reflecting on the magnitude of the human economic endeavor and our search for a path to sustainable investing in a world where central bankers seem hell-bent on changing the very nature of the medium of exchange. All in the name of helping us, to be sure, with the most positive of intentions; but if you are a retired person living on your lifetime of accumulated savings, you might be wishing for a little less of what they call help and a little boost to interest rates, to help you afford a safe and pleasant retirement.

In this contemplative mode, I received a brief essay from one of my favorite thinkers, Dylan Grice, who has left the labyrinthine halls of Societe Generale to work with Edelweiss Holdings. This is a move I applaud, as I expect it will enrich us all by making his writings more accessible. He is a thinker of the very highest order and someone I go out of my way to spend time with. I am being somewhat presumptive in sending to you a portion of his inaugural appearance in Edelweiss Journal, but I don’t think he will mind. (I am under a deadline, and he is appropriately focused elsewhere at the moment.)

Let me preview his work with this one paragraph, where he talks about that most precious of commodities, trust, and its relationship to central banks:

Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Th us, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.

For those who are interested, his website is http://www.edelweissjournal.com/.

I have been seriously off the grid for a few days, up in the Andes at Bill Bonner’s hacienda, which is in as remote a place as I have ever visited. Using the term road in conjunction with getting there does not quite convey the reality. Animal paths, dry riverbeds (where we got stuck in the sand), rock-strewn trails, overhangs, gorges, and river crossings (where we once again had to be towed when we did not make it all the way across), flat tires, wrong turns on unmarked tracks leading to canyons of immense beauty but not exactly on our map. During the rainy season his place is completely inaccessible; but oh dear gods, when we arrived it was to a beauty and serenity seemingly out of place and time.

Then it was all about wood stoves, cold showers, and power for just a few hours a day, but also much laughter and thought-fueled conversation with Bill, Doug Casey, David Galland, and a few others. It is a working cattle ranch (Doug Casey calls them sand-fed beef, but there did seem to be pastures here and there), with high-altitude vineyards producing wines that Parker has rated at 93. I rode a horse and managed to not fall off, although there were a few moments when I wasn’t sure who was more scared, me or the horse.

Bill lives there a few months a year, and until I got there I did not understand the attraction. If he allows me, I will return next year, but with a more appropriate vehicle for the “roads.”

As I sat beneath the most star-filled sky I have ever gazed upon (and I have taken in a few remote and lightless vistas), I took time to reflect on what a remarkable life I have been blessed to lead these last few years. Never in my dreams did I foresee this path. It is not just the places I go, it’s the people I meet everywhere, who invest in my own limited understanding and meager insights. What a fascinating world and time in which we find ourselves. I wake up every day hoping to continue the journey a little longer, thinking about our collective economic path and writing to you of what I learn.

Now, let’s enjoy thinking with Dylan. (And I am off to the gym and then back to my book writing!) If you have not registered to come to my Strategic Investment Conference, May 1-3, you need to do so now. I hope we will create a time and place where you can gather your own insights and have some learning moments. This will be the best conference we have ever done.

Your thinking about the future of work analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

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Would the Real Peter and Paul Please Stand Up?

By Dylan Grice

In a previous life as a London-based ‘global strategist’ (I was never sure what that was) I was known as someone who was worried by QE and more generally, about the willingness of our central bankers to play games with something which I didn’t think they fully understand: money. This may be a strange, even presumptuous thing to say. Surely of all people, one thing central bankers understand is money?

They certainly should understand money. They print it, lend it, borrow it, conjure it. They control the price of it... But so what? What should be true is not necessarily what is true, and in the topsy-turvy world of finance and economics, it rarely is. So file the following under “strange but true”: our best and brightest economists have very little understanding of economics. Take the current malaise as prima facie evidence.

Let me illustrate. Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Thus, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.

One such ‘unmeasurable’ increasingly occupying us here at Edelweiss is that upon which all economic activity is based: trust. Trust between individuals, between strangers, between organizations... trust in what people read, and even people’s trust in themselves. Let’s spend a few moments elaborating on this.

First, we must understand the profound importance of exchange. To do this, simply look around you. You might see a computer monitor, a coffee mug, a telephone, a radio, an iPad, a magazine, whatever it is. Now ask yourself how much of that stuff you’d be able to make for yourself. The answer is almost certainly none. So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now. And what makes it possible for you to have it? Exchange. To be able to consume the skills of these strangers, you must sell yours. Everyone enters into the same bargain on some level and in fact, the whole economy is nothing more than an anonymous labor exchange. Beholding t he rich tapestry this exchange weaves and its bounty of accumulated capital, prosperity and civilization is a marvelous thing.

But we must also understand that exchange is only possible to the extent that people trust each other: when eating in a restaurant we trust the chef not to put things in our food; when hiring a builder we trust him to build a wall which won’t fall down; when we book a flight we entrust our lives and the lives of our families to complete strangers. Trust is social bonding and societies without it are stalked by social unrest, upheaval or even war. Distrust is a brake on prosperity, because distrust is a brake on exchange.

But now let’s get back to thinking about money, and let’s note also that distrust isn’t the only possible brake on exchange. Money is required for exchange too. Without money we’d be restricted to barter one way or another. So money and trust are intimately connected. Indeed, the English word credit derives from the Latin word credere, which means to trust. Since money facilitates exchange, it facilitates trust and cooperation. So when central banks play the games with money of which they are so fond, we wonder if they realize that they are also playing games with social bonding. Do they realize that by devaluing money they are devaluing society?

To see the how, first understand how monetary policy works. Think about what happens in the very simple example of a central bank’s expanding the monetary base by printing money to buy government bonds.

That by this transaction the government has raised revenue for the government is obvious. The government now has a greater command over the nation’s resources. But it is equally obvious that no one can raise revenue without someone else bearing the cost. To deny it would imply revenues could be raised for free, which would imply that wealth could be created by printing more money. True, some economists, it seems, would have the world believe there to be some validity to such thinking. But for those of us more concerned with correct logical practice, it begs a serious question. Who pays? We know that this monetary policy has redistributed money into the government’s coffers. But from whom has the redistribution been?

The simple answer is that we don’t and can’t know, at least not on an amount per person basis. This is unfortunate and unsatisfactory, but it also happens to be true. Had the extra money come from taxation, everyone would at least know where the burden had fallen and who had decreed it to fall there. True, the upper-rate tax payers might not like having a portion of their wealth redirected towards poorer members of society and they might not agree with it. Some might even feel robbed. But at least they know who the robber is.

When the government raises revenue by selling bonds to the central bank, which has financed its purchases with printed money, no one knows who ultimately pays. In the abstract, we know that current holders of money pay since their cash holdings have been diluted. But the effects are more subtle. To see just how subtle, consider Cantillon’s 18th century analysis of the effects of a sudden increase in gold production:

If the increase of actual money comes from mines of gold or silver... the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. ... All this increase of expenditures in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices. ... Those then who will suffer from this dearness... will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners ... All these must diminish their expenditure in proportion to the new consumption.

In Cantillon’s example, the gold mine owners, mine employees, manufacturers of the stuff miners buy and the merchants who trade in it all benefit handsomely. They are closest to the new money and they get to see their real purchasing powers rise.

But as they go out and spend, they bid up the prices of the stuff they purchase to a level which is higher than it would otherwise have been, making that stuff more expensive. For anyone not connected to the mining business (and especially those on fixed incomes: “the landowners, during the term of their leases”), real incomes haven’t risen to keep up with the higher prices. So the increase in the gold supply redistributes money towards those closest to the new money, and away from those furthest away.

Another way to think about this might be to think about Milton Friedman’s idea of dropping new money from a helicopter. He used this example to demonstrate how easy it would theoretically be for a government to create inflation. What he didn’t say was that such a drop would redistribute income in the same way more gold from Cantillon’s mines did, towards those standing underneath the helicopter and away from everyone else.

So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and so on. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.

Keynes was well aware of this insidious dynamic and articulated it beautifully in a 1919 essay:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.... Those to whom the system brings windfalls... become “profiteers” who are the object of the hatred.... the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

Deliberately impoverishing one group in society is a bad thing to do. But impoverishing a group in such an opaque, clandestine and underhanded way is worse. It is not only unjust but dangerous and potentially destructive. A clear and transparent fiscal policy which openly redistributes from the rich to the poor can at least be argued on some level to be consistent with ‘social justice.’ Governments can at least claim to be playing Robin Hood. There is no such defense for a monetary driven redistribution towards recipients of the new money and away from everyone else because if the well-off are closest to the money, well, it will have the perverse effect of benefitting them at the expense of the poor.

Take the past few decades. Prior to the 2008 crash, central banks set interest rates according to what their crystal ball told them the future would be like. They were supposed to raise them when they thought the economy was growing too fast and cut them when they thought it was growing too slow. They were supposed to be clever enough to banish the boom-bust cycle, and this was a nice idea. The problem was that it didn’t work. One reason was because central bankers weren’t as clever as they thought. Another was because they had a bias to lower rates during the bad times but not raise them adequately during the good times. On average therefore, credit tended to be too cheap and so the demand for debt was artificially high. Since that new debt was used to buy assets, the prices of assets rose in a series of asset bubbles around the world. And this unprecedented, secular and largely global credit inflation created an illusion of prosperity which was fun for most people while it lasted.

But beneath the surface, the redistributive mechanism upon which monetary policy relies was at work. Like Cantillon’s gold miners, those closest to the new credit (financial institutions and anyone working in finance industry) were the prime beneficiaries. In 2012 the top 50 names on the Forbes list of richest Americans included the fortunes of eleven investors, financiers or hedge fund managers. In 1982 the list had none.

Besides this redistribution of wealth towards the financial sector was a redistribution to those who were already asset-rich. Asset prices were inflated by cheap credit and the assets themselves could be used as collateral for it. The following chart suggests the size of this transfer from poor to rich might have been quite meaningful, with the top 1% of earners taking the biggest a share of the pie since the last great credit inflation, that of the 1920s.

Who paid? Those with no access to credit, those with no assets, or those who bought assets late in the asset inflations and which now nurse the problem balance sheets. They all paid. Worse still, future generations were victims too, since one way or another they’re on the hook for it. So with their crackpot monetary ideas, central banks have been robbing Peter to pay Paul without knowing which one was which. And a problem here is this thing behavioral psychologists call self-attribution bias. It describes how when good things happen to people they think it’s because of something they did, but when bad things happen to them they think it’s because of something someone else did. So although Peter doesn’t know why he’s suddenly poor, he knows it must be someone else’s fault. He also sees that Paul seems to be doing OK. So being human, he makes the obvious connection: it’s all Paul and people like Paul’s fault.

But Paul has a different way of looking at it. Also being human, he assumes he’s doing OK because he’s doing something right. He doesn’t know what the problem is other than Peter’s bad attitude. Needless to say, he resents Peter for his bad attitude. So now Peter and Paul don’t trust each other. And this what happens when you play games with society’s bonding.

When we look around we can’t help feeling something similar is happening. The ïï% blame the 1%; the 1% blame the 47%. In the aftermath of the Eurozone’s own credit bubbles, the Germans blame the Greeks. The Greeks round on the foreigners. The Catalans blame the Castilians. And as 25% of the Italian electorate vote for a professional comedian whose party slogan “vaffa” means roughly “f**k off” (to everything it seems, including the common currency), the Germans are repatriating their gold from New York and Paris. Meanwhile in China, that centrally planned mother of all credit inflations, popular anger is being directed at Japan, and this is before its own credit bubble chapter has fully played out. (The rising risk of war is something we are increasingly worried about...) Of course, everyone blames the bankers (“those to whom the system brings windfalls... become ‘profiteers’ who are the object o f the hatred”).

But what does it mean for the owner of capital? If our thinking is correct, the solution would be less monetary experimentation. Yet we are likely to see more. Bernanke has monetized about a half of the federally guaranteed debt issued since 2009 (see chart below). The incoming Bank of England governor thinks the UK’s problem hasn’t been too much monetary experimentation but too little, and likes the idea of actively targeting nominal GDP. The PM in Tokyo thinks his country’s every ill is a lack of inflation, and his new guy at the Bank of Japan is revving up its printing presses to buy government bonds, corporate bonds and ETFs. China’s shadow banking credit bubble meanwhile continues to inflate…

For all we know there might be another round of illusory prosperity before our worst fears are realized. With any luck, our worst fears never will be. But if the overdose of monetary medicine made us ill, we don’t understand how more of the same medicine will make us better.

We do know that the financial market analogue to trust is yield. The less trustful lenders are of borrowers, the higher the yield they demand to compensate. But interest rates, or what’s left of them, are at historic lows. In other words, there is a glaring disconnect between the distrust central banks are fostering in the real world and the unprecedented trust lenders are signaling to borrowers in the financial world.

Of course, there is no such thing as “risk-free” in the real world. Holders of UK cash have seen a cumulative real loss of around 10% since the crash of 2008. Holders of US cash haven’t done much better. If we were to hope to find safety by lending to what many consider to be an excellent credit, Microsoft, by buying its bonds, we’d have to lend to them until 2021 to earn a gross return roughly the same as the current rate of US inflation. But then we’d have to pay taxes on the coupons. And we’d have to worry about whether or not the rate of inflation was going to rise meaningfully from here, because the 2021 maturity date is eight years away and eight years is a long time. And then we’d have to worry about where our bonds were held, and whether or not they were being lent out by our custodian. And of course, this would all be before we’d worried about whether Microsoft’s business was likely to remain safe over an eight year horizon.

We are happy to watch others play that game. There are some outstanding businesses and individuals with whom we are happy to invest. In an ideal world we would have neither Peters nor Pauls. In the imperfect one in which we live, we have to settle for trying hard to avoid the Pauls, who we fear mistake entrepreneurial competence for proximity to the money well. But when we find the real thing, the timeless ingenuity of the honest entrepreneurs, the modest craftsmen and craftswomen who humbly seek to improve the lot of their customers through their own enterprise, we find inspiration too, for as investors we try to model our own practice on theirs. It is no secret that our quest is to find scarcity. But the scarce substance we prize above all else is trustworthiness. Aware that we worry too much in a world growing more wary and distrustful, it is here we place an increasing premium, here that we seek refuge from financial folly and here that we expect the next bull market.

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Argentina on Sale

John Mauldin — Wed, 13 Mar 2013 17:29:00 GMT

Argentina: A Lesson in Chaos
Argentina on Sale
Why Don't You Just Stop?
Can the US Experience Argentinean Inflation?
Webinar
The Andes, Sonoma, Manila, and Singapore

When I was younger, so much younger than today,
I never needed anybody's help in any way.
But now these days are gone, I'm not so self assured,
Now I find I've changed my mind and opened up the doors.

– John Lennon, the Beatles

(From Cafayate, Argentina) There are some who worry whether the path that Argentina has taken to monetary ruin on multiple occasions (and that it seems intent on taking again) is one that the US may also find itself on. That worry has crossed my mind a few times, I must confess. Today we will look at Argentina more in depth. From a monetary perspective, it deserves attention. And once again there will be opportunity.

Let me jump right to the conclusion: Just as Spain is not Greece, because each chose a unique route to economic malaise, the US is not Argentina. We are perfectly capable of avoiding Argentina's problems while cooking up ones that are all our own. But there are some worrisome and potentially instructive issues in Argentina.

Argentina: A Lesson in Chaos

At the turn of the 20^th century Argentina was one of the richest countries in the world, due primarily to its vast and fertile farmlands. In 1913, GDP per capita was about equal to those of France and Germany and close to that of the US. By 1950, though, Argentina's GDP per capita wasn't even half that of the United States. (You can read a short, graphic history of the economic chaos that has been Argentina from the 1930s on at http://en.wikipedia.org/wiki/Economic_history_of_Argentina.)

Currency values plummeted. Inflation reached 5,000% at one point in the 1970s. Prices increased by a factor of 20 billion from 1975-1991 – over 300% per year. In 1983, at the urging of the IMF, a new peso was introduced at a value of 10,000 to one of the old pesos. Ouch. And that was just the beginning!

The Peronist government of Menem, elected in 1989, made a deal with the IMF, which promptly collapsed, leading to a rapid 12,000% inflation. On January 1, 1992, a new monetary reform replaced the austral (the name of the currency at that time) with the new peso at a rate of 10,000 australs for one peso. Another 10,000-fold devaluation – twice within ten years! The peso was now fixed to the dollar.

The following chart shows the value of the peso in dollar terms since 1936. The numbers are in German, which makes the chart just too ironic not to use. Note that each one of the horizontal bars represents a devaluation of 90%! (The vertical axis is a log-10 scale.)

I first came to Argentina in 1993. The country had just emerged from economic chaos. Real per capita income had dropped by 20% in the previous 20 years. But even with the chaos, the restaurants were busy at 10 PM, when Argentines like to eat!

Over the succeeding years, with a fixed dollar exchange rate, some industries could not compete and trade deficits grew. As in Greece today, the only way to create a fiscal balance was labor-price devaluation, which was decidedly unpopular. So Argentina went off the dollar standard, and the value of the peso dropped by 50%.

In December 1999 Fernando de la Rúa was inaugurated President, seeking assistance from the IMF shortly thereafter. In March 2000, the IMF agreed to a three-year $7.2 billion stand-by arrangement with Argentina, conditioned on a strict fiscal adjustment and the assumption of 3.5% GDP growth in 2000 (actual growth was 0.5%). In late 2000, Argentina began to experience severely diminished access to capital markets, as reflected in a sharp and sustained rise in spreads on Argentine bonds over U.S. Treasuries. In December, the de la Rua government announced a $40 billion multilateral assistance package organized by IMF. The uneven implementation of fiscal adjustments and reforms, a worsening global macroeconomic environment, and political instability led to the complete loss of market access and intensified capital flight by the second quarter of 2001. Argentine debt, held mostly in bonds, was massively sold short and the government found itself unable to borrow or meet debt payments. [Shades of later Greece!]

In December 2001, a series of deposit runs began to have a severe impact on the health of the banking system, leading the Argentine authorities to impose a partial deposit freeze. With Argentina no longer in compliance with the conditions of the expanded IMF-supported program, the IMF decided to suspend disbursements. At the end of December, in a climate of severe political and social unrest, the country partially defaulted on its international obligations; in January 2002, it formally abandoned the convertibility regime. (Wikipedia)

The economic and political crisis that followed was arguably the worst since the country gained its independence from Spain in 1816. By the end of 2002, the economy had contracted 20% since 1998.Over the course of two years, output fell by more than 15%, the Argentine peso lost three-quarters of its value, and registered unemployment grew to 25%. Income poverty in Argentina grew from an already high 35.4% in October 2001 to a peak of 54.3% in October 2002.

My friend and Uruguayan business partner Enrique Fynn tells stories of coming to Buenos Aires and hearing new prices being announced hour by hour over a public address system in a grocery store. He had dollars, which bought him lots of goods to take back on the ferry.. People who were prescient and had money were able to buy apartments in BA and land in Argentina at what can only be called fire-sale prices.

Argentina on Sale

I remember coming to Argentina about three years ago. I thought prices in Buenos Aires were high – the peso was about 3.50 to the dollar. When I visited again last November, prices were "reasonable" by my travel standards, and here in Cafayate I found good value. I have friends who are building homes here much more cheaply than they could in the US. And the quality is high; there are some real craftsmen here. Their stonework is exquisite.

I was in Buenos Aires last Friday. The official exchange rate is now 5.50 pesos to the dollar. The street price is 7.75, on its way to 8. But the largest bill is a 100-peso note, which is now worth less than $13. Using a credit card costs at least an extra 10%, if not 20%; but the prices you are quoted for using a credit card instead of cash are higher to start with, before the surcharge, so using a card ends up costing you about an extra 40%. But you need to carry a lot of cash if you want to buy anything expensive. (Be very careful if you do not know your way around. I am told there are lots of counterfeit bills passed off on tourists. Not that I exchanged anything, of course this is all theoretical, for illustration purposes.)

I was staying in the Recoleta area, which is one of the most expensive areas of the city and a wonderful place to while away a day or two.

But things were cheap. A simple lunch for two on a fashionable street was around $15. We had a fabulous meal at a restaurant we stumbled on, called Sirop Folie. (I will go again!) It would have been $150 at a comparable place in Dallas or NYC (or Europe), but it cost us just $50, including tip. I left my computer mouse in Dallas but was able to pick one up for $6. Vegetables and cheeses were around half what I am used to paying in Dallas. I began to "shop" in order to look at prices. By US standards, Argentina is on sale. And this was in the high-rent district.

On the way to Cafayate, there were signs on the road for chicken dinners for the local trade priced at $2 equivalent. Our dinner last night for two was less than $40 (all in) at what is considered one of the better local restaurants, Vinas de Cafayate (fabulous menu!). The place was packed by 10 pm, as I was leaving. So Argentina seems inexpensive today. Not a definitive study, admittedly, but the trend is clear.

President Kirchner is again experimenting with price controls. (Peron infamously tried to control even restaurant menu prices in the late 1940s – you'd think he would have known better). The last time price controls failed was in 2005. Now, Argentina has limited beef exports in the futile hope that doing so will drive down beef costs. All that has happened is that cattle herds have been reduced and exports are down. Similar export controls to try to keep bread prices down have seen wheat production fall.

Brazil has seen its cattle exports explode in 20 years, while Argentina's have not grown at all as the government tries to control production and export prices. Argentina used to be the world's largest beef exporter, but Brazil now has a herd almost four times the size of Argentina's. How many jobs have been lost to Brazil? One long-time exporter says, "There are developed countries, emerging countries, and then there's Argentina.

Want to see something sad? An illustration of what governments can do to an industry by trying to control it? Look at this chart. Argentina is now down at #11. Tiny neighbor Uruguay exports twice the beef and veal.

The government is committed to a path of monetization. Inflation is denied by government statisticians, but it is at about 30% and rising. While the government is putting pressure on grocers to maintain prices, which always leads to shortages, as of this morning you can still find anything you want at the local equivalent of a well-stocked Hypermart.

Why Don't You Just Stop?

I sat down for what became a lengthy conversation with Juan Carlos Romero, the current senator from Salta Province. Juan Carlos is my age (which is to say a young 60ish) and is the very image of as an old-style patron, straight from central casting. He was governor of the province from 1995 to 2007 (it's the family business – his father was governor, too) and has been vice-president of the senate and on a national presidential ticket. He is a very successful businessman. We met last time I was here, and I hit it off with both him and his son, Juan Sebastian.

I related to him my surprise at prices and inflation. The last time I was in the Recoleta, in November, there was a protest march (quite peaceful and civilized, if enthusiastic and noisy) of some 700,000 people in the center of town, along 9 de Julio Avenue, which is the widest avenue in the world. It is impressive to walk down.

But things have only gotten worse since then. "Haven't you seen this movie before?" I asked. "Don't you know how this ends? What part of seeming insanity do you keep wanting to repeat? Why can't you stop it?" I will summarize Juan Carlos's answers from the notes I took.

Argentines don't want to hear bad news (does anyone?). Monti gave the Italians bad news, and he only got 9% of the vote. The bureaucracy is out of control in Argentina, and it just keeps growing and creating costs. There are too many subsidies to certain businesses. And, as a result of votes during the last crisis, power is now concentrated in the presidency and a few key positions. There are not the checks and balances we are used to between branches of government in the States. Both major parties voted to nationalize pensions. Government benefits and subsidies are given to a large number of people, who then vote for more government benefits.

"In Argentina, we have the ability to make the same mistake many times, and nothing happens to change things. Why? Because there is a pervasive belief that the state can provide all that people need: jobs, welfare, everything." Perhaps, he mused quietly, that attitude is a heritage from colonial days, when the King of Spain controlled the country and power and privilege and benefits came from the King.

Aerolineas loses $2 million a day, but people believe it is better than a private company. The government is not seen as something owned by the people but as something that exists to solve problems and take care of the people. Both parties and a majority of voters seem to agree that government is better than the private sector. Some sectors have few controls, and others are tightly controlled.

"Even so," I asked, "can't those in control see that inflation is bad?" The problem, he explained, is that those who have the ear of the president see inflation as a way to growth and thus a good thing. Those in power deny there is inflation and think it is caused by "commercial" interests that selfishly raise prices. Kirchner and those around her actually believe that their current policies will work. Meanwhile, 42% of GDP is government expenditures.

In a country of vast lands and unsurpassed beauty, more than half the people live in one city, Buenos Aires. (I think they all try and get out on the roads when I am going to or from the airport.) And that urban power base is central to Kirchner's control – she won the last election handily.

As I walked through the Recoleta, I thought I saw stress on the faces of the people I encountered. You can talk to businesspeople and sense the stress.

How do you cope with such repeated episodes of chaos? Argentines who have money keep it outside the country. As one person told me, "In America, you buy gold to protect yourselves. We buy dollars." The national sport – second only to fútbol – is tax evasion. (They come by both naturally, as about 60% of the population has Italian ancestors.)

And yet there is a thriving business community. The skyline is much more impressive in BA than it was 20 years ago. Argentines are an educated people. And things can and do get done.

Jon Malinski is a Minnesota businessman. He invested in a vineyard in Mendoza and recently bought a vineyard here in Cafayate, in one of the better growing regions. Two years ago, he broke ground on a massive, sophisticated, modern winery here. It is now open for business. He hosted a dinner on my first night here (accompanied by a huge lightning display back up in the mountains).

I have been to a few wineries in my time. This one was rivaled in elegance by only a few in the Napa Valley or France and the Ferragamo estate in Italy. Note: He bought the land and decided to build, and the winery was completed in two years. In the US, for an undertaking this large, you can't even get the approval process underway in two years. One of Jon's competitors told me he probably spent $20 million. For all the Argentinean government controls, in certain sectors you are free to do what you want.

This region is booming. Building is going on everywhere. People smile on the streets and are patient with your mangled attempts at Spanish.

There is a rather amazing contrast between the macroeconomic situation of the country and life on the street. Soon, the peso will once again come to be seen as a medium that will only be usable in immediate exchanges. Unless something is done, Argentina is going to repeat its past. Unlike Germany, which still remembers the Weimar hyperinflation, Argentina just seems to shrug off its past. The economy has recently survived on a boom in soybeans, but there is not much else to rely upon.

Argentina is on sale. I think prices relative to the dollar will rise. This is one sale where the last day is not yet known. Think about coming down here next fall and enjoying the time with me.

Can the US Experience Argentinean Inflation?

I know some readers think the worst of the Fed, and I am not a fan in general (and am opposed to the current QE policy), but I simply can't conceive of the FOMC voting to monetize if inflation tops 10% again. I think there would be serious efforts to curb QE (monetization) at 5-6% inflation, although until we reach that level I think it will be tolerated. With higher inflation than that, voters would simply rebel. Think the '70s: both Ford and Carter lost in part because of the economy and inflation.

In theory, any country can experience Argentinean-style inflation. It just takes a printing press (which today simply involves pushing some electrons around), a willing central bank, and a complicit citizenry. US citizens have an inherent distrust of government, although I admit that is slowly changing. Two factoids:

Nearly a quarter of the voters in the last presidential election were single women, and they voted 2:1 for Obama and thus a larger role for government. (Guardian) Romney won married women voters by a significant amount, but the singles went to Obama, and they are the fastest-growing voter group. Government is increasingly being seen in certain circles as a provider of benefits and support, both for healthcare and as a general safety net. Growing economic malaise and rising healthcare costs only fuel this trend.

And government is expanding the list of people who get direct benefits. Food stamps now go to almost 49 million people. Eleven states have welfare benefits that are higher than the minimum wage. And look at this chart on the growth of disability payments. Over half the recent rise above trend in disability benefits is for the treatment of mental disability and stress.

"How," I had asked Juan Carlos, "can you let it happen?" But how, indeed, can we?

Webinar

If you are a qualified purchaser or a FINRA licensed advisor, please join me and my partners at Altegris for an exclusive Mauldin Circle webinar on Tuesday, March 26 at 12:00 pm EDT/9:00 am PDT. Listen in as I interview Jacob Gottlieb, CIO of Visium Asset Management, a premiere long/short multi-strategy fund manager. We will learn more about Visiums' unique investment approach and how they're finding alpha opportunities in the current environment – both on the long and short side. Visium Asset Management is a firm that I follow closely, and I know you will find our discussion timely.

If you are a Mauldin Circle member and a qualified purchaser or an investment advisor, a webinar invitation will be sent directly to you by email. A replay will also be available to qualified registrants. If you are unable to listen in to the live discussion, be sure to register so that you can receive the replay information. If you are not a member of the Mauldin Circle and are a qualified purchaser, please join today. Upon qualification by my partners at Altegris, you will receive an email invitation . I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. I look forward to having you at this exclusive Mauldin Circle event. (In this regard, I am president and a registered representative of Millenium Wave Securities, LLC, member FINRA.)

The Andes, Sonoma, Manila, and Singapore

Tomorrow I venture off with Doug Casey, David Galland, and Olivier Garret to Bill Bonner's hacienda at Guafin, a few hours from here. A few years back, Bill bought this enormous (200,000-acre) ranch of mostly worthless land some 8,000 feet above sea level, but with magnificent views of the Andes, and he sneaks off there every now and then. I have been to his place in Ouzilly, France (a little easier to get to!) on several occasions, but this one sounds like a real fixer upper. Buying places that need lots of work seems to be his personal addiction (otherwise known as an expensive hobby), but it is a socially acceptable one and fun for his friends who drop in on him. I have known Bill for 30 years, since we were both young and starting out in the writing and publishing business. He has been a huge success, while I am hoping to be a late bloomer. But I have never had a moment with him that was not enjoyable, and most were thought-provoking. He does make me think.

He is one of my favorite writers in the business. I have often said that I feel like a house painter in front of a Rembrandt when I read Bill's musings. Actually, he is more than just a writer; he is a consummate storyteller, a raconteur worthy of the name. I am looking forward to magnificent vistas and a new adventure but also to great conversations with old friends – war horses who have seen lots of battles but are not yet ready to be put out to pasture.

I will be speaking at a special one-day event in Sonoma, California, on April 5. My friend Mike Shedlock is holding a charity fundraiser to support research into ALS (Lou Gehrig's disease. You can find out more at Mish's Conference.

My own conference (co-sponsored with Altegris Investments) is May 1-3. It is filling up rapidly. The line-up of speakers is the best I have seen anywhere this year. We offer an early-bird registration, which is about to run out. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. I hope to see you there.

I will be in Singapore for a speech April 18-19. I was going to go to Cambodia and Angkor Wat, but it is their New Year, so I will postpone that trip till the next Asia speaking trip and see Manila instead, where I have some old friends and have never been. I then hop back to San Francisco for a speech for the National Association of Surety Bond Producers (NASBP) on April 22.

Some final thoughts on Cafayate. This is just a hopping little town with a magnificent vista. Perfect climate in the tropics but at 5,000 feet. The mountains change color throughout the day. My friends have built a first-class resort. The spa is truly world-class, there is a great gym, and a massage will run you about $40. The golf course is the longest one in South America, which means there is more room for me to lose balls. There are very good to great places to eat. I am not one for road trips, but the drive through the canyon to get here is stunning, well worth a few hours' diversion.

The people who seem to collect here are about as eclectic as you can get. Nearly everyone has great stories to regale you with. And they are just generally nice people. This is going to be quite the community. I will plan to be here more, but when I am, let's see how much writing I actually get done.

Somehow, the memo that sequestration was supposed to be about austerity has gotten lost. There have been 2,600 new federal jobs posted since the introduction of the bill, 600 at Homeland Security, which was going cut workers, making lines longer at airports. I guess I am new to this off brand of austerity. But what do I know?

I know it is late, and I need a few hours' sleep. Have a great week.

Your living for places and times like this analyst,

John Mauldin

subscribers@mauldineconomics.com

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Out On A Limb: An Investor’s Guide to X-treme Monetary and Fiscal Conditions

John Mauldin — Fri, 08 Mar 2013 23:48:00 GMT

I landed in Buenos Aires early this morning and have a day layover before heading off to Cafayate; but it is time to send you this weekend's Outside the Box, and what a wonderful, powerful piece it is. I read John Hussman's latest on the way down and had to review it several times. There is just so much meat here. And more than his usual quota of those wonderful graphs he comes up with. Did you know there is a 94% correlation between the price of beer in Iceland and the S&P 500? This is a teaching moment we must heed!

I will tease you with a few paragraphs:

Let's be clear about what Bernanke is saying: "[A 'deferred asset'] is an asset in the sense that it embodies a future economic benefit [to the Fed] that will be realized as a reduction of future cash outflows [to the public].

In effect, to the extent that the Fed experiences losses because it overpaid for Treasury securities that it bought from primary dealers (comprising the too-big-to-fail banks and Wall Street investment firms), the U.S. public will pay for those losses without any need for Congressional legislation. This doesn't mean that the Fed will refrain from continued quantitative easing, but we should all understand how this policy works, and the risks and potential costs that it quietly imposes on the public.

And:

Another assertion that makes me wince is the idea that "since 2009, there has been an 85% correlation between the monetary base and the S&P 500." This is a distressing use of statistics, because two data series will always have an extremely high correlation if both series capture an uncorrected diagonal move. For example, it is equally true that since 2009, there has been a 94% correlation between beer prices in Iceland and the S&P 500. That's not to dismiss the enormous effect that Fed policy has had on the markets in recent years, but the implication of an "85% correlation" is that if one increases, the other is sure to increase as well. There is little basis in the data for that belief. The exception is that when stocks are down significantly from their level of 6-months prior, monetary easing is often eventually capable of boosting confidence and reversing recent spikes in risk premiums."

Hussman also leads us through four economic policy choices and outlines the outcome for each choice. You can make your own decision about what your country is likely to do.

I will be with John in about a month (April 5) in Sonoma, where we will both speak at Mike Shedlock's fundraising event. John is graciously matching your conference fee, and it all goes to ALS research. You can find out more at Mish's Conference. And for the two people left out there who don't know John Hussman, he runs the Hussman Funds and writes his brilliant commentary at www.hussmanfunds.com.

As I left last night the movers were packing up the last boxes to take to storage. My staff members Mary and Shannon have been supervising the move while I just keep working and every now and then agree to throw away more accumulated material (I won't say junk!). I am going to take advantage of a perfect day here in BA and do a little touristy browsing. It has been years since I was in the cemetery here in the Recoleta, and it is just a block away. I fly out early tomorrow to Salta, meet up with my old friend Tony Sagami, and then drive up the magnificently scenic canyon to Cafayate.

I think we will somehow make it to Bill Bonner's Estancia early next week, along with Doug Casey, David Galland, and Olivier Garret. It's way back in the Andes on about 200,000 acres of god-forsaken high desert. I am told it is breathtaking and have been wanting to get there for a long time. It may turn into the longest time I have been without internet in a decade. We will see what the withdrawal symptoms are like. Though I have to confess, I do have close to a thousand pages of miscellaneous reading on my iPad, not to mention 20 books. I think I can cope.

Have a great week; I know I will.

Your letting it all soak in analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

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Learn More About Over My Shoulder

Out On A Limb: An Investor’s Guide to X-treme Monetary and Fiscal Conditions

By John P. Hussman, Ph.D

Government intervention in the U.S. economy is approaching the point where probable long-term costs exceed short-term benefits – straining to maintain the pace of extraordinary fiscal and monetary measures that have repeatedly nudged the U.S. economy from the border between new recession and tepid growth for three years. U.S. Treasury debt now exceeds 105% of GDP (publicly held debt approaching 75% of GDP). Meanwhile, the Federal Reserve has expanded the monetary base to more than 18% of GDP (18 cents per dollar of nominal GDP), where a century of U.S. economic history indicates that a normalization to Treasury bill yields of just 2% could not tolerate more than 9 cents of monetary base per dollar of GDP without inflation.

The federal government continues to run a deficit of about 7% of GDP, which the $85 billion sequester would reduce to about 6.5% under the unlikely assumption that economic activity and revenues don’t contract somewhat. Current Federal Reserve policy absorbs about $45 billion per month in new government debt as part of QEternity, but even the Fed continues this policy indefinitely, U.S. publicly held debt is still likely to expand by several percent annually assuming no recession occurs. Any eventual normalization of Fed policy would dump Treasuries back into public hands (or require public purchases of new debt in the event the Fed decides to let the holdings “roll off” as they mature). Massive policy responses, directed toward ineffective ends, are scarcely better than no policy response at all.

Let’s take a look at the current monetary and fiscal policy environment, and then examine more effective policy initiatives and why they make sense.

Monetary Policy – All In

To offer a visual picture of where monetary policy stands at present, the chart below depicts the current situation, as well as data points since 1929. As of last week, the U.S. monetary base stands at a record 18 cents per dollar of nominal GDP. The last time the monetary base reached even 17 cents per dollar of nominal GDP was in the early 1940’s. The Fed did not reverse this with subsequent restraint. Instead, consumer prices nearly doubled by 1952. At present, a normalization of short-term interest rates to even 2% could not be achieved without cutting the Fed’s balance sheet by more than half. Alternatively, the Fed could wait for nominal GDP to double and “catch up” to the present level of base money, which would take about 14 years, assuming 5% nominal GDP growth.

Of course, 5% nominal growth would likely make it inappropriate to hold short-term interest rates below 2% for another 14 years. So either the Fed will reverse its present course, or we will experience unacceptable inflation, or we will experience persistently weak growth like Japan has experienced since 1999, when it decided to take Bernanke’s advice to pursue quantitative easing. My guess is that we will experience unacceptable inflation, beginning in the back-half of this decade.

Because of the strong relationship between the size of the monetary base (per dollar of nominal GDP) and short-term interest rates, it appears likely that short-term interest rates will be suppressed by Fed policy for some time, until Fed policy normalizes or inflation accelerates. The Fed is now leveraged 55-to-1 against its own capital. With an estimated duration of about 8 years on $3 trillion of bond holdings, every 100 basis point move in long-term interest rates can be expected to alter the value of the Fed’s holdings by about $240 billion – roughly four times the amount of capital reported on the Fed’s consolidated balance sheet.

Accordingly, the Fed recently indicated that it will create a new line called a “deferred asset” on its balance sheet. This “deferred asset” is a phantom accounting entry that represents the anticipation of future interest on the Treasury securities held by the Fed. This interest will not be paid back to the Treasury for the benefit of the public, as the Fed has historically done. Instead, the interest will be retained by the Fed. As Bernanke indicated in his Congressional testimony last week, in language that seems almost intentionally designed to confuse: “It is an asset in the sense that it embodies a future economic benefit that will be realized as a reduction of future cash outflows.”

Let’s be clear about what Bernanke is saying: “It is an asset in the sense that it embodies a future economic benefit [to the Fed] that will be realized as a reduction of future cash outflows [to the public].”

In effect, to the extent that the Fed experiences losses because it overpaid for Treasury securities that it bought from primary dealers (comprising the too-big-to-fail banks and Wall Street investment firms), the U.S. public will pay for those losses without any need for Congressional legislation. This doesn’t mean that the Fed will refrain from continued quantitative easing, but we should all understand how this policy works, and the risks and potential costs that it quietly imposes on the public.

Ultimately, the normalization of the Fed’s balance sheet – outside of weak economic conditions – is likely to press long-term interest rates markedly higher. This would be particularly true in the event that inflation accelerates and forces that attempt to normalize, which we expect in the back-half of this decade. As a result, the next economic recovery will very likely be associated first with a significant steepening of the yield curve, and only later by an inversion as the Fed scrambles to tighten. But in my view, the time to expect higher interest rates is not now.

I continue to expect that the course to the next economic recovery is likely to be punctuated by a global recession that is already underway in the rest of the developed world. At best, U.S. participation in that downturn has been kicked down the road for a quarter or two by QEternity. It also remains possible the final revised data will indicate that the U.S. entered a recession sometime in the third-quarter of last year. Meanwhile, immediate inflation risks do not appear pressing (despite the increase in longer-term inflation expectations), and the overwhelming negative sentiment toward bonds seems likely to be replaced by a flight to Treasuries as a safe haven. The same should not be assumed for corporate or high-yield debt, where yields have plumbed historic lows and current risk premiums appear barely sufficient to cover actuarial default risks.

By varying the amount of monetary base relative to nominal GDP, the Fed has very tight control over short-term Treasury yields and some control over the long-term yields that reflect expectations of the future course of short-term rates. But quantitative easing has also had an effect in suppressing risk premiums in securities that have much less dependence on the course of short-term rates – particularly junk rated debt, corporate debt, and stocks. The apparent blind faith in an automatic link between Fed easing and diagonally rising prices is not supported by the data, however much an uncorrected rally makes it seem otherwise.

The present syndrome of overvalued, overbought, overbullish, rising-yield conditions is the same basic environment that concerned us in 2007, and in 2000 (as well as May 2011, just before the market experienced a near-20% swoon). While the Fed continues its policy of quantitative easing, that policy is fully recognized and investors now fully rely upon its continuation. It is also an element of common knowledge that “everything will be fine until the Fed reverses course,” at which point everybody will presumably be able to sell to nobody. Unfortunately, the support for such complete confidence in Fed policy is vastly overstated.

From an analytical perspective, it’s striking to me that even some thoughtful economists we know have been making assertions about Fed policy that have no basis in the data. For example, we heard last week that “The number of times we actually had a bear market on our hands with the Fed easing and the economy expanding by any amount is around zero.” Wow. That’s not even true in the “active Fed” period. Consider for example March-October 2002, when the market plunged 30% despite reductions in the Federal Funds rate and the discount rate, despite positive GDP growth – two quarters into an economic recovery, and despite a Purchasing Managers Index persistently above 50. Ditto for late-2007 when a bear market had already started, the Fed was already easing and the PMI was still above 50 (despite a recession that wouldn’t be recognized until several quarters later).

Another assertion that makes me wince is the idea that “since 2009, there has been an 85% correlation between the monetary base and the S&P 500.” This is a distressing use of statistics, because two data series will always have an extremely high correlation if both series capture an uncorrected diagonal move. For example, it is equally true that since 2009, there has been a 94% correlation between beer prices in Iceland and the S&P 500. That’s not to dismiss the enormous effect that Fed policy has had on the markets in recent years, but the implication of an “85% correlation” is that if one increases, the other is sure to increase as well. There is little basis in the data for that belief. The exception is that when stocks are down significantly from their level of 6-months prior, monetary easing is often eventually capable of boosting confidence and reversing recent spikes in risk premiums.

In case you’re wondering, since 2000 there has been only a 9% correlation between the monetary base and the S&P 500, but a 99% correlation between the monetary base and the price of beer in Iceland. Why? The S&P 500 has experienced massive up and down cycles, while the monetary base and beer prices have both trended higher over time.

Suffice it to say that in a century of historical data, the market has experienced terribly negative outcomes, on average, following the emergence of severely overvalued, overbought, overbullish, rising-yield conditions that we presently observe. These capture a rare set of historical instances including 1929, 1972, 1987, 2000, 2007 and early 2011 – what I often refer to as a “Who’s Who” of awful times to invest. Profoundly negative outcomes have exerted themselves even in the face of ongoing or subsequent easing by the Federal Reserve. Still, coordinated easing by the Fed and the European Central Bank was able to limit the 2011 instance to a decline of just under 20%, so we are very aware of the need for our approach be nimble. I expect that the two adaptations to our approach we’ve made in recent years will address that need.

Fiscal Policy – Why Deficit Reduction Requires Investment Stimulus

Last week, $85 billion in automatic government spending cuts became reality. It seems likely that a quick round of legislation will mute the more serious effects of these cuts on military spending, air traffic controllers, and other core government services that affect public safety and national security. Other alterations may be harder won on each side, and an extended battle is likely. Meanwhile, the current stopgap spending authorizations that are keeping the government running expire on March 27. The currently-suspended debt ceiling limit comes back into force on May 19. We have thus entered a period of significant budget uncertainty, at a point where economic conditions are borderline at best.

The following are a few notes regarding the appropriate way to pursue budget discipline. Rather than discuss a wish-list of desirable but politically contentious policies, what follows is the single component that I believe is essential to the current policy response.

Let’s begin with an overview of the fiscal situation. The present federal deficit is about 7% of GDP. More than half of the deficit is explained by the shortfall of actual GDP from “potential” GDP (as estimated by the Congressional Budget Office). The remainder reflects both revenues below historical the norm and spending above the historical norm, as a percentage of GDP. With gross federal debt over 105% of GDP, the resulting escalation of debt is likely to become problematic for the capital markets within a small number of years.

The federal deficit is considered to be an “automatic stabilizer” – it tends to widen during recessions, offsetting a portion of general economic weakness, and it tends to narrow during expansions. Given the significant continued weakness of the U.S. economy, a portion of the federal deficit is the natural, stabilizing outcome of higher spending and reduced revenues.

A good way to see this is to plot the government surplus (deficit) as a share of GDP against the “output gap” – the difference between actual GDP and potential GDP. In the chart below, a move to the upper right reflects a stronger economy and improved government finances. A move to the lower left reflects a weaker economy and a deeper deficit. Notably, even accounting for the considerable size of the existing output gap, the current Federal deficit exceeds historical norms by about 3% of GDP (the present data point is highlighted).

The present federal shortfall is driven both by excessive government spending, relative to historical norms, and insufficient revenue. A weak economy with a significantly negative output gap is usually associated with greater federal spending, as a result of unemployment programs and various stimulus measures. Presently, federal spending exceeds historical norms by about 2% of GDP, even considering the existing GDP output gap.

As the economy strengthens, federal revenues tend to improve. As the economy weakens, federal revenues tend to fall short. Federal revenue is presently insufficient, relative to historical norms, by about 1% of GDP, even considering the existing GDP output gap.

Savings, Investment, and Economic Activity

I’ve often noted that recessions aren’t simply a time when total demand falls short. They are usually a time where the mix of goods and services that is demanded becomes out of line with the mix of goods and services supplied by the economy. In order to get that mix back in line, it’s not enough to simply “stimulate demand” – it’s important to encourage innovation and investment in areas where needs aren’t being met, and to allow the transition and reallocation of resources away from areas that are no longer in demand.

To see why investment activity is so important, some basic economics will be useful. So let’s do about a month of Economics 101 in about two minutes. It will be worth the effort.

First, it is an accounting identity that the total amount of saving in the economy must be equal to the total amount of real investment in the economy (even if that investment sometimes represents the accumulation of unwanted inventories).

Economists break GDP (Y) into several pieces: consumption (C), real investment (I), government spending (G), and exports (X), less imports (M). Stick with me – there’s a payoff to this:

Y = C + I + G + X – M

Adding and subtracting taxes (T) and rearranging produces what’s called the “savings investment identity.” It basically says that all investment (factories, equipment, and so forth) must be funded by some form of savings. Taking the economy as a whole, output created by the economy that isn’t consumed by someone (savings) is what we call investment – even if that investment is unwanted inventory accumulation.

Recessions and the “Paradox of Thrift”

Since the savings-investment identity always holds without the need further assumptions, we can use it as a workhorse of economic analysis (and one that I vastly prefer to assumption-laden models using “marginal propensities,” “multipliers” and the like). One of the most widely held views about recessions is that they are caused by inadequate demand. This idea, which Keynes outlined in his General Theory, argues that recessions are caused by an unfortunate desire of consumers to increase their savings. In the Keynesian model, if consumers simultaneously try to increase their savings, they paradoxically become poorer.

The Keynesian theory of recessions is based on two assumptions:

1) Gross investment is fixed and unresponsive to interest rates

2) Individuals attempt to save a greater portion of their income

Look at the savings-investment identity, and notice the effect of these assumptions. Because savings and investment must be equal, and Keynes has already assumed that investment is fixed, the attempt by individuals to save a greater portion of their income cannot actually result in a greater amount of total savings. Instead, other things being equal, GDP must fall. There may be a million individual private decisions that produce this result, but in the end, savings must equal investment.

The Keynesian solution to this is to offset the desired increase in private savings with a decrease in government savings. Keynesians typically want savings rates to be as low as possible, on the assumption that spending automatically generates production. Keynesian theory really doesn’t embody the notion of scarcity and economic tradeoffs very well, and both government spending and investment enter the model like any other class of spending, with little attention to the productivity of that spending over time.

This is why Keynesian economists generally recommend government deficits to offset recessions. But this is only one possible solution, and the present size of the federal deficit makes a continuation of this policy dangerous.

Policy Options in a Recession

Why has economic growth been so weak in this recovery? During the past decade, and particularly during the housing boom, households accumulated unprecedented amounts of mortgage and consumer debt. Much of this debt burden remains in place, and much of the unserviceable debt has not been restructured. In this environment, the desire of households to increase private savings is reasonable. It has been difficult for economic policies (such as the Federal Reserve’s program of quantitative easing) to encourage debt-strapped households to reduce their savings and increase debt-financed consumption.

Having failed any attempt to help homeowners restructure millions of still-underwater mortgages (little wonder why so little housing is being supplied to the market when existing owners would have to take a massive out-of-pocket equity loss in order to sell), debt burdens and fragile household balance sheets continue to be a drag on demand, and propping up risky assets does not help this.

If households desire an increase in private savings, there are four possible ways to avoid a contraction in the economy:

1) Attempt to discourage private savings and increase spending against consumer desires (QEternity)

2) Attempt to reduce “foreign savings” by depreciating the currency and engaging in trade competition

3) Reduce government savings by running a budget deficit (the Keynesian solution)

4) Stimulate gross domestic investment

Consider the first option – discouraging savings and encouraging spending: While the Fed’s policy of quantitative easing has punished savers while promoting speculation in stocks, commodities, and other assets, it has done little to encourage additional consumer spending. There is a good reason for this. Consumers tend to consume from what they view as their “permanent income.” It should be well-known to the Federal Reserve that each 1% change in stock market capitalization has affected real GDP by only about 0.03-0.05%, and even that effect is usually transient. Further efforts at quantitative easing have no place in thoughtful economic policy, and threaten to prove very difficult to unwind without substantial disruption to the economy and financial markets.

What about trade competition and dollar devaluation? This strategy aims to offset the desire for increased domestic savings by reducing the size of “foreign savings” (essentially the opposite of the U.S. current account balance) through dollar devaluation, trade wars, and other beggar-thy-neighbor policies. Unfortunately, even successful attempts to “improve” the trade deficit are likely to be counterproductive. The reason is that there is an extremely high correlation between trade deficits and gross domestic investment: apparent “improvements” in the trade deficit are strongly associated with deterioration in gross domestic investment. So while beggar-thy-neighbor policies may be attractive in theory, they are unlikely to be effective in practice.

The co-movement of trade deficits and gross investment was seen most recently in the GDP revision of Q4 2012. Many analysts expected a very positive GDP revision as the result of a smaller-than-expected trade deficit. Instead, the “improved” trade deficit turned out to be offset by a reduction in investment (particularly inventories), resulting in a disappointingly small net revision to GDP.

The upshot is this. The combined attempt of households and government to increase saving and reduce debt is unlikely to be countered by continued policies of quantitative easing, nor by attempts at beggar-thy-neighbor trade policies. Further deficits are not a viable option, and threaten undesirable long-term consequences. The ideal solution is to pair deficit reduction efforts with policies to stimulate gross domestic investment. “Investment” in this context does not mean financial investment, but real investment in factories, equipment, capital goods, research, and development. Policies to stimulate investment include investment tax credits, accelerated expensing of investment, R&D incentives, and similar programs.

Put simply, the "paradox of thrift" and the Keynesian response to recession (government deficit spending) both rely on the assumption that gross domestic investment is fixed despite a desired increase in private saving. Stimulate real investment, and the paradox of thrift vanishes. As a result, sustained government deficits become unnecessary.

Importantly, significant deficit reduction is unlikely to succeed without increased gross domestic investment. In fact, increases in gross domestic investment tend to lead both improvement in the budget balance, and increased consumption spending. In the chart below, gross investment and the federal surplus are presented as deviations from their respective 4-year averages. Notice that improvements in gross domestic investment (red line) typically occur before corresponding improvements in the budget balance (blue line).

Similarly, improvements in gross domestic investment tend to precede increased consumption and reduced private saving.

Attempts to “stimulate” the economy by suppressing savings and increase consumption, or by pursuing “beggar thy neighbor” exchange rate policies are weak options compared to policies that encourage productive investment, research, and development. A nation’s “standard of living” is reflected by the amount of goods and services that its people can consume as a result of their efforts. A nation’s “productivity” is reflected by the amount of goods and services that its people can produce as a result of their efforts. Ultimately, one cannot increase for long without the other. Robust domestic investment provides the foundation for both.

The only sustainable course to a higher standard of living is to encourage productive investment. Policies like those currently pursued by the Federal Reserve attempt to encourage consumption, but do so by distorting savings and investment decisions toward speculative activity rather than productive investment. Unfortunately, the reluctance of consumers to spend is tightly linked to existing mortgage and consumer debt burdens, many of which remain unserviceable and have not been restructured. Attempts to squeeze greater consumption demand from these individuals, without a strategy to increase productive activity and income, is likely to produce continued failure.

While policies to stimulate gross domestic investment may be viewed as unwanted “tax expenditures” in deficit reduction efforts, these policies are critical to prevent the unintended consequence of economic contraction.

Fred Smith, the CEO of FedEx, recently observed “The only thing that’s correlated 100% with job creation – and particularly good job creation – is business investment. It’s our reduced level of capital investment that has produced our low GDP growth rates and our high unemployment.”

Well, the correlation isn’t quite 100%, but his point is accurate. The correlation between 8-quarter growth in gross domestic investment and 8-quarter growth in non-farm payroll employment is 80%, with payroll growth lagging investment growth by about 6 months. Notably, that correlation is not driven by linear trends, but instead by a close match between cyclical movements of both, with employment lagging investment activity.

Growth in gross domestic investment has already turned lower, and while employment growth doesn’t move in lock-step, it’s fair to say that investment growth is moving in the wrong direction if job creation is an objective of economic policy. All of the QE in the world will not help this situation, but will instead continue to distort investment decisions away from productive allocation of capital and toward brute speculation in financial assets that are already priced to achieve dismal long-term returns.

Joining policies to stimulate gross domestic investment with efforts to broaden the restructuring of mortgage and consumer debt would encourage a significant increase in output and employment. These policy options should not be overlooked as part of the overall policy effort to reduce the federal deficit.

An Infinite Amount of Money

John Mauldin — Thu, 07 Mar 2013 06:13:00 GMT

An Infinite Amount of Money
Et Tu, Italy?
Moving, Argentina, and Sonoma

The three major blocs of the developed world are careening toward a debt-fueled denouement that will play out over years rather than in a single moment. And contrary to some opinion, there is no certain ending. There are multiple paths still available to Europe and especially the US, though admittedly none of them are bright and carefree. There are very few paths available to Japan, as they have skipped too far down the yellow brick road of debt. None of Japan’s remaining paths have good endings. In the US, even as numerous voices declaim on the crisis that awaits if we don’t act, there is seemingly no collective will to actually do anything as yet. Perhaps it will take… a crisis. In Europe, the peripheral countries can already be said to be in crisis.

This week we will look at the mindset that ignores warning signs, and reflect on a hard-to-believe comment from Mayor Bloomberg of New York. It is a teaching moment that does not bode well for my hopeful outcome in the US. Meanwhile in Europe, the risks have been heightened with the recent vote in Italy. We must remember that Italy is the world’s third-largest issuer of bonds – its problems matter on the world stage. While it may all be molto divertente for those of us sitting on the sidelines, the potential consequences are anything but amusing.

But before we get going, if you are a qualified purchaser or an investment advisor in the US, I would like to invite you to listen in as I interview Jacob Gottlieb, CIO of Visium Asset Management, on Tuesday, March 26 at 12:00 p.m. EDT, 9:00 a.m. PDT. Visium is one of the premiere long/short multistrategy managers in the investment industry and of great interest to me. I will ask where they are finding alpha opportunities today, as well as share my own thoughts on the global economy and outlook. This discussion will be hosted by my partners at Altegris Investments. Please register for this exclusive webinar through The Mauldin Circle. If you are already a member of the Mauldin Circle and a qualified purchaser, you will receive an email invitation to the webinar. A replay will be available to registrants unable to attend. I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

An Infinite Amount of Money

I am often asked, “How can anyone not see the problems of growing debt in the US? Why can’t we get a consensus to change?”

Part of the problem is that too many in power just don’t see the impending crisis that you and I see, or at least they don’t see the need to act now. That is changing – or so I thought until I read a most inexplicable statement by the billionaire entrepreneur mayor of NYC, Michael Bloomberg. This is the sort of thing that causes me to despair. Here we have a supposedly (well, relatively) fiscally conservative politician, someone who is no stranger to financial circles, giving us these off-the-cuff remarks last week, commenting on whether sequestration will affect the NYC budget:

“It depends on how long,” Mr. Bloomberg said on his weekly WOR radio show with John Gambling. “If it lasts a few weeks, no. If it [lasts longer], yeah. We get 10 or 12 percent of our budget from the federal government, not all of that is going to be cut back, but there would be effects – not good effects. But in the context of, ‘Is anything going to change tomorrow? Are we going to run out of money tomorrow?’ I’m sure I’ll get that question at the [next] press conference. No.”

Furthermore, while saying the federal deficit does indeed need to be curtailed, Mr. Bloomberg argued the United States could owe “an infinite amount of money” and there is no specific amount that would cause the country to default.

“We are spending money we don’t have,” Mr. Bloomberg explained. “It’s not like your household. In your household, people are saying, ‘Oh, you can’t spend money you don’t have.’ That is true for your household because nobody is going to lend you an infinite amount of money. When it comes to the United States federal government, people do seem willing to lend us an infinite amount of money.… Our debt is so big and so many people own it that it’s preposterous to think that they would stop selling us more. It’s the old story: If you owe the bank $50,000, you got a problem. If you owe the bank $50 million, they got a problem. And that’s a problem for the lenders. They can’t stop lending us more money.” (Observer.com)

I am not sure what his understanding of the word infinite is, but I am pretty sure he is not using the word to mean “limitless or endless in space, extent, or size; impossible to measure or calculate.” In the few times I have met him, he has seemed quite reasonable and in command of the English language. I think he was speaking in a metaphorical sense, as in, there is (to his mind) no practical limit. I certainly hope he was.

I am reminded of former Vice President Dick Cheney’s comment that “deficits don’t matter.” He is right, if the deficit never grows past the rate of the growth of the country (nominal GDP). It might not be wise to approach that limit, but it would not necessarily be a disaster. And, to be charitable to Cheney, I’m sure it never occurred to him that the US could run a deficit close to 10% of GDP. Such a notion would have been preposterous to him. Unthinkable. The US government would pull back from anything even close to that. And that remained true – until it happened and we didn’t pull back.

And that is the problem. Too many of our leaders do not yet think we have approached the limit – hey, we’re not to infinite yet! The political and economic repercussions of restraining ourselves are just too difficult for some of us to resist pushing the limits a little further. Too many in the current administration appear to truly believe that even minor spending cuts (and I mean just cuts to the increase in spending, not actual cuts!) will bring about calamity.

Spending cuts will indeed reduce potential GDP in the short run. And for most politicians, the short run is the world they live in. But at some point, the short run gets longer, and as infinity approaches the bond markets get very antsy.

Greece protested against the austerity imposed on it. But what choice did it have? If it did not cut its budget, the rest of Europe would not fund the new debt the country needed. It is not a God-given right for Greeks to expect Germans (and the rest of Europe) to fund their lifestyle. So the bond markets simply stopped funding Greek debt. Unless the Greeks had agreed to austerity (known in some circles known as “reality”), the budget cuts would have been far larger, as Greece cannot print its own currency. The rest of Europe gave Greece money to avoid the potential debacle of a disorderly exit from the euro, but they did extract a price. The object of the process was to get Greece back to a place where it could fund itself with a smaller government budget. (More on that subject later.)

Austerity is not fun. Ask any teenager whose parents have set limits where previously there have been few or none. Tantrums ensue. It is kind of like the five stages of grief: denial, anger, bargaining, depression, and acceptance. Except that when you are talking about seriously over-indebted governments, the depression (pardon the pun) can last a lot longer than any other stage.

Bloomberg and those who think like him project our current experience into the far future. “Look at interest rates,” they say; “they are telling us the markets are just fine with the levels of US debt and the deficit.” And they are right; there are no bond-market issues now. But those of us with an eye on history know that is not unusual. Bond markets are typically sanguine right up until the BANG! moment. Then they are not. Bloomberg is right to say that there is no specific amount of debt that would cause the markets to cease funding us. Would that there were some convenient, unmistakable line we could see as we approached it. But the experience of over 250 debt crises over the past few hundred years tells us that there is no specific point when the markets lose confidence in a government’s debt. When it happens, though, it is ferocious in its intensity.

That is why I and others are so deeply worried about Japan. The level of denial is majestic. The newly nominated governor of the Bank of Japan, Haruhiko Kuroda, has openly espoused the printing of money and monetization of debt. And Kikuo Iwata, one of the government’s nominees for central bank deputy governor, said the Bank of Japan should buy longer-term bonds to help it achieve a two-percent inflation target.

They both suggest that the monetization planned for 2014 under the old regime could be accelerated into the present. As if to reinforce the perception that Japan can borrow an infinite amount of money, the yield on Japan’s ten-year bond has fallen to 0.585%, the lowest in a decade. If the bond market is so compliant in the face of imminent massive monetization, what could possibly go wrong? The amount of debt Japan has amassed has now topped one quadrillion yen. Not trillion with a “T” but quadrillion with a “Q,” which coincidentally also begins the word “questionable.” You can see for yourself how confident bond buyers are, in this chart:

Infinite means “without limit.” If Japan can borrow such sums at a 240% debt-to-GDP ratio, the thinking surely goes, the US can borrow a few trillion more – or perhaps even an infinite number of trillions. And we have such a long way to go before we even get to a quadrillion!

I warned in Endgame two years ago that the markets could lose patience in 2014 if they do not see a serious attempt to curtail the US deficit. The recent gold standard for a bearish mindset, my friend Nouriel Roubini told me he thinks I am being too pessimistic – we can probably get through to 2015.

If we do indeed see some movement toward deficit reduction, then our date with destiny can be postponed for quite some time. If over time we can bring the deficit back to below nominal GDP, a true debt crisis can be averted. If pressed, I am sure Mayor Bloomberg would now express regret at using the words infinite and debt in the same sentence. I doubt he actually believes what he said; rather (I generously assume), he was trying to make the point that the current sequestration will not bring on a debt crisis.

Until we get enough leaders to press the point, leaders like Simpson and Bowles, et al., we will dig an ever-deeper hole for our children; and if we don’t stop digging pretty soon, we will find ourselves in that hole. Past performance is not indicative of future results: it is not preposterous to think there might be limits.

Et Tu, Italy?

Only last year I was a mild-mannered euro skeptic. My default position was that the eurozone would break up, at least partially, due to economic strains and the unwillingness of nations like Germany to write checks and endure outright monetization. If Germany et al. relented, then I would have to change my position.

Germany has clearly gone along with monetization (while protesting all along the way). I now assume that the eurozone will somehow stay together unless and until we see a political event that creates an exit crisis for some country. The will of European leaders to keep the euro experiment alive at all costs is impressive. Now, the cost of a breakup is almost unfathomable. A breakup is not impossible, but oh dear gods, what a cost. It is now probably cheaper just to continue to bump along, forcing austerity where one can. That is certainly the default political position in most of Europe.

For now, “austerity” is a bad word. It has been openly forsaken in France and Spain. There are massive demonstrations in Portugal. Greece has gone about as far as it can politically for the time being. The Dutch government finally conceded on Thursday that it would not meet the budget-deficit target set by the European Union this year, due to its weak economy and a reluctance to make more cutbacks.

I see two threats to the euro. The first is France. Its budget deficit and economy are getting worse, and so far all French attempts to maintain the EU deficit target have been cosmetic, much to the frustration of Germany, which has brought its deficit down to 1%. However, Merkel does not want a crisis before her elections in September, so she is giving a pass to France and Italy. But that is a topic for another letter.

The second threat is the possibility of a political crisis in a country where an anti-euro government takes actual control. Right now that seems unlikely to happen, but the recent election in Italy has given European elites a case of indigestion.

Some German leaders (pointedly not Merkel) spoke openly and derisively of the success of those they called the Italian “clowns,” speaking of aging comedian Beppe Grillo and his Five Star Movement and the even more aged (76) conservative leader, playboy, and billionaire Silvio Berlusconi, he of “bunga bunga” notoriety, who has refused to go away, to the consternation of much of the rest of Europe.

Italian politics are always difficult to fathom, even for Italians. When I am on vacation there and ask the locals questions about what is likely to happen, I am met with confused shrugs (at least in Tuscany). I don’t get the passionate lectures I heard in Greece or Spain.

The center-left coalition “won” the lower house with 29.6% of the vote. Berlusconi’s coalition won slightly less, at 29.2%. Under the Italian Constitution, which makes the US electoral college scheme appear sane, the party with the most votes gets an automatic 55% of the lower house. So with less than 30% of the vote and a win of just 0.4%, the center-left now controls 55% of the votes in parliament. But the Senate, which has equal power, is not apportioned the same way, and there Berlusconi won control. Unless some grand coalition can be finessed, there is no government that can be formed. Anatole Kaletsky writes at GaveKal:

This is not to say the situation is not pretty messy! The big winner of the Italian election is obviously the protest vote, as illustrated by a 5% rise in abstention, and, much more importantly, a super strong 25% score for Beppe Grillo’s Five Star Movement, a new party founded by geeks and bloggers with an anti-everything discourse (anti-Monti, anti-Berlusconi, anti-euro, anti-establishment, anti-debt repayment, anti-markets, etc.). Ex-comedian Grillo (who is not himself a candidate) has succeeded in gathering protest votes that were usually spread between the extreme-right and the extreme-left.

While the center-left party of Pier Luigi Bersani took 29.6% of the vote (with more than 99.9% of ballots counted) in the lower house, a touch more than Silvio Berlusconi’s 29.2%, Italians have sent a clear message of protest against fiscal austerity, and against tax hikes in particular. Mario Monti’s new party got just 9% of the vote in the lower house, and Berlusconi and Grillo’s combined vote is roughly 55%.

These split votes mean the emergence of a new government in the eurozone’s third largest economy is going to be extraordinarily problematic. Moreover, new elections cannot be called before late May at the earliest, since the president of the Republic (elected for seven years in May 2006) does not have the right to dissolve during the last six months of his mandate. In any case, new elections may not be what the establishment would want (Berlusconi included) since it would fear an even higher score by Grillo.

One possibility is a Bersani/Berlusconi grand coalition. This seems crazy, but after all the two parties “governed” together in 2012, since they were the two main supports to Monti’s technocrat government – until Berlusconi’s party withdrew its backing in a well-calculated move to campaign on an anti-austerity theme in the elections. Another possibility is a coalition between Bersani and Grillo’s Five-Star Movements – bizarre, but who knows with Italy? Whatever the solution, nothing will come easily – and there is the risk that a new market crisis might be a pre-condition for a coalition to be formed.

Anatole’s lifelong friend and partner, Charles Gave, sees the Italian elections much differently. He points out that a majority of voters selected parties openly anti-euro as well as anti-austerity. And I agree with him: that is the apparent outcome. However, when you look at polls, the 25% that Grillo won was clearly a youth protest vote. The vast majority of the Five Star Movement’s voters were under 50 and many under 30. The message was one of protest against the corruption of the current system as well as frustration with the technocrat government (which Berlusconi initially supported, before his polls numbers rose and he decided to stand in an election that he came within a hair of winning). The current prime minister, Mario Monti, got just 9% of the vote – a resounding rejection.

Grillo is an odd character. He refuses to talk to journalists. Italian reporters who have telephoned him and asked to speak to the general secretary of the party claim he has told them, “Hang on, I’ll just pass you to my 12-year-old son.” He said Italy was in such dire economic straits that “In six months, we will no longer be able to pay pensions and the wages of public employees.” He has called for a total repudiation of Italian debt (otherwise known as default).

In an interview with a German magazine, Grillo warned that “if conditions do not change” Italy “will want” to leave the euro and return to the lira. I refer those who are interested in the lurid details to a story in the Telegraph.

Like the Greek Syriza Party, which had to back off its earlier positions with regard to leaving the euro, Grillo may find that he cannot hold his coalition together if the real possibility of his governing ever materializes. He has refused to entertain being part of any coalition government, calling the center-left winner Bersani a “dead man talking.” Not exactly the stuff of which coalitions are formed. One young lady responded by starting an online petition to demand that Grillo not “waste” her vote, and work with Bersani to form a coalition government. In just a few days, she has already had 150,000 5SM voters sign her petition. Waiting six months for another election without a government would not exactly make for inspiring theater, and while no one likes the current government, the voters apparently like chaos even less.

If a grand coalition cannot be formed, it appears another election will be held this summer. And while the concern in Europe is that Grillo might even get more votes, it is also possible that his intransigence and unwillingness to capitalize on his surprise upset will cost him voters.

Throughout Europe, where austerity has been the order of the day there have been protest votes. But will the anti-euro forces actually be able to muster a firm majority? Not so long as Merkel allows relaxation of the Fiscal Compact, as she apparently has. The impetus for protest will wane and find another focus besides withdrawal from the euro.

But we need to keep an eye on these nationalist movements and an even closer watch on France. President Hollande has slumped in the polls to a 30% approval rating just ten months after his election, making him the most unpopular president in 30 years. He seems to feel that France can borrow an infinite quantity of euros. It will be a race between Hollande and Japanese Prime Minister Abe to see who can lose the confidence of the bond market faster. From my perspective, they are both running hell-bent for leather.

Incidentally, Anatole Kaletsky and Charles Gave will both be at my 10^th annual conference, May 1-3 in Carlsbad California, cosponsored by my friends and partners Altegris Investments. Louis Gave will join them on a panel that I will moderate. Having appreciated the vigorous disagreements between Charles and Anatole, and knowing how passionate Louis is, I think that will make for a fascinating panel. To my knowledge, it is the first time they have appeared together other than for their own client conferences. I am honored.

They will be joined by Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Jeff Gundlach; David Rosenberg; Nouriel Roubini; and Gary Shilling, plus a few surprise guests. This will indeed be the macroeconomic event of the year – you seriously need to think about coming. The conference is getting close to capacity and will likely sell out, as it has the past four years. I always seem to have people frustrated with me when I can’t find them a spot, but we really do have a hard limit on attendance, imposed by the size of the hotel. Next year we will move to larger quarters, but if you want to come this year you need to stop procrastinating and register.

We offer an early-bird registration, which is about to run out. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. I hope to see you there.

Oh, and I have just arranged for registrants to have access to the private research of many of our speakers for the two monthinfis prior to the conference. That in itself is worth the price of conference admission.

Moving, Argentina, and Sonoma

My bags are packed, kind of. The movers come this Thursday to empty my house and put everything in storage while we wait for the new digs to close. Apparently, my loan for the new place has been approved, which is a good thing, as I am committed to moving. Hopefully I will not be in a local hotel too long before I can move in, though I know I will be there for at least a few months, until we can combine two apartments into one more comfortable place. The process is longish, but I think the result will be worth the hassle.

I leave Thursday night for Cafayate, Argentina, to be with my friends and partners and a fun group of their friends. As a special treat, I will finally get to go to my old friend Bill Bonner’s (he of Daily Reckoning fame) estancia in the Andes near Cafayate for a few days. I am excited about that, and it will be nice to catch up with Elizabeth as well. It has been too long.

I will be speaking at a special one-day event in Sonoma, California, on April 5. My friend Mike Shedlock is holding a charity fundraiser to support research into ALS (Lou Gehrig’s disease). Sadly, Mike’s wife died last year of ALS, and his commitment to a cure is worthy of support. John Hussman, who is among the notables that are speaking (your humble analyst is there as comic relief), has generously offered to match up to $100,000 in conference registration fees. I have often exchanged notes with John and really look forward to meeting him. You can find out more at Mish’s Conference.

I am going to take most of the next two days to try and reduce the pile of things that I keep moving from place to place. Over the years, we all tend to accumulate stuff we somehow just can’t let go of. My closet is filled with clothes I have not worn in five years, or even in three. Shelves sag with so many books I will never even have time to touch again. Drawers are stuffed full of items I couldn’t imagine parting with at the time. Knickknacks I just don’t need are perpetually on the increase. I keep trying to get the kids to take more, but they know extraneous material (otherwise known as junk) when they see it.

The hard part will be to stay focused as I stumble on memories I don’t want to lose, in the form of treasured relics of an event or time past. That first card from one of the kids. Photos. Handmade gifts that are priceless. My intention is to leave with less than I came in with for the first time in decades of moving. We will see how my resolve holds up. I mean, I might want that sweatshirt someday. And that suit and tie might come back in style; you never know.

Have a great week. I look forward to a night in Buenos Aires before flying to Salta and driving through the majestic canyon that leads to Cafayate. I intend to finish my part of a book, lose a little weight, and enjoy my time with friends. And I will write next week, as always.

Your ready to move on analyst,

John Mauldin

subscribers@mauldineconomics.com

Fifty Trades of Grey

John Mauldin — Sat, 02 Mar 2013 07:02:00 GMT

I get so much broker research that I must admit I don’t usually read it or do so really fast. But the headline above caught my eye, and the piece turned out to be such a fun read, as well as truly thought-provoking and insightful, that I’ve made it today’s Outside the Box. The personalization of a “relationship” with the Fed gives us a decidedly delicious way to think about QE!

Michael Cembalest walks us through the changes in his attitude toward the Fed, from the heady days of early 2009, when

The Fed Chairman’s picture in the paper reminded me of a cross between Sean Connery and King Hussein of Jordan. His message was clear: he was going to shroud the markets in a warm embrace of unbounded, limitless liquidity. It was slow at first, but then appeared everywhere I looked, like an endless, pounding summer rain.

By late summer, though, his impressions shifted:

… as the leaves turned, these opportunities began to fade as capital came back to credit markets. I held on tight, pulled in a convulsion of rising optimism and the search for yield.

But that’s ancient history now, he says:

For the last fifty months, the Fed has been buying Treasuries and Agencies, $2.5 trillion in all … My relationship with the Fed started to change: with its relentless debt purchases and 0% policy rates, the Fed apparently sees me as a rentier capitalist whose savings should be expropriated by keeping short term interest rates below inflation. What’s a rentier capitalist? According to Lenin, someone who ‘clips coupons, who takes no part in any enterprise whatever, whose profession is idleness’. I began to question my feelings about Quantitative Easing, even though it led to a very powerful rally in the credit markets…

He goes on to take a thoughtful look at the pros and cons of QE, with some of the best analysis I’ve seen, concluding with these deathless lines:

A period of diminishing credit returns is upon us, and it’s probably time for those with more than a normal credit allocation to begin saying goodbye. It will not be easy; love knows not its own depth until the hour of separation.

Once credit markets began to tighten, he notes, “investors rushed headstrong into an intense love affair with dividend-paying stocks.” That has certainly been a strong theme here at Mauldin Economics, in both our Yield Shark and Bull’s Eye Investor letters.

I’ll just tease you with the opening lines of his final sections:

What of equity market valuations overall? Has a dreaded Fed-driven overvaluation cycle already begun?...

Reasonable valuations and a modest recovery in the US, China and parts of the developing world should keep the party going….

Nevertheless, the end of the affair will come one day, and probably when I am not expecting it….

I remember the last time I was in this kind of tangled, complicated relationship….

Good stuff and well-written! I will pay more attention to Michael Cembalest in the future, to see if he can keep this up.

This has been a whirlwind week. I finished up in Palm Springs, flew back on Monday, and wrote this week’s TFTF that night. The next day saw multiple afternoon meetings and dinner with Dick Pfister, one of my long-term partners from Altegris. The next morning Jon Sundt, president and founder of Altegris, joined us and we drove out to spend the day with Kyle Bass at his Barefoot Ranch in Athens, Texas, where between meetings and calls we did take a little time for some fun. My son seems to have a knack for skeet shooting, while keeping myself seated on a very gentle horse was more my speed. I needed to see if I could still ride without getting back issues, because I’m supposed to do some trail riding in the Argentinean Andes in a few weeks. I think I am good to go. And we did finalize some plans for helping you navigate the current rather uncertain market landscape. I will let you know as they develop.

Back at home, we are busy making plans to move and put everything into storage while we wait for the new condos to close. I leave for Cafayate, Argentina, next Thursday and will move into a hotel when I return in two weeks, until the new place is finalized. I’ll move in and then move right back out again when construction starts. So, homeless off and on for the next few months, but the end result will be something of a dream come true for me.

The haunting sounds of Ladysmith Black Mombazo’s poignant song “Homeless” keep running through my mind. If you are not familiar with their work, you should be.

Your moonlight sleeping on a midnight lake analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

Fifty Trades of Grey

An illustrated story of investment, temptation, addiction, and the cost of money

By Michael Cembalest, J.P. Morgan Asset Management

Q1 US retail sales were better than expected in January, despite higher tax rates, as the US consumer is still more active than European counterparts (1st chart). It’s too soon to see the full impact of higher US income and payroll tax rates, but a Q4 jump in real wages, improved household balance sheets and a turnaround in housing may offset part of the headwind. We’ll see in a couple of quarters. Meanwhile, in the SOTU address, the President talked about raising revenues. It will be interesting to see where they come from: after the recent tax act, top quintile tax rates are now 5 times higher than the second quintile, up from 2x in 1979 as progressivity increases further (2nd chart). Everywhere I go, however, there’s a different topic on everyone’s minds: what will happen when the Federal Reserve stops purchasing tens of billions in Treasury and Agency debt every month? It’s possible that with a sufficiently dovish Chairperson replacing Bernanke in 2014 that they will never end, and that the US will end up like Ireland, with its Treasury perpetually beholden to its Central Bank; but I don’t think so. The autobiographical story below is my view on Fed purchases and their impact on the world of investing.

Fifty Trades of Grey

I was always the cautious type. I would wait until other people jumped into a lake to make sure it was deep enough. I have never been on a motorcycle, and have never held or fired a weapon. I once rented a Maserati for a day to see what it was like, and drove under the speed limit the entire time. So, it’s not surprising that by the fall of 2007, with mounting problems in housing, over-crowding in hedge fund strategies like statistical arbitrage and very low credit spreads, I got nervous and reduced portfolio risk heading into 2008. The following fall, after the collapse, I imagined a slow and steady approach to reinvesting. It would take time to rebuild confidence after the second 40% equity market decline in a single decade, right? After recessions in 1989 and 1999, you could take your time reinvesting in credit: high yield spreads remained elevated for 3 to 4 years, allowing for a long, relaxed period of risk-taking by investors with the wherewithal to have avoided some of it in the first place.

Then one day in early 2009, everything changed. The Fed Chairman’s picture in the paper reminded me of a cross between Sean Connery and King Hussein of Jordan. His message was clear: he was going to shroud the markets in a warm embrace of unbounded, limitless liquidity. It was slow at first, but then appeared everywhere I looked, like an endless, pounding summer rain. The convertible bonds we bought in November 2008, and the commercial real estate-backed securities and leveraged loans we bought the following spring, rose in a passionate revival of credit markets. During the first few months of 2009, you could earn 10% or more on debtor-in-possession financing, and purchase private equity interests from overextended college endowments at steep discounts. But by the late summer, as the leaves turned, these opportunities began to fade as capital came back to credit markets. I held on tight, pulled in a convulsion of rising optimism and the search for yield.

That’s ancient history now. For the last fifty months, the Fed has been buying Treasuries and Agencies, $2.5 trillion in all (measured in 10-year equivalents). As the Fed ravishes the riskless debt markets, its demand now accounts for ~55% of the entire net supply issued by the Treasury, Ginnie Mae, Fannie Mae and Freddie Mac. My relationship with the Fed started to change: with its relentless debt purchases and 0% policy rates, the Fed apparently sees me as a rentier capitalist whose savings should be expropriated by keeping short term interest rates below inflation. What’s a rentier capitalist? According to Lenin, someone who ‘clips coupons, who takes no part in any enterprise whatever, whose profession is idleness’. I began to question my feelings about Quantitative Easing, even though it led to a very powerful rally in the credit markets…

On the plus side for credit, companies have a lot of cash and cash flow and I do not see a recession brewing, so a messy break- up between investors and credit markets seems unlikely this year based on fundamentals. Net of Fed purchases, there will be almost no net debt new issuance in 2013, a very bullish supply picture. (Debt universe: high yield and high grade bonds, EM sovereign and corporate debt, municipals, Agencies, Treasuries and structured credit.) Furthermore, high yield companies have termed out their debt substantially relative to where they stood in 2008, and there has been a revival in CLO and CMBS issuance as structured credit markets improve. Remember as well that the Fed may not raise rates above 1% until 2015 (extrapolated based on the pace of employment gains, labor force participation and the Fed’s reported 6.5% unemployment threshold). For some investors, every bit of coupon income counts: they will be loath to sell, and feel bound to hold their credit positions forever.

However, I’m also watching underwriting standards as investors weaken their emotional resolve. HY issues rated B- or below are rising as a % of issuance. So are debt-to-cash flow multiples on leveraged buyouts, and in Q4 2012, payment-in-kind and covenant-lite issuance hit 2007 levels. This month, Federal Reserve Governor Jeremy Stein voiced concerns about over-heating credit markets, noting ‘reach for yield’ behavior and deterioration in terms and conditions. While high yield spreads don’t look tight in an historical context, yields tell a different story. Given manipulation of riskless rates, I am inclined towards caution. (If you research estimates of the Fed’s impact on long-term interest rates, you might be surprised at how low they are. The latest paper on the subject puts the impact at 35-45 basis points, and other studies show even lower estimates. See “The Federal Reserve's Large-Scale Asset Purchase Programs: Rationale and Effects”, D’Amico, Nelson, Lopez-Salido and English, December 2012.)

‘Long credit’ is a crowded position, and dealer inventory/liquidity has declined given industry rule-changes (according to Citi, high grade and high yield dealer inventories are 20% of 2007 levels). A period of diminishing credit returns is upon us, and it’s probably time for those with more than a normal credit allocation to begin saying goodbye. (The same view does not hold for credit hedge funds with minimal directional exposure to spreads or rates, and who seek to take advantage of the decline in dealer inventory/market-making and resulting arbitrage opportunities that arise between bonds and credit default swaps.)

It will not be easy; love knows not its own depth until the hour of separation.

Once credit markets began to tighten, investors rushed headstrong into an intense love affair with dividend-paying stocks. The S&P Dividend Aristocrats Index has outperformed the market by a huge margin starting in 2009, so much so that a few months ago, cyclical stocks were trading at the largest discount on record relative to defensive ones, and still appear to be doing so.

What of equity market valuations overall? Has a dreaded Fed-driven overvaluation cycle already begun? It depends on the lens you apply to remembrance of things past. Using 3 years of trailing earnings, the S&P 500 P/E multiple is around median compared to the last hundred years, and reasonable at a time of low inflation. Using 5 years of earnings makes today’s multiple seem more expensive, since it inherently assumes that the earnings collapse in 2008 will occur every decade (I don’t think this is a good assumption).

Some positives: market expectations of future long-term earnings growth are low, and there’s a lot of corporate and household cash lying around, the most in many decades on a combined basis. What about the equity market-to- replacement cost ratio? It can be a useful buy/sell signal when it’s at extremes, but that’s not the case now. As for other equity valuation methods, such as those which flatter stocks by looking at the fact that I am forced to earn zero percent on my cash, I am trying to cast them aside: the deceptions we tell others are nothing compared to those we tell ourselves.

Reasonable valuations and a modest recovery in the US, China and parts of the developing world should keep the party going. When inflation comes back and the Fed tightens, the party will likely end for a while, but at least right now the output gap (a measure of spare US capacity) still looks large. I have even seen remarks by Bernanke’s courtiers, Evans and Yellen, indicating that the Fed will allow inflation to drift above its long term target for a while to ensure a recovery. In other words, they will postpone the inevitable for as long as they can.

Nevertheless, the end of the affair will come one day, and probably when I am not expecting it. Since the Greenspan- Bernanke era of ultra-low policy rates began, the volatility of equities is even higher than before the creation of the Fed in 1913, when the US was beset by frequent recessions and depressions. So here I remain, trapped in a cycle of market passions that careen from sadness to ecstasy, and then back again. The ecstasy phase has more room to run for now, and we are seeing signs that M&A activity (Berkshire Hathaway and 3G purchase of Heinz, Comcast purchase of GE assets, Liberty Media purchase of Virgin Global) and share repurchases are picking up, which is generally good for stocks. The Fed is looking for ‘substantial’ labor market improvement, which means there will probably be another 12 trades of grey before its purchases end. What kind of imbalances will grow during this time? When the Fed stops buying riskless securities, we will find out how ready risky securities are to stand on their own, and how addicted investors are to Fed support.

I remember the last time I was in this kind of tangled, complicated relationship. It was in 2003: the Fed set policy rates at 1%, below the rate of inflation, and set in motion another cycle in which the value of cash was destroyed. (Inflation was at the same level in 2003 as it was in 1997, yet policy rates were 4.5% higher in 1997. This is a point that Stanford’s John Taylor, a critic of current Fed policy, made last November at the Centennial Celebration of Milton Friedman at the University of Chicago.)

Incredibly, investors in US T-bills earned returns below the rate of inflation until September 2005, which was well into the recovery and around the time the housing collapse began. Fed sponsorship of (another) housing boom and the credit markets was great while it lasted, and I thought the affair would never end. But it did end, with sadness and with betrayal: when it came time for the Federal Reserve to warn me about possible consequences of surging home ownership costs, I didn’t even get an email, or a salacious text. Instead, I read one day in the newspaper that the subprime issue was ‘contained’. Love means never having to say you’re sorry.

The Healthcare Blues

John Mauldin — Wed, 27 Feb 2013 22:51:00 GMT

On Being a Professional Worrier
The Healthcare Blues
China, Japan, and a Few Rocks
Stupid Sequestrations
Whiteboard Fun
Argentina, Cambodia, Singapore, Humiliation, and Homeless

It has been some time since we peeked into my worry closet. A few questions this weekend prompted me to think about things I am paying attention to but have not written about, and one thing that I am not worried about at all, despite the apparent media hysteria.

But first, a quick note. My tenth annual Strategic Investment Conference (May 1-3 in Carlsbad, California) seems to be filling up nicely. The speaker lineup is exceptional: Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Charles and Louis Gave; Jeff Gundlach; Anatole Kaletsky; David Rosenberg; Nouriel Roubini; and Gary Shilling.

Seriously, where else can you find a roster like that? And the attendee list has a "who's who" feel to it, as well. Those who come regularly know that the real value is in meeting the other attendees. David Rosenberg noted last year that this is the top investment conference he has ever addressed. The speakers all seem to bring their "A" game. The attendees agree, and this year we will have more interaction than ever.

The conference always sells out, and we offer an early-bird registration, which is about to run out. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page.

But before we go any further, did you know that you can now absorb Thoughts from the Frontline through your ears, if your eyes are otherwise occupied? That's right – our new audio service delivers my weekly letter to your cellphone, iPod, MP3 player, or computer, whenever and wherever you choose. You can check it out right here.

And now, let's peek into my worry closet.

On Being a Professional Worrier

I should note that I am a professional worrier. I get paid to think about what can affect our economy, finances, and investments. Over the years I have become quite good at it. But the sheer volume of things to worry about has grown so much that there is not enough time to worry about everything, so I have had to prioritize.

For instance, there was a time in my life when I worried about what the markets did on any given day. But serious study showed me that worrying about the day-to-day movements of markets was pointless (at least for me, and probably for most of you), so now I let the media and traders do that for me. Instead, I try to think about what could move markets longer term. And yes, I "worry" (as in ponder) what could make the markets go up as well as what could make them go down. It is enough to try to get the direction of the movement right, let alone the day-to-day gyrations.

Further, I do not worry (at least in terms of economics and investments, the beat of this letter) about things that I can either avoid or at least hedge against. I may pay close attention, but I do not spend time worrying.

I try to devote my actual professional worry time to things for which I don't have a solution, and to ponder the likelihood of their happening and what we might do about them.

This prioritization helps my worry closet remain a closet and not expand into the living room. I must confess that my living room is crowded enough with worries about how my kids are doing that I simply have to close the worry closet door every now and then, as they remind me of the here-and-now problems of life. However, problems that they deal with do often find their way into my worry closet. Problems like, where will the jobs come from? (Which is the subject of a book I hope to have off my desk in a few months.) Another such problem is the subject of my central worry in this letter: health care.

For new readers, I have seven kids, so I have lots of opportunity to worry. Five are adopted, so we've been tossed into a random lottery of past family health issues. Some we know about, and some we don't. Henry, my oldest son, is from the Virgin Islands. He played serious high school football (6'1" and 290 pounds, all Dallas-Fort Worth area tackle) and slimmed down a few years after to a ripped 230 pounds. Solid muscle. He is now 31 but still in good shape.

He was diagnosed a few years ago with type 2 diabetes. It is under control most of the time, but something seems to take him to the emergency room about every four months. This past month it was a liver and gall bladder issue. He has a good job with good insurance, except that his employer has cut back the hours he works. He has a union job, and the new employees make about half what he does, so they get the hours. Henry has a young son, and that makes it tough. And with diabetes, he can't afford to quit and take a new job without solid health benefits, yet because of his problem it seems he can't get a job with insurance. So part-time jobs are the order of the day, and they pay less.

Daughter Melissa was diagnosed with thyroid cancer last year, and her thyroid was removed. They were pretty confident they got it all, but recent scans showed some spots on the lymph nodes in her chest area. We are waiting for results from a recent and more detailed scan, which seem to be taking forever. She did not have insurance for the first operation, so I became intimately aware of the costs of medical care. The quality of the hospital and doctors was superb (Baylor in Dallas). In terms of costs, I was pleasantly surprised, as I was expecting a horror story. I thought that all in all it was reasonable. We now have insurance for her, but given her history there are limits to it.

Amanda (adopted from Korea) has a baby due in six weeks and is doing fine. Tiffani has given us a scare or two (the lump in the breast thing). Chad has been in a few serious accidents. Abigail (Amanda's twin) and Trey have nothing out of the ordinary.

I have written extensively in this letter about the unsustainability of the entitlement programs, especially Medicare and Medicaid. They are growing at a much faster rate than the economy. We simply cannot afford as a nation to maintain our current system without reform.

It is one thing to say in the abstract that we have to get the entitlement programs under control and another thing to see the unintended consequences of a healthcare system that works for most of us but can devastate more than a few of us at the wrong time. Melissa was given the best of care because she had a Dad who was fortunately able to help. What about the millions of Melissas who don't?

It's all so very complicated, and it can become very emotionally trying. I get the economic issues of insurance companies having to deal with pre-existing conditions. But I also see what can happen to young people when they have those pre-existing conditions. I deal firsthand with my kids and insurance and healthcare costs. It is very real to me and not at all abstract.

I have been told that in a few weeks or months I am going to be one of the first to receive a new type of genetic analysis. Rather cutting-edge, it will tell me a great deal about my genetic predispositions and tie them into the latest research. I am not sure of the cost (it will not be cheap), but in a few years it will be standard procedure for those who want it and reasonably affordable, as it is one of those things that can be computerized.

In a few months, I will know of a lot of my potential pre-existing conditions. What if my insurer also eventually knows them? Do we work together to prevent a problem before it happens, or will they dump me or limit coverage? I worry about such things. The day is not too far off when such genetic insight will be cheap and easily available to everyone. Should health insurance costs be based on the gene-pool lottery? (Let's not even go into life insurance!)

The Healthcare Blues

For this week's issue of Time magazine, the cover story is Bitter Pill: Why Medical Bills Are Killing Us, by Steven Brill. I had to have something to read while the plane was taking off, and that turned out to be it. (Since I got my iPad I no longer carry books, so I make sure I have something to peruse while waiting to be able to use my electronics in the air.) I have read work by Steve Brill in the past and like his style, so even though I don't usually read Time, I picked up this issue on health care.

I wish I could get every voter in America to read that article and then go to the Internet, Google the piece, and read the comments. I don't agree with all he wrote, but he does a marvelous job of giving us the picture on just how broken the American healthcare system is in terms of costs. He goes into detail about how hospitals create those staggering bills. If you have private insurance or a government plan, you don't have to pay those prices, but what if you don't? The billing system is out of control: $1.50 for a 1.5-cent acetaminophen pill (Tylenol). A simple niacin tablet marked up 240 times. Routine products like gauze marked up 10 times. Billing for a lamp shade? Are you serious? Double and triple billing for routine items that no insurance company or government agency will pay for, but that you will be billed for if you are on your own. You have read the stories or heard them from friends, but Brill makes it real.

We spend almost 20% of our gross domestic product on health care in the US, and that figure continues to climb. I could quote at length from the article, but let me just excerpt six paragraphs:

Taken as a whole, these powerful institutions and the bills they churn out dominate the nation's economy and put demands on taxpayers to a degree unequaled anywhere else on earth. In the U.S., people spend almost 20% of the gross domestic product on health care, compared with about half that in most developed countries. Yet in every measurable way, the results our health care system produces are no better and often worse than the outcomes in those countries.

According to one of a series of exhaustive studies done by the McKinsey & Co. consulting firm, we spend more on health care than the next 10 biggest spenders combined: Japan, Germany, France, China, the U.K., Italy, Canada, Brazil, Spain and Australia. We may be shocked at the $60 billion price tag for cleaning up after Hurricane Sandy. We spent almost that much last week on health care. We spend more every year on artificial knees and hips than what Hollywood collects at the box office. We spend two or three times that much on durable medical devices like canes and wheelchairs, in part because a heavily lobbied Congress forces Medicare to pay 25% to 75% more for this equipment than it would cost at Walmart.

The Bureau of Labor Statistics projects that 10 of the 20 occupations that will grow the fastest in the U.S. by 2020 are related to health care. America's largest city may be commonly thought of as the world's financial-services capital, but of New York's 18 largest private employers, eight are hospitals and four are banks. Employing all those people in the cause of curing the sick is, of course, not anything to be ashamed of. But the drag on our overall economy that comes with taxpayers, employers and consumers spending so much more than is spent in any other country for the same product is unsustainable. Health care is eating away at our economy and our treasury.

The health care industry seems to have the will and the means to keep it that way. According to the Center for Responsive Politics, the pharmaceutical and health-care-product industries, combined with organizations representing doctors, hospitals, nursing homes, health services and HMOs, have spent $5.36 billion since 1998 on lobbying in Washington. That dwarfs the $1.53 billion spent by the defense and aerospace industries and the $1.3 billion spent by oil and gas interests over the same period. That's right: the health-care-industrial complex spends more than three times what the military-industrial complex spends in Washington.

When you crunch data compiled by McKinsey and other researchers, the big picture looks like this: We're likely to spend $2.8 trillion this year on health care. That $2.8 trillion is likely to be $750 billion, or 27%, more than we would spend if we spent the same per capita as other developed countries, even after adjusting for the relatively high per capita income in the U.S. vs. those other countries. Of the total $2.8 trillion that will be spent on health care, about $800 billion will be paid by the federal government through the Medicare insurance program for the disabled and those 65 and older and the Medicaid program, which provides care for the poor.

That $800 billion, which keeps rising far faster than inflation and the gross domestic product, is what's driving the federal deficit. The other $2 trillion will be paid mostly by private health-insurance companies and individuals who have no insurance or who will pay some portion of the bills covered by their insurance. This is what's increasingly burdening businesses that pay for their employees' health insurance and forcing individuals to pay so much in out-of-pocket expenses.

I know about those business healthcare burdens. At my very small business, the fastest-rising cost is health care. I have my staff get bids on health care every few years and try to hold down costs. I should note that after reading the Brill article I am actually going to go back and check a few items to make sure we have proper coverage. You think you do until…

Let's be clear: the US has the best medical care on the planet. Expensive, yes, but our best is truly the best. As I get older and as my kids have issues, having access to good health care seems a very good idea. I want to live a very, very long time. Which is why I worry. I don't want to see our healthcare system get sidetracked.

Now, we are getting ready to dramatically change how we pay for 20% of our economy. I fear Obamacare is going to be a bureaucratic nightmare. Before you consign me to some Neanderthal Republican hell, let me quickly state that any necessary reform is going to be disruptive and expensive. Even if we adopted Paul Ryan's plan, it would be very disruptive. You simply can't change the incentives and payment structures of 20% of the economy without creating macroeconomic problems. There are more unintended consequences than we can imagine lying hidden in the grass of healthcare reform, like hungry lions.

Having to cover pre-existing conditions is going to raise the costs of private insurers. In my business, we are getting reports that our cost will go up by as much as 50%. Individual rates may rise even more.

Under Obamacare, businesses may have sufficient incentive to drop insurance coverage and pay a $2,000-per-employee penalty. I am not certain where they came up with that number, but $2,000 is cheap insurance. Insurance companies are going to lose business customers as they raise prices. If your employees can get government health care (mine can't, I hasten to add!), then from a financial perspective you are better off paying the penalty. When insurance costs rise, the pressure to drop coverage will rise as well, which will mean those still covered have to pay more. It will be an ugly trap until things get sorted out.

By the numbers, Medicare looks like a government program run amok. After President Lyndon B. Johnson signed Medicare into law in 1965, the House Ways and Means Committee predicted that the program would cost $12 billion in 1990. Its actual cost by then was $110 billion. It is likely to be nearly $600 billion this year. That's due to the US's aging population and the popular program's expansion to cover more services, as well as the skyrocketing costs of medical services generally. (Time)

I fear that the Medicare budget will rise even further unless we get aggressive on holding down costs. But that will not be easy. The systemic and political incentives to effect change are just not there until there is a real crisis. And while Brill talks about the excess profit in the system, when you take that away, things will change. Some think they will change for the better, but I am afraid we are all indulging in wishful thinking.

Obamacare may have brought forward the crisis that we all knew was coming. Rather than runaway entitlement spending being a problem for the latter part of this decade, it may soon be a topic for your child's "show and tell" time at school. We either get a handle on the problem this year or things could quickly spiral out of control. Medicare and Medicaid costs could quickly rise by 5-10%, which would blow a hole a mile deep in our national budget. Yes, that would mean that costs that had been absorbed by emergency rooms and picked up by charities would now be paid for by the government, but while they might amount to the same total (unlikely), they would not be part of cost and budget projections.

Maybe the government does a better job at estimating future costs than it did in 1965, but I worry that it won't. And the consequences of being wrong could be very disruptive to a healthcare system that is as vital as food and energy. Honestly, I do not get a good feeling when I think of Washington DC and crisis management. Call me silly, but I worry about that.

I don't have an answer, or at least not an easy one. Should we treat health care as a utility? That is anathema to my free-market sensibilities. Should people be without basic health care? That is also not acceptable. Can we afford universal health care? Not as costs are currently structured. Can we change? Sure, we will have to. But I expect a bumpy ride. I read and think a lot about health care because I am worried it is going to impact our economy in ways we simply don't yet understand.

China, Japan, and a Few Rocks

I also read a lot of material written by other professional worriers – as opposed to amateurs who worry about everything simultaneously, or even worse, the tin-hat crowd that feels compelled to conjure problems and conspiracies that don't exist in order to assign blame to some imagined cabal of bad guys.

(OK, let me generate a lot of negative comments with an example. I find the belief that there is a "Plunge Protection Team" simply bizarre. You know, the guys who are supposed to control the stock market? The "Working Group on Financial Markets"? If there is one somewhere, deep in the bowels of government, they are the most incompetent conspirators ever assembled. And no one has come forth and spilled the beans in a memoir after 25 years? Puh-leeze!)

But when I start to pick up similar themes from people I know and respect who don't know each other, I start to pay attention. And one of those themes has been coming to me from people, including some at very high levels, who have deep knowledge and experience of Japan and China.

They are getting concerned that the level of rhetoric surrounding the Diaoyu/Senkaku Islands dispute is starting to get out of control. The real estate in question is a very small chain of five uninhabited islets and three rocks in the middle of the East China Sea. They are located roughly due east of mainland China, northeast of Taiwan, and west of Okinawa Island (the largest of the Ryukyu Islands), as shown in the map below.

China and Japan have had an on-again, off-again relationship for centuries. At times, it has not been very pretty. China suffered a great deal at Japanese hands during WWII. Just when you thought the old wounds were finally healing, the off-again phase has come back in full force. Japan nationalized what were to them the Senkaku Islands last September. (Technically, Japan bought them from the Kurihara family for 2 billion yen.)

The earliest historical records we have indicate that the Chinese discovered the islands in the 15^th century. The Japanese nationalized them in 1895. After WWII, the US administered them but gave control back to Japan in 1971. Returning control to Japan angered both China and Taiwan, as both countries considered the islands as their own. China and Taiwan then began to officially declare ownership of the islands.

The rub is that these rocks may be perched in the middle of a rather large oil and gas field. The UN identified the petroleum potential in 1969, but no drilling has taken place.

The leaders of both China and Japan have made strong statements, and their citizens have expressed even stronger emotions. The Chinese are boycotting certain Japanese companies, and Japanese exports to China have dropped 14.5% (as of latest data). Recent meetings between the two countries have not been helpful. Recently, in what was supposed to be a speech to smooth things over, a top Japanese foreign policy advisor basically lectured the Chinese on their behavior in Hong Kong. Not the stuff of great diplomatic gestures.

And as I get ready to finish this letter, this timely note has come in from Stratfor:

Japanese Prime Minister Shinzo Abe has warned Beijing that Tokyo is losing patience with China's assertive maritime behavior in the East and South China seas, suggesting China consider the economic and military consequences of its actions.

In an interview The Washington Post published just prior to Abe's meeting with U.S. President Barack Obama in Washington, Abe said China's actions around the disputed Senkaku/Diaoyu islands and its overall increasing military assertiveness have already resulted in a major increase in funding for the Japan Self-Defense Forces and coast guard. He also reiterated the centrality of the Japan-U.S. alliance for Asian security and warned that China could lose Japanese and other foreign investment if it continued to use "coercion or intimidation" toward its neighbors along the East and South China seas.

It is hard for the world to understand the national emotion surrounding a few barren rocks. But stranger things have happened. Remember the Falklands (although they were at least populated)? I bring this issue to your attention not as something to worry about, perhaps, but as something to which you might want to pay closer attention. Let's hope cooler heads prevail; this is not something the world wants to choose sides over.

Stupid Sequestrations

The media and much of the political chattering class seem to think that the upcoming sequestration of certain government spending is going to bring down the republic. The actual reality is that we are talking about some $45 billion this year. In a $16 trillion economy, that is a rounding error. And with a $1 trillion+ deficit, it is not enough cutting.

Yes, across-the-board cuts are stupid. The Defense Department and, yes, even the other government departments should be given leeway to decide where to make the cuts, with proper Congressional oversight. But we need those cuts and more. We should be cutting the deficit by $100-150 billion a year every year until the budget is balanced (by which time we hopefully see some growth). If we simply held spending where it is, the problem would get solved with no cuts. Or if we cut the growth of spending in half, we could get close with some other adjustments.

I worry about a lot of things. But this sequestration is just simply not on the list.

Whiteboard Fun

I want to call to your attention a new whiteboard animation series by my partners at Altegris. Every single one of these videos is fun to watch. I love a good story, and great whiteboard animation is all about storytelling. Through these videos, Altegris has tackled some fairly complex and important alternative investments topics and made them easier to understand in a very engaging way. Take a look at the "edutaining" first video, called Common Myths About Alternatives. This video addresses ongoing myths circulating about alternative investments. I encourage you to watch and then go check out the Altegris premiere lineup of hedge fund managers, normally difficult to access otherwise. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

Argentina, Cambodia, Singapore, Humiliation, and Homeless

I am back home for a few days. Tomorrow Jon Sundt and Dick Pfister, my partners at Altegris Investments, are coming to town for a planning and strategy session (which must of course include a Mavericks game). The next day we drive out to see Kyle Bass and his team at his Barefoot Ranch in East Texas for more in-depth work, some thinking about Japan and global macro investing, and possibly a little skeet shooting.

I leave for Cafayate, Argentina, Thursday after next, for two weeks. I'll spend time with friends and try to relax a little, but mostly I'll work on finishing my part of the book Bill Dunkelberg (chief economist of the National Federation of Independent Businesses) and I are writing on the future of employment. As it turns out, healthcare costs might be partially responsible for the significant drop in new business formation. Go figure.

When I get back from Argentina, I will be living in a hotel until the new place (hopefully) closes. Homeless, sort of.

Last time I was in Cafayate for a few days, I played nine holes of golf with my friends and partners David Galland and Olivier Garret. I had not played any golf for about four years and had a very loose 29 handicap when I did play. I was not expecting much. After a very bad, cold start on the first hole, I slowed my swing way down and found myself hitting the ball where I could find it. I ended up shooting about 51 for the nine holes and was quite happy with that score.

So this past weekend I decided to play in a scramble format with my friends Victor Adair and Michael Campbell of Canadian business radio fame, whom I had never met except by phone during interviews. Victor knows I am good friends with Greg Weldon and arranged for him to be on our team. They were marvelous gentlemen, it was a beautiful day on a magnificent course, and I thoroughly enjoyed the outing.

Except. Golf can be so humiliating. I stepped up to the tee carrying the confidence from my Argentina outing... and sent the ball screaming right into some nasty brush. Oh well, there's always the next hole. And then I proceeded to lose exactly one ball per hole for nine straight holes. I got back in the cart with Victor and muttered something along the lines of, "That may have been the ugliest exhibition of golf you've ever seen." The silence and slight smile from Victor said it all. He was just too polite to agree out loud. Things did get better, though: I only lost three balls on the back nine. (On the plus side, I did make our five birdie putts for the team.)

In the middle of April, I will be speaking in Singapore and will take the opportunity to go see Angkor Wat in Cambodia. It has long been on my bucket list.

Ironically, since I've been writing about health care, I seem to have picked up a slight head cold in Palm Springs, so I think I will just call it an evening. I don't want to jinx myself, but I've been feeling amazingly good lately, so even losing 12 balls hasn't affected my mood tonight.

Have a great week. Don't sweat the small stuff. And remember: it's mostly small stuff.

Your having too much fun to worry too much analyst,

John Mauldin

subscribers@mauldineconomics.com

The Keynesian Depression

John Mauldin — Sat, 23 Feb 2013 05:00:00 GMT

In today’s Outside the Box, Scott Minerd, chief investment officer of Guggenheim Funds, regales us with the not-always-happy history of Keynesian economics – we did what he said when we had to, but not always when we should have. Shoving fiscal and monetary stimulus down the throat of a recession is well and good, but how about the part where we’re supposed to be fiscally conservative during boom times? “What, raise taxes? No thank you!”

The upshot, as Minerd reminds us, is that “As a result of the constant fiscal support without the tax increases, businesses and households became comfortable operating with continuously higher leverage ratios. The conventional wisdom was that this government backstop could never be exhausted.” Today we are testing that premise to the limit, and not only in the US.

Keynes forged his ideas in the fires of the Great Depression, but his disciples have, as Minerd wryly notes, “carried his views much further than could have been imagined during the period in which the master lived.” Consequently, the downturn we now struggle to escape from is very different from the one that plagued the world of the 1930s. The key difference, Minerd tells us, is that:

… for the first time since the 1930s, we have had severe asset deflation (declining real prices) in the face of relative price stability. Periods of asset deflation occurred between the 1960s and 1990s, but nominal prices were supported by rising inflation levels…. This protected asset-based lenders from severe losses resulting from declining nominal prices.

During the 2008 crisis, inflation levels were close to zero and unable to offset falling real asset values to stabilize nominal prices. This caused a debt deflation spiral to take hold as nominal prices fell. In contrast to the Great Depression, policymakers took extreme measures in 2008 to prevent a total collapse of the financial system and head off a deflationary spiral like that experienced in the 1930s. These policies included sharply increasing the money supply and engaging in an unprecedented amount of deficit spending.

To say the least. And all the easing and deficit spending worked to stave off financial disaster – up to a point. The problem is, we have just about reached that point – the point where, as Rogoff and Reinhart have so firmly instructed us, things turn out not to be that different after all. So let’s jump into Minerd’s take on the big picture, and see what he thinks the implications are for our investments.

But first, let me reveal that I find myself in Palm Springs this morning, getting ready to take a few hours off and embarrass myself with friends at the Indian Wells Golf Resort. Greg Weldon was on the plane last night (at 6’10”, he has to be the tallest analyst in the writing game), and he told me to bring my “A” game to the golf course, as we’d be playing together. I just laughed and said I didn’t even have an “X” game. I think if I shoot anything close to 120, I will just declare victory and walk to the clubhouse with a smirk. Big difference from my attitude in the “old days,” when I had time (and a back) to play. Bottom line: It’s a great course and a beautiful day, and I don’t make my living with a golf club in my hand. Greg, on the other hand, brings the same intensity to everything he does, whether it’s trading or golf or the World Series of Poker. I will watch him exult and curse, maybe on the same hole. I only get intense these days when I write. C’est la guerre.

Grant Williams is in town, and we will be spending a lot of time the next few days comparing notes and doing some videos for our readers (that would be you, and you’ll see them shortly). As everyone knows, I am a huge Grant Williams fanboy. It helps that he is also one of the nicest human beings anywhere.

I am speaking at the Cambridge House Natural Resources Conference here. Rick Rule of Sprott is coming in, and we will have dinner. My Mauldin Economics team partners are also in town, to help with the video and plan out some great new letters. I am really excited about the directions we are taking. They are opening up whole new ways for me to help you.

Oddly, it is colder here in Palm Springs than it was back in Dallas, but pleasant all the same. Have a great weekend.

Your wondering where his ball went analyst,

(The real editor’s note: John apparently finished this on his iPad at the third hole. He was probably not kidding about having lost his ball.)

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

The Keynesian Depression

A Premonition From a Halcyon Era

By Scott Minerd, Chief Investment Officer, Guggenheim Funds

In 1968, America was literally over the moon. Apollo 7 had just made the first manned lunar orbit and the nation would soon witness Neil Armstrong’s moonwalk. The United States was winning the war in Southeast Asia and the Great Society was on the verge of eliminating poverty. I remember my father taking me to the Buick dealership that summer in Connellsville, Pennsylvania, where he bought a 1969 Electra. As we drove home I asked him why we had bought the 1969 model when we had the 1968 one, which seemed equally good.

“That’s just what you do now,” my father said, “Every year you go and get a new car.” “Wouldn’t it be better,” I asked as a precocious nine year-old, “if we saved our money in case a depression happened?” I will never forget my father’s reply: “Son, the next depression will be completely different from the one that I knew as a boy. In that depression, virtually nobody had any money so if you had even a little, you could buy nearly anything. In the next depression, everyone will have plenty of money but it won’t buy much of anything.” Little did I realize, then, how prescient my father would prove to be.

Five years have passed since the beginning of the Great Recession. Growth is slow, joblessness is elevated, and the knock-on effects continue to drag down the global economy. The panic in financial markets in 2008 that caused a systemic crisis and a sharp fall in asset values still weighs on markets around the world. The primary difference between today and the 1930s, when the U.S. experienced its last systemic crisis, has been the response by policymakers. Having the benefit of hindsight, policymakers acted swiftly to avoid the mistakes of the Great Depression by applying Keynesian solutions. Today, I believe we are in the midst of the Keynesian Depression that my father predicted. Like the last depression, we are likely to live with the unintended consequences of the policy response for years to come.

This Depression is Brought to You By...

John Maynard Keynes (1883—1946) was a British economist and the chief architect of contemporary macroeconomic theory. In the 1930s, he overturned classical economics with his monumental General Theory of Employment, Interest and Money, a book that, among other things, sought to explain the Great Depression and made prescriptions on how to escape it and avoid future economic catastrophes. Lord Keynes, a Cambridge- educated statistician by training, held various cabinet positions in the British government, was the U.K.’s representative at the 1944 Bretton Woods conference and, along with Milton Friedman, is recognized as the most influential economic thinker of the 20th century.

Keynes believed that classical economic theory, which focused on the long-run was a misleading guide for policymakers. He famously quipped that, “in the long run we’re all dead.” His view was that aggregate demand, not the classical theory of supply and demand, determines economic output. He also believed that governments could positively intervene in markets and use deficit spending to smooth out business cycles, thereby lessening the pain of economic contractions. Keynes called this “priming the pump.”

On Your Mark, Get Set, Spend

Since the Second World War, policymakers concerned with both fiscal and monetary policy have opportunistically followed certain Keynesian principles, particularly using government spending as a stabilizer during periods of economic contraction. In 1968, steady economic growth and low inflation had led optimists to declare that the business cycle was dead. When President Nixon ended gold convertibility of the dollar in 1971 he justified it by declaring that he was a Keynesian. Even Milton Friedman, founder of the monetary school of economics, told Time magazine that from a methodological standpoint, “We’re all Keynesians now.”

In dampening each successive downturn, authorities accumulated increasingly larger deficits and brought about a debt supercycle that lasted in excess of half a century. The complementary aspect of Keynes’ guidance on deficit spending – raising taxes during upswings – was rarely followed because of its political unpopularity. As a result of the constant fiscal support without the tax increases, businesses and households became comfortable operating with continuously higher leverage ratios. The conventional wisdom was that this government backstop could never be exhausted.

The calamity in the financial system in 2007 and 2008 signaled the beginning of the unraveling of the global debt supercycle. The Keynesian model dictated that the best way to fix the problem was to run large deficits and increase the money supply. Keynes had based his prescriptions for this type of action on the early mismanagement of the Great Depression which he felt had prolonged the losses and hardship during that time. As is the case with most groundbreaking philosophies, Keynes’ disciples carried his views much further than could have been imagined during the period in which the master lived.

The Depression My Father Knew

Keynes viewed governments’ attempts at belt-tightening during the Great Depression as ill-timed. Although President Roosevelt invested in massive public works projects under the New Deal starting in 1933, almost four years into the crisis, the U.S. government maintained a policy of attempting to balance the budget as the depression raged on. Keynes’s response was: “The boom, not the slump, is the right time for austerity at the Treasury.” The other problem, according to Keynes, was that the Federal Reserve’s attempts to lower real interest rates and inject cash into the system were too modest and too late to avoid what he referred to as a liquidity trap, leading people to hoard cash instead of consuming.

To illustrate the dynamics of the liquidity trap Keynes cleverly invoked the analogy of “pushing on a string.” He said that at some point, attempting to stimulate demand by easing credit conditions is like trying to push a string that is tied to an object you want to move. Whereas you can easily pull something toward you by the string to which an object is tied (raising interest rates to slow growth), attempting to carry out the opposite by reversed means (lowering interest rates to try to induce lending to otherwise unwilling borrowers) is not always successful. This is especially true when the rate of inflation becomes so low that it becomes impossible to set interest rates below it.

This Time It’s Different

What sets the current downturn apart from any other since the Great Depression is that, for the first time since the 1930s, we have had severe asset deflation (declining real prices) in the face of relative price stability. Periods of asset deflation occurred between the 1960s and 1990s, but nominal prices were supported by rising inflation levels. Against the backdrop of a rising price level, nominal asset prices remained stable or continued to increase as real asset prices declined. This protected asset-based lenders from severe losses resulting from declining nominal prices.

During the 2008 crisis, inflation levels were close to zero and unable to offset falling real asset values to stabilize nominal prices. This caused a debt deflation spiral to take hold as nominal prices fell. In contrast to the Great Depression, policymakers took extreme measures in 2008 to prevent a total collapse of the financial system and head off a deflationary spiral like that experienced in the 1930s. These policies included sharply increasing the money supply and engaging in an unprecedented amount of deficit spending.

In many ways the swift policy action proved highly effective. Instead of the 25 percent unemployment seen in the 1930s, joblessness reached only 10 percent. While unemployment now stands at roughly eight percent, if one uses the labor force participation rate from 2008, the level is still higher than 11 percent. Although there was a 3.5 percent decline in the price level between July and December of 2008, policymakers immediately tackled and reversed the deflationary spiral. This compares with the Great Depression, when between 1929 and 1933 the general price level declined by 25 percent.

The Aftermath

Though some may be cheered by the relative policy successes this time around, at the current trajectory it will still take almost as long for total employment to fully recover as it did in the 1930s. While job loss was not as severe this time, the recovery in job creation has been much slower. Although nominal and real gross domestic production have returned to new highs on a per capita basis, we are still below 2007 levels. In the same way the Great Depression and the depressions before it lasted eight to 10 years, we will likely continue to see constrained economic growth until 2015-2016 (roughly nine years after U.S. home prices began to slide). Only then will the excess inventory in the real estate market be absorbed, allowing the plumbing of the financial system to function, and supporting an increase in the economic growth rate.

At what cost did we attain this “success”? Like any strong medicine, the policies pursued since 2008 have had, and are continuing to have, unintended side effects. The most glaring feature of today’s global landscape is that governments around the world have exhausted their capacity to borrow money and have turned to their central banks to provide unlimited credit. In the United States, it has taken an average annual deficit of $1.2 trillion and multiple rounds of quantitative easing just to keep the economy growing at a subpar rate since 2009.

In their 2009 book, This Time It’s Different: Eight Centuries of Financial Folly, the economists Carmen Reinhart and Kenneth Rogoff catalogue more than 250 financial crises and conclude that the U.S. cannot reasonably expect to circumvent the outcome that has befallen all overleveraged nations. In the authors’ words:

...Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

Sovereign powers saddled with debt loads as large as those of the U.S., Europe, and Japan today are jeopardizing their long-term economic wellbeing.

In an October 2012 whitepaper, Reinhart and Rogoff re-emphasized their findings that the U.S. cannot expect to quickly emerge from what occurred in 2008. They point out that 2008 was the first systemic crisis in the U.S. since the 1930s so the consequences have been much more significant than fall-outs from normal recessions.

What Comes Next?

The most important question for investors concerns how public sector debt levels, which have risen exponentially over the past half-decade, will ultimately be discharged. As Reinhart and Rogoff discuss, there are three options to reducing debt levels. The first is restructuring, also known as default. For obvious reasons this is painful and typically avoided except under the most dire circumstances. Governments can also pursue structural reform, which in today’s case would mean greater austerity. Implementation of this would stand in stark opposition to Keynes’s recommendation that the fiscal and monetary spigots be kept open during hard times. Although tightening is arguably the best long-term path, it appears unlikely that it will be the primary policy of choice in the near future. The third method, toward which I see global central bankers drifting, is to keep interest rates artificially low and permit increasing levels of inflation in the economy.

Pushing down the cost of borrowing and allowing the price level to rise is known as financial repression. The real value of debtors’ obligations is reduced by financially repressive policies. Keynes warned of the dangers of inflation in his early work, The Economic Consequences of the Peace, which presciently criticized the harshness of the Treaty of Versailles:

...By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens ... As inflation proceeds and the real value of the currency fluctuates wildly, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless.

Keynes re-iterated his views in the mid-1940s when he visited the United States and saw programs that were touted as Keynesian although he viewed them as primarily inflationary.

Financial repression is nothing new. Between the 1940s and the early 1980s, the United States reduced its national debt from 140 percent of GDP to just 30 percent while continuing to run sizable deficits. The difference between then and now is the magnitude of the debt mountain on the Federal Reserve’s balance sheet that will need to be eroded. A subtle shift has begun in which policymakers are starting to think of inflation as a policy tool rather than the byproduct of their actions. Despite Keynes’ warnings, it appears that higher inflation will continue to be the monetary tool of choice for central bankers tasked with cleaning up sovereign balance sheets.

Investment Implications

The long-term downside of mounting inflationary pressure will ultimately accrue to bondholders and income-oriented investors. The case can be made that we are marching headlong into a generational bear-market for bonds. During the next decade, holders of Treasury and agency securities will likely realize negative real returns. Despite this, these assets continue to trade at extremely rich valuations. Exactly when the market will awaken to this anomaly in securities pricing remains to be determined. The analogy I would use for the current interest rate environment is that of a balloon being held underwater. When the Fed withdraws from the market and allows interest rates to find their economic level, the balloon will inevitably ascend.

If investors need to stay in fixed-income assets, they should consider transitioning into shorter-duration credit and floating-rate products like bank loans and asset-backed securities. If duration targeting is a concern for liability-matching purposes, adjustable-rate assets can be barbelled with long-duration securities like corporate bonds or long duration agency mortgage securities. Equities and risk assets are likely to rise as the money supply grows.

Gold, as I discussed in my October 2012 Market Perspectives, “Return to Bretton Woods,” has significant upside potentially and should be considered for inclusion in any portfolio designed to preserve or grow wealth over the long-term. Depending on the scale of the current round of quantitative easing and the decline in confidence in fiat currencies, the price of an ounce of gold could easily exceed $2,500 within a relatively short time frame and could ultimately trade much higher.

The World is Waiting

The Great Depression brought about the Keynesian Revolution, complete with new analytical tools and economic programs that have been relied upon for decades. The efficacy of these tools and programs has slowly been eroded over the years as the accumulation of policy actions has reduced the flexibility to deal with crises as we reach budget constraints and stretch the Fed’s balance sheet beyond anything previously imagined. Nations have exceeded their ability to finance themselves without relying on their central banks as lenders of last resort and increasingly large doses of monetary policy are required just to keep the economy expanding at a subpar pace. Some have referred to this as reaching the Keynesian endpoint.

Keynes would barely recognize where we now find ourselves. In this ultra loose policy environment we are limited by our Keynesian toolkit. Today, the world is waiting for someone to come forward and explain how we are going to get out of our current circumstances without suffering the unintended consequences created by so-called Keynesian policies.

Early in his life, Abraham Lincoln wrote that he regretted not having been present during the founding of the nation because that was when all the positions in the pantheon of great American leaders were filled. By resolving America’s Imperial Crisis through the Civil War and the abolishment of slavery, Lincoln would go on to join those lofty ranks himself. Much like that crisis needed Lincoln, the current crisis needs someone who can identify new tools to resolve the present economic crisis. Until then we are condemned to a path which leads to further currency debasement and the erosion of purchasing power, with the result being a massive transfer of wealth from creditor to debtor. Without a new economic paradigm, the deleterious consequences of the current misguided policies are a foregone conclusion. It would seem my Dad could hardly have been more correct when he described the next depression from behind the wheel of his 1969 Buick.

Whatever It Takes

John Mauldin — Wed, 20 Feb 2013 21:48:00 GMT

Who's Got the Map?
Monetization – A Rose by Any Other Name
Super Mario: Whatever It Takes
The New Policy Implications of the Irish Deal
Currency Skirmishes
Toxic Debt Scare
A Special Invite
My Conference, Palm Springs, and Vagabond Shoes

Lord Melchett: "Farewell, Blackadder [hands him a parchment]. The foremost cartographers of the land have prepared this for you; it's a map of the area that you'll be traversing. [Blackadder opens it up and sees it is blank] They'll be very grateful if you could just fill it in as you go along. Bye-bye."

– From the English comedy series Blackadder (Part 2, Episode 3)

Was it only a few years ago I visited the Emerald Isle of Ireland? So recently had this fair land come to such a sad state. The collapse of its largest banks foreshadowed the demise of many other European banks that had borrowed money from British, German, and other European banks to lend against homes and property. The Irish government had to guarantee deposits and bond holders in order to prevent a bank run. I think I am correct when I state that the Central Bank of Ireland was the first central bank to avail itself of large-scale use of the Emergency Liquidity Assistance (ELA) provision of the European Central Bank. This was before we became so familiar with the process in Greece.

The Irish banks had lost a combined €100 billion, borrowed largely from other European banks, which would also have incurred great losses had the Irish government not stepped in. You have to remember that this was before Greece and Spain needed assistance, although as Ireland stepped up to the table, the acronym "PIIGS" was coming into vogue; and some of us were writing about the debt problems that plagued Greece and other peripheral countries. The European Union compelled the Irish government to bail out its banks, and so the Central Bank of Ireland took on the debt (via the ELA) of the six main Irish banks that had failed because of the property bubble.

In the "bailout," Ireland received €67.5 billion (and in addition borrowed another €17.5 billion from its pension and cash accounts), which it pledged with a promissory note to pay back. The public was quite upset, and the government was then overwhelmingly rejected at the polls, in a clear show of sentiment demonstrating that the Irish people did not view that bank debt as something that should be on the public balance sheet.

Government workers had to take large pay and pension cuts and government services were cut, as one of the conditions for getting the money was significant austerity. This was before "austerity" became a bad word in Europe. Meanwhile, unemployment rose from 4% to 14%.

I visited Ireland after the new government took over. I met with some two dozen business leaders, politicians of all persuasions, journalists, and economists. I remarked at the time that the only thing they agreed upon was that Ireland would never pay that bailout money back. A former prime minister told me that they would not have to openly repudiate the debt, but rather were expecting, after Greece and other countries were allowed to default, to be invited not to pay it.

A leading Irish economist who was at the negotiating table told me point-blank that the IMF negotiator told them they would not have to pay it back. But you have to remember that at the time there was true panic and no road map for dealing with such a crisis. Something had to be done. That something was the issuance of bailout funds (which conveniently minimized losses at said German, French, and British banks), which came with a private assurance to Irish leaders that whatever was done for other countries would be available to them as well. "But please, just work with us right now?"

So the Irish, as we say in Texas, took one for the European team. The blow left a rather ugly scar, as the national debt ballooned into impossible-to-manage territory, crippling the national government.

But there was one group in Ireland that was aghast – horrified – at the idea of not paying back that debt: those were the people I met at the Central Bank of Ireland. And they did have a point. The document that created the European Central Bank did not allow a national central bank to not pay its debts. Governments could default (as we learned with Greece), but not national central banks. Those were the rules that everyone who adopted the euro played by.

At the time, I wrote that the Irish would not pay that debt. I had listened to the 99% of the people who told me so. Silly me. Yet, the last two weeks have seen the Irish convert their promissory note into government debt and agree to sell bonds. So it looks like the Irish will pay after all. Except that when you read the details, the Irish (after a great deal of controversy ensues) will end up either not actually paying or not paying anything close to the value of what they borrowed. So how can they both pay and not pay? That is the topic for this week's letter; and an instructive reading it is, not for what it tells us about Ireland but for what it tells us about the EU, the eurozone, and the future of the euro.

Who's Got the Map?

Fans of British comedy will recall fondly the early-'80s series Blackadder, originally about a self-serving courtier of Queen Elizabeth (played by Rowan Atkinson, who later became known in the US for his role as Mr. Bean). At one point, Blackadder is compelled to sail around the Cape of Good Hope in order to remain in the Queen's good graces. The voyage seems, of course, like a death sentence, and Blackadder never intends to sail. His nemesis, Lord Melchett, offers him a map and voices the lines quoted at the beginning of this letter. The map is a blank page. "It's a map of the area that you'll be traversing. They'll be very grateful if you could just fill it in as you go along. Bye-bye."

The document that created the eurozone is right along the same lines. Everyone thought they knew what it meant, or at least the Germans did. The Bundesbank (the German central bank) was quite sure that it prevented monetization of debt. It said so right there in Article 123. But the EU and the ECB (with their faithful companion the IMF) seem to be constantly wandering off into uncharted territory. Banking, credit, and sovereign debt crises seem to require legal maneuvering that was not explicitly detailed in advance. As the rest of Europe looks on, the ECB draws in lines on the map as it goes along.

Article 123, as every good Bundesbank member will tell you, explicitly says there will be no debt monetization. But it turns out that while everyone agrees that monetization of national debts is a bad thing, the definition of monetization is not as clear to much of the rest of Europe as it is to the good German burghers.

Wolfgang Münchau writes rather merrily about the recent "rescheduling" of Irish debt:

Everybody seemed to be talking about monetary financing of debt last week – the ultimate taboo in monetary policy. And hidden behind a veil of unbelievable complexity, the eurozone may have done just that.

Various European central bankers rushed to proclaim that the agreed rescheduling of Ireland's so-called promissory notes would not set a precedent for sovereign debt laundering. In legal terms, the agreement is probably watertight. It may be a borderline issue, but who cares? In economic terms, the situation is much clearer. This is monetary financing in all but name – and a jolly good thing it is too. (The Financial Times).

All this can get quite complicated (trust me). But it essentially boils down to this: Anglo-Irish Bank was bankrupt. The Irish government had to come up with some type of collateral that it could hand to what was in essence a bankruptcy trustee in order to be able to borrow at the ELA (Emergency Liquidity Assistance, sometimes referred to as "Lending Assistance"). The government gave the trustee a promissory note that was supposed to be paid off rather quickly (in ten years). It quickly became a large financial burden for Ireland's government – and a very sticky political problem. Only an Irish central banker could love that debt.

But someone in Ireland came up with a very creative solution. They turned that 10-year note into 25- to 40-year bonds. The interest that the government pays on the bonds to the Central Bank of Ireland goes right back to the government. Münchau is right: this is monetization in all but name. But there is a small fig leaf that keeps it from being outright monetization: the CBI agreed to sell the bonds into the marketplace over time, as the situation dictates. From the Irish Department of Finance press release:

The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.).

Let's put that in context. Ireland issued €2.5 billion in 5-year bonds last month, which are now yielding 2.8%, less than Italy's corresponding bonds. That is also less than the 5.9% the Irish paid last summer when they first came back to the market. (Someone made a rather large profit on those bonds!) The bank deal has evidently reduced the cost of Irish bonds for the government. They expect to raise about €10 billion this year. Right now, issuing another €0.5 billion in bonds is rather easy for them. Granted, the government has to pay the interest to what will be private bond holders, but that is far less than they were paying.

By switching to lower-interest-rate bonds and stretching out the burden of repayments over four decades, Ireland will save itself €20 billion ($26.78 billion) over the next decade and free up €1 billion for future budgets. Goodbody Chief Economist Dermot O'Leary was kind enough to send me a private client letter that shows what a large help this move will be to the Irish government. It gives them a much better chance to actually reduce their deficit to a European-standard 3% within the agreed-upon 2015 time frame. O'Leary thinks they will do even better.

The Irish ran their plan by the ECB staff before they announced this. I was told that initially they did not offer a specific schedule for selling the bonds, but the ECB (the Germans?) required at least a token schedule.

So, the Irish will pay those bonds back. Kind of. Perhaps. I say "kind of" for several reasons:

1. Think back 40 years to the US in 1973. Want a 1973 dollar? It's worth about 19 cents today. How about an Irish punt? An Italian lira? 25-40 years is a long time. And given that the ECB is going to have to print massive amounts of euros to hold the eurozone together, the betting is that when the Irish do pay that debt, it will be in a euro (or successor currency) that costs far less in terms of nominal GDP or buying power.

2. There is a reasonable chance that at some point the European Union, or at least the eurozone, will move to something close to the mutualization of debt and fiscal union. Debt that grew out of the crisis would seem to be a likely prospect for debt mutualization. This would reduce that burden of that debt. Of course, it would bring in other debt, but that's what the long term and central banks are for – or so the logic will go. I most definitely do not agree with that world view, but I will not likely be asked my opinion. In any case, the Irish debt will be so small relative to Spanish and Italian and French(!) debt that it will be considered a rounding error.

3. In the short and the long terms, this is a good deal for Ireland. Those who say the debt should be repudiated altogether would seemingly vote to withdraw from the euro. The time to reject the debt was at the beginning, and they should have. If German, French, and British banks lent money to Irish banks to invest in Irish property, then they deserve the fruits of their investment prowess (or lack thereof), not a taxpayer bailout.

4. Greece and Spain have also gone to the ELA, as have many European countries and banks. At some point, the eurozone is going to have to create some sort of banking union, as much as the Germans do not want to. There is the potential for these ELA loans to be considered banking-related losses. That is part of the negotiation process. Who knows what will happen, so why not cut your expenses in the short run, because the long run may make the whole thing go away.

Monetization – A Rose by Any Other Name

"What's in a name? that which we call a rose
By any other name would smell as sweet…"

There are those who oppose this Irish move. Jens Weidmann, the president of the Bundesbank, has been especially critical. But then, what would you expect? There is a genetic predisposition in Germany against monetizing debt, and has been since at least 1924. And make no mistake, this is monetization, no matter how much legal perfume you slather on it.

Quoting Münchau again:

This is monetary financing for all intents and purposes. The whole structure of this agreement is so convoluted that newspapers do not report all the relevant details. As always, convolution has a purpose. It renders legal what would otherwise not be, and it allows for obfuscation.

In this case, the purpose of obfuscation would be to hide what would otherwise be a contradictory message. You cannot admit publicly in the creditor countries that monetary financing is taking place – this is sacrilege. But then this is what it takes to save Ireland from a debt trap. It was then considered the best strategy to put back the debt repayment by a generation or two.

I am marginally encouraged by this, not so much because I believe that monetising is a good thing in principle, which I do not. What encourages me is that I can see this as one of several components of an ultimate solution of the eurozone crisis. Without some form of arbitrage between debtors and creditors, this would be hard to achieve.

I wrote at least three or four years ago that if you are going to keep the eurozone together, there will have to be monetization. It is going to take trillions of euros, whether they are monetized or in the form of extended debt – or however you care to characterize them – to solve this puzzle. And the only entity that has that type of money is a central bank, in this case the European Central Bank.

Super Mario: Whatever It Takes

You have to give Mario Draghi, European Central Bank president, high marks on your central-banker scorecard for style and creativity. Following hard on the heels of the bland Frenchman, Jean Claude Trichet, Super Mario has pushed the ECB to the point where it is, for want of a better word, central to the European enterprise. In July of last year, with the eurozone in crisis, he stood up in London right before the Olympics opened and stated (now famously):

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The Financial Times named him Man of the Year for 2012.

While I am told that the Irish came up with the plan to monetize the debt (excuse me, I mean to magically change an Irish government promise into German and French [and other eurozone] money; not exactly the same as monetization if you look at it in the right way, perhaps aided by a pint or three or four of Guinness), Draghi had to have approved it. And rather than saying he appreciated the creativity involved, he simply said that the ECB had unanimously decided to "take note" of the Irish actions, whatever that means. "There isn't any decision [to back the Irish debt swap] today. We simply took note," he said. I guess €28 billion isn't enough to officially mess with; you simply take note of it.

The Financial Times reports today that the ECB, rather than giving formal approval, wants to be able to pressure the CBI to actually sell those bonds; and it also gives the ECB some negotiating room with other national central banks, which will want to make similar moves.

The New Policy Implications of the Irish Deal

The ECB is going to need that room. Part of the controversy of the Irish deal is that senior secured creditors of banks are potentially going to lose money. This may represent new EU and ECB policy. That part of the map is not yet clear. Sovereign debt holders have lost money in Greece and will lose more in Spain (unless the ECB gets creative again). Predictably, those most critical are the ones losing money.

Some think that Draghi's recent comments mean the Irish deal will be reexamined. I can see where that might make political sense (to pretend to address concerns, etc.), but taking back this deal would create a major storm in Ireland. The bank debt is a deep wound, and the salve is a reduction in government costs. Taking away that salve is likely to create all sorts of voter backlash and possibly lead to a Sinn Fein government that would want to repudiate the debt outright.

Greece and Cyprus have to be watching very closely. As I wrote a few weeks ago, the chairman of the Council of Economic Advisors in Greece told me that the money they are being loaned to recapitalize the banks will not be repaid, because Greece does not have the financial ability to do so. Ireland was in the same spot, and with this magic they have changed the equation. Will the same deal be available to Greece in the future, if they keep on jumping through hurdles?

Cyprus will likely have a new pro-bailout government in a few weeks and will have to negotiate a €17 billion bailout from the EU and IMF – that's for a country with a population of 545,000, so about $40,000 per man, woman, and child of mostly new debt, taking their debt-to-GDP ratio up to 145%. A family of four will have to pay $10,000 a year (at 6.5% interest) just to cover the new debt. On top of the old debt. Where can a country get such income and remain competitive?

Will there be another haircut on European government debt? Someone somewhere is going to have to lose some money on this deal. Again, the Irish deal opens the way for a new brand of creative thinking in Europe on old debt.

Currency Skirmishes

I continue to think the euro is going to parity with the dollar over time. The ECB in conjunction with its various national banks is going to have to monetize and print (or we can call it by its polite name, "quantitative easing") to an even greater extent than the US Fed. Along with the money gushing from the Bank of Japan and the Bank of England, there are going to be sums injected into the global system that simply cannot be comprehended. And all this easing will force developing nations to compete at the printing press.

The recent G20 meeting basically said, "It is OK to print as long as you are doing it to stimulate your economy and not to devalue your currency. And for heaven's sake, don't talk about it. Shut up already!"

That's a loose interpretation, I admit. But read Super Mario's statement about the G20 meeting, and you make the call:

Most of the exchange rate movements that we have seen were not explicitly targeted; they were the result of domestic macro-economic policies meant to boost the economy… [and] In this sense, I find really excessive any language referring to currency wars… [but] What I did say at the G20 in Moscow, I urged all parties to (exercise) very, very strong verbal discipline.

In an article titled "G-20 Moves Toward Common Ground on Currencies," the Wall Street Journal reported:

… there was more agreement on the need for market based exchange rate and [the G-20] pledged Saturday to refrain from targeting their currency policies to gain a competitive trading advantage….

Germany's central bank president, Jens Weidmann, said it was clear at the meeting that G-20 members agreed that "politically driven devaluations can't sustainably improve competitiveness, don't solve structural problems and produce backlash reactions…."

"The understanding in this meeting was clearly that without going to extremes, developed countries will do what it takes to stimulate their economies, and developing countries—again without going to extremes – will do what it takes to protect themselves from hot-money inflows," said a senior official at a developing-country government that is part of the G-20.

We have not yet seen real currency wars. What we see today are mere skirmishes in what is shaping up to be a brutal battle to simply maintain a competitive stance.

I should note – as I almost hit the send button – that Ian Bremmer (who will be speaking at my conference in May) sent me a recent note about currency wars. He argues that Europe and China do not want to get involved in a currency war and that many emerging nations would also rather not. His argument makes sense, as a currency war is kind of like having an old-fashioned gunfight, except with hand grenades – there are no winners.

China will continue to allow its currency to appreciate slowly, for at least a few years. I can see Bremmer's argument with regard to Europe, in that they would really like to focus on inflation and the ECB would like to be a proper central bank; but Draghi's words keeps ringing in my ears: "… whatever it takes to preserve the euro." And what it takes may be money printing and a little inflation. We will get lip service, but the presses will run.

Korea? Taiwan? They have to compete with Japan. And the rest of Asia has to compete with all three. Can Brazil, Australia, and the other commodity-intensive countries allow their currencies to be priced out of the markets, thus weakening their economies? I think self-interest will trump all. This is the problem of the commons writ large.

Toxic Debt Scare

Finally, while researching this letter I came across the following post written by Colm McCarthy. I find it hilarious (by the standards of economics humor), and I hereby pass a few paragraphs along for your enjoyment. (For the young and those for whom English is a second language, a "knacker" is a person engaged in the trade of rendering animals that have died on farms and are unfit for human consumption.)

Teams of economists have detected traces of bank-debt DNA in samples of Irish sovereign debt in portfolios all over Europe. Genuine Irish sovereign debt is believed safe for humans but bank debt is toxic. The economists believe that as much as 30% of all Irish sovereign debt is not genuine. The source of the contamination appears to be a premises in Frankfurt, Germany. The contamination dates from 2010, when a sovereign debt knackering plant was run from the premises by a Monsieur Trichet, a French national. It is alleged that he gathered up large quantities of toxic bank debt and mixed it up with genuine sovereign debt in the middle of the night, when nobody was looking.

There is no licensing or supervision of sovereign debt knackerers at European level and it is understood that the Frankfurt plant was staffed by people with no previous experience in the trade. Genuine debt from several other European countries was processed through the Frankfurt plant in 2010 and 2011 and may also have been infected. The plant, which claims to be the only sovereign debt processing facility in Europe, is now run by a Signor Draghi, an Italian. Monsieur Trichet has retired from sovereign debt knackering and has commenced a new career in the aviation business.

The Irish Department of Finance has been seeking to return the infected sovereign debt to the Frankfurt plant with a view to removing the toxic component. They are afraid that retailers might remove the sovereign debt from their shelves. Signor Draghi has promised to do his best, but one of his assistants, Herr Weidmann, a German, believes that the toxic bank debt is harmless, and that anyway nobody will notice. He is refusing to operate the decontamination equipment.

A Special Invite

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My Conference, Palm Springs, and Vagabond Shoes

My tenth annual Strategic Investment Conference (May 1-3 in Carlsbad, California) seems to be filling up nicely. The speaker lineup is exceptional: Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Charles and Louis Gave; Jeff Gundlach; Anatole Kaletsky; David Rosenberg; Nouriel Roubini; and Gary Shilling.

The conference always sells out, so I suggest you register at your earliest convenience. Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. Registration is now open. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page There is a significant early-bird registration discount.

I will be in Palm Springs at the California Resource Investment Conference this weekend, February 23-24. My good friend Grant Williams, who writes the blockbuster Things That Make You Go Hmmm… and the Mauldin Economics Bull's Eye Investor letter, will be there, as will the best resource investor I know, Rick Rule, along with my favorite data maven, Greg Weldon. There is a full two-day slate of speakers. The event is free to investors and is always fun, and it's a great time of year to be in California (hate the pensions, love the weather). Come see us! You can read all about it and register at the Cambridge House website.

It has been almost four years since I have moved, and I tend to forget (kind of like childbirth, I suspect) how difficult a process it is. The home-buying part of the process seems to be proceeding apace, with the usual caveats. But I have to move out of my current home before I can move into the future one, so I will have to live in a hotel for a while. Oh, wait, hotel rooms are where I spent most of last year, so no big deal. Then it looks like I will move into one-half of the new apartment (in a Dallas high rise) while waiting four months for the other half to vacate, and then move back into a hotel again for 90 days while renovations are being done. And then, sometime in November – if all goes right – I will be in my new digs. So far, the mortgage process has not been painful.

With this move, I really am going to get rid of all that stuff I have been accumulating for decades. Since I intend to live in the new place for at least ten years, I need to be careful what I bring with me. Interestingly, I think we are going to seriously downsize the office space and more or less go virtual. With the new Internet phones we can be anywhere, and the new condo has a nice board room for the rare larger meeting. Video conferencing, email, texting, etc. all make a physical office less necessary.

I'll put in a small room for staff, for when we need to get together, but the days of a larger office may be over. I have my office in my home now, but we use over 1,000 square feet. All those old files I feel compelled to keep? Now scanned and stored in the cloud. My "office" (which is now simply a desk where my larger monitors sit) will be even cozier if I design it right... with a better sound system and some floor-to-ceiling windows looking out on the Dallas skyline.

Somewhere in the background I think I hear Old Blue Eyes singing These Vagabond Shoes. Have a great weekend.

Your actually trying out buying a home analyst,

John Mauldin

subscribers@mauldineconomics.com

Investing in a Low-Growth World

John Mauldin — Sun, 17 Feb 2013 23:59:00 GMT

The jury – unless you are the Fed and Ben Bernanke or the Congressional Budget Office, which cannot make lower growth assumptions without really blowing their deficit projections out of the water – is pretty well in on GDP growth: it’s going lower. Ed Easterling and I wrote a recent Thoughts from the Frontline on multiple pieces of research suggesting slower future growth. We asked the question, “So what about stock prices; will they follow suit?” Our thought was that, over time, they would.

Not so fast, says Jeremy Grantham in today’s Outside the Box. He was part of the cabal of researchers suggesting slower future GDP growth whose work we used as the basis for our analysis. Longtime readers know that I think Jeremy Grantham (who heads GMO, which now manages $106 billion – see GMO LLC for more wonderful GMO team research) is one of the smartest men on the planet as well as one of the best investors. With his usual thoroughness, Jeremy makes the case, based on in-house research, that both stock-market returns and corporate earnings growth are negatively correlated to GDP growth. At the same time, he’s not overselling his thesis:

For the record, there is also: a) a moderate relationship between higher-priced countries (on Shiller P/E and price/book) and future underperformance; and b) a tendency for more rapidly-growing countries to be overpriced. Therefore we can deduce a logically appealing (but statistically weak) tendency for overvaluation to contribute a second reason for the market underperformance of more rapidly growing countries. (Please notice how carefully said that is.)

He goes on to reiterate important points he has made over the past few months about the effect of growing resource costs on growth, and then adds:

The main new point I wanted to make was that resource costs are treated like GDP increases. Hence, prior to 2002, steadily falling resource costs were treated as a debit when of course steadily lower costs were a great help to well-being and utility. We calculated that adjusted GDP actually grew 0.2% a year faster than stated. Conversely, since 2000, rising costs were a detriment, not a benefit, as shown in GDP. Treated correctly as a negative, resource costs would have reduced real growth by 0.4% a year. This squeeze on growth will continue as long as resource costs rise faster than the growth rate of the balance of the economy.

Always careful of the ground he stands on, Jeremy then throws in a very important caveat to say:

… it is worth remembering that we don’t really know what caused resource prices to spike from 2002 to 2008 so impressively. This was a much bigger price surge than occurred during World War II! Indeed, it may easily turn out that the resource price rises will squeeze future GDP growth substantially more than our estimates.

Or not.

In any case, a careful reading of Jeremy’s work is always instructive. This one is an important think piece, as the direction and magnitude of future GDP growth will be critical as we make business, retirement, and investment decisions. Simply talking past performance is risking your future on the unlikely prospect that the future will look like the immediate past.

I am personally doing a lot of thinking and research on this topic. I strongly suspect that other significant factors will arise to play havoc with projections, in both fantastically positive and uncomfortably dire ways. I am more and more seeing the future as very “lumpy,” that is, quite uneven as to how it will affect individuals and even entire countries. For those who espouse more equality in incomes and outcomes, this is not your optimal scenario. But even with all the “lumpiness,” the average person will be much better off in 20 years – though “average” will cover a much wider spread of outcomes than it does even today. But rather than launch into that book now, we’ll let Jeremy take over.

Have a great weekend. I am enjoying being at home this week. I will be in Palm Springs at the California Resource Investment Conference, February 23-24. My good friend Grant Williams, who writes the blockbuster Things that Make You Go Hmmm… and the Mauldin Economics' Bull’s Eye Investor letter, will be there, as will the best resource investor I know, Rick Rule, along with my favorite data maven, Greg Weldon. There is a full two-day slate of speakers. The event is free to investors and is always fun, and it’s a great time of year to be in California (hate the pensions, love the weather). Come see us! You can read all about it and register at the Cambridge House website.

Your looking forward to catching up this weekend on my reading analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

Investing in a Low-Growth World

By Jeremy Grantham

This quarter I will review any new data that has come out on the topic of likely lower GDP growth. Then I will consider any investment implications that might come with lower GDP growth: counter intuitively, we find that investment returns are likely to be more or less unchanged – a little lower only if lower growth brings with it less instability, hence less risk. Finally I will take a look at the reaction to last quarter’s letter, specifically about my outlook for lower GDP growth.

Recent Inputs on a Low-Growth Outlook

Some information came out after the 4Q 2012 Letter or was missed by us and is worth mentioning. First, the Congressional Budget Office slashed its estimate of the U.S. long-term growth trend from 3.0% to 1.9%! Given the source and the magnitude of the adjustment, I think it is fair to say that their number is “close enough for government work” to our 1.5%. At least it is within negotiating distance. Next, a report from Chris Brightman of Research Affiliates actually came out a week before ours and concluded that long-term GDP was 1.0%, a number that really corresponds to our 1.5% because his report has no reference to our two special factors, resources and climate, which take our 1.5% to 0.9%. I was encouraged by the solidness of his research. It also led me to an article in the Financial Analysts Journal (January-February 2012) by Rob Arnott and Denis Chaves. Rob has been writing about the effects of age cohorts on investment returns for almost as long as I can remember, with the central idea that older people are sellers of assets – houses as well as stocks – that younger members of the workforce buy. But they also include the aging effect on GDP growth, which he shows taking a real hit in all developed countries (except Ireland). They are commendably careful in suggesting that their model may be wrong. When or if you read this article, you will certainly hope that it is indeed wrong, for their models estimate from past experience a far greater drop in GDP growth than our work assumed last quarter. And they certainly attacked that aspect in far greater detail than we did. We had included in our report the effect of aging on the total percentage of the population of working age: there are simply fewer workers and more retirees in the distribution. But Rob and Denis (sorry for the liberty) introduce the incremental idea, apparently provable, that older workers lose productivity, no doubt much more in heavy manual work than, say, in writing this. But definitely alas, including all activities with dire consequences, they argue for productivity and GDP growth.

Would Lower GDP Growth Necessarily Lower Stock Returns?

This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability. (At least not in a major way for, as we shall see later, there may be some indirect or secondary effects that may very modestly lower equity returns.)

All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse.

For there to be a stable equilibrium, assets, including entire corporations in the stock market, must sell at replacement cost. If they were to sell below that, no one would invest and instead would merely buy assets in the marketplace cheaper than they could build themselves until shortages developed and prices rose, eventually back to replacement cost, at which price a corporation would make a fair return on a new investment, etc.

The history of market returns completely supports this replacement cost view. The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of “value” stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that “value” or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market’s faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain’t so. And we at GMO have (somewhat reluctantly for competitive reasons) been talking about it for a few years.

Exhibit 1

GDP Growth Unrelated to Stock Returns

Exhibit 1, shown by us before, shows the moderately negative correlation between GDP growth by country along with their market returns. This is shown for the last 30 years only and for developed countries only, but in earlier work we went back a hundred years for some developed countries and looked at emerging country equity markets as well and all had the same negative correlations. (See Ben Inker’s white paper, “Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns”, August 10, 2012, at www.gmo.com [registration required].) When I asked my colleague Ben Inker if this was for the same reason that growth companies underperform – that they are overpriced – Ben came up with another completely sufficient explanation (in about 10 seconds): the faster-growing countries, at least for the last 30 years, have simply had more slowly-growing earnings per share. This is shown in Exhibit 2. For the record, there is also: a) a moderate relationship between higher-priced countries (on Shiller P/E and price/book) and future underperformance; and b) a tendency for more rapidly-growing countries to be overpriced. Therefore we can deduce a logically appealing (but statistically weak) tendency for overvaluation to contribute a second reason for the market underperformance of more rapidly growing countries. (Please notice how carefully said that is.)

Exhibit 2

Earnings Growth Is Negatively Correlated with GDP

Would Lower Real Rates Lower Stock Returns?

Economic theory can’t get everything completely wrong, and perhaps one thing economists have gotten partly right is that the risk-free rate has some relationship to the growth rate of the economy. If that rate approaches zero, there is clearly less demand for new capital; in fact, given accurate depreciation accounting, there would be zero net new capital required. It is also easy to see the risk-free rate settling at something around nil. The risk premium, however, might be little affected. The demand for risk capital – e.g., to replace an old plant, resulting in no new net growth – would still require that the investor expect an adequate return. If it looked likely to be less than that, he would of course withhold his capital until inevitable shortages pushed up profits enough for the corporation to get a satisfactory return, as we have often discussed.

However, and I bring up this complicated issue with trepidation, it does seem possible that in a world with both lower growth and a lower risk-free rate that the risk premium might also drop a little. A lower growth world might plausibly be less volatile because managing a world where the apparent growth is 1.5% (and real growth is 0.9%) is likely to be easier to stabilize than one (as from 1870 to 1995) appearing to grow at 3.4% but actually growing at 3.6%, almost four times higher. (Another way of stating my negative 0.5% resource adjustment, by the way, is to say that the economy’s costs are growing at 1.5% but that its utility – or something closer to utility than GDP anyway – is only growing at 0.9%.) If returns to equity holders are to fall, then P/Es must paradoxically rise to bring yields and total returns down. Yet, as always, equities have to sell at replacement cost. Therefore the books have to be balanced by returns on equity falling. This after all seems reasonable – if returns on T-Bills drop and returns to stockholders drop, then a system in balance would suggest that returns on corporate investment also drop. This adjustment would likely be modest and should only occur if a lower-growth world were to become less likely, which is far from certain, merely plausible.

Reflections on Our Work on Lower-Growth GDP

With a few months to reconsider the data, old and new, I would have framed last quarter’s issue on declining growth differently to emphasize how routine, even friendly, most of our inputs were. The main new point I wanted to make was that resource costs are treated like GDP increases. Hence, prior to 2002, steadily falling resource costs were treated as a debit when of course steadily lower costs were a great help to well-being and utility. We calculated that adjusted GDP actually grew 0.2% a year faster than stated. Conversely, since 2000, rising costs were a detriment, not a benefit, as shown in GDP. Treated correctly as a negative, resource costs would have reduced real growth by 0.4% a year. This squeeze on growth will continue as long as resource costs rise faster than the growth rate of the balance of the economy. Further, as the percentage of the GDP taken up by resources has recently more than doubled (2002 to 2012), the squeeze on the balance of the economy would also be doubled even if the rate of cost increases stayed constant. Last quarter I estimated that continued increases in resource costs from now to 2050 would lower GDP growth by 0.5%. To prevent that 0.5% effect from accelerating as the share of resources in GDP rises, the rate of resource cost increases must decelerate from the recent 7% a year to a much more modest 2% a year by 2050. (By then, of course, it might well be over the current 7% ... it is just not knowable.) As one can see, this is not nearly as draconian an assumption as it might initially appear to be and in this context it is worth remembering that we don’t really know what caused resource prices to spike from 2002 to 2008 so impressively. This was a much bigger price surge than occurred during World War II! Indeed, it may easily turn out that the resource price rises will squeeze future GDP growth substantially more than our estimates.

Although our low estimate of future GDP growth attracted attention and plenty of opposition, it was only produced as a necessary backdrop to show the potential significance of our two new points: the large deduction for a cost squeeze from resources (0.5%) and a very slight but increasing squeeze from climate damage (0.1 rising to 0.4 after 2030), which latter deduction is considered almost ludicrously conservative by that handful of economists that study the costs of climate change. Our work on the traditional aspects of GDP growth was approached by us as a necessary chore; we were not looking for trouble. Consequently, we tried to keep it simple by using the obvious data sources. “Where on earth did GMO get its pessimistic population data?” ran one complaint. Well, would you believe the U.S. Bureau of Census? And as for productivity, we extended the 1.3% average for the last 30 years out for 30 more years. This is clearly a very friendly assumption given: a) the recent 1.3% in productivity growth of the last 30 years had declined a lot from its 40-year surge of 1.8% after World War II; and b) the fact that the segment of much higher productivity – manufacturing – has declined to a mere 9% of total labor from 19% in 1980 and continues to decline. Even my one override, -0.2% a year for the next 18 years as a result of much-reduced capital spending, seems, based on econometric modeling, to be a very modest debit. For there to be so modest a negative effect needs capital spending to drift back toward normal in the relatively near future. And even then this -0.2% effect was exactly offset in our forecast by a +0.2% bonus for the unanticipated surge in fracking activity and the ensuing burst of momentarily cheap energy. So why the fuss? The resource debit merely reflects the remarkably odd GDP accounting that counts an unfortunate surge in necessary costs as a benefit, and the remaining 1.5% is merely reflecting recent data. Higher growth assumption, Mr. Bernanke should be aware, must prove longer-term improvements in productivity or, tougher yet, increased labor input.

Short-Term Behavioral Impacts on the Market from Lower GDP

Of course, in the short term there are always temporary behavioral responses. If GDP growth drops unexpectedly, corporations might easily be caught mis-budgeting or overexpanding (although this current ultra-cautious U.S. corporate system, which only reluctantly makes capital investments, is unlikely to be caught out too badly), and perhaps more importantly investors may be shocked by continuous revenue warnings, which might cause the market to sell off. Recent corporate announcements, while usually still claiming exceptional profit margins and generally hitting earnings targets, are increasingly missing revenue targets and issuing future revenue warnings. We must admit, though, that recent revenue warnings have not stopped the market from rising, nor has the unexpectedly slightly negative growth for the fourth quarter GDP.

Within sectors there would quite likely also be a shift in preferences. Growth stocks might seem relatively more attractive: “If the system isn’t growing, the least I can do is pick a few companies that clearly are still growing.” Perhaps quality franchises would also become more appealing with the logic being that at least in the transition to lower top-line revenue growth, competition would become more severe and, hence, defensive moats even more than usually desirable.

Engineered Low Interest Rates

The Fed’s negative real rates regime, designed to badger us into riskier investments in order to push up equity prices and grab a short-term wealth effect (that must be given back one day when least comfortable and least expected), has gone on for a long and, for me, boring time. This low interest rate period is serving, therefore, as a sneak preview of what a permanently lower rate regime might look like (although any permanently lower rates reflecting lower GDP growth would be by no means as low as these engineered rates that we are currently experiencing). So what are some of these effects? The artificially low T-Bill rates first work their way slowly up the curve. Next, the most obviously competitive type of equities – high yield stocks – begin to be bid up ahead of the rest of the market, as has happened. “I’ve just got to squeeze out some higher rates somewhere, anywhere,” is the pension fund plea. Then, this low rate competition begins to filter into other securities, historically sought after for their higher yields: higher-grade real estate, where the “cap rates” slowly fall; and, unfortunately, also forestry and farmland, mainly of the larger and more standard varieties that appeal to institutions, which show declines in their required yields, i.e., their prices rise. The longer the engineered rates stay below true market rates, the higher asset prices become until, yes, you’ve got it, corporate assets begin to sell way over replacement cost. Then, if the heart of capitalism is still beating at all, a long period of over-investment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good healthy market crunch. (This strategy will be seen in future years as archetypical of the Greenspan-Bernanke era: badger and bully investors into taking more risk and eventually pushing assets – houses or stocks or both – far over replacement value, followed eventually, at long and hard-to-predict intervals, by exciting crashes. No way to run a ship, but it does produce an environment that contrarians like us, who can take a few licks, can thrive in.)

Stock Option Culture Messes Things Up

The normal capitalistic response described above runs smack into the new tendency for corporations to either sit on money or buy stock back (regardless of how expensive it may be!), which works in the opposite direction to create shortages, drive prices up, and, as a by-product, lower job creation and GDP growth. So where does this all come out? You tell me. All that I know is: a) if we in the U.S. don’t invest, others will and it will, in the longer run, definitely end badly; b) that even if there is a lower-return world in the future it is still better to own the cheaper assets; and c) it behooves buyers of “cap rate” type assets like real estate to realize that the current low rates are flattered by current Fed policy, which will, like everything else in life, pass away one day, leaving them looking overpriced. It can’t be too soon for me. In the meantime for us at GMO it means emphasizing care and maintaining a heightened sense of value discipline, not only in stock selection, as the whole world is once again bid up over fair value in a way so typical of the post 1994 era, but also in forestry and farmland. GMO has investments in those areas too and recognizes the need to sidestep overpricing by emphasizing the nooks and crannies. Fortunately there are more nooks and deeper crannies in forests and farmland than there are in almost any other area, certainly including stocks.

Danger of the Fed Overestimating Growth

This doesn’t really fit in with a quarterly letter emphasizing important good news, but being about the Fed, I have to make an exception. The Fed appears to be still assuming a 3% growth rate for future U.S. GDP. It would be safer and more confidence-inspiring, now that Bernanke appears to take his responsibility for growth seriously, that he at least have a reasonable growth target (preposterous as that notion is to me that the Fed should or even could affect long- term growth simply by messing about with interest rates). The growth in available man-hours has definitely declined by about 1% a year, yet Bernanke’s assumption for our GDP’s normal trend growth appears unchanged at its old 3%. Ergo, he must be assuming an offsetting rise of 1% in productivity. But why? We should treat these assumptions quite seriously for this is famously (for me) and painfully (for all of us) the man who could not see a 33⁄4-standard- deviation housing market, and indeed protested that all was normal, etc., etc., etc. (Dear handful of niggling readers, this 33⁄4-standard-deviation event is calculated on the assumption of a normal distribution, as is often done in investing, even though we [especially at GMO] know this is not true but is just a convenient statistical device. In fact, we at GMO know quite a bit more on this topic for we have studied more or less all assets for as long as we can find data and we have found a remarkable total of 330 “bubbles,” 36 of which we call “major, important bubbles,” which we define as 2-standard-deviation events, given the same assumption. Well, a 2-sigma event should occur every 44 years in a normally distributed world and they have occurred every 31 years. This is much closer to random than we had previously thought. Yes, financial asset data is fat-tailed; that is, there are more outlying events than are found in a normally distributed series, but they are not extremely fat-tailed. They show up as 2-sigma events but occur as often as 1.8-sigma events would occur in normal distributions. Extrapolating, we can assume that Bernanke’s 33⁄4-sigma housing bubble would occur, adjusted for our fat-tailed real-life history, not every 10,000 years, but somewhere more like 1 in 5,000 years! I previously used “a 1-in-1,200-year event” as a casually selected very large number to describe the 2006 housing bubble. But under challenge, these current numbers are more accurate. No, this does not mean we have 10,000 years of data or even 5,000. It is just statistics, full as always of assumptions, which in this case we hope approach rough justice. What it does definitely mean, though, is that it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it. This is a doubly amazing miss because his and Greenspan’s policy caused this bubble in the first place!) In comparison, his willingness to target an unrealistic 3% level for GDP growth is statistically a microscopic error, a picayune mistake. Unfortunately, though, in the hands of probably the most influential man in the global economic world, it is an extremely dangerous one. I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy). I assume he keeps beating it until it either turns into a horse or drops dead from too much beating! Fine-tuning economic growth, an impossible job for the Fed anyway, is hardly likely to get any easier by badly overstating trend-line growth. It seems nearly certain, therefore, that the Fed will keep trying to whack the donkey for far too long. The likely consequences of this policy are, to be frank, over my head, but my colleague Edward Chancellor will address them briefly if I can nag him effectively.

Investment Implications

Courtesy of the above Fed policy, all global assets are once again becoming overpriced. This reminds me of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome! But, as always, asset prices are not uniformly overpriced: emerging markets and, we believe, Japan are only moderately overpriced. European stocks are also only a little expensive, but in today’s world are substantially more risky than normal. The great global franchise companies also seem only moderately overpriced. Forestry and farmland, which is not super-prime Midwestern, is also only moderately overpriced but comes with our nook and cranny sticker attached. But much of everything else is once again brutally overpriced. Notably, U.S. stocks (ex “quality”) now sell at a negative seven-year imputed return on our numbers and most global growth stocks are close to zero expected return. As for fixed income – fugetaboutit! Most of it has negative estimated returns on our data, and longer debt, as always, carries that risk that may be slight in any period, but is horrific if it occurs – accelerating inflation.

When one combines the apparent determination and influence of those who do the bullying with the career risk and short-termism of the bullied and the desire of the general public to believe unbelievable good news, these overpricings can go much further and the Fed can win another round or two. That’s the problem. A clue to timing would be when we begin to hear more passionate new era arguments: profit margins will always be higher; growth will snap back to 3% for the developed world; and new ones I can’t think of ... maybe “when the discount rate is this low the Dow should sell at, perhaps, 36,000.” In the meantime, prudent managers should be increasingly careful. Same ole, same ole.

How Not to Run a Pension

John Mauldin — Thu, 14 Feb 2013 22:23:00 GMT

How Not to Run a Pension
Stupid Government Tricks
Illinois Is Digging a VERY Deep Hole
Catastrophic Success
Time to Buy a House?
Looking Over My Shoulder
Palm Springs, Argentina, and Singapore

"The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what."

– A journalist in Greece

For all the focus on the unfunded liabilities of Social Security and Medicare, there is another unfunded crisis brewing, and this one is in your own back yard. It's coming to you even if you live outside of the US; it just might take a little longer to get there. I wrote ten years ago that state and local pension funds might be underfunded by as much as $2 trillion. It turns out that I was being overly optimistic. New government research suggests that the figure might be as high as $3 trillion. But what if you take into account that retirees are living longer? An IMF study that we'll look at in a few minutes does just that. And if we live a lot longer? Oh my. The problems are not universal – some cities and states will do fine, while others are already in deep kimchee – but it's a big problem and getting worse.

At the end of the letter, I'll add a personal note on housing. Longtime readers know that I was bearish on housing well before the bubble. I sold my home (for personal reasons) and decided to lease until things became more settled. I have said several times that I would tell you if and when I decided to buy a home. Now, I have put an offer in on an apartment and it has been accepted. But it's more complicated than that. (Isn't it always?)

Before we get rolling, though, I want to announce the speaker lineup for my 10^th annual Strategic Investment Conference, May 1-3. Here they are, in alphabetical order: Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Charles and Louis Gave; Jeff Gundlach; Anatole Kaletsky; David Rosenberg; Nouriel Roubini; and Gary Shilling. The noted geopolitical analyst Ian Bremmer (a professor at Columbia and founder of the Eurasia Group) has now been added to the list. I heard Ian last year speak on his theme of a G-Zero World and was blown away. You have to hear this one. We subsequently met in NYC and compared notes. I am really happy we could get him.

The conference is cosponsored by my longtime partner Altegris Investments. All the credit for hosting a first-class conference goes to the staff at Altegris, who do a massive amount of work to pull off an event of this size and scope. All I do is get a few friends to come and speak. Oh, and this year Bloomberg will cover the conference live.

The conference always sells out, so I suggest you register at your earliest convenience. Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. Registration is now open. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. There is a significant early-bird registration discount.

How Not to Run a Pension

It is almost too easy to pick on California and Illinois, but I am going to do it anyway in order to create a teaching moment. Plus, this sorry tale will make us think about the nature of the social contract and the fabric of society. It would be almost be funny if it were not so serious.

Let's start with a few paragraphs that appeared in the Wall Street Journal. Carl Demaio writes this week:

Consider California, where just 10 individual pensioners will cash $50 million in pension checks from state and local governments over the next 25 years. Already some 30,000 retired California government employees pull in pensions higher than $100,000 a year. One retired librarian in San Diego receives a $234,000 annual pension. Beach lifeguards in Orange County are retiring at age 51 with $108,000 annual pensions plus health-care benefits.

Note that those benefits are cost-of-living-adjusted. But the problem is not just in California; it is nationwide.

A 2011 study by the Congressional Research Service pegged the combined liabilities faced by state and local pension funds at over $3 trillion. That is more than all the bonded debt officially listed on state and local balance sheets combined. To put the issue in perspective, all the federal tax hikes approved by Congress on Jan. 1 would pay less than 20% of America's state and local pension debt over the next 10 years. (Wall Street Journal)

Another study by the Congressional Budget Office comes to the same general conclusion. You can read it here.

Steven Malanga wrote a powerful essay for the City Journal exposing the huge problems in just one California pension fund, CalPERS (California Public Employees' Retirement System). It is a well-written chronicle of how one fund has locked California into a debt spiral that threatens the solvency of the state: The Pension Fund that Ate California.

It is almost impossible to read Malanga's report without comparing it to Michael Lewis' essay on Greece. For the past two weeks I have written about regulatory capture in Greece and how the Greeks must break the control of vested interests over government. The corruption that Malanga chronicles is similar: the vested interest of public employee unions trying to get the "best deal" for their members is no different from what I described going on with various Greek industries. Whether it is Greek or California taxpayers, someone has to pay for all those promised benefits.

The State of California recently passed a "balanced budget." But it is only balanced if you ignore the sound accounting practices detailed in the Congressional Research Service report cited above. And even that report assumes investment returns that CalPERS has not achieved for the last five years.

CalPERS manages $230 billion. The fund now calculates that it is underfunded by $80 billion. The management arrives at this number by assuming they will make 7.5% (which they only recently dropped from 7.75%). In 2009, they estimated that the fund was underfunded by only $49 billion. That means they missed their targets by $30 billion in a roaring bull market.

In a December 2011 study, former Democratic assemblyman Joe Nation, a public finance expert at Stanford University, estimated that CalPERS's long-term pension debt is a sizable $170 billion if CalPERS achieves an average annual investment return of 6.2 percent in years to come. If the return is just 4.5 percent annually – a rate close to what more conservative private pensions often shoot for – the fund's long-term liability rises to a forbidding $290 billion. (Malanga)

I was just in Norway. It has a sovereign fund that is larger than CalPERS but that benefits from some of the best management in the world. My talks with people involved in the fund and those who are very familiar with it suggest that they would be very happy to get 4% over the next 5-10 years. And CalPERS ranks in the bottom 1% of all pension fund managers. Given all the resources they have, they are spectacularly bad at managing money. And when I say "they," I mean the board of directors.

Malanga points out that CalPERS is a wholly owned subsidiary of the government-employee trade unions that control the board. He painstakingly chronicles the extent to which the unions dictate policy and investment decisions, leaving the professional management shackled.

Remember the Greek journalist who told us this?:

The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what.

The number of regulations differs from Greece to California, but the principle is the same: regulatory capture of the bureaucracy by government workers' unions has handcuffed government, not just in California but all over the US.

Let's think about what it means for a pension fund to be $290 billion underfunded in a state with a (plus or minus) $100 billion annual budget. And bear in mind that instead of the $3 billion a year in taxpayer support CalPERS assumes it will need, it could soon be 4-5 times that much. Go to your own state budget and figure out how to carve out 10-15% from it. Given that a huge percentage goes to health care, education, and security, there is just not that much "waste" in state budgets. And the states with pension problems tend to be the ones with higher taxes already.

CalPERS now consumes (or will shortly) more than the 23-campus California State University System, which gets $2 billion annually. And that is not the entire shortfall in California; it is just one fund, albeit the largest. Other funds have similar issues. Taxpayers' costs are projected to rise to more than $7 billion by 2014-'15 – if you believe the funds' own expectations for investment returns. You shouldn't.

Above we see a chart of projected CalPERS returns, showing what they would be over the next 30 years if they ran at 7.5% or 5% or 2.5% (hat tip to Mike Shedlock). The numbers on the left are in billions. The fund might be doing quite well in 30 years at a steadily compounded 7.5%, but at 2.5% or even 5%? Not so good.

The next chart shows that even if you assume a 5% return, you are down almost $1 trillion in 30 years.

Think 5% or 2.5% is pessimistic? CalPERS made a 1% return over the past year it reported, to June 2012. In a bull market, thank you. Over the last five years? A negative 0.1%, basically flat. (CalPERS annual report)

Let me say a small word in defense of the CalPERSes of the world. If you are a fund this size, you don't invest in the market; you are the market. The fund did very well in the '90s. CalPERS has lagged its peers badly, but I know of no very large ($50-100 billion+) public pension fund that has gotten 7.5% over the last five years. There may be one, but I can't find it. Smaller funds can be more nimble in selecting investments. CalPERS has to invest an average of $230 million in 1,000 different assets and funds and strategies. That is an impossible task and one that will only get harder as it grows, which it must if it is to meet the needs of its 1.3 million (and swelling) current and future beneficiaries.

I must admit, it is fascinating to Google "California pension problems." You can spend hours swept up in the sheer scandal of it all. Hundreds of state employees who are managers and who theoretically get no overtime are allowed to work second jobs in their departments and get paid for them. Doctors in the prison system can make hundreds of thousands of extra dollars a year. Prison guards retire with $100,000 a year – and can then take another job and get more benefits from another pension fund! Cool.

Stupid Government Tricks

Until this past January 1, California state employees were allowed to buy "air time" of up to five years to shorten their required time on the job before they would qualify for a full pension. The rationale by CalPERS was that as long as the fund got 7.5% annually there would be no risk to the fund.

"Ultimately, we don't truly know until everybody who has purchased dies," said Amy Norris, a Calpers spokeswoman, referring to the size of the payouts. "Our actuaries say that it is safe to say it is cost-neutral at this point." Fifty thousand employees have elected to participate.

California public-sector employees now earn approximately 30% more for doing the same jobs as workers in the private sector. California did pass some modest pension reforms last year, mostly affecting future workers and retirees. Current retirees saw no reductions. But within a few months legislation was introduced that exempted 20,000 workers, and unions are looking for other such exemptions. In a Democrat-controlled legislature, they could quite possibly pass.

"Double dipping" is my personal favorite of the scams that are being run. Why not retire with your $100,000 pension and then take another job and earn another $100,000 pension? One San Jose police chief now gets over $400,000 a year, after he retired from his San Jose job and went to work in San Diego.

The current San Jose police chief will retire at 51 with a $150,000 pension, and he too can take another job, although he has "no immediate plans." He is not alone.

Illinois Is Digging a VERY Deep Hole

Illinois has a $33 billion state budget – and five pension funds that are officially underfunded by almost $100 billion. Remember that sky-high projection of investment returns by CalPERS? Illinois pension funds estimate they will earn anywhere from 7.5% to as much as 8.5%. But the state-employee fund made less than 0.1% last year, barely beating out CalPERS.

(By the way, you can see the projected returns of your state funds in a January 2013 NASRA Issue Brief. Scroll to the bottom. I was aghast to see that much of Texas was looking to make 8%! The Houston firefighters project 8.5%! I keep reading about problems with the funding of liabilities in Houston. As I said, this is a nationwide scandal. California and Illinois are just the easiest to pick on.)

Without 8% returns, the shortfall for the Texas Employees Retirement System (ERS) could be twice the current projections. The system is scheduled to pay out $133 billion between now and 2045. It has $11 billion. For these assets to cover future payouts, ERS would need to see average investment returns of 21.5% per year – or see big-time payouts from the government budget. Think they can find an extra $5 billion a year for the next 20 years? From a $30 billion budget? And get 8%?

But back to Illinois, which has a legal problem. It is one of two states (New York being the other) that in its Constitution is prohibited from impairing promised retiree benefits. This makes for a rather tough negotiating stance.

You can find the same exotic stories about large pensions in Illinois that you do in California; but it seems to me the pension for rank-and-file teachers is not overly generous, considering that they pay 9.5% of their salary into the pension fund, while the state is supposed to fund less than 10% of that amount and then doesn't even manage to do that. Putting the teachers on Social Security would cost the state a lot more (6.2% in matching funds).

Yes, there are the 28 Illinois state troopers who retired at 51 and draw over $100,000 a year. And the politicians get eye-popping amounts, but their retirement fund is underfunded by 74%. Care to make a wager which pension fund gets enough money to survive, the teachers' or the politicians'?

And while all this sounds delectably scandalous, it is actually very sad. Consider this story:

Last Thursday night, 57-year-old Dick Ingram, a bald guy in a dark suit, stepped onto the stage in a cramped, muggy auditorium at a south suburban high school. In his remarks to an audience full of teachers, Ingram repeated the same message he's been delivering for months: Be afraid. Be very afraid.

Ingram is in charge of Illinois' biggest pension fund, called the Teachers Retirement System. With $52 billion in unfunded liabilities, it's arguably worse off than any state pension fund in Illinois – which is saying something, considering Illinois has the worst-funded pensions in the country.

"I don't think it's any secret that finances in the state of Illinois are a train wreck," he told the crowd of about 350 working and retired teachers. "We cannot, today, feel secure in telling a 45-year-old or a 25-year-old teacher in Illinois that they're gonna get their pension," he told the crowd. "We face the possibility, and the real likelihood, of insolvency."

Several teachers at last week's meeting excoriate Ingram for talking too much, saying he's just providing fodder to politicians who want to cut teachers' retirement benefits.

But if you stop and consider what's going on here, it's pretty radical: Ingram, the guy in charge of the retirement savings for 370,000 people, is telling anyone who will listen that the money may not be there when they quit working – that teachers, in his words, have "been getting screwed for decades." (Illinois Public Media)

These teachers put in 9.5% of their salaries, and their retirement could be in jeopardy. Think about what it would be like to work for 35 years, doing the right thing and saving. You make your retirement plans, and then at some point, say 10 or 15 years into your career, the deal changes.

This is rubber-meets-road sort of stuff. Much of our society is finding itself severely burdened to meet past promises made by politicians. It is pretty easy to make them when you are spending someone else's money, especially when that someone is 30 years in the future. Except that now the future is here. The bellwether is San Jose, whose citizens voted last year (70% in favor) to cut current pensions and benefits for municipal employees. That's liberal, socially progressive San Jose, which finds itself under severe funding pressure just to fulfill basic city services.

I have talked about the "abuse" of the California pension system, with double-dipping by policemen, et al. – except they are doing nothing illegal or even unethical. They are taking deals offered to them under terms both parties agreed to. The fault, dear Brutus, is not in our stars but in our politicians and we who elect them.

Catastrophic Success

Underfunded pensions are not a problem that is going to go away. Let's assume that the secular bear market finally runs its course, the financial repression of the Fed and ECB ends, and interest rates go back to normal so that pension funds again have a chance at those juicy 7% returns. We make up for lost time with a few more dollars of funding, and then it's problem solved, right? That is the line you hear from pension consultants.

But what almost no pension fund does is to plan for the current trend of people living longer to continue. We have added almost two years of life expectancy every decade for the past century, although the number of additional years you can expect to live if you make it to 65 is not as dramatic. Still, the increase is significant.

The International Monetary Fund did a study last year that asked, "What if we live three years longer by 2050?" That is far less than trend for the last century, but even that small increase yields some very interesting conclusions:

...if individuals live three years longer than expected – in line with underestimations in the past – the already large costs of aging could increase by another 50 percent, representing an additional cost of 50 percent of 2010 GDP in advanced economies and 25 percent of 2010 GDP in emerging economies.… [F]or private pension plans in the United States, such an increase in longevity could add 9 percent to their pension liabilities. Because the stock of pension liabilities is large, corporate pension sponsors would need to make many multiples of typical annual pension contributions to match these extra liabilities.

Thus, we may need to add 50% to the pension underfunding I highlighted earlier. It gets ugly. (You can access the IMF study and see commentary here.)

I can hear a few of you objecting that this is a problem that remains far in our future. Why worry about 2043? Well, because pension returns rely upon compound interest, the eighth wonder of the world. A dollar in a pension fund doubles every 10 years at 7.5%, and in 30 years that dollar invested now is $8. If we wait for ten years to invest it, it only becomes $4 in 30 years. And there will be only $2 in the pot if we wait 20 years to find out that today's retirees are living another three years on average.

Pensions require initial savings and compound interest to work. If you fail to properly fund your pension or if you get low returns, your retirement will suffer. We all know that is the case for private funds, but it is the same for public funds as well. Taxpayers will have to make up the difference if returns are lower or benefits rise due to longer lives. Or retirees will not get what they were promised. Ask Irish pensioners what a 15% cut in their pensions feels like. Ask people in any country that has seen the ravages of inflation.

When you sit down with your financial planner, you make assumptions about how long you will live. And then, if you are prudent, you make plans to live much longer than that. You want to make sure you will have enough funds to meet your needs for your entire life. And that means planning on living a few years longer than the average person in your family has in the past.

Yet we don't do that with our pension funds. Just as we assume that the past performance of 8% returns in the last bull market will somehow materialize in our future, we also assume that the actuarial tables of the past will continue to apply, even though they have been regularly updated for a century.

Most of us would deem it a success if we lived ten years longer than the current average. Yet such a success on the personal level would be catastrophic for our pension funds, if we all managed it. Thus, living longer may turn out to be a catastrophic success!

I happen to be part of the bunch who thinks the biotech revolution is just beginning and that we will end up living a lot longer (on average) than anyone now expects, and be healthier to boot! Of course, the counterargument is that many of us won't get there because we refuse to take care of the basics of eating right, exercising, not smoking, and taking our medicines.

Whatever your view on longevity, a three-year average increase over the next 40 years seems a most reasonable and conservative assumption – which means that every dollar our public and private pension funds save now is even more important for future retirees. Unless we want to burden our children and grandchildren in the rapidly approaching future, we need to deal with our pension issues today, before we find them consuming the funds we need for basic services or forcing tax increases that will hurt overall growth and job creation. The choices are difficult now, but they will only get harder if we wait.

Time to Buy a House?

Let's move briefly to another topic. The lease on my home here in Dallas was going to be up at the end of this year, and I more or less intended not to renew it and to start to pay attention to what the housing market is doing, come fall. Then my landlord dropped me a note a few weeks ago saying he would let me out of my lease if I moved out in a month. He evidently thinks the real estate market is good in Dallas, which is what I am hearing from my realtor friends.

A few months ago I dropped by the new apartment of my good friend David Tice. (Some of you will remember him as the man who started and ran the Prudent Bear funds.) He had purchased two apartments in a local high-rise with stunning views of downtown Dallas, and combined them into one apartment. I fell in love with the energy of the views and the location.

As it turns out, I can get two adjoining spaces in the same building with slightly different views but still that dramatic downtown view I love. The odds of getting two adjoining apartments to come on the market at the same time are not high, so I decided to go ahead and accept the offer to move. Prices have dropped considerably for comparable places in Dallas and are now beginning to find a market. So we made an offer, and it was accepted. Now comes the hard part: getting financing, taking on a construction project to turn the two units into one, finding a place to live in the meantime, and then moving.

I am finding out that financing is not straightforward. I asked my investment-banker friends what the loan would be and got quoted a very nice rate for a ten-year ARM. But the mortgage desk would not do it (this is a very large, name-brand bank). Since it is two apartments and two titles and someone is leasing one of the units right now, and since there will be significant construction costs, what I want to do does not fit into a simple, check-the-box home mortgage. No exceptions allowed! I was rather surprised that it would be that hard. I clearly qualified, or so I thought. I dropped back to punt, and the realtor quickly introduced me to two local banks that do custom projects like this. So that process begins this week.

Additionally, David (and another local friend) did something that I want to do, too. He got a yen-denominated loan. We are working out how to do that. (I would love to speak to a senior investment-bank executive of a large Japanese bank. I sense an opportunity here.)

As I promised years ago when I last talked about buying, I will let you know the details as they develop – costs, interest rates, interim loans, etc. But at least here in the Dallas market (and I know it's true in other markets as well), this bear is coming out of hibernation. Stay tuned.

Looking Over My Shoulder

The world doesn't sit still, and as you all know, neither do I. Each week I delve into 100-plus articles, economic forecasts, investment outlooks, financial reports, etc., all of which come to me through my own extensive network. My goal, of course, is to be constantly building on my own research, staying right on top of what's going on out there. This learning experience is a labor of love for me, and one I'm pleased to share with you through my Over My Shoulder service.

As I filter through my weekly reading, I pick out the 5-10 items that I think will be most important to your investments and money management. This research, compiled by my contacts, is generally information you will not come across in your own ongoing reading – and that's why I think you will find a subscription to Over My Shoulder very useful. Subscribers have given me very positive feedback, and I encourage you to join us in reading, thinking, and preparing for the events of 2013 – this most pivotal of years.

Palm Springs, Argentina, and Singapore

I will be in Palm Springs at the California Resource Investment Conference February 23-24. My good friend Grant Williams, who writes the blockbuster Things That Make You Go Hmmm… and the Mauldin Economics' Bull's Eye Investor letter, will be there, as will the best resource investor I know, Rick Rule, along with my favorite data maven, Greg Weldon. There is a full two-day slate of speakers. The event is free to investors and is always fun, and it's a great time of year to be in California (hate the pensions, love the weather). Come see us! You can read all about it and register at the Cambridge House website.

I will be in Cafayate, Argentina in the middle of March, working on a book and relaxing a little while with my partners and friends at their resort. (If you are interested, you can come as well. Just click on this link.) In April, I will do a speech in Singapore and hope to take a few days off to visit Cambodia and Angkor Wat. My old friend Tony Sagami is planning to come over from Bangkok to show me around Cambodia.

It has been an emotional day for me. I attended the memorial for Chris Kyle, whom I wrote about last week. He is the former Navy SEAL and author of American Sniper who was tragically murdered last week. They had to hold the service in the Dallas Cowboys stadium. His casket rested on the star in the center of the field. I will never again be able to look at that star without thinking of him.

A remarkable number of former SEALs and other military attended, honoring a gentle man who is now legend. Hearing the stories from his comrades and friends made for the most moving memorial service I have ever attended. You can donate to a family trust fund being set up for his wife and two young children at Craft International.

Then I went to yet another funeral service, this one for an elderly relative, only a few miles away. The contrast in emotions was palpable. And then on the way home, I got a text from my daughter Melissa. Last year about this time she had her thyroid and some large tumors in her lymph nodes removed. They felt they got it all, and subsequent checkups seemed OK. But today they noticed some large lymph nodes in various parts of her chest and neck. They got her in to see her specialist on an hour's notice, which seems fast. It could be just an infection, but more scans are now on order.

And now I face the joys of jury duty in a few hours, although no sane attorney would want me on a jury. At least I will get in some reading time, waiting for them to reject me. And with that I will hit the send button.

Your contemplating life more than usual analyst,

John Mauldin
subscribers@mauldineconomics.com

The Good, the Bad, and the Greek (Risks)

John Mauldin — Wed, 13 Feb 2013 18:11:00 GMT

Save the Dates: May 1-3
Prisoner of the Bureaucracy
A Deep Sense of Injustice
The Good, the Bad, and the Greek (Risks)
Chris Kyle, R.I.P.

"The euro will not survive the first major European recession." – Milton Friedman, 1999

"It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." – Milton Friedman, 1999

"… there will be asymmetric shocks hitting the different countries. That will mean that the only adjustment mechanism they have to meet that with is fiscal and unemployment: pressure on wages, pressure on prices." – Milton Friedman, 1998

"Barry Eichengreen (1990b), in a detailed analysis of the potential lessons for EMU from the U.S. experience, concluded that monetary integration would limit fiscal independence. He argued that the extent of fiscal transfers in the European Union would have to significantly exceed the extent of fiscal transfers in the United States to be successful, as regional shocks were likely to be significantly greater in EMU countries than in the states of the United States." – From a lengthy (and exhausting) paper at the Econ Journal Watch, analyzing the writing of scores of US economists about the euro from 1989-2002. The paper was humorously titled "It Can't Happen, It's a Bad Idea, It Won't Last: U.S. Economists on the EMU and the Euro, 1989-2002."

Greece was (and is) the first real test of the euro. Until the Greek crisis, there was no real need for any eurozone country to actually write a check for any other member. Ireland obligingly shouldered the responsibility for its own bad bank debts, paying off mostly German, French, and British bankers. But Greece required someone else to take the losses and write the checks to bail the country out. The European Central Bank had to agree to allow the Bank of Greece to create euros to bail out its banks (with the fig leaf that somehow Greece will pay them back). As the Greek economy collapsed in the aftermath of the recent crisis, it became evident even to European bankers and regulators that Greece could not pay its debt. Money began to flee Greek banks.

Greece is a small country with large implications. Last week we began to explore what I learned from my recent trip to Greece. In this week's letter we will finish those observations and in particular look at some of the comments from my meetings with over 40 people: owners of small businesses and large ones, billionaires, taxi drivers, politicians, central bankers, investors, ex-patriots, wives, and mothers. I believe we can arrive at some small understanding of the problems Greece faces. Then we will consider the broader consequences for Europe.

Save the Dates: May 1-3

But first, I take great pleasure in announcing the speaker line-up for my 10^th annual Strategic Investment Conference, May 1-3. Here they are, in alphabetical order: Kyle Bass, Mohamed El-Erian, Niall Ferguson and his wife, Ayaan Hirsi Ali, Lacy Hunt, Charles and Louis Gave, Jeff Gundlach, Anatole Kaletsky, David Rosenberg, Nouriel Roubini, and Gary Shilling. We are finalizing a few other well-known names as well. Seriously, where else can you see a roster like that? Those who come regularly know that the real value is in meeting the other attendees. The conference is cosponsored by my longtime partner Altegris Investments.

Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. We are now going to open up registration. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business.

If you think you should have had an invitation or missed it, call or write your Altegris representative. Otherwise, you can start the process by going to http://meetings.StrategicInvestmentConference10. There is a significant early-bird registration discount. The conference always sells out in a few weeks, so I suggest you register at your earliest convenience.

Prisoner of the Bureaucracy

As I noted last week, I visited Athens with my friend Christian Menegatti, who is head of research for Roubini Global Economics. Between the two of us, we stayed very busy with meetings. Below is some of what I learned. (I will put generalized quotes in italics, and the commentary after them will be mine.) Let's start by recalling the story we finished with last week:

The next night offered quite a contrast. In the evening we walked to the base of the Acropolis, found what looked like a promising venue, and entered. It was early by Greek standards, but a performer was playing a guitar and singing Greek tunes to a table of six (ahem) older gentleman, clearly old friends eating and drinking together. (Later we found out they had been gathering once a month like this for 20 years.) As the evening went on and the wine kept flowing, they began to sing. A second guitar appeared. The aromatic cigars came out and were smoked directly beneath the no-smoking sign, with no sense of irony. One patrician gentleman stood a few times to have his picture taken with locals who dropped by that evening.

The singer sang on for three hours without a break, clearly into the moment. Evidently, you cannot sing certain songs without using your arms. At first it was just one participant providing the counter-melody, but then others joined in a multi-part chorus of practiced harmony.

The young owner of that tavern came by, and we started out as we had the night before, asking questions. When he found out what we were looking for, he went to the table and pulled one of the elderly gentlemen away and introduced us. It turned out that he was an economic journalist and chairman (emeritus) of a Greek journalism society. I quickly borrowed a pen and began to take notes on a paper placemat.

He was an odd mixture of pessimism and hope, a perfect living metaphor for what I found from top to bottom in Greece. This was the best government he had seen in his life: "I trust this government." But when asked if he was optimistic, he shook his head wearily and said no. When we pressed him as to why – and we had heard variations on this throughout the trip – he said, "The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what."

Another of the gents added, "The problem is a problem of laws: you get new laws and yet the old laws don't go away; who knows what to do? If you don't know what laws to follow, that becomes the biggest problem. Actually there are two problems: the number-one biggest problem in Greece is the legal system – there is no rule of law. Number two, the legal system is slow; you can't get a ruling." A lot of heads nodded in agreement with this statement.

The first guy continued, "Remember the spectacle a few years ago, when a new government came in and found massive debts and accounting irregularities? They blamed all the problems on the old government as they negotiated for new loans from the EU. Of course, the people they were blaming were bureaucrats they themselves had appointed, the last time they were in power.

"The government still to this day does not know how money is spent. They will try to change. But even if they pass new laws, under the rules a minister does not have to enforce them."

It seems the bureaucracy is the prisoner of the associations – what we refer to in the US as regulatory capture. This results when a regulatory agency, "created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as an encouragement for firms to produce negative externalities. The agencies are called 'captured agencies.'" (Wikipedia)

And that is a common theme we heard in meetings with businessmen. There is general agreement that the bureaucracy must become smaller and some frustration that it has not: "We lost time by not restructuring. The most important problem is the inefficiency of the public sector; it simply costs too much money start a business."

The Greek banking system has collapsed. Banks simply have no money to lend. First they had to take huge losses on their Greek government debt. Then they incurred large losses on their regular bank portfolios, as Greek GDP shrank 20% and businesses had no ability to pay and went bankrupt. Finally, their deposits dropped significantly (€86 billion fled), either converted to cash or sent to banks in other countries, as Greeks worried that the country would leave the euro and return to the drachma.

Depending on what document you read (or who you listen to), Europe has arranged up to €50 billion to help recapitalize the Greek banks. €27 billion has been injected to capitalize the four largest banks; but they have to be able to come up with about 10% of the money from private sources, and that money is just not showing up. The Financial Times writes this weekend: "Greece's banks have begun a frantic lobbying of the bodies behind the country's bailout, in an effort to ease the conditions imposed on their recapitalisation and avoid full nationalisation." (Sound familiar? Shades of TARP!)

The only other option on the table right now, other than laying hands on the rather paltry amount of private money, is full nationalization. "One banker who declined to be named said Greek banks' books were worse than many realise, given that asset valuations and recapitalisation estimates date back to 2011. 'Greece has performed worse than in the adverse scenario,' the banker said. 'The macroeconomic contraction was much bigger in 2012 than forecast. Loan portfolios are still deteriorating.'" (FT)

All the other, smaller banks will be nationalized outright. This will certainly help. More than one businessman told us he or she was no longer worrying about profits but simply managing for cash flow and survival, hoping that at some point a stable banking system would return. "New investment laws, maybe the approval of some large project, must give people a reason for money to come back. Greek investors and citizens must be assured that Greece will be a part of the euro. We must do things to make long-term money feel safe. There is a dilemma: money has left because of fear of leaving the euro, and now it is not coming back because of concern about taxes. But if we grant amnesty for repatriation, it will create ill will. This is not easy to do."

And taxes are on everybody's mind. They have gone up, and there are serious efforts to collect them. But there is still suspicion everywhere that others are not paying. I heard from numerous sources that the worst offenders are doctors and lawyers, the upper-income earners.

A Deep Sense of Injustice

And that opinion was echoed by the leader of the left-wing SYRIZA parliamentary group, Alexis Tsipras, who spoke to Wall Street Journal columnist Bret Stephens last week:

But Mr. Tsipras takes a dimmer view of health delivery in his native land. "Why in a public hospital, in order to have an operation, do [patients] have to slip [doctors] an envelope with a certain amount of money?" he asks. "Why indeed? " I ask back.

"Because the state gives low wages to doctors, thinking it's completely natural for them to add to their salary" by accepting those cash-stuffed envelopes.

I suggest to Mr. Tsipras that maybe the difference between Greek and American doctors is that the latter have so far operated in a mainly private market, though that's about to change. He demurs and instead says something about the need to have a "revolution in conscience" by Greek citizens, plus "the will of the state" by Greek leaders. It sounds like the sort of thing you'd expect from someone who names Karl Marx and Antonio Gramsci as sources of intellectual inspiration – romantic in its impulses, repressive in its implications.

But I don't think Mr. Tsipras is the budding totalitarian or demagogue his detractors say he is. He talks of the "deep sense of injustice" that pervades Greek society, the sense that they have been systematically used and betrayed by their own economic elites and elected officials.

The short article is well worth reading. Stephens is a very good writer.

That sense of betrayal Tsipras mentions, palpable to me while I was there, is also part of the system. In the '70s a leftist government came in and began to put "cousins and nephews" of their supporters into jobs in the bureaucracy. And when a conservative government came to power they did the same thing. I kept hearing that 30% of government workers don't even show up for work. (I'm not sure where that actual stat came from, but it gets repeated.) Some bureaucrats even hold down jobs in the private sector while they continue to collect a government pay check. And because the government is such a large sector of the economy, everyone has someone in the family or a friend's family who is part of the problem. If you change things, they lose their jobs. Up until recently, the impetus for change was just not there. But that may be changing:

"In the '60s every Greek wanted to own his own business, in the '80s they wanted to be public servants, and now they want to be in business again."

But the problem is that there are no jobs. Unemployment is 27% (the government's number); and the Chairman of the Council of Economic Advisors, Panos Tsakloglou, told us he was worried it could rise to 30% before it finally begins to turn around.

Tsakloglou was quite candid. He said that the IMF, ECB, and EU would have to accept some form of debt forgiveness and not just put it all on the private sector. Greece still has too much debt for the private sector to be able to service.

Evidently, more is needed than just debt extension. That has happened already. The chart below shows extensions out for 35 years. I invite my US readers to think back to 1978 and ponder the notion that the US national debt was extended for 35 years from that point, and then try to imagine what the dollar would be worth by now if it had been.

Unemployment among Greek youth is over 50%. That worries Tsakloglou, because young people are leaving the country. If things turn around quickly, they can come back. But if you stay away long enough, you have kids, and then it's harder to come back. That was echoed in other meetings: "The problem is, young people are leaving as salaries are going down. There is opportunity if these guys leave and then come back, but in five years we'll need to repatriate the Greek diaspora."

Greeks think about Europe a lot. Many are ready to see a stronger Europe, with less sovereignty for their own government. "But something must happen about the trade imbalances."

Remember that quote from Econ Journal Watch at the very top of the letter? It noted Barry Eichengreen's conclusion that "monetary integration would limit fiscal independence. He argued that the extent of fiscal transfers in the European Union would have to significantly exceed the extent of fiscal transfers in the United States to be successful, as regional shocks were likely to be significantly greater in EMU countries than in the states of the United States."

(I met Barry in South Africa last year when we spoke at the same conference. Really thoughtful on a very wide set of topics.)

I was already writing a few years ago about the extremely unfavorable balance of trade that Greece endured. That imbalance is going away (that happens in depressions, as there is no money to buy imports), as is the wage differential with the rest of Europe. Estimates are that by the end of 2014 the wage gap will be nearly gone. One business manager said that his Greek plant was as productive as his German plant. The cost difference came in dealing with the bureaucracy. "Not just the cost of bribes, but even worse is incompetence."

Let's look at another chart from Morgan Stanley:

There was general agreement on the need for foreign investment. There is no domestic saving to speak of, which limits deposit growth, which means banks will be tight-fisted, even with the new European money to help recapitalize them.

The Good, the Bad, and the Greek (Risks)

Even with all the problems, there was a hint of tempered optimism in the air. One formerly highly placed government official said, when asked if he was willing to invest his own money in Greece, "In six months if things go well." And that time frame was on everyone's lips.

There is more austerity coming, and it will have to be agreed to. It will not be popular. The coalition government has already seen defections and is left with a majority of only 13 votes out of 300, with 16 lost since last May. They can't take many more breakaways.

There is worry about political unrest this spring, which could cause some coalition members to withdraw support. New elections would have economic consequences. It is the lack of certainty that is one of the biggest problems in Greece. Everyone seems to expect that the tourist season will be robust and things will begin to turn around by summer. But getting there is risky, and that has people focused.

Many were candid that their optimism was based in part on the prospect of the government having to give in to the Troika on reducing bureaucracy and the size of government. They welcome the new controls on the government and worry that they might go away.

And to its credit, Greece may be that rarity in Europe, a government that actually hits it budget targets. They are close to a "primary surplus" (a surplus if you ignore debt service), which is the first step in recovering access to the bond market. With increased tax collections, major new austerity measures may be avoided.

We met with Notis Mitarachi, the Deputy Minister of Development. Two years ago he was a private investment banker in London. He came back to Greece and ran for parliament and won. For his sins (for working in finance), he was given a very important post, one that requires him to sort through the bureaucracy and help foreign investors put money to work in Greece. He brings that experience with him and wonders why Greece can't become as easy to do business in as London. He dreams of structural reforms but is not waiting for a committee to act. He is there to help larger investors cut through the issues. Greece needs foreign investment if the government is to survive, and that is his current mission. If there are more like him, then Greece has a chance.

The risks inhere in something old and something new. While Europe has so far been willing to write checks in return for significant budget cuts, if there is "Greek fatigue" in some capitals of Europe that results in demands for even more austerity, it would be difficult to sell to the populace. Greece is going to be on some type of support program from Europe for a long time.

One source of risk that kept coming up seemed odd to me on first hearing, and that is tiny Cyprus, whose banking system is also bankrupt – but those banks are four times larger than the country, financially. And there is considerable political turmoil in Cyprus, with elections due in two weeks (February 17). While the cash problem amounts to only about 10 billion euros, the procedural problem is challenging. When you deal with Cyprus, you will be establishing a precedent for dealing with the rest of Europe. Ireland will be watching very closely, wondering why it too doesn't get debt forgiveness. There is no consensus on what to do about Cyprus among the nations of Europe. Russia would like to be a player (and hopes to gain a foothold in the banks, I assume) and is offering the possibility of money to what might be a communist government. If the Cypriot government takes on enough debt to address its banking problem, then the government becomes insolvent. Bottom line: Cyprus is closely tied to Greece and will affect the Greek economy.

The good news on Greece is that I see little reason or even any serious movement on its part to leave the euro. I have long been a euro-skeptic from a pragmatic economic viewpoint. At the same time, I hope the euro experiment succeeds, as I think the world is better off with a united and strong Europe, and the fledgling eurozone is part of that process. In any case, I am not the one who has to write checks to bail out the various and sundry countries; but among those who do write them – the citizens of the eurozone – the sentiment is distinctly pro-euro, and they seemed to be prepared to pay the costs.

I look at how difficult it was to get the US government to release aid to victims of Hurricane Sandy. I would have thought that would go through easily. The votes were, however, highly regional, and it took way too long. Then again, I think about what will happen when Illinois comes to DC hat in hand, asking for a bailout. I don't think many states will want to help it address its lack of budget discipline with US taxpayer money.

And that is the larger lesson of Greece. Europeans wrote a check for Greece. You know they were not happy to do so. They had to wonder why they let Greece in. Yet they looked at the mess that was Greece and held to their vision and found the money, even if it was from anonymous taxpayers. Such decisions can only be made through strong general agreement. The consensus in Europe is to do what is necessary. If that means austerity for some and taxes for others, then that is the price.

Merkel's opposition is even more pro-European than she is. The determination on the part of Europe to "hang together" is strong. I applaud it. I hope it can stay that way when it is time to call for France to deal with its own budget imbalances. We shall see.

The challenge for Greece is not to become Germany or the Netherlands. Every country and region in Europe has its own personality. The challenge is for Greece to become a better Greece. That means changing its systems and cleaning up its bureaucratic mess.

Greeks are renowned for their patriotism. It is time for them to move past being just Greek patriots and become Greek citizens, working together to build their future.

Chris Kyle, R.I.P.

I first met Chris Kyle a few years ago at an economics event at Kyle Bass' ranch in East Texas. That was before he had written his book, and Kyle Bass pulled me aside and briefed me on who would be taking me out that afternoon for my first ever attempt at skeet shooting. Chris had recently retired from the Navy SEALs. He had been in all the major Iraq confrontations and had the most confirmed kills of any special-operations soldier in the history of the US, as a sniper. His longest shot was a 2,100-yard strike against a man armed with a rocket launcher.

We went out to the range, where he patiently worked with a few of us. Despite being from Texas, I did not grow up with guns. They were around, just not around me. Chris was soft-spoken and polite – the best that West Texas breeds. I recognized the roots that ran deep in him. We wandered over to the pistol range, where I shot a real pistol for the first time in my life. I was rather surprised by the kick of the gun –it was hard to hold it on target. It looks so much easier in the movies. I remember expressing my frustration.

Chris came over, gave me a few pointers, and then showed me how it was done. He took the gun from me, slipped in a new magazine, and turned to the target. He emptied the gun as fast as he could pull the trigger, which was fast. The target had one small, round hole in the middle where every bullet had gone. I may never again personally see such skill with a weapon. Later that day he worked with us on rifles, showing us some of his skills. Governor Rick Perry came by, and Chris set him up to shoot the 50-caliber sniper rifle, treating the governor in the same manner as he did everyone else.

That night I heard a few stories about Fallujah that amazed me. They sounded a lot like those of my son-in-law Allen, who was a very young Marine when he went into combat there. Chris was one of the snipers who kept Allen and hundreds of others like him alive.

Chris went on to write a searing story of life, family, and combat called American Sniper, which became a major best-seller. I read it last year and shuddered at what we put our young men through and the courage it takes to do what they do. The book gave me insights into battle, combat, and the mind of a warrior that I had never experienced.

There were two times when Chris was literally counting down the seconds until he ran out of ammo and his site was overrun, yet he kept protecting his fellow soldiers. The cavalry did show up at literally the last second, so he survived; but I marvel at a man who could calmly do his duty right up till the moment he thought was his last. And then go out and do it again the next day.

Chris took no pleasure in killing, but of course there was tremendous satisfaction in saving the lives of "his boys." His regrets were for the lives he could not save. And he was the best at what he did. There are a lot of young men like my son-in-law, the father of my next granddaughter, who are alive today because of Chris. I looked forward to getting to meet him again from time to time.

Chris was tragically murdered this weekend while helping another soldier with post-traumatic stress disorder. They were at a gun range, where he would go with soldiers and ex-soldiers to help them out. It was one of the ways he gave back. There are many accounts in the news today, if you want to know more.

I and all those who knew him are shocked and profoundly saddened at something that is so seemingly senseless. My heart goes out to his family (he leaves a wife and two children) and to his friends. He was an American hero and a true Texan. And now he is legend. R.I.P., Chris Kyle.

I am sure there will be a charity to which you can donate to honor his life. Drop me a note at warrior@2000wave.com and I will let you know when I find out. And with that, I will hit the send button.

Your marveling at how life works analyst,

John Mauldin

subscribers@mauldineconomics.com