John Mauldin's Outside the Box : OTB

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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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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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.

Catastrophic Success

John Mauldin — Tue, 20 Dec 2011 17:04:00 GMT

New readers to my musings often find it interesting, when they meet me in person, to find me quite an optimistic person, given the nature of my current predictions about the economy. And regarding the short term, defined as less than five years, my writing is admittedly less than sanguine. We do have some problems that are not easily dealt with. And even longer-term, those of a bearish natural disposition can find reasons a-plenty to tone it down.

But five years (at least at my age) is not all that long. One way or another we will get through the current mess. My studies on the nature of progress in a number of fields give me a rather optimistic longer-term slant on life, and most especially in biotechnology. Long-time readers know of my interest in the potential for biotechnology to be completely transformational and disruptive (in a positive way) to society. It is one of the few places I am "long" and willing to get even more long.

Today's Outside the Box is from a source that is no stranger to my regular readers. Pat Cox called last week and told me about an amazing announcement that was made public last Friday, so we are almost "breaking news" here this week. BioTime (BTX) has announced the ability to detect most cancers with a simple blood test that detects markers. This holds the prospect that within a very few years we will all routinely get a blood test for cancer as part of our regular blood work, allowing for very early detection. And as Pat notes, cancer becomes far more treatable if detected early.

As Pat and I talked, I asked him to give us an update on the BioTime story but also on the state of some of the really promising cancer cures. And let me note, these are but a few. There are literally dozens, if not hundreds, of real potential cures. We do live in remarkable times. Comments in the text below in brackets [ ] are mine.

Pat is one of my favorite sources for new, transformational technology. We talk regularly and compare notes. Pat (like me) likes to look over the horizon and think about what is coming. The companies he writes about are typically early-stage research and development plays, in a variety of fields (not just biotech – last month he was writing about robotics!).

You can subscribe to his letter by going to http://www.PatCoxLetter. Warning: his publisher likes rather aggressive marketing, but I just like his letter and research.

Note: I have invested (for quite some time now) in some of the companies he mentions below or have associations with them that I note in the copy. And some I have no knowledge of.) I have not done any transactions in the last few months and will not do anything for at least two weeks. And do NOT chase these stocks. They are typically very small-cap with smaller volumes, and are research and development companies with no guarantees of success. Do your homework, and if you buy then do it for the long term.

I do comment below on one private firm that some of you who sit on foundations and charities that focus on cancer and heath care might want to look into.

Now let's take a look at what Pat and I sincerely hope is the future.

Your planning to live a lot longer than you think analyst,

John Mauldin, Editor
Outside the Box

Catastrophic Success

By Pat Cox, Editor
Breakthrough Technology Alert

When the second stimulus bill passed in February, 2009, I explained to my readers that the "crowding out effect" would guarantee its failure. I took no pleasure in predicting accurately that increased government borrowing would crowd out private investment in innovation, from which flows economic and employment growth.

I bring this up simply because I have extraordinarily good news regarding cancer therapeutics, and I don't want you to assume that I am afflicted with blind optimism. For decades, in fact, I've been among the economists who have warned that our current distress was coming. As you know, we were ignored by the intelligentsia. As a result, the entirely avoidable mortgage and housing bubbles expanded and collapsed, which accelerated our even larger problem – the entitlements crisis.

Political corruption and malfeasance were involved, we now know. I suspect, however, that the larger reason the warnings signs were ignored was essentially psychological. Most people avoid extremely unpleasant news until they no longer have a choice.

This is particularly true with regards to the entitlement crisis because it involves perhaps the greatest unpleasantness of all. It is the reality that we are all facing the prospect of aging, serious illness, and death – in that order.

The aging population, however, is the root cause of our financial problems. More than a third of the federal budget goes to transfer payments and services for people age 65 or older. Nevertheless, we're behind on the payments and the bill is increasing as more and more people live longer.

This is the result, primarily, of unexpected scientific breakthroughs that have dramatically expanded our medical options. Unfortunately, Social Security was designed in 1935, when fewer lived to see the retirement age of 65. Only a fringe of visionaries believed that new technologies would push life spans close to 80 by the end of the century.

Nevertheless, it has happened. Retirement ages, though, have not adjusted, so Social Security is running on empty. Medicare may not have been designed to benefit the aged, but about half of all healthcare services are consumed by the five percent of the population that is dying. They are, it's no wonder, almost all older people.

These worsening fundamentals have not plateaued. The demographic pyramid, with large numbers of young payers and very few aged beneficiaries, is flipping. I'm sorry to be the bearer of bad news, but I hope at least to convince you that I'm not in denial about the problems we face. Therefore, I hope you'll take me seriously when I say that very recent scientific breakthroughs are more than capable of solving our entitlement and debt crises.

The End of Cancer as a Deadly Threat

Last week, an announcement was made by BioTime Inc. that could quickly cut the cost of cancer in half, saving in excess of $100 billion annually. This breakthrough is not a cancer treatment. It is a revolutionary diagnostic technology.

To understand why it is so important, we need to understand that cancer isn't a single disease at all. The medical term is "malignant neoplasm," which encompasses any condition of uncontrolled cell growth. There are hundreds if not thousands of different types of malignant neoplasms, and many have almost nothing in common with any of the others.

This has made cancer diagnostics very inefficient, though it is a multi-billion-dollar industry. A test for prostate cancer, for example, won't detect breast cancer. Even current breast cancer tests don't detect all breast cancers.

If all the existing diagnostics were used to test one individual for early-stage cancers, it would cost many tens of thousands of dollars – perhaps more. If all people were checked for all cancers on a regular basis using existing diagnostics, it would bankrupt our entire healthcare system.

To make matters even worse, many diagnostics are notoriously inaccurate. Some miss as many as half of cancers but return extremely high false positives that have their own costs. False-positive PSA (prostate-specific antigen) tests, for example, generate unnecessary biopsies, surgery, impotence, incontinence, and other problems. Some diagnostic procedures, I might add, are also extremely unpleasant.

As a result, most people are tested for cancers only when there is reason to believe they may have the disease. Most diagnostics are used, therefore, to gain information about existing and problematic cancers, not to detect them before they become a problem.

As a result, many cancers are not found until they are sadly well-established and aggressive. It is an oft-repeated truism in oncology that early detection translates into far more successful treatment. Early detection also dramatically reduces the costs of therapy.

What we need, obviously, is a simple blood test that would, with high accuracy, find cancers in their early stages. Combined with revolutionary new cancer therapies that are just around the corner, we would see the end of most catastrophic cancers. Even with existing therapies, the impact on lives and healthcare budgets would be enormous.

Moore's Law, Bioinformatics, and Genomics

Over the last few years, I've written often about BioTime's ACTCellerate program, one of the most important projects in contemporary science. Dr. Michael West and BioTime scientists are decoding and cataloging the genetic changes that occur in human cells as they progress from their original embryonic state.

To accomplish this monumental task, BioTime scientists rely on large-scale genomic analysis and bioinformatic analysis of the data, using increasingly powerful computers. Thus far, BioTime scientists have mapped over 40,000 gene sequences expressed in different cell types.

This information will allow BioTime to turn a few of your blood cells into induced pluripotent cells, and then into any type of cell you need. Those cells will be completely rejuvenated and functionally young. Already, BioTime's ReCyte Group is on track to reverse age-related cardiovascular and immune-system conditions.

However, the knowledge and tools that the company has created have far more uses than hacking cellular codes. BioTime used the same tools to examine hundreds of adult cell types, both normal and cancerous. In the process, they discovered that many genes being activated in cancers had never before been associated with malignant neoplasms.

Genes express proteins that can be easily detected. (A simple consumer version of a protein detector, by the way, is the home pregnancy test.) And having identified the genes activated by the most-common cancers, it was a relatively simple process for BioTime to design a blood test for the proteins expressed by those genes.

This is off-the-shelf technology. Many medical device companies manufacture diagnostic devices that identify proteins in blood. But early in-house tests found that BioTime's prototype was more accurate in terms of identifying cancer-free individuals than is commonly observed in PSA cancer tests. This discovery convinced the company to prioritize development of the technology.

BioTime's commercial cancer-detection device will probably be priced no higher than existing diagnostics that test for only one type of cancer. I expect the device will detect a wide range of cancer types, including cancers of the breast, lung, bladder, uterus, stomach, and colon, as well as others.

My guess, looking at wholesale prices for similar laboratory devices, is that the cost in materials for testing an individual for a broad spectrum of the most-common cancers will eventually be no more than $15. It is impossible to predict the size of the market for a simple broad-spectrum cancer detection test, because no such diagnostic exists; but the potential is huge.

[The test itself should retail for about $100 in the beginning (with the price falling over time), giving the company extremely healthy margins. Which means they can do even more research. BioTime CEO Mike West is one of the most driven men I know, but he is also a genuinely nice guy and soft-spoken gentleman, not given to hyperbole.]

The von Eschenbach Connection

This is a true disruptive technology and its impact will be noticeable both in terms of average life expectancy and healthcare costs. The announcement explains why, several months ago, Andrew von Eschenbach, Ph.D., joined the board of BioTime.

I've long considered BioTime the leader in the field of regenerative medicine. I was nevertheless puzzled when von Eschenbach joined the team. His resumŽ includes former jobs such as commissioner of the FDA during George W. Bush's term and director of the National Cancer Institute. He is considered by many to be the leader in the fight against cancer. In 2003, when he was director of the National Cancer Institute, von Eschenbach announced his goal of eliminating suffering and death due to cancer by 2015.

His motive for working with BioTime is now obvious. I've spoken to him since then, and he's confirmed that he believes the BioTime pan-cancer diagnostic will have an enormous impact as soon as it is widely implemented. Moreover, he believes subsequent applications of the technology have the potential to deliver true personalized medicine with extremely effective therapies specifically tailored for individual patients.

Von Eschenbach's goal of reducing cancer to an irritation rather than a killer is achievable – even if his time frame was off. It might not be that inaccurate, however, as BioTime has chosen to go first for European approval of the CE marking process . As approval of devices in Europe is much faster than it is the US, we could see the test on the market there before the end of 2014. Many countries outside of Europe take their lead from the EU, so it should move rapidly into Canada and other markets. With post-market data from these nations, I would expect that approval in the US would take as little as one additional year.

Then, because early detection of the most common cancers would be simple and inexpensive, insurance companies would find it in their own financial interest to encourage routine PanC-Dx testing, as BioTime is calling their technology. Because physicians are already familiar with this type of testing, market penetration will not require overcoming a learning curve. Cancer rates and costs will begin to fall dramatically.

That, however, is only the beginning of the story. Simultaneously, a raft of next-generation cancer therapies will be coming to market.

Though I've already tested your attention span, I'd really like to give you just a brief overview of some of the most exciting new drugs coming to oncology. These are drugs so far beyond anything you've seen yet, they make current treatments seem medieval by comparison.

[John here. I talked with BioTime's Mike West last week, and he is very charged up about the cancer tests. But then we talked at length about the challenges facing his regenerative medicine work. He is still optimistic, and progress is being made. The regen work is my interest and why I own a small number of shares. I also agree with Pat about the inclusion of Andy von Eschenbach, whom I have met several times and really like. He is a very impressive and focused researcher.]

Bexion Therapeutics

Bexion, while still private, has attracted enormous attention where it matters. Their drug consists of a nanotech joining of two naturally occurring substances found in human cells. Together, they have the ability to exploit one of the few characteristics that all cancer cell share, the transfer of phosphatidylserines to cell wall exteriors to fend off immune response.

When the Bexion drug is administered, these nano-probes seek out phosphatidylserines and collect on the surface of cancer cells. There they trigger natural cell suicide, or apoptosis. Cancers die but healthy cells are unharmed.

Bexion's drug has been shown effective in preclinical tests against an extraordinary range of cancers. Moreover, its seek-and-destroy mechanism could make it an ideal diagnostic tool for use in conjunction with BioTime's broad-spectrum blood test. Because a marker can be attached to the Bexion drug, it is possible to light up cancers using scanning technology, giving doctors a 3D view of neoplasms.

Most remarkably, in animals testing, Bexion's drug appears to somehow bypass the blood-brain barrier. This makes it a most promising candidate for treatment of brain cancers, which are among the most lethal of cancer types. Clinical tests are expected to begin in 2012.

[There is a long story here, but I found this company through Pat as I was trying to help a friend find a possible cure for his young son's glioma (brain tumor). It was too early for human trials, but we became enamored with the technology and helped raise a small round of funds for the firm, including my own funds. I encourage you to go to http://www.bexionpharma.com/ and look around, click on the technology link, and see how the animal studies have progressed and why I am so excited about Bexion. Look at their boards and research. If you sit on the board of a foundation or charity that works with cancer-related issues, I urge you to take a deeper look, as each cancer must have its own trials, and the sooner we get started the sooner a cure can be approved. I am hopeful, and I think if you take an in-depth look you may share my optimism. You can contact the company from their website.]

Provectus Pharmaceuticals

Rose Bengal is an amazing molecule first used in the 1800s as a wool dye. Then it was employed as a diagnostic marker due to its unique ability to penetrate diseased or damaged cells but not healthy cells. In World War II it was used widely and successfully to protect soldiers from malaria, though it was never popular because it turned the whites of users' eyes blue.

In post-war Japan it was used as a food dye, and researchers discovered that humans and animals that consumed the most had the lowest cancer rates. Fast-forward to the Oak Ridge National Laboratory, where scientists were fascinated by the molecule's remarkable electronic characteristics, as well as its ability to absorb and convert light and other low-level radiation.

Extensive "compassionate usage" of a modified Rose Bengal molecule has shown remarkable efficacy in the treatment of metastatic melanoma. Phase II human clinical tests for liver cancer have been completed, with spectacular results. Preclinical indications show similar promise for other organs. Like Bexion's drug, these modified Rose Bengal molecules are dangerous only to cancer cells. I could go on.

Inovio Pharmaceuticals

Inovio is a leader in DNA vaccines. Using an extremely small electrical pulse, the company puts engineered DNA plasmids into cells. These circular rings of DNA utilize the body's own genetic mechanisms to manufacture RNA proteins that train and mobilize the immune system to attack various diseases, including cancers.

Inovio is in Phase II human tests for both leukemia and cervical displasia. Positive results in HIV and hepatitis-C show the adaptability of this technology for treatment of a wide range of diseases.

Galectin Therapeutics

Building on the work of one of the greatest Russian scientists of all time, Alexander Oparin, Galectin Therapeutics is the leader in an entirely new field of science known as glycoscience, which involves the use of complex carbohydrates – essentially foods – as drugs.

One of the deadly characteristics of cancer tumors is their ability to protect themselves by producing proteins that bind with sugars. These are galectin-3s, and tumors use them to create a lethal cloaking field that allows them to hide from our immune systems.

T cells have evolved to attack disease and pass information back to the thymus so specifically targeted T cells can be manufactured in large numbers. However, when T cells encounter a cancer's lethal galectin net, they are shut down and eventually die.

Galectin Therapeutics' naturally occurring plant sugars have the nearly unbelievable ability to protect and resurrect dying T cells. This makes their nontoxic carbohydrate drug, on its own, effective against cancers in general. In conjunction with cancer vaccines or drugs, however, it magnifies the effectiveness of the therapy to a quite astonishing degree.

Currently, the esteemed Ludwig Institute for Cancer Research, the largest international nonprofit dedicated to conquering cancer, is funding Phase I/II clinical tests of a Galectin Therapeutics carbohydrate drug in conjunction with a melanoma vaccine. Oh, and by the way, this drug also appears to reverse the fibrosis that causes cirrhosis of the liver and subsequent liver cancers.

[I am on the board of directors of Galectin (GALT) and have a small position, which I have announced I intend to add to.]

In Conclusion

John Mauldin recently published a letter here that included the term catastrophic success. The banishment of lethal cancers provides us with an example. It will lengthen lives, reduce healthcare costs, and enrich investors. If, however, we do not come to grips with dramatically extended health spans, it could make our entitlement crisis far worse and eventually lead to complete national collapse.

As a society, we failed to heed the clear warnings regarding Fannie Mae, Freddie Mac, and the mortgage and housing bubbles. Many of our so-called intellectuals are still pretending it didn't happen. Similarly, they are behaving as if the entitlement crisis is not serious.

Imminent cancer diagnostics and therapies, as well as breakthroughs in heart disease, Alzheimer's, liver disease, and more will give us the ability to grow our way out of the current financial mess. All we've got to do is stop pretending that a retirement age set in the 1930s makes an ounce of sense today.

Productive life spans will continue to lengthen and the costs of dying will be pushed back significantly. This will give us a window of opportunity to balance our budget. Then, regenerative medicine will really kick in, growing life spans even more rapidly.

These disruptive innovations will change everything. If exploited wisely, they will enable a period of unprecedented prosperity. If they are used to fund political fantasies, though, things will get much worse.

The Euro Debate Gets Philosophical

John Mauldin — Tue, 06 Dec 2011 05:21:00 GMT

Europe is rapidly approaching the denouement, the Endgame, of its currency experiment. The outcome is not clear, at least to your humble analyst, as the debates rage and there are huge pluses and minuses the 17 nations must decide upon. But the proverbial road down which the can is tumbling and clattering, kicked along haphazardly, is coming to its end, and soon a rather sharp turn, either to the left or to the right, will be required. Let us hope they choose wisely.

Today's Outside the Box is a rather philosophical debate between my friends at GaveKal, which they have graciously shared with us. It is important to note that Charles Gave, Louis-Vincent Gave and Francois-Xavier Chauchat are French. Louis served in the French army, studied at Duke, and has lived in Hong Kong for over a decade. Charles (his father) is the quintessential French patriot and patrician right from central casting, whose voice has the authority of God. Anatole Kaletsky is supremely British and one of the most influential economic thinkers in Europe. He is Editor-at-Large and Principal Economic Commentator of The Times, for which he writes a thrice-fortnightly column on economics, politics, and financial markets. These are Europeans vigorously debating the European future as only good friends can.

What we have is an email exchange among them on the future of the euro and the inherent philosophical tensions that are faced by European leaders. I have read it three times and will read it several times more. (Do not feel bad if you need Google to keep up with some of the references. When Anatole refers to Sedan, for instance, he is not talking about cars but a major battle the French lost to the Germans in 1870. Interesting Wikipedia page for you history buffs.)

Let me give you a taste, from so many great lines. Here's Louis (who I will see Monday in Dallas – more below):

"Above, Charles focuses on the philosophical hurdles to any mass intervention. And while I subscribe to Charles' reading of the German institutional framework, my concerns are far less intellectual and far more practical. Basically, we have to remember that the average sovereign debt buyer is not a hazardous investor. The guy who buys a government bond is looking for a very specific outcome: he gives the government 100 only so he can get back 102.5 a year later. That's all the typical sovereign debt investor is looking for. Nothing more, nothing less.

"But now, the problem for all EMU debt is that the range of possible outcomes is growing daily: possible restructurings, possible changes in currencies, possible assumption of other people's debt, possible mass monetization by the central bank etc. Given this wider range of possible outcomes, and the consequent surge of uncertainty, the natural buyer of EMU debt disappears. Again, the typical sovereign investor is not in the game of handicapping possible outcomes; he is in the game of getting capital back!

"... Even if the Bundesbank did agree to monetization (which is hardly a foregone conclusion), the window for this to work may now have closed."

I will be with Louis and Anatole this coming Monday morning in Dallas at a seminar for money managers and accredited investors. If you would like to attend, drop me a note and I will get you an invitation.

And you can find out more about GaveKal consulting services and funds at www.gavekal.com.

What fascinating times. What an interesting period in which to live. And don't we all want to get through this and have more certainty, in place of the roller-coaster ride we are now on? I will be glad to get back to long-term investing, but in the meantime we should appreciate the fascinating spectacles. It will make for interesting stories to tell our grandkids. Have a great week, and in the midst of spectacle enjoy the holiday season.

Your amazed to finally see it all happening analyst,

John Mauldin, Editor
Outside the Box

The Euro Debate Gets Philosophical

GaveKal
Nov. 29, 2011

Anatole: Clausewitz, the Prussian military theorist, said in his reflections on the Napoleonic period that “war is the continuation of policy by other means”. If so, then it would seem that Germany is again at war with Europe; at least in the sense that German policy is trying to achieve in Europe the characteristic objectives of war: the redrawing of international boundaries and the subjugation of foreign people.

Likening German policy to warfare is a controversial argument, to put it mildly, so let me begin by briefly reviewing how events in Europe have unfolded in the past few months. Angela Merkel has consistently claimed that Germany would “do whatever it takes” to save the Euro. But what has she actually done? She consistently refused to take any of the actions that could actually work to save the Euro and has prevented European institutions from taking such actions, even when the German veto had no legal or moral justification.

As the Euro crisis has intensified and spread from clearly bankrupt countries such as Greece to Spain, Italy and now France, it has been universally acknowledged, at least outside Germany, that three actions are absolutely essential to resolve the Euro crisis and put the European economy back on its feet.

1. The first step would be to restore financial stability through massive purchases of government bonds by the European Central Bank. To succeed, these would have to be on a scale at least comparable to the “quantitative easing” undertaken in the past two years by the US Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank.

2. The second step would be to restore long-term solvency to all the nations of Europe by issuing new bonds, jointly guaranteed by the entire Euro-zone, which would replace part of the government debts run up in nations such as Greece and Portugal which are clearly insolvent.

3. The third step would be to improve and coordinate economic policies in all Euro-nations to restore economic growth, ensure that the restructured debts can be serviced and that another crisis does not occur.

By blocking the first two of these actions—large-scale ECB intervention and the issue of joint European bonds—Germany has guaranteed the failure of the third step, the restoration of economic growth and national credit. Why then has Merkel so blatantly contradicted her own stated policy of “doing whatever it takes” to save the Euro?

The initial judgment was that Merkel did not understand economics, or was too beholden to longstanding monetary traditions, or was simply incompetent. But while the crisis has intensified, Merkel has become ever more stubborn in her refusal to do what was obviously needed to save the Euro, as David Cameron discovered last week. So a different interpretation of her inconsistencies must now be considered. Is it possible that Germany, far from trying to save the Euro, actually wants to break it up? A clear historical precedent is the sabotage of the European exchange-rate mechanism (ERM) in 1992. And the institution that now seems to be working to destroy the Euro is the same one that organised the ERM breakup—the Bundesbank.

The Bundesbank, as an institution, has always opposed European monetary unification, except insofar as it meant the imposition of German economic philosophy on other countries. This attitude of monetary imperialism was summarised by a remark in nt Times obituary published for Richard Medley (the legendary hedge-fund consultant who was at the centre of the ERM breakup as George Soros’s political consultant). Helmut Schlesinger, the Bundesbank president in 1992, was asked why he disliked the precursor of the Euro, which was called the Ecu. He replied, “I have nothing against the Ecu apart from its name—I think it should be called the Deutschemark”.

Back in 1992, the Bundesbank encouraged Soros and other speculators to sell Sterling and the Italian Lira in order to break up the ERM. But the Bundesbank also discretely hinted that the French Franc should be supported because France was in a different category as a German ally from Italy, Britain and Spain. As Soros later said in an interview, also quoted in last week’s obituary for Medley: “I felt safe betting with the Bundesbank. The Bundesbank clearly wanted the Pound and Lira devalued, but it was prepared to defend the French Franc. I did better than some others by sticking to the Bundesbank’s side.”

Today, the role of the Bundesbank in destabilising the European financial system is much more open than it was 19 years ago. Axel Weber, the former Bundesbank president, and Juergen Stark, the former vice-president, both voted against ECB support for Greece back in May 2010 and then publicly denounced these measures to the German media, in an almost unprecedented breach of central banking protocol. Last summer, when the ECB decided to extend its half-hearted support to Spain and Italy, Weber and Stark both resigned in protest—and launched openly political attacks on their own government’s European policies. A few weeks later a story emerged in The Financial Times reporting that Siemens had become nervous about the French banking system and withdrawn its cash balances from Societe Generale to deposit them “for safety” at the ECB. It is hard to imagine who could have leaked this story other than the Bundesbank?

Today, the Bundesbank is in the forefront of a campaign to persuade the German public and the German government that ECB bond purchases and quantitative easing are illegal under European law. In truth, the EU treaties specifically allow the ECB to buy bonds, as long as it does not do this directly from governments. And EU laws say nothing at all about the effects of quantitative easing—which is not surprising since QE is a complex issue of economic theory that could not possibly be subject to determination by the courts. What the Bundesbank believes, however, is that European law should have made bond purchases and expansionary monetary policy illegal—and if other European countries refused to write these laws into EU treaties they will just have to be imposed by Germany through financial main force.

In short, the Bundesbank policy on the Euro crisis is to present the other countries of Europe with a stark ultimatum: either they accept German economic directives, German monetary theories, German financial practices and even governments imposed by Germany, as part of a draconian new regime for national insolvency and administration. Or they must face financial chaos and expulsion from the Eurozone, under a new exclusion procedure now demanded for nations that refuse to submit to German rules. In short, Germany is trying to achieve through monetary diplomacy what were previously the objectives of warfare: redrawing the boundaries of Europe and imposing German ideas on those nations that remain within. That, surely, is a continuation of war by other means.

Charles: Dear Anatole, my first answer to the above is that there is nothing new here. I have argued incessantly in every single one of our debates since Axel Weber’s resignation that the Bundesbank was now in an open war with the concept of the Euro. I have also pointed out that, in my career, I have seldom made money when betting against the Bundesbank.

Now there are of course many reasons behind the hostility of the Bundesbank to the Euro. The first is obvious enough: the Euro was thrust on an unwilling Bundesbank by Mitterrand and Delors as a compromise to France accepting German re-unification. So the Euro’s very birth was an unhappy one to start with.

Beyond that, the hostility rests, I believe, on important philosophical differences. Indeed, Max Weber suggested two sets of ethical virtues that a proper political education should teach: the ethic of conviction (Gesinnungsethik) and the ethic of responsibility (Verantwortungsethik). According to the ethic of responsibility, an action is given meaning only as a cause of an effect; i.e., what matters is the consequences. According to the ethic of conviction, on the other hand, a free agent should be able to choose autonomously not only the means, but also the end; “this concept of personality finds its „essence‟ in the constancy of its inner relation to certain ultimate „values‟ and „meanings‟ of life”. Weber recognized a gulf between his “Two Ethics,” one which is concerned with consequences and one which is duty– and rules-bound. His problem arises from the recognition that the kind of rationality applied in choosing a means cannot be used in choosing an end. Increasingly, the current debate on the Euro is nothing but a conflict between these two forms of ethics.

In one camp, are those who, like François and yourself, say that nothing is more important than preventing a collapse of the Euro. In the other camp, the Germans say that nothing is more important than upholding the international treaties, and maintaining the supremacy of the law over the pressure of short-term solutions.

Now because of its unfortunate history, this debate can get emotional very quickly in Germany. Indeed, more than any other people, the Germans have suffered from adopting the second view, with huge negative consequences for Europe and the world. As a nation, it is thus my impression that Germany has come to the conclusion that, at the end of the day, one should never tamper with the law, whatever short-term benefits such tampering might bring.

If we apply this distinction to what money is, those who believe that money is a tool which belongs to the political sphere and can be manipulated to meet political goals, justify their destruction of money by an ethic of responsibility (fighting unemployment, creating economic growth, etc). For what it is worth, let’s call them “Keynesians”. On the ethic of conviction, we have the Bundesbank and the German population (but not so much the German political system) who say that money is a common good which does not belong to the state, and that the economy has to adapt to this reality, and not the other way around. Let us call them the “Austrians”. As our readers know, Anatole, you are intellectually very much in the first camp, while I plant my flag in the second. With that in mind, the current debate on the Euro can be framed as such:

· On the one hand, there are those who believe that the end justifies the means. If saving the Euro requires the destruction of the notion of money as a common good, so be it. The fact that the Euro is slowly destroying Europe (as was entirely predictable—and predicted in our pages), thus leads our “Keynesians” to recommend measures and actions which have been specifically forbidden in the treaties, the German constitution, or the bylaws of the ECB.

· On the other hand, there are those who remember that Hitler said that treaties and constitutions were nothing but pieces of paper. For such Germans, it is simply inconceivable that the law could be made subservient to a political or economic goal. They believe that destroying the law is far more dangerous than destroying the Euro, and they say to the others that the solution is simple: they signed the Treaties, they now have to respect them.

I respect the German vision. The treaties creating the ECB and the Euro were built around the German notion of money and everybody knew it. So when Merkel says that the others have to become Germans, she is perfectly entitled to do so, since it was exactly what the treaties said (and why the British, Swedes and Swiss rightly refused to join). In my view, on this point, the Germans are right. Frankly, one does not sign a treaty with Germans in the hope that the Germans will be flexible. They never were, and given their own history, are now less so than ever.

I also have a lot of sympathy for the German view of questioning why we should sacrifice every rule, and treaty, to uphold a currency that is clearly not working for a number of countries? Must the survival of the Euro in Southern Europe really only occupy every waking hour, of every European policymaker (and investor)? Must it really take precedence over every other institutional framework? In short, is the Euro really the end-all, be-all of European civilization; the altar on which everything else can be sacrificed? Is this really as good as we get? Or are European policymakers only trying to save the Euro (and sacrificing the youth of a number of countries) to avoid having to admit that they made a colossal mistake?

Louis-Vincent: In all our previous debates, and in The Divergence in European Spreads—Why Now?, I argued that there were four possible resolutions to the European crisis:

1. The first was for troubled countries to leave and redenominate their debt in their local currencies, thereby avoiding a default but imposing massive foreign exchange losses on foreign bondholders.

2. The second was for Germany to leave—though this seemed highly unlikely as this would in essence bankrupt every German bank, insurance company and pension fund (whose liabilities would be redenominated in DM and whose assets would remain in Euros).

3. The third was for the weaker links to default and restructure their debt.

4. The fourth was for the ECB to become far more aggressive in its purchases of troubled-country bonds and swell its balance sheet.

Now up to just a few months ago, the Europtimists kept arguing that all these events were just not going to happen. Instead, the more likely scenario was one of deep structural reforms combined with some fiscal transfers and a little bit of help from the ECB. Such a combination, I was told in many meetings and even in some of our internal debates, would help to keep the Euro-show on the road.

Fast forward to today, and every Europtimist (see the latest The Economist) is now arguing that solution 4 has to be the answer. Obviously, this is also what Anatole is arguing for by equating the German resistance to such an outcome to an “act of war.” So already we have witnessed quite a paradigm shift. But is it now too late for this? In other words, have Europe’s debt crisis and deflationary-bust moved beyond the powers of an ECB’s magic wand? Not that I don’t believe in Santa Claus, or in the ability of central banks to cure every ill, but it seems to me that, should the ECB decide (a day late and a Euro short?) to now intervene in size to prevent the European bond markets from deteriorating further, it would face some very significant hurdles.

Above, Charles focuses on the philosophical hurdles to any mass intervention. And while I subscribe to Charles’ reading of the German institutional framework, my concerns are far less intellectual and far more practical. Basically, we have to remember that the average sovereign debt buyer is not a hazardous investor. The guy who buys a government bond is looking for a very specific outcome: he gives the government 100 only so he can get back 102.5 a year later. That’s all the typical sovereign debt investor is looking for. Nothing more, nothing less.

But now, the problem for all EMU debt is that the range of possible outcomes is growing daily: possible restructurings, possible changes in currencies, possible assumption of other people’s debt, possible mass monetization by the central bank etc. Given this wider range of possible outcomes, and the consequent surge of uncertainty, the natural buyer of EMU debt disappears. Again, the typical sovereign investor is not in the game of handicapping possible outcomes; he is in the game of getting capital back!

This is very problematic because once uncertainty creeps in, bonds will tend to gradually drift towards what I have come to call the bonds “no-man’s-land”. Basically, once sovereign bonds reach 90c to par, they tend to have a much higher volatility and much greater uncertainty. As a result, they are no longer attractive to the typical bond manager or asset allocator looking to buy bonds to diversify equity risk (think how Italian bond yields are now correlated to European equities. If you want to be bullish Italian bonds, you may now just as well spend a fifth of the money and buy European banks for the same portfolio impact…). And once a bond enters into no-man’s-land, it has to fall a lot before attracting the attention of distressed debt and vulture investors (usually yields of 15%+). So the first obvious problem is that more and more European debt markets are entering this “no man’s land” bereft of “normal” investors.

Of course, this invites the conclusion that the ECB should thus do everything in its power to bring the bonds out of this no-man’s land. But what are those magical powers the market keeps referring to? After all, the various European institutions (ECB, EFSF…) and the IMF have mopped up almost a third of the Greek debt and yet it is now trading at 25c on the Euro! Perhaps this goes back to the way a typical sovereign debt holder thinks? Indeed, let us imagine that, tomorrow, the ECB follows every editorialists’ advice and comes in to mop up a third of Spanish and Italian debt in a bid to get yields fixed at, say 5%. Will our Spanish and Italian bondholders a) jump at the chance to get out of their positions with a smaller loss than forecast? Or b) sit tight and allow themselves to be transformed into junior bond holders?

Indeed, the Greek precedent (where basically the ECB insisted on being made whole while the private sector shared in the losses of lending money to the spendthrift Greek government) means that the default assumption of sovereign debt holders should be that a mass intervention of the ECB into their markets will relegate them to the “junior ranks.” And needless to say, most institutions who invest in sovereign bonds are not looking to be junior bond holders. They are looking for absolute safety. So in a perverse way, massive purchases by the ECB may actually highlight that the asset one owns is anything but safe; implying that for an ECB intervention to work, the amounts would likely have to be staggering. This is why I tend to believe that even if the Bundesbank did agree to monetization (which as Charles highlights is hardly a foregone conclusion), the window for this to work may now have closed. Instead we should brace ourselves for either defaults, or countries leaving and re-denominating debt in local currencies.

Anatole: Charles, your Weberian response to my article on Germany's war against Europe is thought-provoking. But it leaves out two crucial points:

Firstly, It is not at all clear that asking the ECB to buy bonds in the secondary market conflicts with any law. This is Merkel's interpretation of the EU treaty. But all that the treaty actually says (Article 123) is that the ECB will not finance governments by providing “overdraft facilities” and buying their debt directly in the primary market. The legislative history of this article is interesting. The Germans wanted a tougher prohibition about monetary financing written into the Maasrticht Treaty, but the other countries refused. The compromise was Article 123. Merkel is now trying to interpret this article as if it enshrined the laws that theywanted. It is therefore the Germans who are trying to twist the law in their favor, not the French, Italians, etc.

Secondly, laws need to be changed with the passage of time. That is what government, and especially democracy, is for. Therefore a dogma of upholding the law as it is, regardless of circumstances, and refusing to change it is not justifiable even for Weber's “ethic of conviction”. Your response to this objection would presumably be that some laws are so important that they should never be changed even by a democratic decision—for example, laws on human rights, racial equality and religious freedom, constitution arrangements and other fundamental laws (which is actually what Germany calls its constitution). I fully agree with this, although even constitutions always contain an amendment process—at least if they are properly drafted, which of course the treaty on European Union never was! Still, it is clear that your ethical argument (and Merkel's) only applies to tampering with fundamental laws, not the much larger number of everyday regulations that are needed for society to function, e.g.: driving speed limits, postal charges...

The question, therefore, is whether monetary laws should be treated as ethically fundamental in the same way as laws on free speech, political association, religious freedom, property rights, capital punishment, etc. I personally do not think so. To me economics is a pragmatic activity with no clear answers. The “right” of a central bank to operate independently of government is not, in my view, an ethical question, comparable to capital punishment or even the right of the citizens to adequate healthcare. This is, I think, the fundamental point on which you and I disagree.

Which leads to my third objection: even if we accept that the “right” of central bank independence is a fundamental right comparable to other constitutional requirements, Merkel is not upholding this right. In fact she is doing the opposite. She is issuing political instructions to the ECB on what it cannot do. If the Germans genuinely believed in the rule of law and in central bank independence, they would not try to prevent the ECB from doing whatever it thought was necessary and desirable. If the ECB board, as properly constituted under the EU Treaties, voted to buy the entire Italian, Spanish and French secondary bond market and to engage in QE to the tune of €10trn, then Germans would have to calmly accept this as a lawful consequence of the treaties their government had freely signed. In fact, therefore, Merkel is not exemplifying the respect for law and ethics of conviction as you describe. She is reinterpreting laws and tampering with treaties in whatever ways happen to suit her.

Charles: Anatole, since we are treading on philosophical grounds, could I say that we must both have studied casuistry in our youth for this is increasingly looking like a debate between a Jesuit and a rabbi.

On your first point, if a French commercial bank subscribes to a French bond and sells it in the following second to the ECB, what do you call this? Moreover, doesn’t the treaty specifically forbid joint responsibility of the debt and the mutualisation of said debt? What the ECB is doing in buying in the secondary markets in amounts higher than those needed for its open market operations is not compatible with these parts of the treaty (even if it is compatible with article 123), since Germany could be on the hook if a country failed (through the participation of the Bundesbank in the ECB). So it seems to me that Merkel is perfectly entitled to her legal views: the ECB’s recent actions are de jure and de facto against both the letter (no mutualisation of the debt) and the spirit (no financing of budget deficits by the central bank) of the treaty.

On your second point, I most definitely do believe that money is far too important to be left under the control of politicians (especially French ones!) and let me explain why. The purpose of economics is to understand why things have a value and why those values change over time. To do so requires a measurement in “money”. But no economist has ever been able to explain why money has any value since it has a marginal cost of production of zero. For me, money is a kind of social contract which binds a “demos” (Plato called it a “convention”) where citizens accept to use it in their transactions or for their savings. But this convention is a very fragile thing.

Renan used to say that a nation is defined by the willingness of its citizens to live together, and this willingness was what created a “demos.” There is no European demos, so there is no possibility of a European currency. To make it simple: to each demos its currency. There is no European Nation, there is a European Civilization, which is not at all the same thing (see Was the Demise of the Soviet Union a Negative Event?). Money thus does not belong to the government, but is a common good of the demos.

If I have learnt something after the debacle of the so-called “financial revolution of the last twenty years” it is that one should never put the monetary policy under the control of the politicians, and that money should never be “privatized,” or put under the control of the market, since it has a marginal cost of production of zero. The privatization of money which started under Clinton, and was continued under Bush and Greenspan, led to the current disaster. In my view, money is a common, (and more importantly—perhaps as I am getting older) trans-generational good that no generation should be able to manipulate for its benefit. The only role of the government should thus be to regulate the credit system without which an economy cannot work. The attempt to regulate this credit system internationally rather than at the national level is the root cause of the current problems, the governments having failed miserably in their regulatory role. Since they have failed, like any bad trader, they are now busy doubling and tripling down. This never works.

On your third point, I have read a thousand times that if the board of the ECB decides on monetization of the debt, the Germans should just accept that decision. Except of course that the board is bound by the bylaws or the treaties which specifically forbid such a decision. What Merkel is saying is thus very simple: if the board gives in to the French or the Italians because they have the majority, then this decision will not be legally binding for Germany. In other words, she is telling the board members to respect the treaties, which guarantee the ECB independence against French or Italian politicians looking for an easy exit, as they always do, or else…

This seems to me perfectly fair and leads me back to my original point, which our latest exchange of emails amply proves: you believe that the end justifies the means (ethic of responsibility). I (like the Germans) do not (ethic of conviction). To conclude on a historical note, I believe that Chamberlain practiced the ethic of responsibility and Churchill the ethic of conviction. And reviewing Chamberlain’s actions, Churchill said “they accepted dishonor to avoid war. They will have the war and will have lost their honor”. Looking at your proposed remedies, your solution is to destroy money to avoid ruin. We will have the ruin; it is too late and will lose our “money” anyway. Destroying money does not create wealth any more than deregulating it.

Anatole: As you have raised the issue of casuistry I must return the compliment and say that your casuistic education must have been even better than mine.

You are right that the ECB has been funding EU governments via the banking system, but the Germans never objected to this—and still do not—for the simple reason that this form of government funding is considered acceptable in Bundesbank theology. Why this is so has never been clear to me, but it must originate in some theorem of Austrian economics which I never studied. Last year, I had the chance to put this question to Axel Weber himself and he confirmed in the clearest terms that ECB lending to banks which then on-lend to governments is a perfectly acceptable way to conduct monetary policy.

Incidentally, some of the people I met in Frankfurt last week were as baffled as I was by the Buba doctrine that financing the Greek government directly is unacceptable, whereas funding insolvent Greek banks so that they can finance their government is perfectly OK. In any case, this issue of financing governments was thoroughly debated and negotiated in the Maasrticht Treaty talks. The result, as I said in my earlier email, was that the other countries refused to go as far as the Germans wanted in forbidding monetary financing under Article 123. Moreover, the German demand for a prohibition on mutualisaing debt, which you mention, was also rejected by the other countries at Maastricht. I know the Germans are always quoting the so-called "no bailout clause", but like the monetary financing clause this part of the treaty does not say what the Germans now claim. The no bailout clause (Article 125 of the new Lisbon Treaty) says this: "A Member State shall not be liable for or assume the commitments of central governments...or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project."

This leaves plenty of scope for EU member governments to agree on mutual guarantees for institutions such as the EFSF and ESM to execute a specific project like the rescue of the Euro. Again, this is a case where the Germans, having failed to achieve their objectives in the original treaty negotiations, signed up anyway and are now trying to reinterpret the laws retrospectively to get what they want. Far from showing respect for Laws and Treaties, this is uncomfortably reminiscent of the German attitude to the Treaty of Versailles.

Now you may be right that money is a public good which should not be subject to political manipulation, but the precise mechanisms for issuing and managing money have always been subject to change—and rightly so, in my view. We both agree that returning to the gold or silver standard would not be a good idea even though money was “always” managed like that until the 1930s. Of course, others have different ideas about the gold standard and these are quite legitimate. And there are a multitude of different views about whether it is best to control money by using interest rates or inflation targets or monetary targets and which ones - eg monetary base, M1 or M3 or the exchange rate.

These different views about monetary management are not about moral or philosophical issues. They are empirical judgments about what works best in the real world. Thus the German idea that monetary financing of government deficits will always and everywhere generate inflation and destroy confidence in the public good money (which you seem to share) is not a moral principle. It is a particular view about how the economy works which can only be judged by whether it turns out empirically to be right or wrong.

As it happens, an important experiment is now being conducted in monetary financing all over the world. If the US, Britain, Japan and Switzerland, all of which are now engaged in monetary financing, suffer serious inflation and a loss of confidence in the value of money, then the Germans (and you) will be proved right. Thus far, however, most of the evidence points in the other direction. (By the way I am not claiming in the last sentence that monetary financing has been successful in managing the US, British, Japanese and Swiss economies—that is another issue—but merely that it has not undermined the public's desire to hold money, as the Germans and you seem to believe).

Finally, I have already responded to your point about what the laws actually say above. So let me comment on your claims about unprincipled pragmatism.

It seems to me that “The End justifies the Means” is actually a good description of your approach to this whole single currency disaster. For you, ‘the End’ is the breakup of the Euro and you are willing to endorse all kinds of dishonest and economically destructive behavior from Germany to achieve this end. I believe, on the contrary, that Merkel should be judged on the effects on the world of what she is doing as well as on her party’s motivations, which are politically self-serving and short-sighted. Like you, I would prefer to see the Euro break up, but I am not going to pretend that Merkel and Axel Weber are morally right, simply because their behavior happens to be advancing my side of the argument.

So in conclusion, I would return to a point that I have made before; namely that if Germany continues to want to play by its rules, rather than the rules of the community, then France should invite Germany to leave the Euro.

François: Anatole, even if your scenario of Germany leaving the Euro made economic sense for France (on which I am not convinced), I am sure that you have already noticed that French politicians are not that interested in economics. Instead, plans that are economically consistent but that threaten the French political influence in large parts of Europe remain a non-starter for our dear énarques. And you will never convince the French that they might eventually regain this influence thanks to the indirect, magical effects of a devalued currency. They won't believe in it (I don’t either, by the way), and even if they did believe in it, they would never have the guts to bet on it anyway. Maintaining the status quo remains the default option for any French politician.

In Capitalism 4.0, you wrote how many UK economists and politicians had been surprised by the good performance of the economy in the years after the Pound left the ERM. You explained that many in the UK initially feared that this "loss of monetary anchor" would lead Britain to nowhere. On the contrary, it provoked renewed internal confidence. Could this benefit happen to France and Italy? Implicitly, this is your bet, and I find it very interesting. But as you know the UK Pound did not stay in the ERM for long, while France and Italy have anchored their monetary destiny upon Germany for more than 30 years. It is in this respect very telling that Italy did not stay long outside the ERM after it was forced to leave in 1992 (it joined back in 1996). Similarly, France did not leave the ERM in 1983. For sure, these successive political choices might be seen as meaningful of countries that lack self-confidence, and these different episodes might well have represented lost opportunities to pursue more sensible economic policies. But for both historical and economic reasons, France and Italy have felt that they needed to keep up with Germany in order to participate to the elaboration of a soft-power of global dimension, which is what the European project is about. Whatever opinion we may have about how this project is being conducted, it is a very respectable project. And after so many years and so much capital invested in it, its possible dismantling would leave much deeper scars and provoke a much larger chaos than when the UK Pound left the ERM.

Anatole: François, you have hit the nail on the head. I agree with you completely that the French enarques would not want to break with Germany even if it could be demonstrated with 99% probability that such a policy would make France stronger and more prosperous. Such is the power of what I believe you call the “pensée unique”. But the problem is not a political one but is now an economic one. In other words, French politicians may decide to ignore economics but the rules of economics are not ignoring France and France may well not be able to cling to Germany much longer. This is especially true if the Germans now realise that France has become completely subservient and that, therefore, Germany no longer needs to compromise in any significant way to accommodate French demands. In short, France is currently living through yet another “Sedan”!

Louis: Speaking of Sedan, once it becomes apparent that the enarques are turning France into a German colony isn't it possible that the public will rebel? In other words, could we not see another “Paris Communes”? At the very least, we will likely see Marine Le Pen make new gains for the National Front in May, and likely make it to the second round. And who is to say that, as the French economic situation deteriorates further, she doesn’t face off against another fringe candidate, perhaps from the far left? Let us not forget that the combined far left (communists, various Trotskyites parties…) have typically polled a combined 15-25% in French elections. Fortunately, they were always scattered amongst many parties (in a scene reminiscent of “The Life of Brian” with the “Judean People’s Front,” the “Popular Front of Judea,” etc…). But now that they are gathered under the Melenchon roof...

Francois: Since 1983, French voters have indeed voted more and more against the traditional parties (2007 was an exception to this rule). It is however not that easy to assess why. Many countries with independent economic policies are seeing the rise of the extreme right or left, while in a suffering Euro country like Spain, the traditional parties continue to attract 95% of the votes. I would thus not be able to demonstrate that the rise of political tensions and dissatisfaction in France or Italy has been due to the anchoring of economic policy on Germany, contrary to what the you suggest.

Moreover, in France, the return of the German constraint upon economic policy is for now leading the country more towards introspection (the realization of the huge costs of our so-called social model) rather than towards resentment against Germany. In fact it is even possible that, contrary to what you suggest, the centrist parties attract more, rather than less, votes in the next elections as more and more people realize that the country needs to be more seriously managed. We will see.

Finally, what exactly are the real benefits of a rebuttal of the German constraints? I suspect that Anatole is too much influenced by the success of the devaluation of the Pound in 1992. But in Italy, which left the ERM at the same time, the following years were far less fun, as the chart below illustrates:

Indeed, the UK could enjoy the benefit of the 1992 devaluation because its economy had been re-vitalized by the reforms of the Thatcher era (meanwhile, today, after more than a decade of creeping Blair-Brown health and nanny-statism, it is a very different story!). Anyway, I do not think that anyone in France would suggest that if Germany left the Euro, or if France simply refused the German constraint, the French economic situation would improve. Our problems are of our own making and are not so much related to having the wrong currency, as to having a welfare, and regulatory, state on steroids.

A Special John Mauldin Outside the Box: Taking Control of Your World

John Mauldin — Thu, 01 Dec 2011 22:25:00 GMT

Today I offer something a little different from normal economic fare. As I keep saying, I think it is important that as business people and entrepreneurs we look for ways to increase our business while others are pulling back. While innovation can mean new technologies (and their costs!), in my experience it is often even better to figure out a new way to offer your products and services to the market, leveraging (in a good way!) your existing work.

Today, simply because you are one of my 1 million closest friends, I have arranged for you to receive absolutely free and with no strings attached some of the best (if not THE best) marketing and innovation materials I have ever read, from a long-time friend of mine who has sold this information for tens of thousands of dollars (and more!). It is my way of saying thanks for allowing me to come into your life each week. (The link is near the end of the letter.)

And for those who just want economic ideas from me, delete this now and move on. Seriously. No problem at all. I get it. This is not everyone's cup of tea. I offer you this material because it has made a real difference in my business life and the lives of so many others. Though I should point out that it's because of how I handle my business that I can write my weekly letter to you for free. Every week for 11 years. So before you put me in a "box" of your construction, you might want me to take a look and see what I see. And remember, when I say free, I mean free. If that is not a good price for you, then…

Now, with that out of the way, if you can't directly benefit from what I am going to share with you, I bet you know someone who can (young people starting out?)! Read on…

John Mauldin, Editor
Outside the Box

A Different "Take" on Improving Business Performance

I want to introduce a little personal note into the difficult times we are facing as business people, entrepreneurs, and investors. While my economic forecasts are decidedly not positive for the next 4-6 years, I really do not advocate digging a hole and crawling into it and pulling a cover over yourself.

Wrong, wrong, wrong! As business people we need to focus on how to improve our own situations. It is the collective acts of multiple millions of businesses, new, small and large, that will ultimately pull us out of this malaise. To let the dysfunctional actions of government prevent you from taking charge of your own world is precisely the wrong thing to do.

I believe you have far more control over the performance of your business than you might realize.

Years ago (in another bad economy) I remember reading an interesting perspective on business growth. The economist writing it acknowledged that it was tough times for any business. It was easy for entrepreneurs to think that this was not a time to grow, but rather a time to "bunker in" and focus on how to quickly cut operating costs.

But he went on to point out that that was reaction, not action. In looking at history (he pointed out) and the patterns and cycles of the economy, you see a bigger picture: one that tells us difficult times are the perfect time for explosive growth: when the giant trees fall in a forest, it's the new shoots that fill the gaps.

Did you know that the Great Depression created the largest number of new business millionaires in America? One key strategy these "positive deviants" (who defied reactive wisdom) used was developing innovative, breakthrough market strategies and business tactics that maximized their success. This let them gain the upper hand on larger, established brands that were focused on cutting costs or services. In short, they took positive strategic action while others simply reacted.

More recently, I was struck by these paragraphs sent to me by Daniel Stelter of the Boston Consulting Group:

"What Businesses Need to Do Now

"Nearly a year ago, we interviewed executives at companies that had dealt successfully with the downturn of 2009. They shared their approaches to managing through the recession – and, more important, to permanently improving their competitive position. All these winners in the crisis had set similar priorities.

"Innovation. Without exception, the manager we interviewed emphasized how innovation would play a decisive role in enabling them to exploit the opportunities arising over the next few years, particularly with less savvy competitors cutting back. As one of them observed, ‘The crisis is a catalyst for change in the technological environment. Things that we only gave half a thought to in the past are suddenly being addressed very quickly.' Many innovations are geared to optimizing processes and reducing non-personnel costs. Fundamental issues are also being broached: ‘Without innovating,' said one manager ‘it won't be possible to prosper over the next few years.' One characteristic shared by all the companies surveyed is that none reduced spending on research and development. On the contrary, some even increased it sharply because, as another executive emphasized, ‘The capital market is looking longer term – at least for now.' The winners are making the most of the opportunities arising from modified investor perspectives."

I am a big believer in innovation. We try and use the latest technology we can to enhance service, increase productivity, and cut costs. But innovation is not just about using some fancy piece of new tech or software. I think the most important innovations are in marketing. The right marketing innovation can make all the difference in the world between mere survival and prosperity. I have learned that lesson time and time again and have seen it done hundreds of times. And there is almost no limit to the possibilities of marketing innovation that you can access. Many actually reduce your costs, especially in cost per sale (while you sell more people more things, more often). And that funnels right into your bottom line.

I'm equally reminded of two staggering quotes from legendary business guru Peter Drucker. I'll paraphrase both, for brevity.

Peter said: Marketing and innovation are the only two factors that generate business. Everything else is an expense. He also said innovation refers to anything (technology or otherwise) that brings greater advantage, access, impact, interest, connection, trust, and buying motivation to the customer.

In a past life, some 30 years ago, I was considered something of a marketing wunderkind. I traveled around giving seminars, speaking at industry conferences, writing papers, and pioneering a few cutting-edge techniques in the direct marketing world. Then along came the financial world, in 1981 (for me personally, that is, as I got involved in the financial publishing industry). I began my economic studies in earnest and ended up today where I always wanted to be up until I left college in 1972 – as a writer. Who knew? I certainly did not see the path, but simply "took the fork in the road" when I came to it.

Along the way I met one person who I consider to be maybe the best marketing mind in the world.

I spent a lot of time with Jay Abraham, absorbing the perceptive, always useful information he dispensed in his own rapid-fire, almost maniacal, but truly brilliant way. Some of the best ideas I ever used I learned from Jay (the same was true of dozens of other companies I dealt with that Jay was also advising). We became good friends and are to this day. I am privileged that I can call Jay up and talk and don't have to pay the $50,000 a day he sometimes gets (if you're asking "What could a person know, do, or see in a given business situation that's worth $50,000 a day, the answer is "A lot!").

Jay has been laser-focused on how to maximize explosive business success for over 25 years. He's helped companies of all types and sizes find what I call "the difference that IS the difference" and add enormous profit and value to their brands, products, and companies in any and all economic climates. He has developed a vast breadth and depth of understanding on how true exponential business growth and profit increases happen – oftentimes doubling and even redoubling companies' current profit levels through the shifts in marketing, strategy, or their business model that Jay innovates.

Jay has had numberless accolades from serious partners and publications. Forbescalled him "the real thing." Investor's Business Daily said, "He knows how to get maximum results from minimum effort." The list of clients he has worked with (and engineered breakthroughs for) is huge, a "Who's Who."

Jay started out (about when I met him) only doing business with companies that would pay him a piece of the profits from new ideas he generated for them. He's almost unreal when it comes to finding hidden assets, overlooked profits, untapped opportunities, and underperforming activities a company isn't mining.

Over time he drifted into doing expensive seminars (we're talking up to $40,000 per attendee) and reports (priced up to $10,000 each) and sold tens of millions (lots of tens of millions) of proprietary "information" pieces. I have sent Tiffani to his seminars, and she always comes back charged up! But not merely motivated with optimism. Rather, she'd return armed with highly actionable, specific strategies and techniques we could apply right away.

And of course, eventually all of Jay's information got ripped off and repackaged by others. And the cost of the information dropped, even as the actual information remained the best out there. Jay correctly decided he did not wish to do battle with a bunch of internet information knock-off artists. He preferred competing on the front lines of capitalism, by personally helping real-world businesses grow and prosper.

So, Jay is coming full circle, back to private, performance-based advisory work and looking for a small handful of suitable, high-quality companies that he can work with on a contingency basis. He simply wants a piece of the money he makes them. He'll focus on improving their strategy, marketing, selling approach, business model, and competitive position).

He asked me if I could help him find a few such companies, betting that they are in my list of 1 million closest friends.

As I thought about it, I told him, "Yes, but there's a catch: I want you to make ALL of the best material you have done over the last 30 years available – for free – to ALL of my readers. Because 99.99% of my readers aren't the companies you can help, but any business can use your ideas if they spend the time and effort to read and study. And, you'll generate a huge sea of goodwill and referrals if you give freely to my friends."

Jay "got it" instantly, nd enthusiastically offered to give each of my business owner/CEO subscribers highly desirable resources – completely gratis – with his and my compliments and best wishes. He agrees that benefiting from all he'll freely share is the best possible way to get some of you excited about working with him, and build goodwill with all of you. (You can jump right in at http://www.abraham.com/gifts)

If you are a business owner or manager, you can take these ideas and apply them directly, meaningfully, and profitably to your particular situation; and my bet is you will improve your offering or unique selling proposition. Many of you will thank me and find this helps your situation more than my macroeconomic forecasts. At the very least, your mindset and methods of doing business will go through one of the most stimulating "reality checks" you ever experienced.

Below is a short list of what you will get. It doesn't begin to do justice to these resources. You access the full list by clicking the link above or below, along with information on how you can set up a personal interview to see whether you and Jay want to work together.

And let me just note that I have known Jay for more than 30 years. He does what he says, and delivers.

It's Like an Early Christmas for Business Owners and CEOs:

You'll receive (when you click on this link):

* Both of Jay's top-rated business books, containing 336 examples, 21 ways to outperform the competition, and 9 ways to turn stagnant performance into accelerated growth.

* Two full-length, two-hour-long, famous interviews of Jay. One by Anthony (Tony) Robbins, the other by Fran Tarkenton. Both will come in audio and text format.

* Two separate assessment test/questionnaires. One is an 87-question self assessment, the other is a 200-question giant Jay uses when evaluating profit-partner deals with companies.

* Two hours of watching Jay in action, performing 35 rapid business interventions/makeovers, which will show you how to think differently.

* The Strategy of Preeminence– A three-part collection (transcript, audio, reference notes) that teaches you now to hurtle your company from commodity status to preeminence in all you do –culture-changing, relationship-changing, impact-changing.

* 35 separate, short, 2-4 minute videos, each designed to instantly teach a different "Point of Power" or "Ex Factor" (for exponential growth) or strategic distinction.

* The transcript of a two-hour interview Jay conducted with Stephen M.R. Covey, teaching how to build greater trust between you and your marketplace.

* "Nine Drivers of Geometric Growth," which identifies the nine biggest upside leverage forces within any business/company that you can most effectively implement.

* Jay interviews Fran Tarkenton on how he's built over $250 million worth of entrepreneurial businesses.

* League of Extraordinary Minds – Jay and colleagues interview 57 of the business world's foremost icons on ways to make your business perform better right now!

* "The Abraham Mind Shift Challenge" – A 53-page dossier that teaches paradigm-shifting nonlinear thinking and a multitude of higher and better ways to think about your business possibilities, options, and opportunities – with 45 case studies.

* "How To Win Friends and Influence the Right People" (the right way) using social media. This provocative, four-segment compendium explains how to authentically connect, impact, and engage strategically in social media for your business.

You can get started changing your business life by clicking here.

Also, because each one of these resources is truly valuable – and there is a lot he is offering you– Jay and I don't want you to get overwhelmed. So he has carefully described each resource and recommended a program of orderly progress to follow to maximize your grasp of all he has to share. Also, when you opt in you'll get automatic access to Jay's periodic eclectic business perspectives and insights.

OK, the price is right. I truly believe you will learn a great deal and earn a great deal for your business. Now, go out and innovate and help get this economy moving! The link again is http://www.abraham.com/gifts.

One final thought. And it's important. In times like this, you must take forceful, innovative action to capitalize on economic opportunities in order to achieve real business growth. Jay Abraham is an excellent person to help you make this happen – whether you merely use his ideas, strategies, advice, and expert guidance on your own,– or collaborate with him directly and personally.

Your hoping to help analyst,

John Mauldin

P.S. Steve Jobs and Steve Wozniak started Apple in 1976. America was then at a low point, following the 1973-74 recession, the Arab oil embargo, the Watergate scandal, and the fall of Saigon. Other US companies that were started in bad times include General Electric, IBM, Hewlett-Packard, and Microsoft.

Question: Do tough times beget a disproportionate number of great companies? If so, why? Something to ponder.

So, you've got nothing to lose. There are no costs or hidden sign-up fees. No BS. Just solid, transformative information.

Warning: If your idea of marketing is to placidly cast something out there and hope people find you, then you will not like this work. This is not for business wimps. Will every idea make your business better? Obviously not, but what would 3-4 transformative ideas be worth? Yes, to get them you might have to do some reading and head scratching. I can't read your mind and tell you the five pages in Jay's work that will really light up your situation. And maybe getting outside your comfort zone will spur you to new vistas. So click and get started!And then write and tell me how you did!

It’s All Greek To Me

John Mauldin — Tue, 08 Nov 2011 06:15:00 GMT

Long-time readers will be familiar with Michael Lewitt, one of my favorite thinkers and analysts. He has gone off on his own to write his letter, and I am encouraging him to write even more. I call Michael a thinker because he really does. He reads a lot of thought-provoking tomes and then thinks about them. And then writes, making his readers think. The world needs more Michael Lewitts.

Today, he roams the world, commenting as he goes, starting of course with Europe. I have permission to use the first half of this most recent letter as today’s Outside the Box, leaving off the investment recommendations that he shares with his subscribers. If you are interested you can subscribe at www.thecreditstrategist.com.

I am back from the Kilkenomics Economics Festival in Ireland, where there was a lot of attendee angst about their banks. They are not happy about taking on private debt with public money, and the mood in Ireland is to tell the ECB to take their debt and (insert your favorite personal expletive). Clearly, the rest of Europe wants the Irish to pay.

I told them to be patient. When the rest of European banks are upside down sometime next year and France, Spain, et al. have to pay, the mood among voters everywhere will be quite different. I said they could probably default on their bank debt at that point and no one would notice, amidst the massive debts that are going to implode on the Continent. My remarks excited a measure of schadenfreude-tinged laughter from the crowd.

Michael Lewitt agrees. Noting this interview with Oliver Sarkozy, the half-brother of France’s Nicholas Sarkozy, he says:

“Institutional funding has a three-year average life, so European banks need to generate more than $800 billion each month to fund maturing institutional borrowings. This is, in Mr. Sarkozy’s words, unsustainable. And the markets are saying so. The CDS market for European banks is back at or above the peak levels seen during the 2008 financial crisis. While Mr. Sarkozy does not come out and say it, TCS will – the likely future for European banks is Dexia SA, which was nationalized by France and Belgium when it ran aground a couple of weeks ago.”

I will write more about what I learned in Kilkenny later this week, but Europe is getting ever closer to imploding, one way or another. There is no end of problems for the markets to focus on. I can only hope that we in the US will observe the increasingly sad state of affairs in Europe and become sufficiently motivated to fix our own problems. If we do not, we will end up in an even worse condition, which will then be worse for the entire world. I remain somewhat optimistic that we will fix what ails us, as not doing so is just too horrible to contemplate.

On that bright note, have a great week. I am off to Atlanta tomorrow and then DC this Sunday, and then home for a few months (more or less).

Your seeing too much to worry about analyst,

John Mauldin, Editor
Outside the Box

It’s All Greek To Me

By Michael Lewitt

“This is a great trap of the twentieth century: on the one side is the logic of the market, where we like to imagine we all start out as individuals who don’t owe each other anything. On the other is the logic of the state, where we all begin with a debt we can never truly pay. We are constantly told that they are opposites, and that between them they contain the only real human possibilities. But it’s a false dichotomy. States created markets. Markets require states. Neither could continue without the other, at least, in anything like the forms we would recognize today.”

– David Graeber, Debt: The First 5,000 Years

For a couple of days last week, European authorities appeared to have settled on a massive monetization scheme that would have eliminated the imminent risk of a collapse of Europe’s banking system. We wrote “appeared to have settled” because less than a week after the plan was announced, Greek Prime Minister Papandreou unexpectedly called on Monday for a public referendum on the plan. The vote wouldn’t occur until January 2012, which would extend the period of uncertainty for two more months. The market reaction to this announcement was dutifully panicked, with European bourses plunging (the DAX and CAC indices were both down 5 percent) while German bond yields dropped 26 basis points to 1.76 percent as investors flocked to safety. Systemic risk was placed squarely back on the table and cut out the legs from the rally that boosted markets out of the upper end of their trading range at the end of last week.

The markets thought they could step back from the brink on the news that the European Financial Stability Facility (EFSF) would be leveraged by 400 percent and European banks had agreed to write-off 50 percent of their Greek debt. These measures had convinced the market that Armageddon would have to wait for another day. Now the markets are not so sure. Counting on byzantine Greek politics to deliver certainty is a dubious proposition to say the least. But the plot thickened even further as money managers around the world were pulling out their remaining strands of hair. On Tuesday, November 1, shortly after European markets closed, reports surfaced that the Greek referendum was off. As I wrote to one of my friends, every time I tried to put this issue to bed, more news came out of Greece that made it impossible to know exactly what to say. At this point, I am starting to feel like Sybil, the girl with 27 personalities (and now we’ve learned –like we didn’t already know – that she was a complete fabrication in the first place). Nonetheless I will do my best to wade ahead with the limited number of personalities I have left.

At best, the proposed bailout plan would have been/will only be a temporary solution to a long-term structural problem that requires an entirely different set of solutions than monetization and leverage. Our initial reaction to the plan was decidedly positive, however. We believed it would lead to a strong rally because it would remove systemic risk through the end of 2012 even though it did not provide a permanent solution. TCS wrote the following last month: “If the plan ultimately takes the form of leveraging the EFSF, the markets will likely rally and ignore the fact that such a program would at best place a Band-Aid on the underlying wound. Even a flawed plan will be perceived to be better than no plan at all. Unfortunately, such a plan would only create the illusion of stability while allowing the underlying imbalances and flawed policies to fester”(The Credit Strategist, October 1, 2011, “Confidence Games,” p. 1). The markets were desperate for a genuine solution but would have settled for stopgap measures. Now, unfortunately, they aren’t even being granted the latter.

In terms of the substance of the plan, it is obviously designed to cover Italy’s and Spain’s collective €1.5 trillion of borrowing needs over the next three years as well as those of Greece, Portugal and others. In that respect, however, it leaves little, if any, margin of error. After all, the EFSF is not an actual pool of money but merely a collection of IOUs that have to be fulfilled by 17 European states, at least two of which (Italy and Spain) are unlikely to keep them. As a result, one can expect further strains in the arrangement and market volatility resulting therefrom if the plan actually proceeds. If the plan does not proceed, investors will be begging for volatility as a welcome alternative to what they could be facing.

As one who has written that there is little chance of a long-term solution to these problems without a radical rethinking of global economic policy, the Europeans still have little choice once they peer over the cliff to realize other than to step back and buy some time before taking the inevitable leap. For, in the end, they have no other options than to jump. If they can squeeze a favorable vote out of Greece in January, they will then face the test of trying to implement meaningful pro-growth economic policies as their banks absorb their Greek losses. Skeptics are certainly correct to raise questions about the prospects for long-term solutions, but investors were not being reckless in acting as though systemic collapse was a worry for another day. They were wrong-footed by the announcement of a Greek referendum, which came as a surprise to us and to many others. But the removal of imminent systemic risk was a reasonable short-term buy signal for those with short-term investment horizons.

European economies are facing severe economic contractions in late 2011 and 2012 with little clarity on pathways toward growth. This is not news to the markets. Italian 10-year bond yields took little time to blow back through 6 percent and have now widened by 225 basis points this year. The European Central Bank might as well thrown money down a rat hole as purchased Italian bonds earlier this year. Yet, while Italy seems to be getting most of the attention of both the media and European political leaders pressuring its Prime Minister to implement budget cuts, Spain is starting to experience alarming degrees of economic pain.

In the third quarter, Spain’s unemployment rate reached the highest level in 15 years –an abominable 21.5 percent. The number of households without any income also reached a record level – 559,900, or 3.2 percent of all families. This is a result of the exhaustion of unemployment benefits for a growing number of Spaniards. In Spain, these benefits end or decline significantly after 24 months, compared with 3 to 5 years in some other European countries. While the Spanish government is looking for ways to stimulate job growth through government spending, the European Union is pressuring the country to reduce its budget deficit from more than 9 percent of GDP to 3 percent by 2013. The struggle between the government safety net and budget discipline will be increasingly painful across the union for the next few years.

Greece is mired in a depression that is getting worse by the day as it is forced to meet its northern neighbors’ austerity demands in order to receive aid that still won’t get it out of the bottomless economic pit it has dug for itself (the country needs to exit the EU, something that may be addressed in the referendum – if there is one). Banks taking 50 percent haircuts on Greek debt will now have to raise additional capital either in the public markets (highly unlikely) or via the EFSF, which will further dilute their already washed out stocks and divert them from the business of lending into recessionary economies (see below for more on European banks). The rating agencies are licking their chops in anticipation of dunning France’s AAA-rating, and Germany is only slightly further behind on their list for downgrade (for more on Germany’s credit rating, see below). The costs of fiscal union are proving to be somewhere between excessive and prohibitive.

One of the rabbits that the Europeans succeeded in pulling out of their hats is deeming the 50 percent write-off of Greek debt something other than a “credit event” that would trigger payment under the credit insurance contracts governing Greek debt. According to The Wall Street Journal, only a relatively small amount of money would have actually changed hands had a “credit event” been deemed to have occurred - $3.7 billion. But European leaders were able to convince holders of the debt to accept a “voluntary” write-down, which does not trigger a payment under the insurance contracts (known as credit default swap contracts, or CDS). The concern raised by market participants is that CDS will lose its utility as a hedge if parties are able to negotiate around it as they did in this case. A number of bankers were fretting in the media that this would result in higher borrowing costs for sovereigns by making it harder for buyers of sovereign debt to hedge their positions. To a limited extent that argument may have some merit, but for the most part CDS is used to speculate and not to hedge. If these self-interested bankers are really concerned about lowering sovereign borrowing costs, they should simply support a ban on naked sovereign CDS. That would leave investors with the ability to hedge, which would lead borrowers to lower their yield demands, and eliminate the pressure on rates placed by speculators who sell short sovereign credit without actually owning it. One of the reasons European leaders were so focused on not invoking a “credit event” in a Greek debt restructuring was to prevent speculators from profiting from Greece’s troubles.

European Banks

Figure 1

The Banks That Swallowed Europe

A key part of the European rescue plan is leveraging the EFSF so that banks will be able to take the write-downs of their Greek debt holdings and then access capital so they will not be rendered insolvent (although since the entire edifice is built on debt it is unclear how they will be able to pull that off: It would seem that some non-traditional financing structures are going to be required for European banks. Among the structures that should be considered are bonds with warrants and convertible securities. Lenders will be taking equity risk and should be compensated accordingly. They should also be granted appropriate covenants that limit the ability of managements to make the same kind of stupid decisions that got them into their current messes). Nonetheless, the dilemma facing Europe’s banks is truly formidable. Banks represent a much larger presence in European economies than they do in the United States, as Figure 1 illustrates above.

In an appearance on CNBC’s Squawk Box and in an important essay in the Financial Times, Oliver Sarkozy, the half-brother of France’s Nicholas Sarkozy, laid out the challenges facing the sector. (Oliver Sarkozy, “Europe’s dithering over banking risks 2008 again,” Financial Times, October 25, 2011, p. 9.) Mr. Sarkozy notes that Europe’s banking sector has $55 trillion of assets, four times larger than the U.S. sector. As a result, European banks are funded through institutional (what he calls wholesale markets, which he describes as much less stable and much more fickle than depositors. European banks rely on institutional markets for about $30 trillion of their funding, about 10 times more than U.S. banks. In the third quarter, this market was essentially closed to European banks, leaving them with only internally-generated sources of cash to repay institutional funding as it rolls off. Institutional funding has a three-year average life, so European banks need to generate more than $800 billion each month to fund maturing institutional borrowings. This is, in Mr. Sarkozy’s words, unsustainable. And the markets are saying so. The CDS market for European banks is back at or above the peak levels seen during the 2008 financial crisis. While Mr. Sarkozy does not come out and say it, TCS will – the likely future for European banks is Dexia SA, which was nationalized by France and Belgium when it ran aground a couple of weeks ago. Figure 2 below shows the horrible performance of European bank stocks over the past few years and since January 2011(readers will note that TCS has been recommending that investors short European banks all year).

Figure 2

The Heart of the Problem

Mr. Sarkozy suggests that European banks will require $2 trillion of recapitalization, twice the amount that is provided for in the plan announced by European leaders.TCS would like to ask what type of financial prestidigitation is going to be required to transmogrify EFSF borrowings into bank equity. Either way, the problem is enormous and is unlikely to be solved by what the Europeans have proposed thus far.

U.S. Economy

Fears of a double dip recession can placed on the back burner as the U.S. economy grew at a respectable 2.5 percent annual rate in the third quarter. After six months of below one percent growth, this was a welcome recovery. The main contributors to growth were personal spending, which increased by 2.4 percent (adding 1.7 percent to annualized GDP) and business fixed investment (which added 1.5 percent to annualized GDP). Inventories subtracted 1.1 percent from GDP growth and government spending was flat. If readers are puzzled by the contribution of personal spending in the face of 9.1 percent unemployment and a persistent housing crisis, we are too. The will-to-spend of the American consumer is something to behold, and apparently the addition of even a disappointing 100,000-125,000 jobs per month is sufficient to keep it afloat. But it should also be recognized that personal spending remains below the levels of previous recoveries (as does pretty much every other sign of economic health). Business spending is responding to decent demand in the emerging world, but there are indications that this is starting to slow. The point to be taken from these numbers is that the U.S. would do well to maintain growth in the 2.5-3.0 percent range going into 2012. This is a growth rate that is going to have to be proven; it is not something to bank on.

The Global Debt Albatross

In a late August interview on Bloomberg television with Tom Keane, I argued that one of the major factors suppressing economic growth in the U.S. is the enormous weight of debt throughout the economy. Debt service is a drag on economic growth today because much of this debt was not incurred with respect to productive activities. Instead, much of this debt is related to either housing (which is an unproductive asset) or financial speculation in the markets. Accordingly, economic actors are required to commit their capital to service debt that didn’t contribute to productive economic growth.

Figure 3

A Civilization Built on Debt

There is also increasing evidence that the sheer amount of debt has reached the point where it is retarding growth and that additional debt will place additional downward pressure on the economy. TCS came across confirmation of its argument in the always indispensable writings of our friend Christopher Wood. Mr. Wood wrote in the October 6, 2011 issue of GREED & fear that: “the evidence increasingly suggests that the Western world has now reached a point where further increases in total aggregate indebtedness are bad for growth even if it is assumed, optimistically, that the authorities are successful in triggering private-sector deleveraging.”

Mr. Wood cited a Bank of International Settlements (BIS) Working Paper written by Stephen Cecchetti, M.S. Mohanty and Fabrizio Zampolli entitled “ The real effects of debt.” This paper was presented at the August meeting of central bankers in Jackson Hole, Wyoming. The authors of this report analyzed data for 18 OECD countries for the 30-year period 1980-2010. Their findings are disturbing (though hardly surprising). First, the ratio of debt-to-GDP (total government, corporate and household debt but excluding financial sector debt) has risen from 167 percent to 314 percent during that period. Second, regression analysis showed that debt becomes sufficiently large to slow economic growth as follows: government debt – 85 percent; corporate debt – 90 percent; household debt – 85 percent. Needless to say, the United States has exceeded those levels today with no diminution of the debt burden in sight. U.S. government debt is at 97 percent and household debt is 95 percent. Only corporate debt, at 76 percent, is below the threshold. Figure 3 above shows these statistics for all of the countries studied. It is not a pretty picture.

One thing to focus on in Figure 3 above and in Figure 4 below is the fact that Germany, the country on which the economic fate of Europe largely rests, is itself heavily indebted. Germany carries a total non-financial debt-to-GDP ratio of 241 percent (government – 77 percent; corporate– 100 percent; household – 64 percent). One can see why it is far from certain that Germany will have the economic or political wherewithal to bail out its weak European neighbors even if it musters up the political will to do so.

Figure 4

Germany– Going, Going, Gone?

One of the other points made in the BIS paper – something TCS discussed in the Introduction to The Death of Capital – is the enormous impact that aging populations will have on countries throughout the world. Figure 5, which appears on the next page (it appears on page 24 of The Death of Capital), was developed by the International Monetary Fund to show that spending on the 2008 financial crisis, which was in the trillions of dollars, is dwarfed by the projected costs of caring for aging populations. On average, aging populations will cost the advanced G-20 countries 14 times more than the financial crisis.

The point made in both the BIS study and my book is that it is incumbent upon advanced economies to bring their debt under control. Otherwise, the world is at risk of not having the resources to deal with the problems that they are going to face in the future. These problems include natural disasters (like Japan’s tsunami); environmental degradation and climate change; nuclear proliferation; terrorism; military conflict; pandemics, and hunger and poverty. Each one of these poses a potential threat to human survival (and is precisely the type of Black Swan for which most investors are not prepared). To continue to run our economies like a bunch of drunken sailors is incredibly reckless in the face of these future challenges.

Figure 5

Debt May Kill Us Before Old Age Does

It should also be noted that China, the Great Hope of the global economy, is hardly a paragon of fiscal rectitude. China’s total non-financial debt-to-GDP ratio is 174 percent (government debt –44 percent; household debt – 19 percent; corporate debt – 111 percent. This does not include the massive amounts of debt hidden on the balance sheets of opaque Chinese banks. China is concealing its own debt problem and the opaque nature of the situation renders it a bit of a wild card in the global economic picture.

Zuccotti Park

The “ Occupy Wall Street” movement has received more than its fair share of media attention. There is no doubt that the protestors are emitting a primal scream against the system of “ capitalism for the poor, socialism for the rich” that characterized the steps that both led to the 2008 financial crisis and those that were taken to stem it. A growing percentage of the citizenry is coming to believe that a system that privatizes profits and socializes losses lacks legitimacy.

At the same time that protestors are railing against the current capitalist regime, and European leaders are doing everything in their power to perpetuate it, legal authorities in the United States are doing their part to insure that little will change. The recent insider trading prosecutions have properly attacked a flagrant and distasteful underside of the capital markets, although someday it will have to be explained how it is not insider trading when a well-known investor is permitted to accumulate a position in a company before publicly disclosing it and watching it soar in value. Leaving that aside, however, there is another legal assault that raises far more important systemic questions that the insider trading prosecutions. TCS is speaking of the lawsuits against the nation’s largest financial institutions for their sales of toxic mortgage securities. Last August, the Federal Housing Finance Agency sued 17 major Wall Street and European banks for selling more than $200 billion of these mortgage securities to Fannie Mae and Freddie Mac. At the same time, a number of state attorney generals are suing mortgage servicers for various abuses. Finally, there are a number of specific ongoing investigations (and a lawsuit or two) against specific underwriters for transactions similar to the Abacus abortion that brought so much shame on Goldman Sachs (and might one say that the Gods have exacted their revenge this year on John Paulson for his profiteering from that dirty business?). Where these legal proceedings will ultimately end up is anybody’s guess (although one can say with certainty that they will enrich the attorneys working on them).

TCS would like to raise a broader issue. The people camping out in Zuccotti Park are evidence of societal unease about the legitimacy of the current form of crony capitalism that has contributed to this country’s economic difficulties. Contributing to this unease has been the often-heard complaint that virtually nobody has gone to jail for causing the financial crisis. There is a very good reason for that, however. And that reason is not the one we heard from the U.S. Attorney with respect to its failure to bring charges against the incompetents who ran Washington Mutual, that the evidence did “ not meet the exacting standards for criminal charges.” Of course there was no evidence of criminality – the perpetrators of the conduct are on the same side of the table as the prosecutors! The reason that blatantly dangerous and unethical behavior cannot be prosecuted under our current system of laws is that there is no independent, third party, arm’s-length arbiter of behavior for the system. The system is worse than one in which the fox is guarding the henhouse. In our system, the fox is the architect that designed the henhouse!

Our justice suffers from a design flaw. It requires an independent investigative/prosecutorial arm that is part of the judicial rather than the executive or legislative branch of government. The only individuals that have truly stepped up and challenged the status quo that governs the political-financial ascendancy are federal judges such as Jed Rakoff. Judge Rakoff has given hell to the Securities and Exchange Commission over its bogus settlements with the large banks over settlements that are obvious political accommodations rather than true holdings to account. The judicial branch, which is certainly less beholden to large financial interests than the legislative branch (our bought-and-paid-for Congress) and the Executive Branch (our bought-and-paid-for President and Justice Department), is well positioned to serve as an independent arbiter of financial wrongdoing. It therefore offers the best opportunity to restore legitimacy to a system that has lost any right to judge its own conduct.

The Devolution of Wall Street

During the final segment of CNBC’s Strategy Session (which TCS will miss), David Faber made a very compelling comparison between two financiers – Michael Milken and John Paulson. Mr. Faber made the point that when he began his career as a Wall Street journalist (he started in the same year that I joined Drexel Burnham Lambert, Inc. –1987) the most highly compensated financier of the era was Michael Milken. Today John Paulson wears that crown. Mr. Milken famously earned $550 million in1987 (which pretty much sealed his legal fate regardless of the validity (or lack thereof) of the charges brought against him) while Mr. Paulson earned an astounding $5 billion in 2010 (and a couple of billion more in 2009 from his bet on subprime mortgages). Mr. Faber then went on to point out that Mr. Milken created the high yield bond market, which has expanded into a major economic force that financed many new businesses such as telecommunications (MCI), cable television (John Malone), and casinos (Steve Wynn and others). In contrast, Mr. Paulson has created nothing and instead profited from mere speculation. The difference between how these two men made their fortunes not only says a lot about how Wall Street has devolved over the last 25 years, but also how the U.S. economy has deteriorated during that period.

Perspectives on the Crisis in Europe

John Mauldin — Tue, 01 Nov 2011 03:59:00 GMT

This week's Outside the Box will be unusual. Rather than one essay, I give you a number of short ones, and links that are representative of the confusion that is Europe, along with a little history. As I noted this weekend, last week's Eurozone announcement was short of details, and very little of the real work had been done. Merkel has to get her own country on board, keep the other nations that are in trouble from demanding haircuts, and keep the markets from trashing Italian and Spanish debt. Berlusconi has to figure out how to get the Italian budget balanced while staying out of jail and "balancing" his social calendar. Maybe he can dollar-cost average with a 70-year-old date? (Sorry, that was snarky, but it is so easy.)

Europe's problems will visit shores all over the world. China will not come to the rescue, at least not cheaply. It is becoming increasingly unclear where they will get the money without ECB participation, but that is VERY euro bearish.

I don't want to seem like I am piling on Euroland, but they are the crisis du jour. And it's just a matter of time until it's the US. Sigh.

And lest I forget again, let me say a special thanks to Joan McCullough for pointing me last week to Mike Masters, who was very helpful in understanding the intricacies ofcredit default swaps and their implications.

Another busy week and lots of airplanes. It will be my first time ever on Aer Lingus, as I fly to Ireland. This weekend will be fun, and even though I will do a few speeches, it will b a very different crowd than I normally speak to. No PowerPoints, just explanations of how the world works to average people – while professional stand-up comedians try and keep me honest! We shall see how that works.

Your keeping it simple analyst,

John Mauldin, Editor
Outside the Box

Perspectives on the Crisis in Europe

From David Zervos (of Jeffries and Company), writing this morning:

Seeing Greek bond investors take a 50 percent haircut, the 10yr BTP/Bund spread back to the August wides above 400 and the 10yr OAT/Bund spread north of 100 at the same time spoos have rallied 20 percent and CDX HY has fallen nearly 300bps over the past month is about as good as it gets for our "Fed Reflation vs European Detonation" view of the world. We are heading into the final few laps of the 2011 race with US equity indices up 2 to 5 percent for the year, European peripheral yield spreads at or very close to multi-decade wides, and European banks – many of which are down close to 50 percent on the year – about to be forced to raise heaps of capital. Those banks that cannot raise in the private sector, like the Greek and Cypriot ones which were lobotomized during the haircut process last week, will be forced into the EFSF vortex of pain. In there, ROEs will drop like a stone as executives are forced to delever and dilute. The only future allowable investments for these institutions will be in government-sponsored companies like the European version of Solyndra. When governments take over your capital allocation process it's "game over" – this is all part of the longer term "European Detonation" trade.

Importantly, there is NOTHING in the EU plan from last week that should make anyone comfortable about investing in European sovereign credit – or European banks. The barber shop is now open – who is the next customer? And of course this is no ordinary barber shop, in fact it's run by Sweeney Todd. The price that Greece is paying in austerity adjustment is heavy. The Portuguese, Irish and even the Italians and French are watching Athens closely. The Greek press and the Greek polls suggest that this debt relief is not being celebrated – rather it's a time for more and more violent protests (see the Salonika parade cancelation – http://www.keeptalkinggreece.com/2011/10/28/unprecedented-thessaloniki-parade-cancelled-due-to-protests/ and the other protests –http://www.keeptalkinggreece.com/2011/10/28/national-day-parades-turn-into-protests-with-eggs-yogurts-and-black-flags-pcts-videos/ post bailout).

If your bankers were to cut your mortgage and credit card debt by 50 percent, you certainly would celebrate. But if the haircut came with a forced sale of your prized possessions, a 50 percent cut in your wages, a 50 percent cut in your pension, a repossession of your car and a loss of nearly all of your state benefits such as education and health care, then maybe you too would be throwing molotov cocktails on the streets. Welcome to Syntagma Square. Oh yes and all of this austerity is happening while inflation is running well north of 3 percent.

This is NOT going to end well in Greece. And it's NOT going to end well for Europe. This barber shop is nothing more than the little shop of horrors and the Euro is the monster named "Audrey 2". But enough with the Broadway show metaphors. The point is simple, steer clear of a complicated and caustic Europe, and stick with our homeboys in the USA. Their reflationary policies are much easier to trade.

As promised last week I wanted to spend a little time on Greek history because I think it is crucial to understanding how the next phase of the crisis will unfold. This history sets the stage for how the political tides will turn in Greece during the coming "EMU exit" phase of the crisis. The 28th of October – the day last week when the final details of the EU haircut/bailout meeting were released – was ironically a very important Greek holiday. It is the day in 1940 when Benito Mussolini presented the Greek prime minister/dictator Ioannis Metaxas with an ultimatum – allow Axis forces to occupy strategic parts of Greece or face war. Metaxas answer was a simple "oxi". Oxi – pronounced oh-hee in Greek – means NO. This was the beginning of WWII in Greece. The Italians however never really fought hard against the Greeks – they were not particularly interested in battle. More than likely they all sat around having coffee together in the town squares. It was the German forces that ultimately came through Greece a year later and ravaged the country. And after the end of WWII, there was no reprieve for Greece – it became the center of the cold war battle. From 1946 to 1949, a British and ultimately US-backed fight against communism displaced over 15 percent of the population and generated more casualties than the German occupation. The Truman doctrine in 1947 was the beginning of US involvement in Greek government that would span 3 decades. For those that think the US will not take notice of a geopolitical crisis in Greece please reread Truman's speech to a joint session of Congress in 1947 – http://ourdocuments.gov/doc.php?flash=true&doc=81&page=transcript. Importantly, Communism was outlawed in Greece in 1947 and communist fighters against the Axis in WWII were declared enemies of the state. The battle between the left and right in Greece divided the country for decades and tore the country to shreds. During the 50s 12 percent of the population left Greece (including my father who walked off a Greek naval ship in New London CT in 1958). Many of the communist fighters and their children retreated into eastern bloc countries.

Greece entered NATO in 1952, and the right wing was largely in control with strong American financial backing. The move to the right culminated in a military coup in 1967 that lasted until 1974. During that period, many of the remaining left wing sympathizers were imprisoned and/or deported. The fall of the dictatorship in 1974 opened up Greece's entry into the EU. It applied for EEC membership in 1975 and entered in 1981. Also in 1975 Andreas Papandreau formed PASOK, the modern day socialist party in Greece. Further, the communist party was legalized and a new constitution that guaranteed individual rights and free elections was put in place. Importantly, it was not until 1975 that Greece even had a democracy post WWII. In 1981, PASOK took control of the government and allowed communist fighters from WWII to return from the eastern bloc to reestablish their estates. These fighters and many others that fought through the struggle with fascism were awarded generous state pensions. It was Andreas Papandreou in the 1980s who took Greece down the path of excess political patronage, excess debt and unsustainable budgets. It was a massive wealth redistribution process that not only came from within Greece, but more importantly from within the European Economic Community (the EEC).

Papandreou threatened leaving NATO and the EEC to secure constant funding from the West. In fact, in 1985, he blocked the admission of Spain and Portugal into the EEC until he was given nearly 30 billion in EEC funds. Jaques Delors finally caved! There is a constant and overriding theme in post WWII Greek politics: the world has used Greece as a pawn, and hence the world owes us. The Germans, the British and the Americans kept Greece from democracy and freedom until the late 70s. It suited their wartime aspirations. And while we in the US were going through the Reagan revolution in the 80s, the Greeks were still trying to right the many perceived wrongs from the WWII and Cold War battles. Much of Greece's debt troubles can be traced back to reparations for the tragedies associated with those two wars. There are strong senses of entitlement, retribution and redistribution that have taken Greece down this path of excess debt for the last 30 years. The political culture of redistribution that came with freedom in the 1980s, morphed into a culture of unsustainable state entitlement.

With this political backdrop, the endgame for Greece is extremely complex. Austerity will not last in Greece, and the threat of exit will ultimately be used by the citizens of Greece to attempt to secure a continuation of the welfare state. The stakes are high, and Angela Merkel is no Jaques Delors. The next chapter for Greece will be exit, and the losses to Western creditors will be seen rightly or wrongly – in Greece – as just part of the payback. Good luck trading!

___________________

From Dennis Gartman:

Firstly, for example, the 50% "haircut" is apparently only going to apply to the Greek sovereign debts that the private institutions own; that which the "public" of government institutions own shall be left with the 21% "haircut" previous agreed upon. We are now being told that the €150 billion held by the "Troika" and the ECB will not be included in the "haircut." As we understand the numbers, Greece had approximately €350 billion in outstanding debts, so already the haircut is far less than had been initially thought. The market was convinced as of late last week that Greece's outstanding debts had been… or would eventually be… cut to €175 billion and at that level perhaps Greece could be made fiscally stable over time. Now, however, we see that Greece's outstanding debts had been cut to €275 billion… far less than the market had thought. At that level, Greece will never be returned to solvency.

__________________________

Two links viaBill King Reports:

China warns it cannot 'cure' eurozone's debt crisis

China has stressed it will not be a "saviour" to Europe as President Hu Jintao embarks on an official visit to the continent that will take in this Thursday's crucial G20 summit in Cannes.

The official Xinhua news agency, used to communicate Communist Party policy, said…"China can neither take up the role as a saviour to the Europeans, nor provide a 'cure' for the European malaise," it stated. "Obviously, it is up to European countries themselves to tackle their financial problems."

– http://www.telegraph.co.uk/finance/financialcrisis/8858816/China-warns-it-cannot-cure-eurozones-debt-crisis.html

Merkel: Must prevent others from seeking hair cuts

[It's too late, baby, now, it's too late.]

Chancellor Angela Merkel said on Friday it was important to prevent others from seeking debt reductions after European Union leaders struck a deal with private banks to accept a nominal 50 percent cut on their Greek government debt holdings.

– http://www.reuters.com/article/2011/10/28/us-eurozone-germany-merkel-idUSTRE79R3NL20111028

_______________

And from Reuters:

Italy at heart of crisis as borrowing costs climb

Italy's Prime Minister Silvio Berlusconi talks to the media as he leaves a euro zone leaders' summit in Brussels October 27, 2011.

By James Mackenzie and Valentina Za

(Reuters) – Italy's borrowing costs jumped to record levels Friday, underlining its vulnerability at the heart of the euro zone debt crisis and skepticism about whether the struggling government of Prime Minister Silvio Berlusconi can deliver vital reforms.

The 6.06 percent yield paid at an auction of 10-year bonds was the highest since the launch of the euro, and not far from the level reached before the European Central Bank intervened in August to cap Rome's borrowing costs by buying Italian debt.

Italy, the euro zone's third largest economy, is again at the center of the debt crisis, as fears grow that its borrowing costs could hit levels that overwhelm the capacity of the bloc to provide support amid chronic political instability in Rome.

In a speech in Rome, Berlusconi insisted that Italy would meet its target of balancing the budget by 2013.

Tainted by scandal and repeatedly at odds with his coalition allies, Berlusconi has promised European partners a package of measures to spur Italy's stagnant economy and cut its towering public debt, but has failed to convince markets made skeptical by his repeated failure to deliver reforms.

European leaders welcomed a letter of intent on reforms that he delivered to their summit last Wednesday, but emphasized that the measures must now be implemented.

"The interest rates that they are paying are punitive," said Monument Securities strategist Marc Oswald. "Italy ... is still the 'bete noire' of the whole euro zone problem."

"They are still going to carry on having to pay higher yields unless they come up with reform plans and implement them. But anyone who expresses an optimistic opinion about that is probably looking through rose-tinted glasses," he added.

EXASPERATION

France and Germany have expressed open exasperation at a succession of unfulfilled reform promises by Berlusconi, and fear the crisis in Italy could spark a wider emergency that would threaten the very existence of the single currency.

Even if a weakened government manages to pass the promised reforms, most will not come into force until mid-2012. Markets are unlikely to remain patient for so long.

In his speech Berlusconi took aim at the euro, calling it a "strange" currency.

"There is an attack on the euro which as a currency has convinced no-one, because it belongs to more than one country but does not have a bank of reference and guarantee," he said, referring to reluctance by Germany and other countries to allow the European Central Bank to be used as a lender of last resort.

He later issued a statement saying his words had been interpreted in a "malicious and distorted" way.

"The euro is our currency, our flag. It is precisely to defend the euro from speculative attacks that Italy is making great sacrifices," the statement said.

Berlusconi, who is facing two court cases for accusations of fraud and one for allegedly having sex with an underage prostitute, complained that he faced 37 judicial hearings between now and mid-January. He says leftist magistrates are persecuting him in an attempt to undermine democracy.

Speaking after Wednesday's summit, French President Nicolas Sarkozy addressed fears that the crisis could spread to Italy.

"If we had allowed Greece to fall, and the speculation shifted on to attack Italy, the markets would then have said we will allow Italy to fall too, and that would be the end of the euro," he said in a television interview.

As Italy sinks deeper into the debt crisis, tensions in the government have grown sharply, prompting widespread speculation in the press and even Berlusconi's party that the government will fall, leading to an election in 2012, a year early.

"COALITION IS SOLID"

Berlusconi, whose ratings have been torpedoed by a mix of scandal and economic and political problems, rejected speculation that he might be forced into an early election.

He said his alliance remained solid with the pro-devolution Northern League party, whose leader Umberto Bossi has expressed open skepticism about the survival of the coalition.

"There is an absolute need for political stability and Bossi thinks exactly the same way I do. The pact we have with the League has never been up for discussion," Berlusconi said.

"No credible political alternative exists."

This week the League rejected plans to raise the pension age to 67, leading to tense late-night talks before a compromise was reached in time to take to the summit in Brussels.

The proposals, including an increase in the pension age, rules making it easier to lay off staff and provisions to place civil servants in special redundancy schemes, have raised fierce opposition from unions and skepticism about whether they will ever be implemented.

In Italy's increasingly murky politics, there has been speculation that the package is part of a deal between Berlusconi and Bossi to take the government to the end of the year before triggering an election in the spring.

Friday, Berlusconi dismissed such suggestions and said an election campaign in the middle of the crisis would be "very seriously damaging to Italy."

(Additional reporting by Marius Zaharia in London and Brian Love in Paris; Editing by Barry Moody and Alistair Lyon)

Things That Make You Go Hmmm…

John Mauldin — Tue, 25 Oct 2011 04:30:00 GMT

Do we need a law that makes it illegal to push a moose out of a moving aircraft? In baseball, what are the odds of a perfect game? How difficult will it be to solve the problems of the Eurozone? These and other issues are meditated upon by Grant Williams in his Things That Make You Go Hmmm… letter, which is this week’s Outside the Box. Maybe it was the baseball set-up (as my Rangers battle the Cardinals in the World Series) or that I keep getting asked about Europe here in New Orleans at the 2011 Oppenheimer Wealth Management Roundtable, but Grant really pulled me through his weekly missive when I got started, and I believe you will enjoy it as well. Long and short, Grant lays out the problems that we face in a very realistic assessment. I will also point out that he makes me look like a euro-optimist.

I am working on recovering from this past weekend, as this was the first time in 12 years I missed a letter due to simply not feeling well. But I guess that means I should be grateful I am not sick all that often. I hated to not write. The spirit was willing but the flesh was weak. It seems like I was “gifted” by my granddaughter with a nasty bug, which decided to show itself while I was in South Africa. Aaah, the joys of being a grandfather. Another round of catching nasty stuff from your progeny.

Your ready for some rest and baseball on TV analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm…

“Everyone needs the ECB to step up to the plate. The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the Euro Zone. If that happens, nobody will be able to profit from its virginity.”
- PAUL DE GRAUWE

“Simple Math:

The total overall cap [of the ESM] is 500 billion Euros

160 billion Euros has been spent

340 billion Euros remains

340 billion Euros + zero Euros = 940 billion Euros“

- Mike Shedlock, on the latest European ‘Masterplan’ to merge the EFSF + ESM

“The trouble with quotes on the internet is that it’s difficult to determine whether or not they are genuine”
- Abraham Lincoln

Lee Richmond, meet everybody. Everybody? Meet Lee Richmond.

It’s difficult to put an exact number on the number of games of professional baseball that have been played since 1900 - most estimates seem to be clustered around the high 300,000s though. For the purposes of this exercise, I am going to take the number provided in no-nonsense fashion by Wiki answers: 390,536.

In amongst those 390,536 games were home runs, walks, steals, strikeouts and singles, doubles and triples too numerous to keep track of; or rather, just too numerous for anyone but the most die-hard of stat geeks to even contemplate tallying.

(at this point, I should apologise to any non-baseball fans amongst you for whom the terms used above have induced a frantic bout of head-scratching and a desire to skip ahead – stick with me for a while longer and the fog will clear – I promise).

Part of the innate beauty of baseball to me is the fact that (certainly in the modern era), game by game, season by season every aspect of it is measured, quantified and evaluated and the myriad ways the numbers can be dissected enables you to drill down into any part of it and gain a real understanding, through those numbers, of exactly what is going on. You can't fudge the numbers. The Oakland Athletics' Billy Beane showed the power of this approach, which was documented so brilliantly in Michael Lewis' 'Moneyball'

But let's get back to Lee Richmond.

In 1880 Richmond became the first of only 20 men in baseball history to pitch a perfect game when he pitched the Worcester Ruby Legs to a 1-0 victory over the Cleveland Blues at the Worcester Agricultural Fairgrounds on June 12.

Think about that for a second.

Over 130 years. 390,536 games. 2 teams in each contest. That's 781,072 opportunities for a perfect game to be pitched or, to put it another way, the odds on a perfect game being pitched are 39,053:1 - and rising. In fact, more people have orbited the moon than have pitched a MLB perfect game and NOBODY has done it more than once.

(At this point I will again attempt to keep the non-baseball aficionados with us by the use of this short explanation of a 'perfect game':

A perfect game is defined by Major League Baseball as a game in which a pitcher (or combination of pitchers) pitches a victory that lasts a minimum of nine innings and in which no opposing player reaches base. Thus, the pitcher (or pitchers) cannot allow any hits, walks, hit batsmen, or any opposing player to reach base safely for any other reason - in short, "27 up, 27 down")

Interestingly enough, although it is technically possible for multiple pitchers to combine for a perfect game, to date, every major league perfect game has been thrown by a single pitcher.

That record needs to change. And fast.

Right now, the team comprising the ECB, EU and the various parliaments that make up that fractured and faltering alliance are sending pitcher after pitcher to the mound (sometimes in groups of two or three) trying to combine for the perfect game that they NEED in order to escape the debt trap they have backed themselves into.

Being in a situation where you lose unless you can pull something off against odds of multiple-thousands to one and pitch a 'perfect game' is a ridiculous spot in which to find yourself, but as this month has rolled by, it has become ever-more apparent that that is precisely where the Brussels Eurocrats now find themselves. It appears as though, as the pressure has ratcheted up this week, we are now in the ninth inning.

Personally, my own belief (as regular readers are by now well aware) is that the very best the Eurocrats can hope for is to extend the game by an inning or two, but their arms are tired, their bullpen is empty and, at some point, we are going to see an absolute avalanche of runs scored against them as the whole thing finally topples under its own weight.

This past week has been nothing short of farcical as the tension has built towards a crescendo that seemed at first to be willfully engendered in order to generate just enough sense of impending crisis to enable a resolution to be forced through in a similar fashion to that which preceded Henry Paulson and Ben Bernanke's now-infamous closed-doors fright-fest (hyphenation alert!) that led to the passing of the TARP in late 2008.

Obviously any and all capitulation towards outright bailouts (or 'QEU') must at least be seen to be against the will of the Germans and that proviso goes a long way towards explaining the raft of headlines that have flooded the Reuters and Bloomberg screens of investors all around the world this week. We have seen misdirection, scaremongering, u-turns and abject incompetence as well as the kinds of 'leaks' that are, frankly, laughable - the prime example being the 'leaked' draft copy of the Euro Summit statement which was printed, in its entirety, in the Daily Telegraph on Thursday - coincidentally at the precise moment when things were starting to come unglued as it became clear that this Sunday's Summit would NOT produce the magic bullet required.

The statement itself is priceless. It begins with a bit of back-slapping for the passing of the EFSF (after no less than six months of wrangling and an eleventh-hour drama in Slovakia):

The strategy we have put into place encompasses determined efforts to ensure fiscal consolidation as well as growth, support to countries in difficulty, and a strengthening of euro area governance. At our 21 July meeting we took a set of major decisions. The ratification by all 17 Member States of the euro area of the measures related to the EFSF significantly strengthen our capacity to react to the crisis.

The agreement on a strong legislative package within the EU structures on better economic governance represents another major achievement. The euro continues to rest on solid fundamentals

It then moves on to more familiar ground; an agreement to display their strong determination to fix things. Nothing concrete, of course, but they sure as hell are determined:

The crisis is, however, far from over, as shown by the volatility of sovereign and corporate debt markets. Further action is needed to restore confidence. That is why today we agree on additional measures reflecting our strong determination to do whatever is required to overcome the present difficulties.

The rest of the text, should you want to read it, is here, but allow me to summarise it through a few select phrases that will save you the trouble of doing so:

“blah, blah, blah… All Member States are determined, blah, blah, blah… We want to reiterate our determination, blah, blah, blah… We reaffirm clearly our unequivocal commitment that, blah, blah, blah… All other euro area Member States solemnly reaffirm their inflexible determination, blah, blah, blah… The euro area Heads of State or Government fully support this determination, blah, blah, blah… All tools available will be used in an effective way to ensure financial stability in the euro area, blah, blah, blah… We fully support the ECB, blah, blah, blah… “

See. I told you they were determined.

But, buried deep in the draft are (amazingly enough) some specific measures that will surely help solve the crisis:

• There will be regular Euro Summit meetings bringing together the Heads of State or government (HoSG) of the euro area and the President of the Commission. These meetings will take place at least twice a year

• The President of the Euro Summit will be designated by the HoSG of the euro area at the same time the European Council elects its President

• The President of the Euro summit will keep the non euro area Member States closely informed of the preparation and outcome of the Summits

• As is presently the case, the Eurogroup will ensure ever closer coordination of the economic policies and promoting financial stability.

• The President of the Euro Summit will be consulted on the Eurogroup work plan and may invite the President of the Eurogroup to convene a meeting of the Eurogroup, notably to prepare Euro Summits or to follow up on its orientations

• Work at the preparatory level will continue to be carried out by the Eurogroup Working Group(EWG)

• The EWG will be chaired by a full-time Brussels-based President. He/she should preferably also chair the Economic and Financial Committee

…and my personal favourite:

• Clear rules and mechanisms will be set up to improve communication and ensure more consistent messages.

It’s at this point that the non-Europeans amongst you are possibly finally beginning to get the joke that anybody caught in the tractor beam of ineptitude that is ‘Europe’ (and by‘Europe’ I mean the bureaucratic construct rather than the land mass) has understood for years.

THIS IS HOW EUROPEAN BUREAUCRACY WORKS, PEOPLE!!!!

Millions of Euros spent on days of‘talks’ to come up with solutions that fail to address any REAL problems.

Don’t believe me?

Article 47 of the Common Fisheries Policy will ensure that every fish caught by an angler is notified to Brussels so that it can be counted against that countries quota. If you go out for a days fishing and catch a couple of cod or mackerel you will now be required to notify the authorities or face a heavy fine.

There are EU regulations on the greenness of the person on the pedestrian crossing lights.

There are 3 separate EU directives on the loudness of lawnmowers.

Regulation (EC) 2257/94 - a great read, by the way - stated that bananas must be ‘free from malformation or abnormal curvature of the fingers’. It also contained stipulations about ‘the grade, i.e. the measurement, in millimetres, of the thickness of a transverse section of the fruit between the lateral faces and the middle, perpendicularly to the longitudinal axis’ ...

And then there are cucumbers:

Under regulation (EEC) No 1677/88 cucumbers are only allowed a bend of 10mm for every 10cm of length.

Do you think any of those were drawn up in 10 minutes on a single piece of paper?

No. (Actually, in fairness to Europe, they don’t have a monopoly on silly legislation: there IS a law in Alaska that makes it illegal to push a moose out of a moving aircraft.)

The Brussels bureaucracy has always been something of a laughing stock amongst the people of Europe - since long before the final creation of the EU, in fact. Way back in 1955, with a European union freshly on the drawing board ten years after the end of WWII, Russell Bretherton, an English Civil Servant was dispatched to Brussels to inform European ministers what Britain thought of plans for an ambitious new European treaty. Upon arrival, he had these words of wisdom for those assembled:

“Gentlemen, you’re trying to negotiate something you will never be able to negotiate. If negotiated, it will not be ratified. And if ratified, it will not work”

Three years later, the Treaty of Rome was signed, establishing the European Economic Community and from that day to this, the degree of meddling, interference and sheer bureaucracy has increased year after year until we find ourselves here.

Europe is broken and the people charged with trying to fix it are clearly not up to the job. There are way too many vested interests, too many national peccadillos and way too many good, old-fashioned egos in play for it to come down to anything but a last-ditch solution when they are forced into it - and that solution WILL be the printing of money in some shape or form which will help to magically inflate the debt away. The other alternatives are either just too painful (default/ forgiveness) or plain unworkable (growth).

A look at a selection of newsflashes that hit screens this week shows just how ridiculous things have become as everybody involved in trying to sort out the mess that is Europe attempts to get themselves in front of a microphone in order to let the world know just how important they are. Some of these appearances, it would seem, are stage-managed for maximum effect on markets - others are simply self-important politicians who just can’t bring themselves to utter the words “no comment”:

*GERMAN COALITION SOURCES: MERKEL SAYS LEVERAGING EFSF VIA ECB IS RULED OUT

*MERKEL TOLD LAWMAKERS MOVING FORWARD MILLIMETER BY MILLIMETER

*ECB TRICHET: CAN’T USE MONPOL TO CORRECT FAILURES OF GOVERNMENTS

*ECB NEVER ACTS AS A SUBSTITUTE FOR GOVERNMENTS: NEWSPAPER INTERVIEW

*FINANCIAL STABILITY IS THE RESPONSIBILITY OF GOVERNMENTS

*EMU HAS PRICE STABILITY TODAY; INFLATION EXPECTATIONS FIRMLY ANCHORED

*TRICHET REJECTS ASSERTION THAT ECB HAS OVERSTEPPED ITS LIMITS

*TRICHET: EURO WILL EXIST IN 10 YEARS

*SEIBERT SAYS `DREAMS’ OF SWIFT EURO SOLUTION WON’T MATERIALIZE

*GERMAN COALITION SOURCES: MERKEL SAYS LEVERAGING EFSF VIA ECB IS RULED OUT

*DJN-DJ REPORT EFSF FIREPOWER TO REACH EUR2T ‘TOTALLY WRONG’-SOURCE

*MERKEL SAYS NEXT EU SUMMIT IS `NOT THE END POINT’ FOR CRISIS

*DJ GERMAN GOVERNMENT DOESN’T EXCLUDE DELAYING OCT. 23 SUMMIT

*MERKEL CANCELS FRIDAY SUMMIT ON LACK OF EFSF DETAILS

*MERKEL CANCELS EFSF SPEECH ON DEADLOCK ON LEVERAGING: LAWMAKERS

*FRANCE, GERMANY SEE NEED FOR GLOBAL, AMBITIOUS CRISIS RESPONSE

And the piece de resistance:

*MERKEL SAYS EUROZONE TALKS STUCK. FLIES TO FRANCE: REUTERS

*SARKOZY SAYS EUROZONE TALKS STUCK, FLIES TO GERMANY: REUTERS

Amidst this barrage of headlines, Nicolas Sarkozy was quoted in two articles which outlined his own fears for Europe:

“Allowing the destruction of the euro is to take the risk of the destruction of Europe. Those who destroy Europe and the euro will bear responsibility for resurgence of conflict and division on our continent.”

And...

“If there isn’t a solution by Sunday, everything is going to collapse”

There’s something eerily familiar about that last sentence. Let’s see what Google Translate makes of the original French version, shall we?:

“If money isn’t loosened up, this sucker could go down”

Those words were uttered by another President on September 26, 2008 - a few days before TARP was passed into law.

No matter how long this charade continues, it seems impossible to see how it doesn’t end in a EuroTARP. The ECB have a brand new, never-been-used printing press just sitting there in a locked room waiting to be called into action. The only problem is; the Germans have the key to the door. How long they continue to try to do the ‘right’ thing before capitulating is pretty much the only unknown quantity right now.

Having backed themselves into a hopeless corner early last week with promises of a ‘solution’ come the end of this weekend’s summit, the Eurocrats have now postponed the decision until next Wednesday. On hearing this, the markets were eerily calm, as the UK Guardian noted:

(UK Guardian): Investors’ thinking seems to be that the adoption of a new deadline - “Wednesday, at the latest,” according to last night’s communiqué - could be construed as good news, or at least neutral from the point of view of share prices and bond prices. This theory says that more time to reach agreement makes a watertight plan more likely to happen.

Really? The notion sounds like a triumph of hope over experience. Okay, last night’s statement still promised “a global, ambitious response to the crisis currently facing the Eurozone” but it seems just as likely that more time will simply entrench disagreements between Germany and France. As the clock ticks, the definition of “ambitious” could simply be watered down..

But is this sense of calm justified? Well, in a word, no.

Overnight, the latest leaks out of the ongoing Crisis Summit paint an ugly picture about what happens next and, if the leaks are anything to go by, we are in for anything BUT a period of calm:

(UK Daily Telegraph): Europe’s leaders are threatening to trigger a formal default on Greek debt and risk a “credit event” if banks refuse to accept losses of up to €140bn (£120bn) on their holdings.

Hardline eurozone members, backed by the International Monetary Fund (IMF), delivered the ultimatum this weekend after an official report found that in a worst-case scenario Greece could need a second bail-out of€450bn – twice the current package and more than the entire €440bn in the eurozone’s rescue fund.

Vittorio Grilli, a senior EU official, travelled to Rome yesterday to present the “take it or leave it” deal to the Institute of International Finance, which is leading the negotiations for the banks. “The only voluntary element for the banks now is to take a 50pc haircut or face a credit event, a default,” said an EU diplomat.

Apparently, even a once-taboo idea of a centralized Treasury is also now on the table:

(UK Daily Telegraph): European Union chiefs are drawing up plans for a single “Treasury” to oversee tax and spending across the 17 eurozone nations.

The proposal, put forward by Herman Van Rompuy, the European Council president, would be the clearest sign yet of a new “United States of Europe” — with Britain left on the sidelines.

The plan comes as European governments desperately trying to save the euro from collapse last night faced a new bombshell, with sources at the International Monetary Fund saying it would not pay for a second Greek bail-out..

Or how about an EFSF SPV that will attract money from our old friends the Sovereign Wealth Funds (surely, by now, even THEY are starting to understand the folly of investing in these things?):

(UK Guardian): Finance ministers from the 17 eurozone countries are discussing the option of creating a “special purpose vehicle” for the European Financial Stability Facility (EFSF) in order to boost its current€440bn (£383bn) lending capacity.

The idea, according to sources, would be to attract further money from official and private investors, with the sovereign wealth funds of countries such as China, Singapore or Qatar a prime target. Some of these already invest in European banks such as Barclays and UBS.

So here we are.

It’s Sunday morning in Asia as I finish writing this week’s missive and the messages coming out of Europe are as mixed as ever, despite the clear need for a ‘solution’ (which has been perhaps the only consistent communique for about two years now). Sadly for the Eurocrats, the time when they have to stop telling us how important a ‘solution’ IS and actually devise one that WORKS is now at hand.

Any more prevaricating and the markets will give them their solution whether they like it or not.

The chances are that we will see another photo-op featuring the region’s finance ministers this week as they unveil their latest ‘plan’ that will fix everything. There will be a communique issued which lays out exactly how determined they are to solve everything and quantifies all the important steps they have so far taken as well as the improvements they are seeing in the finances of the PIIGS. There may be some criticism of the banks for forcing them to this point, and there will most likely be certain promises made about how they aim to extract retribution for their forced largesse, but they will take one more swing at a solution - one that stops short of the massive steps they need to take to shore things up once and for all.

Then the markets will have their say.

Ultimately, the only realistic way to fix Europe’s problems is to shovel money into the gaping hole that is the region’s finances. Which means that the REAL question that has to be answered is fairly simple:

Where is that money going to come from?

Growth? Nope.

Inflation? Not quickly enough.

Forgiveness or default? Not if you don’t want M. Sarkozy’s prediction coming true.

The ECB’s printing press? Only if you can change German minds.

Until German minds are harder to change than the immutable laws of mathematics, I suspect we have our answer.

Only one Perfect Game has been thrown in a World Series game - when it REALLY counted. The year was 1956, the pitcher that day was Don Larsen and, as the 27th opposing batter was finally struck out, Larsen leapt into the arms of a man whose words of wisdom have graced the cover of Things That Make You Go Hmmm..... on several occasions: Yogi Berra.

The latest European Crisis Summit? Well, as Yogi would probably have said, it’s déja-vu all over again.

∞∞∞∞∞∞∞

So what do we have for you this week? Well, naturally, there’s a whole lotta Europe including warnings of a French downgrade from top economists, warnings of a ‘downgrade blitz’ across the EMU from S&P and a warning for Mario Draghi as he prepares to take the crown from Jean-Claude Trichet’s greying head in a little over a week.

Morgan Stanley explain Europe’s‘Triangle of Terror’, we hear how the EU is mulling over a $1.3 trillion fund and little Belarus is doing its bit to show that austerity is the way forward by heading to eBay.

Amidst Boston’s own ‘Occupation’ we find some of the most delicious irony of the year, the next wave of mortgage-backed lawsuits is set to traumatize Wall Street yet again, Peter Tchir imagines the EFSF as a hedge fund and we investigate the mysterious China International Fund and its activities in Africa.

Gillian Tett examines the possibility that there is a ‘shadowy plot’ behind gold, we look at common equity to total asset ratios that are downright scary, examine Libya’s population pyramid and examine the implications for other Arab nations and see how the cost of oil extraction and the yields on Italian government debt are both heading in the same direction.

Finally, we put the price of gold in Weimar Republic Marks in stark perspective and hear from Rick Santelli, Doug Casey and Paul Brodsky who all have something important to say and do a damn fine job of saying it.

That’s all for me for another week.

Play Ball!

Hoisington Quarterly Review and Outlook

John Mauldin — Tue, 18 Oct 2011 03:37:00 GMT

Dr. Lacy Hunt and Van Hoisington of Hoisington Investment Management write a “Quarterly Review and Outlook” that is a must-read for me. This quarter they focus on US monetary policy, noting that “After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter.” (I mentioned the importance of the velocity of money in judging inflation vs. deflation prospects in this week’s e-letter, too.)

They say, “If our analysis of a new contraction in GDP is correct, the U.S. economy should be viewed as operating in the midst of a long-term slump, regardless of terminology.”

They borrow a riff from Harvard economic historian Niall Ferguson, who has asserted that the world is experiencing a “slight depression”; and mention that this conclusion has been backed up by Gluskin Sheff’s notable economist, David Rosenberg, who reminds us that “Depressions are basically long recessions lasting three to seven years.”

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 $4 billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies.

Your kicking up my heels in the Big Apple analyst,

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook

Third Quarter 2011

Dr. Lacy Hunt and Van Hoisington
Hoisington Investment Management Company, 6836 Bee Caves Rd. B2 S100, Austin, TX 78746 (512) 327-7200 www.Hoisington.com

Downturn

Negative economic growth will probably be registered in the U.S. during the fourth quarter of 2011, and in subsequent quarters in 2012. Though partially caused by monetary and fiscal actions and excessive indebtedness, this contraction has been further aggravated by three current cyclical developments: a) declining productivity, b) elevated inventory investment, and c) contracting real wage income.

a) productivity

In the last half of 2010, real GDP grew about 2.%. The consensus forecast for 2011 was for growth to accelerate to 3%-4% due to the massive easing of Fed policy (QE2), social security tax cuts, and other fiscal stimuli. Surprisingly, real GDP growth slowed to less than 1% in the first half of this year. When growth slows abruptly and it is markedly at variance to expectation, businesses find they have more employees than desired. Normally, firms are reluctant to resort to layoffs, but a failure to do so means unit labor costs rise swiftly as output per man hour (productivity) falls. This was exactly the experience in the first half of 2011. In the very broad, non-farm business sector, productivity did decrease at a .7% annual rate. Accordingly, unit labor costs surged at a 4.8% rate over the same time period, exceeding the rise in consumer prices.

Historically, a sustained and meaningful drop in productivity and a parallel rise in unit labor costs have been precursors to increased layoffs as businesses struggle to restore margins and profitability. Once these job losses commence, broad negative ramifications are felt throughout the economy (Chart 1).

b) inventory reversal

Inventory investment, the most volatile component of the economy, has contributed substantially to the recovery since 2009. From the second quarter of 2009 to the second quarter of this year, real inventory investment surged by $222 billion, accounting for 35% of the rise in real GDP over that period. Now inventory investment accounts for 1.18% of real GDP, which is .18% above the average since 1990. In July and August, production of consumer goods increased at a 3.2% annual rate versus the second quarter, while real retail sales contracted at a 1.4% rate; therefore, inventory investment moved to an even higher, likely undesired, level. Consequently, as firms move to rebalance inventories, the stage is set for a slowdown in production, requiring a further need to pare staffing levels.

c) real wages

Real average hourly earnings has fallen by 2.2% over the twelve months ending August 2011. Real disposable income (a broader measure of income) was lower in August than last December. Initially, consumers responded to this lack of income growth by cutting their saving rate back to the recession low of 4 .%, but now an evident slowdown in spending has occurred. Real spending expanded by only .7% in the second quarter, and remains sluggish in the third quarter. This lack of real income growth will contribute to the negative changes in GDP in coming quarters (Chart 2).

This reduction in real income can be traced, in part, to the misguided attempts to spur economic growth by the Federal Reserve via quantitative easing (QE2). The QE2 expansion in the Fed’s balance sheet backfired as the boost in stock prices (a positive for some consumers) was more than offset by the negative impact of food and fuel inflation on the average family budget. While rising equity values helped a few consumers, inflation in necessities such as food and fuel, decimated real incomes for the average family. Thus, the emergent cyclical weakness that lies ahead can be directly related to the unintended consequences of quantitative easing.

Monetary Policy

Although many measures of economic performance worsened during QE2, the Fed might argue that the recent M2 acceleration may eventually contribute to an improvement in economic growth as deposit growth fuels income expansion. In our opinion, such an optimistic assessment is not warranted.

In the past three months, M2 increased at a rapid annualized pace of more than 20%, and the annual increase in M2 is about 10%, well above the post 1900 average annual increase of 6.6%. This rise in M2, however, appears to reflect a massive balance sheet shift of assets, not a net creation of new assets. Theoretically, if funds are switched from non-M2 assets into M2 assets, M2 velocity would decline and bank loans plus commercial paper would be stable.

This is exactly what has been happening. After peaking at 1.69 in the second quarter of 2010, M2 velocity declined for four consecutive quarters, and we estimate that a major contraction in velocity to 1.59 is likely for the third quarter (Chart 3). Also supporting this idea of asset shifting, bank loans plus commercial paper in September totaled $7.845 trillion, down from $7.906 trillion in June 2010.

In an environment where short-term interest rates are close to zero, commercial paper has become an increasingly unattractive investment since the low interest rates do not cover the risk premium. As commercial paper has rolled off, issuers have been forced to meet funding requirements from bank loans. However, there are other balance sheet changes taking place along with the shift away from commercial paper. With the credit rating of major European banks sliding, companies operating globally may have moved euro-based deposits into dollar-based ones. Supporting this hypothesis, the dollar strengthened during this surge in M2. Economic stresses and uncertainty are responsible for the increased level of M2, not QE2. The real impact of QE2 was that inflation was boosted and real economic growth stunted.

Maturity Extension Program

The initial market reaction to the announcement of the Fed’s latest policy move, known as the Maturity Extension Program (MEP) or Operation Twist, was for commodities and stocks to fall, the dollar to strengthen, and bond yields to decline. Thus, the reaction was to reinforce trends already in place. These market reactions were the exact opposite of what occurred during QE2. Lower commodity prices and the firmer dollar will diminish inflation, thus serving to reverse the drop in real wages that millions of households suffered during QE2. This benefit will not be apparent immediately because the economy has to work through the negative consequences of falling real income and dropping productivity that occurred under QE2. Unfortunately, it is unclear whether Operation Twist will ultimately accrue any benefit to the economy because efforts to achieve very low interest rates could produce counterproductive or unintended consequences.

Banks and other financial intermediaries earn a profit by investing or lending at a rate that exceeds their cost. Due to the low interest rate structure and other considerations, this has become exceedingly difficult, if not impossible. Overnight interest rates are close to zero; thus, to earn a rate above 1% in the treasury market banks must invest at a maturity longer than five years. While this is a positive interest rate spread, all costs may not be covered as banks have to expense payroll, rent, taxes, elevated FDIC fees, and other overhead, and must have a risk or default premium when they lend to a private sector borrower. Therefore, profit erosion of banks and other intermediaries is likely with a lower interest rate structure.

Historical verification of this development is obvious in Japan where more and more of the bank balance sheets have been shifted to government securities rather than to private borrowers. In other words, normal bank lending functions are essentially shut down. This risk now confronts the U.S. with the zero short rate policy and with Operation Twist aimed at lowering yields in the intermediate and long end of the yield curve.

Fiscal Drag

Though budgetary reductions have yet to materialize, fiscal policy via tax increases is also acting as a retardant to growth. The effective tax rate on households can be calculated each month by expressing the sum of federal, state and local taxes as a percent of personal income. From the middle of 2009 to last month, the effective tax rate has risen from 17.5% to 17.9%, a $247 billion tax increase (Chart 4). This rise mainly reflects increased taxation by state and local governments to cover their persistent deficits.

These increases more than offset the first quarter reduction in FICA taxes. Econometric research indicates the U.S. economy will not grow out of the ongoing slump if additional major tax increases are implemented.

In summary, the case for an impending recession rests not only on cyclical precursors evident in productivity, real wages, and inventory investment, but also on the dysfunctionality of monetary and fiscal policy.

Slight Depression

The appearance of a renewed slump only a short twenty-one months after the end of the last recession is highly remarkable. Many statistics support the fact, however, that the U.S. is worse off today than it was prior to the onset of the previous recession. For instance: a) the economy has nearly 9. million fewer fulltime workers employed than at the peak in 2007 (Chart 5); b) real GDP is still below the level reached in Q4, 2007; c) industrial production is 6.7% less than its December 2007 reading; d) real retail sales is $13 billion below its 2007 peak, and e) real personal income (less government transfers) is more than $515 billion below the 2008 peak (Chart 6). The financial markets concur with this “things are worse off” idea. The S&P Index is over 20% lower, and bond yields have dropped more than 40% from their peak levels in 2007. Harvard economic historian Niall Ferguson recently noted that the world is experiencing a “slight depression”. This sentiment has also been cogently expressed by Gluskin Sheff’s astute economist, David Rosenberg, who notes that, “Depressions are basically long recessions lasting three to seven years.” If our analysis of a new contraction in GDP is correct, the U.S. economy should be viewed as operating in the midst of a long-term slump, regardless of terminology.

This economic malaise is a direct result of the accumulation of excessive levels of debt and subsequent reduction in the price level of underlying assets. This is a process that U.S. economist Irving Fisher discussed in his 1933 paper The Debt-Deflation Theory of Great Depressions. According to Fisher and confirmed subsequently by Reinhart and Rogoff and the McKenzie Global Institute, a long period of time is required to unwind previous borrowing excesses. These views were recently econometrically verified in a September 2011 publication by the Bank for International Settlements entitled The Real Effect of Debt. This article, authored by Stephen G. Cecchetti,

M. S. Mohanty and Febrizio Zampolli, stated, “Debt is a two edged sword. Used wisely and in moderation, it clearly improves welfare, but when it is used imprudently and in excess, the result can be disaster. For individual households and firms, over-borrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government’s ability to deliver essential services to its citizens. High and rising debt is a source of justifiable concern.”

Global Debt

We have assembled, with support from Capital Economics in London, foreign debt to GDP ratios that are comparable to the U.S. debt to GDP ratio. The debt figures in these ratios include both private and government debt; thus, they are measures of aggregate indebtedness. These statistics indicate that the euro currency countries as a group, the United Kingdom, Japan and, interestingly Canada, are all more deeply indebted than the United States. This should not give the U.S. solace, nor detract from our severe problems. However, the greater debt in these areas may serve to provide backhanded support for the dollar. More critical is that all major countries are destined to experience slower growth because of excessive indebtedness.

The latest readings indicate that debt to GDP ratios are about: 450% for the Euro zone and the United Kingdom; 470% for Japan, and 410% for Canada. Thus, the Euro Zone, UK, Japan,and Canada ratios are 100%, 100%, 120%, and 60% higher, respectively, than the U.S. debt to GDP ratio of 350%.

We would like to be able to extend this analysis to China because of its rising importance on the global scene. While the Chinese don't provide these statistics, a new book Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise by Carl E. Walter and Frasier J.T. Howie (John Wiley, 2011) sheds light on this issue. Carl Walter holds a Stanford Ph.D., is fluent in Mandarin, and resides in Beijing where he has lived for two decades. Walter and Howie acknowledge that China's model has produced super growth, lustrous office towers, massive, grand new airports and other visible signs of wealth and success. Their disquieting theme is that beneath this glamorous veneer the growth model is flawed and fragile. Specifically, they argue that indiscernible, substantial risks are accumulating in the Chinese banking system--in other words, over-indebtedness.

The Bond Market

During the latter part of the 19th and the early 20th centuries the construction of the Trans-Continental railroad created an excessive accumulation of debt. The result was a period of low interest rates when the long treasury yield averaged less than 2.% for more than a decade. In a parallel case, the highly-indebted Japanese economy has seen its thirty year bond yield average about 2% or less since 1998.

In view of the United States extreme over-indebtedness, we believe that 2% is a an attainable level for the long treasury bond yield. In the previous historic cases yields tended to remain close to their record lows for an extended period of time, coinciding with a long period of deleveraging. Presently the U.S. is in its fifth year of deleveraging, and patient investors in the long end of the treasury market have been financially rewarded. We continue to hold long positions in thirty-year treasury debt, but remain increasingly wary of the potential for further adverse meddling by Federal Reserve authorities.

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

Absolute Zero

John Mauldin — Tue, 27 Sep 2011 01:12:00 GMT

It was Gary Shilling – way back in the last century – who first woke me up to the real whys and wherefores of deflation, with his 1998 best-seller, Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business, and personal affairs. I had read various works on deflation, but nowhere was it put together as well as Gary did it. He followed it up the next year with Deflation: How to survive and thrive in the coming wave of deflation, and in that one he strongly urged his readers out of the stock market – just ahead of the 2000 dot-com bubble burst. But Gary has been so right over the past three decades. (He recently updated Deflation with The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. It’s on Amazon at http://www.amazon.com/Age-Deleveraging.

Today’s Outside the Box is a condensed version of Gary’s monthly INSIGHT newsletter, and in this one he tackles the lack of effectiveness of the Fed’s QE1 and QE2 and delves into the “strange things [that] happen in security, currency and commodity markets that don’t fit normal rules” when the Fed and other central banks take interest rates down close to zero. He notes that at the same time QE2 was fomenting a global commodity bubble and stock-market advances through 2010 and into early 2011, it was also punishing lower-income households with higher food and energy costs, and saddling them with falling home prices “that are likely to drop another 20%.” Crucially, the Fed is “pushing on a string” that, with “the depth and breadth of the financial crisis, the collapse in housing, the ongoing sovereign debt crisis in Europe, Japan’s continuing two-decade-old deflationary depression, the impending hard landing in China, etc. make the monetary policy string much more limp than usual.”

Picking up a theme from his most recent book, The Age of Deleveraging, Gary also examines the question of whether the US is headed for a deflationary depression like the one that has beset Japan for more than two decades. I won’t spill the beans on his conclusion here, but let’s just say that we have our work cut out for us.

If you appreciate Gary’s lucid analysis and want to subscribe to INSIGHT, be sure to mention Outside the Box, and you’ll get 13 issues for the price of 12, PLUS their January 2011 report in which Gary lays out his investment strategies for the year. The price via email is $275, and the address is insight@agaryshilling.com, or you can call them at 1-888-346-7444.

Your loving London but lusting for Ireland analyst,

John Mauldin, Editor
Outside the Box

Absolute Zero

(excerpted from the September 2011 edition of A. Gary Shilling's INSIGHT)

In its written release after its August 9 Federal Open Market Committee policy meeting, the Fed included a statement that was highly unusual because of its specificity. “The Committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid 2013.”

In the recent past, the Fed has stated its plans to keep rates low for an “extended period,” but we can’t recall the central bank ever being this precise on any policy. The statement was also significant because it means that unless the economy takes off like a scalded dog, the overnight federal funds rate will continue close to zero, its absolute bottom. Not surprisingly, longer term Treasury rates dropped on the announcement. The 2-year note yield fell to 0.185%, an all-time low, and the 10-year note yield hit 2.033%, below the previous 2.034% low reached on Dec. 18, 2008, after the collapse of Lehman Brothers drove investors to the safe haven of Treasurys.

Not Alone

The Fed is not alone in keeping central bank short-term rates close to zero (Chart 1) in response to sluggish and declining global economic growth and the inability of massive monetary and fiscal stimuli to revive economic activity. The outlier among major central banks is the ever-inflation wary European Central Bank, the spiritual descendant of the German Bundesbank and based in Frankfurt, Germany, for good reason. The ECB raised its target rate in April and again in July to 1.5% in response to Eurozone consumer inflation above its 2% annual rate target for the overall index. Nevertheless, ECB President Trichet apparently has put further increases on hold and may later cut its rate in response to unfolding weakness and persistent financial turmoil in Europe.

Zero interest rates are significant for several reasons. Zero is the floor below which rates normally don’t fall, although the 3-month Treasury bill rate recently was negative amidst investors’ mad rush for liquidity and the safe haven of government paper. More importantly, at zero interest rates, strange things happen in security, currency and commodity markets that don’t fit normal rules. This doesn’t mean that actions are illogical and don’t follow rational behavior, but rather that the rules of difference. Most observers don’t understand thoroughly the new norms, their causes and effects. Most significantly, central bankers and fiscal policy managers don’t seem to either, which makes forecasting the outcome of their actions and the unintended consequences extremely difficult.

How We Got Here

You’ll probably recall how the Fed got to its current federal funds target of 0-0.25%. In early 2007, the subprime residential mortgage market started to fall apart. By August, the Fed had cut its discount rate and the federal funds target rate shortly thereafter, initiating the declines that resulted in the current levels.

In 2008-2010, in what became known as QE1, the Fed bought $300 billion in Treasurys, $1.25 billion in residential mortgage- related securities and $100 billion in Fannie Mae and Freddie Mac securities in an attempt to further prop up the faltering housing market and reduce mortgage rates. But these efforts were of little aid to the housing market, and prices resumed their decline in mid-2010 after the effects of the tax credits for new home buyers expired. So, in August 2010, Fed Chairman Bernanke hinted at QE2, which was implemented in late 2010, ran through mid-2011 and initiated the purchase of a net additional $600 billion in Treasurys.

No Follow-On Effects

Like QE1, QE2 did put money in the hands of investors in return for Treasurys, but had no follow-on effects. As we’ve discussed repeatedly in past Insights, the Fed creates reserves by buying Treasurys and other securities. It doesn’t print money, as the media insists, except for paper currency to satisfy public demand. It requires the cooperation of the banks as lenders and the creditworthy borrowers to turn those reserves into loans and money. But banks and borrowers have been reluctant to do so and excess reserves over and above reserve requirements now total about $1.6 trillion. Nonfinancial businesses have more than ample cash and little desire to borrow. Creditworthy individuals are also reluctant to borrow, and instead are paying down their mortgage and other debts.

Mortgage Rates

With QE2, the Fed did not achieve its goal of reducing mortgage rates further to aid distressed homeowners. When Fed Chairman Bernanke hinted at QE2 last August, 30-year fixed rate mortgage rates did fall along with 10-year Treasury note yields to which they are linked, but then rose when the program was finally announced in November. Was this a classic case of buy the rumor, sell the news?

The central bank did, however, succeed in staving off the threat, or at least the fear, of deflation as QE2 fueled the already rapidly expanding commodity bubble. And it succeeded in stimulating stock prices. Apparently, investors reacted as usual to Fed ease by buying equities even though the usual and crucial intervening step—the creation of money through the lending of bank reserves to finance those purchases—has been missing. The same response no doubt hyped the commodity bubble, which also has been fed by expectations of China and other developing lands buying all the industrial and agricultural commodities in existence.

The leaps in stocks and commodities were reversed last spring, however. The 2010 sovereign debt crisis in Europe was re-run with increased intensity and, now, the feeling of hopelessness. U.S. consumer confidence has nosedived in response to Washington’s handling of the federal debt limit and fiscal restraint as well as persistent high unemployment. And the prospects of slower global growth if not recession threatens recent rapid growth in corporate profits (Chart 2).

Two-Tier Recovery

Furthermore, we doubt seriously that the Fed’s goal with QE2 was to aid just the folks on top while punishing the lower tier with the higher energy and food costs that flowed from the commodity bubble. But that’s what happened. Until very recently, Americans on the top have benefited from the two-year rally in stocks, commodities, foreign currencies and other investments that were slaughtered during the Great Recession. The rest of Americans are more affected by lingering high unemployment and by falling house prices that are likely to drop another 20%.

Pushing On A String

Despite their lack of effectiveness, QE1 and QE2 as well as earlier non-interest rate Fed policy actions were undertaken because conventional monetary policy, cutting the federal funds rate, was not doing the job. And for two distinct reasons.

First, as usual, the Fed was pushing on the proverbial string. Pulling the string, raising rates, works because borrowers are priced out of the market by rising interest costs. But lowering rates, pushing on the string, may not be effective if creditworthy borrowers, as at present, don’t want to borrow and banks, due to fear and regulations, don’t want to lend. Second, the depth and breadth of the financial crisis, the collapse in housing, the ongoing sovereign debt crisis in Europe, Japan’s continuing two-decade-old deflationary depression, the impending hard landing in China, etc. make the monetary policy string much more limp than usual.

No QE3

Many forecasters expected Chairman Bernanke to announce some sort of QE3 at August’s Jackson Hole conference, but were unclear what it would entail or how it would help. Would adding another $500 billion in excess reserves to the current $1.6 trillion do any more to induce lending and borrowing? In any event, at that conference, Bernanke proposed no new measures but said that the Fed still has “a range of tools that could be used.”

The Fed Chairman seems to be admitting that the Fed is out of bailout buckets with federal funds now at zero and quantitative easing anything but a raging success. It’s also true that except for bailouts of specific banks, monetary policy is very unspecific. Cutting interest rates may or may not encourage borrowing and investing, but it’s up to the lenders and creditworthy borrowers to decide where any loans get spent. QE2 temporarily helped the upper tier holders of stocks and commodities, but hurt the lower tier at which it probably was aimed by pushing up grocery and gasoline prices, as noted earlier. In contrast, fiscal policy measures can be quite precise. Helping the unemployed by extending jobless benefits does put money in their specific pockets.

Zero-Rate Problems

We’ll turn to the effects of zero interest rates outside the Fed shortly, but first note that it creates problems for the central bank itself, often with unknown

consequences. Reaching the zero federal funds rate forced the central bank into the quantitative easing business with unexpected and, on balance, poor results and meager effects. This and earlier non-interest rate actions also pushed the Fed uncomfortably close to fiscal policy, which put it in unknown territory and threatened its independence.

This zero federal funds target also led to the strange negative return on 1- month Treasury bills on August 4 during the stampede for liquidity. Investors were paying the Treasury to lend it their money (Chart 3)! Furthermore, a zero federal funds rate leaves the Fed no room to cut it when the next recession looms and the central bank want to provide some offset.

Some observers believe that the recent first time ever negative return on the 10-year Treasury Inflation-Protected Securities (TIPS) is so strange that it belongs in Ripley’s Believe It Or Not! Those folks neglect to mention that TIPS returns are adjusted for inflation. So if inflation over 10 years turns out to be 2% annually, a zero yielding 10-year TIPS will return 2% per year for that decade. Indeed, the spread in returns between TIPS and comparable maturity Treasurys measures market expectations for inflation. The current 2% difference for 10-year securities suggests that investors expect a 2% inflation rate because they are indifferent between the TIPS at 0% and the 10-year Treasury note at 2%.

Bond Bubble

Many observers believe that low, zero short-term rates have forced investors into longer-term Treasurys, which has pushed yields down and prices up (Chart 4), creating a bond bubble which is sure to break. Well, maybe, but we’ve been hearing similar "bond bubble" arguments since 1981 when 30-year Treasurys yielded 15.25% and we declared that “We’re entering the bond rally of a lifetime.” The rest, as they say, is history.

We persist in our conviction that 10-year Treasury coupon yields, which briefly fell below 2% in August, will continue to drop (Chart 5). We also continue to forecast a further drop in 30-year yields, now 3.6%, to 3% and perhaps even to the 2.6% reached at the end of 2008 amidst the Lehman collapse scare. One well-known bond manager sold off all his Treasurys early this year and then sold them short. He said that owners of government bonds were like frogs slowly being boiled alive and oblivious to the risks of owning Treasurys. As they say, the rest is history.

Bank Famine

U.S. banks are paying almost nothing for deposits, which continue to rise in a mad stampede for safety and liquidity. 2.5% Since December 2007, domestic deposits have leaped $1.1 trillion to $8.1 trillion. Indeed, Bank of New York Mellon last month began charging a fee for corporate cash deposits of over $50 billion, and others may be contemplating similar moves. The reason is that even cheap deposits—which on average pay 0.79%, with checking accounts close to zero—aren’t profitable to banks unless they can be lent at margins big enough to cover costs.

And that’s increasingly difficult as the yield curve flattens. One-month Treasury rates were essentially zero two years ago, as they are now, but in the meanwhile, rates for the longer term, in which banks normally lend or buy Treasurys, have fallen considerably. Of course, things aren’t as severe for bank spread lending as in early 2007 when the yield curve was inverted with short rates actually above long rates. The Fed had raised its federal funds target in the 2004-2006 era before it began slashing it in reaction to the financial crisis.

The squeeze on bank interest rate margins couldn’t come at a worse time for banks. With the sluggish economy, total loan demand has been subdued. That weakness is across the board, including commercial and industrial loans to business and consumer credit card borrowing. And with another recession in prospect, loan demand is destined to fall considerably.

Leveraged Up

Bank yields on assets are in a distinctly downward trend, which will no doubt persist as the Fed continues to keep short rates at zero for two more years and as the likely recession unfolds. No wonder that all of the six largest U.S. bank stocks recently traded at less than their net worth.

U.S. banks also have considerable exposure to the sovereign dent troubles in Europe. Of their global total exposure, 26% is in the Eurozone and it’s 45% if the U.K. is included. European banks are in worse danger due to their heavy ownership of the sovereign debt of troubled Eurozone countries. And their stocks were dumped by shareholders last month. Of course, the Standard & Poor’s downgrade of U.S. Treasurys didn’t help American and foreign banks that hold huge quantities of U.S. government securities.

Treasury Downgrade

The essentially zero federal funds rate measures the Fed’s reaction to persistent economic weakness and financial woes here and abroad. These same realities resulted in the seemingly diametric reaction in Treasury bonds when S&P cut its rating on government obligations after trading ended on August 5. This long-anticipated announcement was expected by many (but not us) to result in a collapse in bond prices as Americans and foreigners abandoned tarnished Treasurys. After all, S&P was reacting to the nonstop leap in federal deficits and debt and Washington’s weak response during the debt limit debate charades.

Instead, when trading opened on Monday, August 8, Treasurys continued the leap that commenced at the beginning of the month. And that day, 1-month and 3-month Treasury bills yielded a mere 0.02%. Why? The downgrades enhanced the global rush for safety and liquidity that had started in late July in reaction to the European sovereign debt crisis and slowing global economic growth with necesary overtones. On August 8, the Dow Jones Industrial Average fell 5.5%, the biggest drop since December 2008. Amazingly, all 30 Dow stocks fell and all 500 stocks in the S&P 500 Index suffered losses. Furthermore, corporate bonds and commodities were dumped. Falling confidence in Europe turned joy over ECB plans to support Spanish and Italian bonds to dismay over a possible downgrade of France’s triple-A credit rating.

Follow-on downgrades of government-controlled Fannie Mae and Freddie Mac as well as five triple-A insurers that tend to have sizable Treasury holdings also enhanced the stampede to Treasurys and other safe havens. The $2.9 billion loss for Fannie on home mortgages in the second quarter and posted August 5, up from $1.2 billion a year earlier, and its request for $2.8 billion more in government bailout money didn't help either. Also downgraded were 73 bond funds, ETFs and hedge funds with 50% or more direct and indirect exposures to Treasurys and government agency securities. We continue to have big 30-year Treasury bond holdings in portfolios we manage, but fortunately aren't rated so we couldn't be downgraded. Ten of the 12 Federal Home Loan Banks also had their credit ratings cut by S&P as were the ratings on 11,000 municipal issuers—to keep them in line with the lower Treasury rating.

Without doubt, there is a huge global crisis of confidence at present. It essentially results from the realization that governments, through their monetary and fiscal policies, have no magic bullets they can fire to return the economy to the 1980s-1990s salad days of rapid growth and soaring stocks. This is The Age of Deleveraging, and all the government efforts to date pale in relation to the deleveraging in the private sector.

Since early 2006, U.S. federal plus state and local debt has jumped from around 3% of GDP to 9.6% in the first quarter, or about a seven percentage point rise. But during the same time, the private sector delivered from about 16% borrowing-to-GDP to -0.5%, a 16 percentage point drop. So all the government deficits that lay behind that borrowing and the fiscal stimulus they represent offset less than half the deleveraging of the private sector.

Negative Effects

A key reason why monetary and fiscal policymakers are out of ammo is because of the questionable effects of earlier efforts. Quantitative easing by the Fed piled up $1.6 trillion in excess bank reserves that lie idle while pushing up grocery and gasoline prices for lower-tier consumers, the very people the Fed aimed to help. Fiscal stimuli added over $1 trillion to federal deficits and debt, spawning such a public and political outcry that further massive programs are off Washington’s table.

In Europe, it’s becoming clear that the Eurozone either breaks up or moves toward more unity and more bailouts. We’ve believed since the euro was established in 1999 that the basic flaw was combining the Teutonic North with the Club Med South under a common currency with no central fiscal control or prospect of it in such diverse lands. The current hope is to create a Eurobond to finance sovereign debts for which the Eurozone as a whole will be responsible.

But that would require central control over national tax and spending policies, a difficult change to sell to profligate countries like Greece and Portugal. It also means that the strong countries, led by reluctant Germany, would continually subsidize the Club Med set. At present, the Eurozone fiscal deficit as a whole is about 4.4% of GDP, not that bad since it’s held down by the Teutonic North’s fiscal discipline, and debt-to-GDP is around 87%, far from the number for Greece and Ireland.

So the Eurozone as a whole would be a strong borrower. But how much more debt could be piled on the underlying backs of Germany, the Netherlands, Finland and other strong economies before Eurobonds become junk? Furthermore, eurozone economies are slipping toward recession, as evidenced by the nosedives in consumer and business confidence.

Government Deleveraging

The reality is that governments, which escalated their monetary and fiscal leverage to bail out financial markets and other private sectors, are now being forced to join those private economic units in deleveraging. Attempts to hold back the tide, such as the limits on selling stocks short in France, Italy, Spain and Belgium, are ineffective attempts to blame market weakness on rumor-mongers and unscrupulous traders.

This is not to say that all the earlier monetary and fiscal stimuli here and abroad was in vain, even though it didn’t offset the massive private sector deleveraging and return economies and finance markets to robust health. The basic data shows that from the beginning of the recession in December 2007 through July 2011, disposable (after-tax) personal income rose $960 billion, $705 billion from increases in government transfers and tax reductions. From the $960 billion, 31% was saved, much more than the current average saving rate of 5%, but 78% was spent.

Dash To Cash

With the global crisis of confidence has come a universal lust for liquidity, especially cash. In the week ending August 1, the M2 money supply, which includes currency in circulation, bank deposits and retail money market funds, leaped $159 billion, or 1.7%, the third biggest jump since 1980. In perspective, the biggest was 3.2% right after 9/11 and the second, the 2.3% gain in the week of September 2, 2008 when Lehman collapsed (Chart 6).

In Europe, bank deposits at the ECB hit a 2011 high of €145 billion in early August even though that central bank pays a lower interest rate than interbank markets. And many banks probably will need the money later. The July “stress tests” were widely viewed as too easy to pass, as reinforced by an unusual move recently by the International Accounting Standards Board. It said that some European banks are using their own models to value Greek debt rather than the required market prices to determine the securities’ fair value. The “mark to model” rather than “mark to market” approach vastly overvalues the troubled Greek government debt they hold that has collapsed in value. Yields on 2-year Greek government debt hit a record of 43% in late August. Similarly, drops in the value of Spanish and Italian government bonds have impaired the balance sheets of their banks which hold large quantities of those sovereigns.

In July, the Committee on the Global Economic System, a central bank oversight group, said that an increase in “sovereign risk adversely affects banks’ funding costs through several channels, due to the pervasive role of government debt in the financial system.” The declining value of government debt, the panel went on, could weaken bank balance sheets and make bank funding more difficult. Indeed, European banks have been scrounging for U.S. dollars to add to their already-large liquidity hordes as U.S. money markets and other traditional sources became reluctant to lend to them.

Stressed Greek Banks

Meanwhile, Greek banks are stressed by massive withdrawal of deposits that move to safe-deposit boxes and under mattresses. One unlucky saver stashed cash in a brick wall but rats ate it. Deposits in Greek banks by households and businesses peaked at €238 billion in September 2009, but plummeted to €188 billion this June. About half of these withdrawals have fled the country, the central bank estimates, as chronic tax evaders fear a crackdown.

The Greek bank withdrawals have led to a bank liquidity shortage and increased reliance in the ECB for funding, and also to bank lending cuts and a further deepening in the Greek recession. The government now estimates a 5% drop in GDP this year compared to the 3.8% decline forecast on July 1.

Furthermore, Greek banks have heavy exposure to Greek government bonds, now rated junk, so they're frozen out of the interbank lending market. Piraeus Bank recently announced a €1 billion writedown of its bond holdings. It's also borrowing from a special central bank fund used to cover cash needs, the second Greek bank to do so, since its collateral is too weak to back ECB loans. The Piraeus writedown was part of the second Greek bailout deal reached in July.

The ongoing banking crisis no doubt was key to the recent decision of EFG Eurobank Ergasias and Alpha Bank, Greece’s second and third largest banks, respectively, to merge into the nation’s largest. This strikes us as two drunks leaning on each other in an attempt to keep each other standing.

Junk

Another result of the zero interest rate world was the earlier investor rush to junk securities in their zeal for higher yields. That drove the spread between junk bonds and Treasurys from its 20 percentage point peak in December 2008 almost back to the previous low in June 2007, according to our friend, Prof. Ed Altman of NYU. In 2009, junk bonds’ appreciation and interest returns combined were 57.3% and a further 15.3% in 2010. As in earlier boom times, investor zeal made refinancing sub-investment-grade securities easy, so defaults in the first half of 2011, at 0.2%, were also near record lows. Refinancing money was so readily available that defaulting on junk securities took real skill.

But the August agonizing reappraisal of financial markets has hit junk hard. Retail investors, who poured $2.8 billion into junk mutual funds in July and $43.8 billion between March 2009 and February 2011, yanked out $4.6 billion in the first three weeks of August. That forced junk mutual funds to sell securities, resulting in a -5.1% total return in the same weeks.

The junk yield spread over Treasurys, using Barclays Capital High Yield Index, leaped to 7.66 percentage points last month— the highest since November 2009—from 5.87 points at the end of July. This spread level, in the past, is associated with recessions when slow growth and lack of junk security financing hypes default rates.

With this rapid reversal, it’s not surprising that the junk issuers raised only $1.2 billion in August, down 93% from July’s $18.2 billion and the lowest since the market dried up in December 2008.

REITs also benefited from investor zeal for yield in a low interest rate world. Also, investors earlier saw them as immune from Europe's debt crisis and benefiting from the expected revival in economic growth and employment and the resulting demand pick-up for commercial real estate. In the first half of 2011, the Dow Jones Equity All REIT Index was up 9.9% vs. 6% for the S&P 500. In the last two years, REITS returned about 30% annually.

As Insight readers know, however, we've been cautious on REITs except for those involved with rental apartments and medical office buildings, and felt their stocks got way too far ahead of themselves. Recently, they've fallen back along with stocks in general. Also, lending for commercial real estate-backed securities is drying up, curtailing REIT acquisitions and debt refinancing. And the looming recession will cut demand for office space, hotel rooms and warehouses.

Are Stocks Cheap?

Low and zero interest rates also influence investors’ views of the values of stocks. The theory says that lower interest reduces the discounting rate that converts future earnings into current stock values and thereby raises their present worth. Also, lower interest rates are supposed to raise price-earnings ratios by making stocks cheaper relative to bonds.

In any event, stock bulls and many equity analysts believe that corporate profits growth has been so robust that even considerable economic weakness will not depress stock prices significantly from current levels. And, as usual, equity analysts see robust company-by-company earnings for 2012, with a gain of 14.4% for this year’s estimate for S&P 500 operating earnings. More sober, top-down strategists still look for a rise of 5.9%. Those numbers put the S&P 500 currently selling at 10.3 and 11.4 times next year’s earnings, respectively—reasonably cheap relative to the 19.0 average P/E since 1960.

But only two quarters of 2011 earnings are recorded so far, and estimates for the second half may prove to be far too rosy, jeopardizing the bottom-up analysts’ forecast of a 17.8% gain for 2011 and 14.8% for the top-down strategists. Similarly, their forecasts for 2012 may prove unrealistically optimistic.

We’ve never understood the concept of P/Es that compare current prices with next year’s earnings forecast. It strikes us somehow as double- discounting, of forecasting future earnings and then treating those forecasts as certain enough to determine the current values of stocks. This approach works in long bull markets with steady earnings gains, but come a cropper when the bear visits.

Our friend, Yale Professor Robert Shiller, avoids this problem as well as the volatility of recent corporate earnings by calculating the S&P 500 P/E based on earnings over the last 10 years (Chart 7). His average since 1960 is 19.4, implying that stocks in July when his P/E was 22.9 were 18% overvalued. More important, in reaching that long-term average P/ E of 19.4, stocks spend about half the time above it and half below. Most of the last decade has been above the average line, so there may be some catching up on the down side. This fits our view of a decade or so of deleveraging and a secular bear market that started in 2000.

The U.S. and Japan

Interest rates close to zero and all the related issues are relatively new in the U.S. and Europe, but they’ve been around in Japan for two decades. So, many wonder if the U.S. is headed for Japan’s 20-years-and-running deflationary depression. And regardless, what does the Japanese experience tell us about living in this atmosphere?

There are a number of similarities that suggest that America is entering a comparable long period of economic malaise. The Age of Deleveraging forecasts a similar decade, at least quite a few years, of slow growth and deflation as financial leverage and other excesses of past decades are worked off. The recent downgrade of Treasurys by S&P parallels the first cut in Japanese government bond ratings in 1998, followed by S&P’s cut to AA-minus early this year and Moody’s reduction from Aa2 to Aa3 last month.

The recent slow growth in the U.S. economy—real GDP gains of 0.4% in the first quarter and 1.0% in the second—looks absolutely Japanese. Furthermore, the prospects of substantial fiscal restraint in the U.S. to curb the federal deficit is reminiscent of tightening actions in Japan in the mid-1990s. The economy was growing modestly, but deficit- and debt-wary policymakers in 1997 cut government spending and raised the national sales tax to 5%. Instant recession was the result.

Big government deficits in recent years are another similarly between these two countries and the U.S. net federal debt-to- GDP ratio is headed for the Japanese level. Japan’s gross government debt last year was 226% of GDP, far and away the largest ration of any G-7 country. All governments lend back and forth among official entities so their gross debt is bigger than the net debt held by non-government investors, and Japan does more of this than other developed lands. Still, on a net basis, her government debt-to-GDP is only rivaled by Italy’s and leaped from a mere 11.7% in 1991 to 120.7% in 2010. Is the U.S far behind (Chart 8)?

Japan, in reaction to chronic economic weakness, has spent gobs of money in recent years, much of it politically-motivated but economically questionable, like paving river beds in rural areas and building bridges to nowhere. Is that distinctly different than the U.S. 2009 $814 billion stimulus package that was supposed to finance shovel-ready infrastructure projects when, in reality, the shovels had not even been made yet?

A key reason for the 2009 and 2010 U.S. fiscal stimuli and continuing deficit spending in Japan is because aggressive conventional monetary ease did not revive either economy. Zero interest doesn’t help when banks don’t want to lend and creditworthy borrowers don’t want to borrow . Both central banks found themselves in classic liquidity traps, so both resorted to quantitative ease, without notable success.

But Differences, Too

There are, then, many similarities between financial and economic conditions in the U.S. and Japan. Nevertheless, there are considerable differences that make her experience in the last two decades questionable as a model for America in future years.

The Japanese are stoic by nature, always looking for the worst outcome while Americans are optimistic—not as optimistic as Brazilians, but still prone to look on the bright side. Otherwise, why would the Japanese voters stand for two decades of almost no economic growth? Japanese are comfortable with group decision-making while Americans revere individual initiative, something the Japanese disdain. The nail that sticks up will be pounded down, is a favorite expression there. Perhaps because of this, the government bureaucracy in Japan is much stronger than in the U.S. while elected officials have less control and room for initiative.

Despite little economic growth, Japanese enjoy high living standards. And the Japanese are an extremely homogenous and racially-pure population.In a related vein, immigration visas don't exist in Japan, so there’s nothing in Japan like the chronic shift of U.S. income to the top quintile. Nothing like the two-tier economic recovery that benefited top-tier stockholders in 2009-2010, but left the rest struggling with collapsing prices for their homes and high unemployment.

Export-Led

Japan in the post-World War II era has been an export-led economy. “Export or die,” is the watchword. The result of robust exports and weak imports linked to anemic domestic spending is her perennial current account surpluses, which, along with earlier high saving by households and now by businesses, allow her to finance her huge government deficits internally, with foreigners owning only 5%. As a result, her government bond yields are extremely low.

In contrast, the U.S. is a chronic importer with a chronic current account deficit. So foreigners have perennially bought Treasurys with the resulting dollars they earn, and they now own about 50% of them. And Treasury note and bond yields are much more controlled by global forces and higher as well than in Japan.. The U.S. is largely an open economy but Japan’s, except for her formidable export sector, is largely closed to the outside world.

Another big difference is the chronic strength in the yen and long-time weakness in the dollar, resulting in part from the difference between Japan’s chronic current account surplus and America’s chronic deficit. Even near-zero short-term rates and 10-year government bond yield of about 1% do not deter those who lust for the yen. Of course, in a zero interest rate world where interest returns have dropped close to traditionally low Japanese levels in the U.S. and elsewhere, Japan at present does not have much of a competitive disadvantage.

The yen’s strength has led to Japanese manufacturers moving much of their production to lower-cost areas, but deflation in Japan has offset some of the difference. Corrected for deflation and on a trade-weighted basis, including trading partners such as Switzerland with robust currencies, the yen has been relatively flat since the 1980s, according to a Bank of Japan analysis.

Nevertheless, the government has intervened in currency markets numerous times, most recently spending $13 billion in early August, to arrest the yen’s climb vs. the greenback. And, of course, a government intervening against its own currency can’t run out of ammunition since it can easily create more of its own currency to sell on the open market. Still, intervention success has been limited, short- lived and expensive. Even a determined government with unlimited ammo has not been able to overcome the gigantic global currency markets that trade trillions of dollars daily.

We conclude that the differences between the U.S. and Japan are too great to use the Japanese economic experience in the last two decades as a template for the U.S. in coming years. Still, as discussed in The Age of Deleveraging, we expect a similar lengthy period of slow growth and deflation as the economy delevers. In any event, can policymakers do much to forestall this outlook? We argue in The Age of Deleveraging and did so earlier in this report that they can’t any more than the Japanese have been able to generate robust economic growth.

Savers Mauled

As we’ve been discussing, near-zero interest rates have distorted the financial and economic scene by pushing many investors into risky investments in foreign lands, commodities, junk securities and other investments they may come to regret. But many remain in bank CDs and money market funds for safety despite almost nonexistent returns.

Money market 7-day interest returns in August were a trivial 0.03%, and they would have been negative in many cases if fund managers had not waived their fees. And this condition will likely persist. The federal funds rate target, which rules other short-term returns, has been in the 0 to 0.25% range for three years, and the Fed intends to keep it there for two more years, barring a burst of inflation or a big drop in unemployment.

Save More or Less?

Will Americans be discouraged by low returns and save less, or will they save more to reach lifetime goals? They'll do the latter, in our judgment, which is one more reason why we expect the saving rate to jump back to double digits. Others, which we’ve discussed many times, include distrust of volatile stocks, the shrinking house appreciation that was tapped earlier to fund oversized spending, the postwar babies’ desperate need to save for retirement and chronic high unemployment, which encourages saving for contingencies.

CBO Forecasts

In last month’s Insight article, “Debt Bomb?,” our analysis slowed how important interest rates are to interest paid on the federal debt, the resulting contribution to deficits and to the growth in the debt total. As we noted then, the average maturity on the public U.S. debt outstanding was only 4.75% in 2010, at the low end of the yield curve. Furthermore, long-term Treasurys’ share of the debt outstanding has shrunk in the last decade.

The nonpartisan Congressional Budget Office’s new projections, which incorporate the reductions in federal spending enacted in August but also assume that the Bush tax cuts will expire on schedule, result in deficits totaling $3.5 trillion over the next decade, down from the $7 trillion forecast in January. The CBO assumes that GDP growth basically catches up from the depressed rates of recent years, rising to 5.0% annual growth in 2015 before dropping back to 2.3% in 2020 and 2021.

In contrast, we see slower annual growth, 2.0%, throughout the decade. The unemployment rate is assumed by the CBO to drop back to 5.2%, again very optimistic in our judgment. Faster economic growth propels taxes and thereby restrains the deficit while also reducing the deficit-to-GDP and debt-to-GDP ratios by enlarging their denominators. Lower unemployment also eliminates the deficit-enhancing pressure to create more jobs that concerns us.

The CBO sees 3-month Treasury bill rates rising gradually to 4.0% over the next decade and 10-year Treasury note yields to 5.3%. Its net interest paid projections divided by the CBO's debt forecasts yield its effective interest rate for financing the debt, and it rises from 2.2% last year to 4.6% in 2021. As a result, net interest-to-GDP peaks at 2.8% in 2020, below the earlier peak of 3.2% reached 20 years ago. Even with the CBO’s assumptions that the effective interest rate on the federal debt jumps from 2.2% to 4.6%, interest costs-to-GDP does not skyrocket. With our projection of no rise in interest rates over the next decade, interest costs-to-GDP reaches only 2.4% in 2021 even if we assume that the debt held by the public rises $1 trillion per year for a decade and nominal GDP rises only 2% annually. Either way, relatively low interest rates in future years will help contain interest paid-to-GDP ratios for the federal government and, therefore, growth in the government deficits and debt.

Obama’s Dilemma: U.S. Foreign Policy and Electoral Realities

John Mauldin — Thu, 22 Sep 2011 18:26:00 GMT

Folks, this piece from STRATFOR has compelled me to focus on the US for one more day before I head off to Europe. You've seen the articles and other insights I send on occasion from George Friedman, my friend and prophetic author of The Next 100 Years and The Next Decade, both bestsellers. Well, this article takes the cake. George is the founder of a geopolitical intelligence company called STRATFOR, whose focus is international affairs. But on the rare occasion when domestic politics and international affairs intersect, it's always a treat to get George's insight.

I don't even want to give away any spoilers here. It's better to let you follow first-hand, as George builds his argument and arrives at a profound final conclusion. Let me just say: In Endgame, as you know, I predict that we will deal with the deficit in a controlled manner, or face disastrous consequences. Here, we learn how the realities of the next 14 months before the presidential election present some potential global consequences of their own.

If these occasional samples (which I get special permission from George to send) aren't enough for you, my intelligent readers, I recommend you get full access as a STRATFOR subscriber. OTB readers get a<<steep discount on subscriptions and a free copy of George's latest book>>, which I mentioned above. I suggest you investigate. I read them every day myself.

John Mauldin, Editor
Outside the Box

Obama's Dilemma: U.S. Foreign Policy and Electoral Realities

September 20, 2011

By George Friedman

STRATFOR does not normally involve itself in domestic American politics. Our focus is on international affairs, and American politics, like politics everywhere, is a passionate business. The vilification from all sides that follows any mention we make of American politics is both inevitable and unpleasant. Nevertheless, it's our job to chronicle the unfolding of the international system, and the fact that the United States is moving deeply into an election cycle will affect American international behavior and therefore the international system.

The United States remains the center of gravity of the international system. The sheer size of its economy (regardless of its growth rate) and the power of its military (regardless of its current problems) make the United States unique. Even more important, no single leader of the world is as significant, for good or bad, as the American president. That makes the American presidency, in its broadest sense, a matter that cannot be ignored in studying the international system.

The American system was designed to be a phased process. By separating the selection of the legislature from the selection of the president, the founders created a system that did not allow for sudden shifts in personnel. Unlike parliamentary systems, in which the legislature and the leadership are intimately linked, the institutional and temporal uncoupling of the system in the United States was intended to control the passing passions by leaving about two-thirds of the U.S. Senate unchanged even in a presidential election year, which always coincides with the election of the House of Representatives. Coupled with senatorial rules, this makes it difficult for the president to govern on domestic affairs. Changes in the ideological tenor of the system are years in coming, and when they come they stay a long time. Mostly, however, the system is in gridlock. Thomas Jefferson said that a government that governs least is the best. The United States has a vast government that rests on a system in which significant change is not impossible but which demands a level of consensus over a period of time that rarely exists.

This is particularly true in domestic politics, where the complexity is compounded by the uncertainty of the legislative branch. Consider that the healthcare legislation passed through major compromise is still in doubt, pending court rulings that thus far have been contradictory. All of this would have delighted the founders if not the constantly trapped presidents, who frequently shrug off their limits in the domestic arena in favor of action in the international realm, where their freedom to maneuver is much greater, as the founders intended.

The Burden of the Past

The point of this is that all U.S. presidents live within the framework in which Barack Obama is now operating. First, no president begins with a clean slate. All begin with the unfinished work of the prior administration. Thus, George W. Bush began his presidency with an al Qaeda whose planning and implementation for 9/11 was already well under way. Some of the al Qaeda operatives who would die in the attack were already in the country. So, like all of his predecessors, Obama assumed the presidency with his agenda already laid out.

Obama had a unique set of problems. The first was his agenda, which focused on ending the Iraq war and reversing social policies in place since Ronald Reagan became president in 1981. By the time Obama entered office, the process of withdrawal from Iraq was under way, which gave him the option of shifting the terminal date. The historic reversal that he wanted to execute, starting with healthcare reform, confronted the realities of September 2008 and the American financial crisis. His Iraq policy was in place by Inauguration Day while his social programs were colliding with the financial crisis.

Obama's campaign was about more than particular policies. He ran on a platform that famously promised change and hope. His tremendous political achievement was in framing those concepts in such a way that they were interpreted by voters to mean precisely what they wanted them to mean without committing Obama to specific policies. To the anti-war faction it meant that the wars would end. To those concerned about unilateralism it meant that unilateralism would be replaced by multilateralism. To those worried about growing inequality it meant that he would end inequality. To those concerned about industrial jobs going overseas it meant that those jobs would stay in the United States. To those who hated Guantanamo it meant that Guantanamo would be closed.

Obama created a coalition whose expectations of what Obama would do were shaped by them and projected on Obama. In fact, Obama never quite said what his supporters thought he said. His supporters thought they heard that he was anti-war. He never said that. He simply said that he opposed Iraq and thought Afghanistan should be waged. His strategy was to allow his followers to believe what they wanted so long as they voted for him, and they obliged. Now, this is not unique to Obama. It is how presidents get elected. What was unique was how well he did it and the problems it caused once he became president.

It must first be remembered that, contrary to the excitement of the time and faulty memories today, Obama did not win an overwhelming victory. About 47 percent of the public voted for someone other than Obama. It was certainly a solid victory, but it was neither a landslide nor a mandate for his programs. But the excitement generated by his victory created the sense of victory that his numbers didn't support.

Another problem was that he had no programmatic preparation for the reality he faced. September 2008 changed everything in the sense that it created financial and economic realities that ran counter to the policies he envisioned. He shaped those policies during the primaries and after the convention, and they were based on assumptions that were no longer true after September 2008. Indeed, it could be argued that he was elected because of September 2008. Prior to the meltdown, John McCain had a small lead over Obama, who took over the lead only after the meltdown. Given that the crisis emerged on the Republicans' watch, this made perfect sense. But shifting policy priorities was hard because of political commitments and inertia and perhaps because the extremities of the crisis were not fully appreciated.

Obama's economic policies did not differ wildly from Bush's — indeed, many of the key figures had served in the Federal Reserve and elsewhere during the Bush administration. The Bush administration's solution was to print and insert money into financial institutions in order to stabilize the system. By the time Obama came into power, it was clear to his team that the amount of inserted money was insufficient and had to be increased. In addition, in order to sustain the economy, the policy that had been in place during the Bush years of maintaining low interest rates through monetary easing was extended and intensified. To a great extent, the Obama years have been the Bush years extended to their logical conclusion. Whether Bush would have gone for the stimulus package is not clear, but it is conceivable that he would have.

Obama essentially pursued the Bush strategy of stabilizing the banks in the belief that a stable banking system was indispensible and would in itself stimulate the economy by creating liquidity. Whether it did or it didn't, the strategy created the beginnings of Obama's political problem. He drew substantial support from populists on the left and suspicion from populists on the right. The latter, already hostile to Bush's policies, coalesced into the Tea Party. But this was not Obama's biggest problem. It was that his policies, which both seemed to favor the financial elite and were at odds with what Democratic populists believed the president stood for, weakened his support from the left. The division between what he actually said and what his supporters thought they heard him say began to widen. While the healthcare battle solidified his opposition among those who would oppose him anyway, his continuing response to the financial crisis both solidified opposition among Republicans and weakened support among Democrats.

A Foreign Policy Problem

This was coupled with his foreign policy problem. Among Democrats, the anti-war faction was a significant bloc. Most Democrats did not support Obama with anti-war reasons as their primary motivator, but enough did make this the priority issue that he could not win if he lost this bloc. This bloc believed two things. The first was that the war in Iraq was unjustified and harmful and the second was that it emerged from an administration that was singularly insensitive to the world at large and to the European alliance in particular. They supported Obama because they assumed not only that he would end wars — as well as stop torture and imprisonment without trial — but that he would also re-found American foreign policy on new principles.

Obama's decision to dramatically increase forces in Afghanistan while merely modifying the Bush administration's timeline for withdrawing from Iraq caused unease within the Democratic Party. But two steps that Bush took held his position. First, one of the first things Obama did after he became president was to reach out to the Europeans. It was expected that this would increase European support for U.S. foreign policy. The Europeans, of course, were enthusiastic about Obama, as the Noble Peace Prize showed. But while Obama believed that his willingness to listen to the Europeans meant they would be forthcoming with help, the Europeans believed that Obama would understand them better and not ask for help.

The relationship was no better under Obama than under Bush. It wasn't personality or ideology that mattered. It was simply that Germany, as the prime example, had different interests than the United States. This was compounded by the differing views and approaches to the global financial crisis. Whereas the Americans were still interested in Afghanistan, the Europeans considered Afghanistan a much lower priority than the financial crisis. Thus, U.S.-European relations remained frozen.

Then Obama made his speech to the Islamic world in Cairo, where his supporters heard him trying to make amends for Bush's actions and where many Muslims heard an unwillingness to break with Israel or end the wars. His supporters heard conciliation, the Islamic world heard inflexibility.

The European response to Obama the president as opposed to Obama the candidate running against George Bush slowly reverberated among his supporters. Not only had he failed to end the wars, he doubled down and surged forces into Afghanistan. And the continued hostility toward the United States from the Islamic world reverberated among those on the Democratic left who were concerned with such matters. Add to that the failure to close Guantanamo and a range of other issues concerning the war on terror and support for Obama crumbled.

A Domestic Policy Focus

His primary victory, health-care reform, was the foundation of an edifice that was never built. Indeed, the reform bill is caught in the courts, and its future is as uncertain as it was when the bill was caught in Congress. The Republicans, as expected, agree on nothing other than Obama's defeat. The Democrats will support him; the question is how enthusiastic that support will be.

Obama's support now stands at 41 percent. The failure point for a president's second term lurks around 35 percent. It is hard to come back from there. Obama is not there yet. The loss of another six points would come from his Democratic base (which is why 35 is the failure point; when you lose a chunk of your own base, you are in deep trouble). At this point, however, the president is far less interested in foreign policy than he is in holding his base together and retaking the middle. He did not win by a large enough margin to be able to lose any of his core constituencies. He may hope that his Republican challenger will alienate the center, but he can't count on that. He has to capture his center and hold his left.

That means he must first focus on domestic policy. That is where the public is focused. Even the Afghan war and the U.S. withdrawal from Iraq are not touching nerves in the center. His problem is twofold. First, it is not clear that he can get anything past Congress. He can then argue that this is Congress' fault, but the Republicans can run against Congress as well. Second, it is not clear what he would propose. The Republican right can't be redeemed, but what can Obama propose that will please the Democratic core and hold the center? The Democratic core wants taxes. The center doesn't oppose taxes (it is merely uneasy about them), but it is extremely sensitive about having the taxes eaten up by new spending — something the Democratic left supports. Obama is trapped between two groups he must have that view the world differently enough that bridging the gap is impossible.

The founders gave the United States a government that, no matter how large it gets, can't act on domestic policy without a powerful consensus. Today there is none, and therefore there can't be action. Foreign policy isn't currently resonating with the American public, so any daring initiatives in that arena will likely fail to achieve the desired domestic political end. Obama has to hold together a coalition that is inherently fragmented by many different understandings of what his presidency is about. This coalition has weakened substantially. Obama's attention must be on holding it together. He cannot resurrect the foreign policy part of it at this point. He must bet on the fact that the coalition has nowhere else to go. What he must focus on is domestic policy crafted to hold his base and center together long enough to win the election.

The world, therefore, is facing at least 14 months with the United States being at best reactive and at worst non-responsive to events. Obama has never been a foreign policy president; events and proclivity (I suspect) have always drawn him to domestic matters. But between now and the election, the political configuration of the United States and the dynamics of his presidency will force him away from foreign policy.

This at a time when the Persian Gulf is coming to terms with the U.S. withdrawal from Iraq and the power of Iran, when Palestinians and Israelis are facing another crisis over U.N. recognition, when the future of Europe is unknown, when North Africa is unstable and Syria is in crisis and when U.S. forces continue to fight in Afghanistan. All of this creates opportunities for countries to build realities that may not be in the best interests of the United States in the long run. There is a period of at least 14 months for regional powers to act with confidence without being too concerned about the United States.

The point of this analysis is to try to show the dynamics that have led the United States to this position, and to sketch the international landscape in broad strokes. The U.S. president will not be deeply engaged in the world for more than a year. Thus, he will have to cope with events pressed on him. He may undertake initiatives, such as trying to revive the Middle East peace process, but such moves would have large political components that would make it difficult to cope with realities on the ground. The rest of the world knows this, of course. The question is whether and how they take advantage of it.

Is the US Monetary System on the Verge of Collapse?

John Mauldin — Tue, 13 Sep 2011 06:04:00 GMT

This week we take in a piece that is somewhat outside my own box. There are a number of people who feel strongly that the US (and world governments in general) cannot pull out of the downward spiral they are in, that monetary policy is fixed on printing ever more money, and that the problems of fiat currencies are now coming to the fore.

I was interviewed last week by David Galland and Doug Casey of Casey Research. Those of you familiar with them know they (and especially Doug) have a strong libertarian bent and a distrust of government. Not all that unusual, of course, except that they work at finding ways to invest based on their philosophy. That has meant a lot of gold and natural resources, plus new tech, which has worked at rather well overall.

In the interview, I was the “optimist.” By that I mean I was the guy who thinks the US government will do what is necessary to bring down the deficit beginning in 2013. David pointedly asked, “So you mean your ‘optimism’ is based on your faith that the US political leaders will do the right thing?” And the blunt answer is, “Yes, because not doing it would be a disaster, and I think, based on conversations with some of them, that they actually get that.”

Which is the case I outlined in my book, Endgame.But if I am wrong and we do not deal with the deficit in a controlled manner, then all bets are off. Sadly, the guys at Casey would be right. So, today’s Outside the Box is an op-ed from David Galland.

If you like it you can click on the link at the end and, for the exorbitant price of your email address, you can see the entire webinar (and my part in it), or sign up now at http://www.americandebtcrisis.com?ppref=JMD420ED0911A.

I think this week we’re going to be focused on Europe. I am getting ready for my trip there at the end of next week, so I am reading more about the situation there to prepare myself. But right now let’s focus on the US.

Your wondering where the time goes analyst,

John Mauldin, Editor
Outside the Box

Is the US Monetary System on the Verge of Collapse?

By David Galland of Casey Research

Tune into CNBC or click onto any of the dozens of mainstream financial news sites, and you’ll find an endless array of opinions on the latest wiggle in equity, bond and commodities markets. As often as not, you'll find those opinions nestled side by side with authoritative analysis on the outlook for the economy, complete with the author’s carefully studied judgment on the best way forward.

Lost in all the noise, however, is any recognition that the US monetary system – and by extension, that of much of the developed world – may very well be on the verge of collapse. Falling back on metaphor, while the world’s many financial experts and economists sit around arguing about the direction of the ship of state, most are missing the point that the ship has already hit an iceberg and is taking on water fast.

Yet if you were to raise your hand to ask 99% of the financial intelligentsia whether we might be on the verge of a failure of the dollar-based world monetary system, the response would be thinly veiled derision. Because, as we all know, such a thing is unimaginable!

Think again.

Monetary Madness

Honestly describing the current monetary system of the United States in just a few words, you could do far worse than stating that it is“money from nothing, cash ex nihilo.”

That’s because for the last 40 years – since Nixon canceled the dollar’s gold convertibility in 1971 – the global monetary system has been based on nothing more tangible than politicians' promises not to print too much.

Unconstrained, the politicians used the gift of being able to create money out of nothing to launch a parade of politically popular programs, each employing fresh brigades of bureaucrats, with no regard to affordability.

Such programs invariably surged during political campaigns and on downward slopes in the business cycle when politicians hearing the cries of the constituency to “do something” tossed any concern about balancing budgets out the window of expediency. After all, the power to print up the funds for debt service whenever needed makes moot any concern over deficit spending.

Former VP Cheney, who fashions himself a fiscal conservative, let the mask drop when, in 2002, he stated that “Reagan proved deficits don’t matter.”

Those words were echoed just a few weeks ago, when both former Fed Chairman Alan Greenspan and Obama economic advisor Larry Summers, in separate interviews, said almost the same, paraphrased as, “There is no chance of the US defaulting on its bonds, not when our government can borrow dollars and print new dollars to meet any future obligations.”

Of course, Greenspan and Summers were referring to an overt default – of just not paying – and not to a covert default engineered by inflation. Unfortunately, like virtually all of the power elite, both miss the point that the mountain of debt that has been heaped up since 1971 is fast reaching the point of collapsing like a too-big tailings pile and taking the monetary system down with it.

Importantly, the debt shown in this chart whistles past the government's unfunded liabilities, in particular for the Social Security and Medicare systems. Adding those would more than triple the US government’s acknowledged obligations – to over $60 trillion.

Given the role the US dollar plays as the world’s de facto reserve currency – with all major commodities priced in dollars, and dollars forming the bulk of reserves held by foreign central banks –the dismal shape of the US monetary system spells trouble for the global monetary system.

Making matters worse, following the lead of the United States, governments around the world long ago adopted similar fiat monetary systems. You can see the deficit contagion in this next chart. It is worth noting that the dire condition of the United States now leaves it in the same muddy wallow as Europe’s desperate PIIGS.

In a recent article in The Telegraph, Ambrose Evans-Pritchard referenced a paper out of the BIS that paints the picture using appropriately stark terms.

Stephen Cecchetti and his team at the Bank for International Settlements have written the definitive paper rebutting the pied pipers of ever-escalating credit.

“The debt problems facing advanced economies are even worse than we thought.”

The basic facts are that combined debt in the rich club has risen from 165pc of GDP thirty years ago to 310pc today, led by Japan at 456pc and Portugal at 363pc.

“Debt is rising to points that are above anything we have seen, except during major wars. Public debt ratios are currently on an explosive path in a number of countries. These countries will need to implement drastic policy changes. Stabilization might not be enough.”

Viewing the situation from another perspective, we turn to the work of Carmen Reinhart and Ken Rogoff, who studied the factors contributing to 29 past sovereign defaults. They found that default or debt restructuring occurred, on average, when external debt reached 73% of gross national product (GNP) and 239% of exports. Using the Reinhart/Rogoff findings, Casey Research Chief Economist Bud Conrad prepared the following chart showing that the US government is already far along on the path to bankruptcy.

It’s hard to argue against the contention that the situation is, to be polite, precarious. Given that the obligations of the US government, as well as most of the world’s other large economies, are now impossible to repay and that their reserves are just IOUs backed by nothing, the stage is set for a highly disruptive but entirely necessary do-over of the fiat monetary system.

“Preposterous!” say the lords of finance and masters of all.

Is it?

Of course, these very same mavens completely missed the looming housing crash and the depth and duration of the subsequent crisis – a crisis that is still far from over. In other words, listen to them at your peril, because in our view it’s essential in calibrating your financial affairs to understand that, if history is any guide, we are now well down the road to a collapse in the monetary system.

In fact, over its relatively short history, the US monetary system has come unglued time and time again thanks to politically expedient attempts to interfere with the workings of a free market in order to reward constituents or kick the can on the economic problems of the day down the road.

Thus it is our contention that while the mainstream media focus on the daily gyrations of equity markets or the futile political charade that is Washington, they overlook powerful tectonic rumblings indicating the world’s prevailing monetary system is about to fracture.

A Brief Timeline of US Monetary System Failures

Here’s a brief history of past disruptions here in the United States. Importantly, with the US dollar now the de facto reserve currency of the world, this time around it’s global.

1861 –When the Civil War begins, the dollar is convertible into gold and silver.

1862 –Congress passes the Legal Tender Act and authorizes the issuance of non-redeemable "Greenback" currency. Convertibility into gold and silver is suspended for all US currency.

1863 –National Banking Act authorizes the chartering of banks by the federal government.

1865 – A 10% tax is levied on the issuance of bank notes by state-chartered banks, effectively ending that practice.

1879 –The US Treasury resumes redeeming dollars for gold and silver.

1900 – Passage of the Gold Standard Act, adopting the gold standard by the United States and demonetizing silver.

Specifically, the act provided for "...the dollar consisting of twenty-five and eight-tenths grains (1.67 g) of gold nine-tenths fine, as established by section thirty-five hundred and eleven of the Revised Statutes of the United States, shall be the standard unit of value, and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard..."

But 33 years later, to gain the power to inflate the currency and collect the profit from doing so…

1933 – By executive order, Franklin Roosevelt prohibits the private ownership of gold. Congress passes the Gold Reserve Act, which enacts Roosevelt's executive order, abrogates all gold clauses in all contracts public or private, past or future (which cancels the convertibility of Federal Reserve notes into gold), though it confirms the convertibility of US Treasury notes held by foreigners into gold. Eleven years later, the US government takes its show on the road…

1944 – Bretton Woods system adopted with signature countries agreeing to tie the exchange rates of their currencies to the US dollar, which itself is linked to a fixed price of gold. Foreign trading partners retained the right to swap dollars for gold, imposing a de facto restraint on printing more dollars. For all intents and purposes, the US dollar becomes the world’s reserve currency. But 27 years later…

1971 – Nixon abruptly closes the “gold window,” unilaterally reneging on the Treasury's promise to allow foreign governments to redeem dollars for gold. Bretton Woods collapses. With no remaining tie to a tangible, the dollar is reduced to a paper token. The transition to a global fiat monetary system is complete.

Until 40 years go by and the inevitable consequences of giving politicians free rein over money creation become untenable…

Present day – Sovereign debt crisis. Desperate, debt-laden governments around the globe – the bulk of their reserves composed of fiat US dollars and euros at risk of going up in smoke – turn to the only thing they know, printing more money and issuing yet more debt. The global monetary system cracks and heads toward failure with no workable alternative on the horizon.

Governments, corporations and investors alike are caught unprepared in the downward spiral of failing fiat currencies and are wiped out by a combination of frantic currency debasements, higher taxation, exchange controls and worse. Social unrest spreads, with the public paradoxically demanding that governments do more, not less.

That’s because all the world’s major currencies are at risk, simultaneously, as the issuers engage in a dangerous race to the bottom. As the monetary system moves inexorably toward terminal debasement and collapse, the results will be catastrophic for the unprepared.

Importantly, while the list of historical attempts to re-jigger the US monetary system have, to this point, more or less succeeded in kicking the can a bit further down the road, the sheer scale of today’s government obligations has driven us into a box canyon, with no way out. As the government’s debt and spending obligations are mathematically impossible to resolve, it is now a certainty that a lot of people are going to wake up one morning to the reality that they are a lot poorer than they thought.

Fortunately for those now paying attention, the collapse of a monetary system doesn't happen in a flash. It is a progression, like the spiral of water down a drain. Thus, while no one can predict exactly when the downward spiral will accelerate out of control, there is still time to prepare.

Dark though the lens may be, this is the lens through which we here at Casey Research view all our investments. Simply, being right or wrong about your investment decisions in the years just ahead will be insignificant if the currencies underpinning those investments shrivel to just a fraction of their current values.

The dismal state of the US economy and out-of-control government spending affects every American’s life and wealth. In the free online video event, The American Debt Crisis– How Big? How Bad? How to Protect Yourself, held on September 14, 2011, a Casey Research team of Doug Casey, Bud Conrad, Olivier Garret, Terry Coxon and David Galland will be joined by guests John Mauldin, Mike Maloney and Lew Rockwell to discuss the potential for a breakdown in the monetary system, and specific ways to protect and build your assets. Register for this free event today at www.americandebtcrisis.com?ppref=JMD420ED0911A

Things That Make You Go Hmmm…

John Mauldin — Tue, 06 Sep 2011 17:15:00 GMT

I love Grant Williams and his writing in his letter Things That Make You Go Hmmm... And this week's Outside the Box is the first section from his recent post, where he starts with a brief history of Gadhafi and ends up giving us a tutorial on oil pricing. This may be "inside baseball" (too much detail) for some of you; but these details are important, as the very ground of oil pricing is shifting away from the traditional sources. What will the mainstream media do? Wonder when they will shift, which will result in a LOT higher costs for most of the world. Besides, this is a fun read, and Grant is a great writer.

And quickly, this note From Dennis Gartman: "Finally... and we shall cover this at some greater length tomorrow... S&P has said over the weekend through one of its senior spokespeople in Europe that if a EUR-bond is underwritten it shall have the rating of the lowest rated constituent country involved and thus will have coupon far, far above that of Germany, or France or Belgium et al. A EUR-bond would thus have the credit rating of Greece!"

I may have to write about Europe again this week, as there is just so much going on. The key to watch is the German Constitutional Court decision, due Wednesday. If they rule against the euro, all h#$% will break loose. And they could, although I expect a more moderate outcome, as they realize the entire future of the euro project is riding on their ruling. Do they want to get blamed for imploding the euro?

This week's OTB comes at the end of Labor Day, when all my kids and various friends (some 30-odd) have shown up for food and grilling. I think I am a fair to middling writer and analyst, but I am a brilliant cook (none of this humble analyst stuff in the kitchen!), as all who get to sample my culinary offerings agree. Definitely not low-calorie offerings. Cooking is an all-morning and day affair. Partner Steve Blumenthal of CMG came down Monday morning for some needed businesses meetings, and it may be the first time we met in the kitchen while his partner was cooking. I had to attend to the serious stuff! Butternut squash/carrot soup must cook for 6-8 hours. Mushrooms, veggies, meat, grilling seasoning. They all take time and great attention to detail.

And Steve and Billy Peters (of Baton Rouge) took me to the LSU-Oregon game this Saturday evening in Cowboys Stadium with 87,000 fans, most of whom were from LSU. I have never seen such a rabid (the correct word) crowd. It may be something like English football crowds. I attend professional events all the time, but nothing prepared me for the volume of noise.

Have a great week. The house is starting to smell awesome, and my kitchen calls.

Your my ears are stilling ringing analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm...

"Formula for success: rise early, work hard, strike oil"

– J. PAUL GETTY

"China gets their oil from Libya. Why isn't China involved? They're going out spending billions of dollars a day on trying to take over the world economically. And we're spending billions and billions and billions of dollars on policing the world. Why isn't China involved with Libya?...we don't get oil from Libya, China does."

– Donald Trump

Pythagorean theorem: 24 words
Lord's prayer: 66 words
Archimedes' Principle: 67 words
Ten Commandments: 179 words
Gettysburg address: 286 words
US Declaration of Independence: 1,300 words
US Constitution with all 27 Amendments: 7,818 words
EU regulations on the sale of cabbage: 26,911 words

– Europe's Problems Summed Up

(Thanks Cyril)

On September 1st, 1969, a 27 year-old army captain and son of a Bedouin farmer who had been born in a tent in the Libyan desert in 1942 staged a bloodless coup when King Idris I travelled to a Turkish Spa to receive treatment on an injured leg.

The army captain, one Muammar al-Qaddafi, had graduated from the University of Libya a mere six years earlier and the Libyan military academy in 1965, but somehow he forced himself to the forefront of a group of Arab nationalist insurgents and, once the monarchy had been abolished and Idris banished to first Greece and finally Egypt, he took his place at the head of the newly-formed Libyan government.

And there he would stay – for almost exactly forty two years.

The History Channel takes up the story:

Blending Islamic orthodoxy, revolutionary socialism, and Arab nationalism, Qaddafi established a fervently anti-Western dictatorship in Libya. In 1970, he removed U.S. and British military bases and expelled Italian and Jewish Libyans. In 1973, he took control of foreign-owned oil fields. He reinstated traditional Islamic laws, such as prohibition of alcoholic beverages and gambling, but liberated women and launched social programs that improved the standard of living in Libya. As part of his stated ambition to unite the Arab world, he sought closer relations with his Arab neighbors, especially Egypt. However, when Egypt and then other Arab nations began a peace process with Israel, Libya became increasingly isolated.

It all sounds rather idyllic, doesn't it? Liberating women, improving the standard of living and attempting to unite the Arab world. Let's see Wikipedia's take on the aftermath of Gaddafi's arrival at the helm of the world's 17th-largest oil producer:

After seizing power, Gaddafi proceeded to eliminate any opposition and severely restricted lives of ordinary Libyans. Gaddafi's ideology was termed the Third International Theory and it was described in the Green Book. Gaddafi and his relatives took over much of the economy. Gaddafi started several wars, had a role in others, and spent on acquiring both chemical and nuclear weapons. More covertly, he directed the country's revenues to sponsor terror and other political activities around the world. The United Nations called Libya under Gaddafi a pariah state.

Gaddafi was unpredictable, radical and a force to be reckoned with by the West and his combative stance towards Western oil companies was rewarded with the kind of concessions that would alter the balance of power between OPEC and its biggest customers:

(Wikipedia): In The Age of Oil, historians considered Gaddafi's success in 1970 to be the "decisive spark that set off an unprecedented chain reaction" in oil-producing nations. Libya continued a winning streak against the oil companies throughout the 1970s energy crisis; Later that year, the Shah of Iran raised his demands to match those of Gaddafi. OPEC nations began a game of "leap frogging" to win further concessions from the oil companies after following Gaddafi's lead.

Gaddafi and the Shah of Iran both argued for quadrupling the cost of oil in 1975.

SOURCE: BP

'The oil price' is something of an interesting animal.

Since 1970, the oil price, which had nominally traded in the tightest of ranges since the late 1800s, has experienced enormous volatility with twin inflation-adjusted spikes almost 30 years apart finally being breached earlier this year when Brent hit a high of $126.65 on April 8th of this year.

Back in 2008, when 'the oil price' was hitting record high after record high – peaking at $145.29 in July of that fateful year – 'the oil price' being referred to was West Texas Intermediate (WTI), the light, sweet crude delivered into the facility at Cushing, Oklahoma which holds, at various times, between 5 and 10% of US crude inventory. That same 'oil price' now trades almost 40% lower at $88. Except...

The rumblings began in earnest in 2007 with the release of a Lehman Brothers report which argued that WTI was no longer the benchmark for 'the oil price' due to the fact that it was highly localized and, with the tendency for inventory spikes in what is, with all due respect to any Cushing-based readers, well..... before I get myself into any trouble, I will let an aerial map of Cushing, OK (below) do all the heavy lifting for me.

SOURCE: GOOGLE MAPS

Any questions? Good. Let's press on.

In October of 2009, WTI was dealt another hammer blow by Saudi Arabia:

(FT): Saudi Arabia yesterday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange.

The decision by the world's biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world's most heavily traded oil futures contract...The move reveals the growing discontent of Riyadh and its US refinery customers with WTI after the price of the benchmark became separated from the global oil market this year.

The surge in oil inventories in Cushing, Oklahoma, where WTI is delivered into America's pipeline system, depressed the value of the WTI against other global benchmarks, throwing the global oil market into disarray.

Argus Sour Crude, 2010 – Present

SOURCE: BLOOMBERG

Saudi Arabia moved to a new index developed by Argus in London; the Argus Sour Crude Index. This was assembled to track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon:

(FT): ...Argus said the change in policy reflected the "increased importance of the US Gulf coast sour crude market, in which both production and trading activity was rising sharply".

Paul Horsnell, head of commodities research at Barclays Capital in London, said Saudi Arabia's decision was likely to reflect a "wider discontent" from its customers in the US about WTI performance.

Edward Morse, chief economist at LCM Commodities in New York, said: "It is a recognition by large players that WTI sometimes does not reflect the true value of crude oil in the waterborne market."

Saudi Arabia has priced its oil using WTI since 1994.

And so it was that 'the oil price' gradually became less about the little town in Oklahoma with a population of 9,596 and more about the real world price: and that meant Brent.

Brent Crude, 2006 – Present

Brent Crude vs. WTI, 2007 – 2011 (% change)

SOURCE: BLOOMBERG

It is notable that when people talk about oil having hit its 'highs' of $140 back in 2008 and now trading almost 40% lower they are referring to the price of WTI, which has tumbled back into the $80s, but both Argus Sour Crude (left, top) and the more ubiquitous Brent Crude (left, middle) contracts are still trading within shouting distance of their lifetime highs. The bottom chart shows how Brent and WTI have disconnected from an almost perfect correlation EXACTLY at the time QE2 was announced back in August of 2010 - not that Quantitative Easing is in ANY way responsible for an increase in the price of commodities of course. I want to make that QUITE clear....

Naturally, it is useful when one is in the business of managing an economy and attempting to control inflation while simultaneously printing as much money as one can get away with, to be able to point to a falling oil price as evidence that the dreaded spectre of inflation is not an immediate concern and the weakness in WTI has afforded the US government and their Central Bank sidekicks the luxury of being able to do that, but the stubbornly high price of Brent is becoming something of an irritant.

Back in June when the IEA announced they were releasing 60 million barrels of oil from OECD inventories due to the high price of crude, it was suggested that the main reason for such an action was the loss of oil production that accompanied the beginning of the popular uprising against Colonel Gaddafi and a look at a chart of world oil production (below) shows just how severe a drop-off in price the unrest in Libya caused. What is even more interesting, however, is the chart that follows, which shows Saudi oil production levels at the time of the virtual shutdown of Libyan oilfields with the March data for both countries' output circled. Clearly, Saudi Arabia was either unwilling or unable to plug the Libyan output gap:

SOURCE: GREGOR/EIA

SOURCE: THE OIL DRUM

At the time, Reuters reported on the Saudi response to the supply disruption and it appeared as though they were opening up the spigots:

Saudi Arabia has increased its oil production to more than 9 million barrels per day (bpd) to compensate for disruption to Libyan output, an industry source familiar with the kingdom's production told Reuters on Friday.

"We have started producing over 9 million barrels per day (bpd). We have a lot of production capacity," the source said, but said he could not say when the change had taken place.

But clearly, from the graph (above, right), the 'change' had taken place gradually over the preceding six months - the Saudi response to Libyan production dropping off the proverbial cliff could hardly be labelled 'shock and awe'.

The Oil Drum leaned distinctly in the direction of 'unwilling' as the reason for the less-than-dramatic response:

Back in 2006, when [Saudi] production started to gradually decline from 9.5mbd even as global oil prices were in the worst spike since the 1970s, I was an advocate of the view that the decline was largely involuntary: they'd never produced more than 9.5mbd, they'd underinvested for decades, and some of their big fields were getting very tired (particular northern Ghawar and Abqaiq) and they were starting a big rash of new projects and ramping up their rig counts at the same time.

I see current events differently. The reduction in late 2008 was clearly voluntary to support prices in the face of the great recession. There's no new projects announced, and the rig count hasn't taken off. So my take is that the failure to increase production to compensate for Libya is deliberate. We can only speculate, but my guess is that, having watched how the west has helped to ease Mubarak and Ben-Ali out of power and is intervening in Libya to the same end, the Saudi regime is in no mood to care about our desire for more oil. Instead, they are very much in the mood to build as large a war chest as possible with which to appease their own population, strengthen their defense measures, etc.

So, instead of Saudi production increasing to compensate for Libya, total world production decreased, and oil prices went up sharply to enforce the necessary conservation on the world's oil consumers.

The debate about Peak Oil has been raging since the fateful day in 1956 when M. King Hubbert presented to the American Petroleum Institute his theory that oil production would follow a bell curve and, at an unspecified stage in the future, enter a terminal decline, but that debate is too multi-faceted for these pages so we will simply use a couple of charts (which would coincidentally appear to support Dr. Hubbert's thesis) in order to flesh out the remainder of our discussion for today.

First up, a list of the world's biggest oilfields:

SOURCE: AAPG/OGI/EIA

The list of the 18 largest 'supergiant' oilfields (left) highlights one of the biggest challenges facing the oil industry to date in that the average age of these fields is exactly 60 years old. Moreover, the most recent discovery was made 35 years ago when the Cantarell Complex (highlighted) was found by a fisherman named Rudesindo Cantarell 80 km off the coast of Mexico in the Bay of Campeche.

Cantarell complained that oil seepage was ruining his fishing nets and the good folks at PEMEX (Mexico's national oil company) kindly investigated the problem for him - only to find the motherlode.

In 2004, however, PEMEX suddenly announced that production from Cantarell was forecast to steeply decline from 2006 - at a rate of 14% per year.

By 2008, the annual rate of decline had reached 36% and by 2009 it hit 38%.

In graphical form, the fall from grace of the Cantarell supergiant is even more amazing:

SOURCE: FEDERAL GOVT OF MEXICO

Clearly, in oil we have a commodity the world cannot live without which is the subject of great debate as to whether its future supply is sustainable. The largest concentration of this commodity resides underneath the most combustible region on the planet, the guardians of that oil are very secretive about their production rates and have a vested interest in maximising profits from the sale of their only asset, the evidence that is in the public domain (such as that surrounding Cantarell along with Great Britain's experience with North Sea Oil) would seem to suggest that once the decline stage is reached it will be rapid and.... what was the other thing?

Oh yes, the institution in charge of producing the colourful pieces of paper which can be swapped for that commodity are committed to producing as many of them as they can get away with before anybody notices.

As stock markets plummeted in August, one thing that was noticeable was the resilience of both 'the oil price' (in the shape of Brent Crude, of course) and that of copper - two bellwether indicators of any slowdown in growth that can be relied upon to flash signals when a recession is nigh.

To be sure, the data reported in August was dreadful. In the US we saw a slew of appalling regional manufacturing reports, (the Philly Fed and Empire numbers could genuinely be described as 'shockers'), shattered consumer confidence numbers and rising inflation all topped off with a big fat goose egg in the NFP report last Friday, while in Europe, as the periphery continued to confirm just how week their economies continue to be, the real shocks came from the region's perennial powerhouse economy, Germany.

German private investment and consumption were down, government spending rose, GDP was below forecast and the PPI number was alarmingly elevated on both a month-on-month and year-on-year basis and the ZEW survey (Germany's barometer for economic growth expectations) had its biggest fall since July 2006. On balance, it looks for all the world as though the two largest and most powerful regions on Earth are about to head into synchronised recessions - the only possibility that this turns out NOT to be the case would seem to be that they are both already IN recessions.

So why doesn't 'the oil price' reflect this likelihood? Simple:

1. China has a LOT of paper money and is happy to swap it for hard assets that it knows will ultimately be far more beneficial in the long run as Western governments continue to debase their currencies.

2. Western governments continue to debase their currencies.

But it isn't just 'the oil price' that has shown remarkable resilience into the teeth of what looks like another severe recession. Throughout August, sitting out here in Asia, it was plain to see that there was a firm hand bidding for copper in the Shanghai market and, realistically, nobody in the region was in any doubt as to exactly who that firm hand belonged to. Consequently, copper - that great barometer of both economic activity and inflationary pressure - held up surprisingly well given the poor economic backdrop and the 'risk off' episodes that littered the first half of the month.

Shanghai Copper

Brent Crude

SOURCE: BLOOMBERG

The signs are clear: Inflation is not only the preferred option to soothe the pain of a world drowning in debt, but (semantics about which 'oil price' to use aside) pretty much the only bullet left in the guns of central bankers and, until somebody stamps a 'sell-by date' on such things as copper, oil or our old friends gold and silver, the Chinese will continue to swap their paper for hard assets and, realistically, the price is of secondary importance to them.

Ben Bernanke's 'disappointing' speech at Jackson Hole was received poorly by markets that have become used to a generous helping of stimulus from the Fed Head whenever things looked bleak but subsequently, with a non-farm payrolls report that showed the US economy produced precisely zero jobs last month, further wobbles in stock markets that are focusing ever-more intently on the debacle that is Europe and the remarkably pro-stimulus words of two Fed officials, it has become even clearer that, come the Fed's extended two-day meeting in late September, QE3 (or whatever it ends up euphemistically being labelled) is pretty much a done deal.

Add to that the increasing likelihood that the ECB begin to monetize their own problems via Eurobonds and rate cuts (ECB mandates and approval by the citizens of Europe be damned at this point in the game) and the odds on seeing a meaningful retreat in 'the oil price' - even in the face of a global recession - are becoming thinner by the day.

The surprising relative strength in 'the oil price' is signaling that the familiar paradigm of slowing growth being accompanied by a falling oil price to help equilibrium be reached at which point growth can begin again is just another casualty of central bank interference in markets via unprecedented monetary printing experiments. The inevitable inflation that results from massive money-printing operations is a concern to many, and, while it is seemingly not apparent in Western government numbers, it is out there. Believe me. It is out there in the price of oil, and copper it can be seen in the price of gold and silver and it is in the price of such vital things as Thai Hom Mali rice which has risen 26% this year and looks set to rise a further 25% NEXT MONTH ALONE according to the Bangkok Post. If you want to see what problems inflation can cause, keep an eye on the price of rice here in Asia. The fact that the US CPI appears benign, means very little. The less obvious signs are far more important.

Of course, the other thing to consider is the new man at the head of the Libyan government when it is finally established. We don't know who he is. We don't know how he thinks. But surely, the new leader of the world's 17th-largest oil producer HAS to offer more stability to both the world in general and 'the oil price' in particular than Muammar al-Qaddafi.

Surely?

Some Problems With Banks

John Mauldin — Mon, 29 Aug 2011 21:20:00 GMT

This week your Outside the Box offers two views, one from the US and one from Europe, both dealing with banks and financing. First, back in July, my friend Chris Whalen at Institutional Risk Analytics wrote an important comment about how the situation in the housing market is blocking efforts by the Fed to stabilize the US economy. IRA is a rating agency that follows every US bank and consults for a number of large commercial and governmental institutions on bank performance and risk.

(You can see the IRA reports of all the failed banks since 2008 on their website. The folks at IRA have a retail website (www.irabankratings.com) that allows you to follow your bank’s performance for just $50 per year or subscribe to see all US banks for $1,000 per year. Many large corporations, investment advisors, insurers, and banks use the retail IRA bank ratings for counterparty risk management and other bank credit tasks. It is a great value for people who want to sleep soundly at night with reliable knowledge about their banks.)

One of the things that Chris has been writing about for the past several years is how the policies followed by the top four banks – Citigroup, JPMorgan Chase, Wells Fargo, and Bank of America – plus Fannie Mae and Freddie Mac, are preventing millions of American homeowners from refinancing their homes. While banks and corporate issuers of debt have benefited greatly from the Fed’s low-rate policies, consumers have been locked out. At long last, we now see President Obama and other politicians talking about the need to refinance American homeowners. Chris and his colleagues in the mortgage market, like Alan Boyce, are largely responsible for educating policy makers on this issue. Hopefully they are not too late to make a difference.

The second and shorter part of today’s OTB is two articles from Ambrose Evans-Pritchard of the Telegraph, on the current crisis in Europe. You need a scorecard to keep up with the latest developments, and he certainly provides one. Things could get very volatile, if he is even close to correct.

Have a great week, and my sympathies to all my friends who have “issues,” as in no power, etc., in the Northeast. Makes 100+ degrees seem like nothing.

Your waiting for cooler weather in Texas analyst,

John Mauldin, Editor
Outside the Box

The Institutional Risk Analyst

Are the Housing GSEs and TBTF Banks Blocking the Economic Recovery?

Yesterday our colleague Chuck Gabriel at Capital Alpha Partners in Washington put out a research note indicating that the Obama Administration has decided to support a two-year extension in the conforming loan limit for Fannie and Freddie.

As we have noted in past comments, the limit on loans that can be guaranteed by the GSEs is set to fall back to pre-crisis levels at the end of September. Loan markets around the US have already begun to seize up in anticipation of the change.

But while this eleventh hour fix is good news of sorts, it does not change the fact that the Obama Administration and most of the federal regulatory community have badly botched the government's response to the mortgage crisis. Part of the issue is a lack of understanding of the problem, but mostly it is the big banks and GSE continuing to exercise their cartel pricing power to deny American home owners their legal right to refinance.

Let's review the history so we can all get on the same page. In 2002, when the Fed dropped interest rates dramatically after the banking industry and markets went into a stall, the mortgage markets saw a wave of home refinancings. This is precisely what the Federal Open Market Committee wanted to see happen; liquefy households and boost consumer demand.

In response, the GSEs started to accelerate their purchases of private label securities ("PLS"), buying the "AAA" pieces of PLS to help to maintain the yield on their retained portfolios. Remember that a decade ago, we were still pretending that the GSEs were private corporations and their officers were busy enhancing earnings to build their bonus pool.

Paul Krugman, Bob Kutner and Frank Portnoy, among others, are right when they say that Wall Street's greed drove the mortgage debacle. But they forget that Fannie Mae and Freddie Mac were considered part of Wall Street until the collapse of Lehman Brothers and Bear Stearns in 2008. You cannot separate the private and public sector contributions to the crisis; it was a true partnership, but one that starts with the government intervention in the housing sector with the New Deal.

While the GSEs were buying all of that "AAA" rated PLS paper from the Wall Street dealers for the retained portfolio, the inferior tranches went to fuel the CDO machine, paper that was eventually bought by EU investors. While liberal commentators still argue that Wall Street and not their beloved New Deal agencies caused the crisis, the fact is that those CDO deals built on "A" through "BB" tranches would never have been done without the GSEs providing a ready market for the "AAA" rated tranches.

The surge in prepayments in 2002 drove the banks and GSEs to loosen their criteria in order to generate new, high spread at time of origination or SATO loans to replace the RMBS in portfolio that were seeing very high prepayment speeds. This decrease in credit quality at banks and by the GSEs had the same motivations, namely greed. But, again, it is impossible to separate the role of the government and the private banks in creating this mess. The two constituencies were locked in a loving embrace that went on for years and with the full connivance of both political parties in Washington.

In 2008, when the Fed again dropped interest rates to liquefy households and boost consumer demand, the GSEs responded by raising the barrier to home refinancing by changing the loan level pricing adjustment or LLPA. This move defeated the Fed's LSAP program to purchase mortgage securities and thereby drive a significant increase in home refinancing. Rich people got refinancings, but the vast majority of Americans now had the legal right to refinance in 2008 and 2009 were locked out by the banks and the GSEs, who did not want to see the high coupon, high SATO loans produced between 2002 and 2007 prepay. Again the reason, greed, both by banks and the GSEs.

Remember that the biggest holders of these RMBS are the GSEs themselves and the Fed, followed by banks and private investors. But because of the actions of the GSEs to prevent Americans from exercising their legal right to refinance, the holders of the high coupon securities have been overpaid for years.

Hundreds and hundreds of billions of dollars worth of Fannie and Freddie securities should have prepaid years ago, but instead the GSEs and other holders of these securities have been receiving above-market yields on their investments. This is not only unfair to American home owners, but it also means that the US economy is not going to recover until the government forces the GSEs to change their LLPAs and aggressively start to refinance these high SATO loans.

Senator Barbara Boxer (D-CA) has introduced a proposal to force the GSEs to refinance the loans in their portfolios as well as in pass through securities. The Obama Administration has finally put forward a proposal to force trustees of private RMBS to allow principal reductions on mortgages to help keep up to 1 million people in their homes. Both of these initiatives are important and necessary for the US economy to recover. But both proposals also represent a deliberate government-mandated default on these debt instruments. So much for the arguments about raising the federal debt ceiling that rely on the need to avoid default.

In the event, this new wave of refinancings will mean a massive prepayment to the GSEs and to private investors, who have been free riding at the expense of home owners and the American economy. A broad program of refinancing will make the losses at Fannie and Freddie soar and will reduce the cash flow going to banks and other investors in GSE paper. It is likely that several large financial institutions will be forced into a Dodd-Frank restructuring when the government rips away half of their net interest margin as a result of prepayments on vintage RMBS.

These two proposals will be very bad for the support of bond owners of PLS for future participation in the mortgage market, but senior bond holders will likely do much better. The Boxer and Obama proposals are probably good for loan servicers too as they are first in line to get repaid servicing advances when the loan is sold. This is a "servicer safe harbor" issue, but the larger economics are always better for all investors on a short sale or modification than a long drawn out foreclosure process.

But shed no tears for holders of private RMBS. The excess spread that these investors have been receiving because of the GSE efforts to block home mortgage refinancings for the past three years more than compensates for the lower yields they will receive when the proceeds of prepayments are reinvested at today's market rates. Strange as it may seem, we support the Boxer proposal. Indeed, we suspect that Senator Boxer may have been reading the work of our friend Alan Boyce, head of the Absalon Project.

For the past three years and more, Boyce and other member of our Berlin-Los Angeles axis of understanding have been trying to educate members of Congress and other inhabitants of Washington as to the reality of the GSE-bank mortgage market cartel. In particular, Boyce has focused on how the GSEs and the largest banks are actively seeking to prevent Americans from refinancing their mortgages -- and at the same time thwarting the Fed's efforts to stabilize the economy through QE.

Click here to see the latest version of Alan's presentation. Note particularly Page 13, which shows that high income home owners who could qualify for the tighter LLPAs put in place by the GSE's in 2008 were twice as likely to refinance as lower income borrowers. The bottom and lower middle income households with high SATO loans are precisely the mortgages that the GSEs and banks own in their portfolios.

"Now that it's the one year anniversary of Dodd-Frank, there has been lots of discussion on what should be done in the future," Boyce notes, "but no discussion of what is happening on a daily basis."

Bottom line: If the Obama Administration wants to see the US economy recover, then we must start the real process of restructuring that Washington & Wall Street have been avoiding since 2007. President Barack Obama may not be able to turn things around before the 2012 election, but he will be remembered more kindly in the history books if he has the courage to do the right thing. As always, we are available to help in this process as and when somebody in the White House or Treasury wants to pick up the telephone.

And from the Telegraph:

Euro bail-out in doubt as "hysteria" sweeps Germany

German Chancellor Angela Merkel no longer has enough coalition votes in the Bundestag to secure backing for Europe's revamped rescue machinery, threatening a constitutional crisis in Germany and a fresh eruption of the euro debt saga

Seething discontent in Germany over Europe's debt crisis has spread to all the key institutions. Photo: AP

By Ambrose Evans-Pritchard

28 Aug 2011

Mrs Merkel has cancelled a high-profile trip to Russia on September 7, the crucial day when the package goes to the Bundestag and the country's constitutional court rules on the legality of the EU's bail-out machinery.

If the court rules that the €440bn rescue fund (EFSF) breaches Treaty law or undermines German fiscal sovereignty, it risks setting off an instant brushfire across monetary union.

The seething discontent in Germany over Europe's debt crisis has spread to all the key institutions of the state. "Hysteria is sweeping Germany " said Klaus Regling, the EFSF's director.

German media reported that the latest tally of votes in the Bundestag shows that 23 members from Mrs Merkel's own coalition plan to vote against the package, including twelve of the 44 members of Bavaria's Social Christians (CSU). This may force the Chancellor to rely on opposition votes, risking a government collapse.

Christian Wulff, Germany's president, stunned the country last week by accusing the European Central Bank of going "far beyond its mandate" with mass purchases of Spanish and Italian debt, and warning that the Europe's headlong rush towards fiscal union strikes at the "very core" of democracy. "Decisions have to be made in parliament in a liberal democracy. That is where legitimacy lies," he said.

A day earlier the Bundesbank had fired its own volley, condemning the ECB's bond purchases and warning the EU is drifting towards debt union without "democratic legitimacy" or treaty backing.
Joahannes Singhammer, leader of the CSU's Bundestag group, accused the ECB of acting "dangerously" by jumping the gun before parliaments had voted. The ECB is implicitly acting on behalf of the rescue fund until it is ratified.
A CSU document to be released on Monday flatly rebuts the latest accord between Chancellor Merkel and French president Nicholas Sarkozy, saying plans for an "economic government for Eurozone states" are unacceptable. It demands treaty changes to let EMU states go bankrupt, and to eject them from the euro altogether for serial abuses.
"An unlimited transfer union and pooling of debts for any length of time would imply a shared financial government and decisively change the character of a European confederation of states," said the draft, obtained by Der Spiegel.
Mrs Merkel faces mutiny even within her own Christian Democrat (CDU) family. Wolfgang Bossbach, the spokesman for internal affairs, said he would oppose the package. "I can't vote against my own conviction," he said.
The Bundestag is expected to decide late next month on the package, which empowers the EFSF to buy bonds pre-emptively and recapitalize banks. While the bill is likely to pass, the furious debate leaves no doubt that Germany will resist moves to boost the EFSF's firepower yet further. Most City banks say the fund needs €2 trillion to stop the crisis engulfing Spain and Italy.
Mrs Merkel's aides say she is facing "war on every front". The next month will decide her future, Germany's destiny, and the fate of monetary union.
++++++++++++++++++++++

European banks set cash test by IMF chief

European banks face ordeal by fire this week after the International Monetary Fund called for “urgent” action to shore up their defenses, if necessary with state money and under legal compulsion.

Recovery is in danger if we don’t shore up defenses, says Christine Lagarde. Photo: AP

By Ambrose Evans-Pritchard

9:27PM BST 28 Aug 2011

Christine Lagarde, the IMF’s new chief, set off tremors at the Jackson Hole summit over the weekend with warnings that the global financial system is on very thin ice and vulnerable to the slightest shock.

“We are in a dangerous new phase. The stakes are clear: we risk seeing the fragile recovery derailed, so we must act now,” she said.

“Banks need urgent recapitalisation. If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalisation,” she said.

Europe’s lenders are already reeling from a share price collapse since the debt crisis spread to Italy and Spain, threatening to overwhelm Europe’s bail-out fund and leave banks exposed to sovereign defaults.

Shares of Intesa SanPaulo, Credit Agricole and Commerzbank are all below the extremes seen during the panic in March 2009.

Europe’s inter-bank market is effectively frozen and EMU banks have lost access to America’s $7 trillion (£4.3 trillion) money markets. Lenders have parked €126bn (£112bn) at the European Central Bank for safety rather than risk exposure to peers.

The IMF exhorted Europe’s banks over the last two years to beef up their capital base while the rally lasted. Many failed to do so and will now face harsher terms. Some may fall under state control, wiping out shareholders.

The eurozone economy ground to a halt in the second quarter, tightening the noose on EMU’s weaker states and their banks. Julian Callow from Barclays Capital said Europe is already in “industrial recession” and risks tipping into outright economic slump.

“The recent slide is eerily reminiscent of the pattern during the third quarter of 2008,” he said.

Mrs Lagarde issued a thinly-veiled attack on the ECB’s rate rises and Europe’s fiscal austerity drive. “Monetary policy should remain highly accommodative, as the risk of recession outweighs the risk of inflation. Fiscal policy must navigate between the twin perils of losing credibility and undercutting recovery,” she said.

Tim Congdon from International Monetary Research said it is folly to force Europe’s banks to raise money too quickly or crystallize losses abruptly. This will cause a monetary implosion and a repeat of the 2008 disaster.

He said the ECB’s restrictive policies over the last 18 months and the lack of EMU fiscal union have doomed the euro. to certain break-up.

“It cannot be saved. Banks will suffer large losses,” he said.

The Geopolitics of the United States, Part 1: The Inevitable Empire

John Mauldin — Fri, 26 Aug 2011 02:08:00 GMT

Take a good look at the image below. You'll see how a picture is not only worth a thousand words, but can explain the success of an entire nation. Crops to rivers, rivers to ports – the trade foundation of a country can be summarized in a single image. Sure it stirs up memories of Mark Twain's Huckleberry Finn and the Mighty Mississippi, but this is the foundation of the US as a global power and a fascinating look at the backbone of the American economy.

We all remember junior high geography (well, some of it, anyway). But somehow it didn't cover how critical geography is in the development of a nation... and that it is, for example, the primary reason the United States became a global power. The territory of the U.S. simply comprises all the right geographic elements to make its occupants an inevitable global force. Yesterday, STRATFOR, my favorite source for geopolitical analysis of world affairs, published The Inevitable Empire, part I of a fascinating assessment of the United States. In it you'll learn how geography shaped the nation's behavior throughout history, and what it means for U.S. foreign policy today. It's a perfect example of the kind of insight STRATFOR provides that you won't find anywhere else.

>> Join STRATFOR at the special rate for OTB readers << just in time for their release of The Geopolitics of the United States, Part 2: American Identity and the Threats of Tomorrow. In addition, you'll get a copy of The Next Decade, the New York Times bestselling book released earlier this year by STRATFOR Founder and CEO George Friedman. But check it out now, I hear this deal only lasts until Monday.

Your proud to be an American analyst,

John Mauldin, Editor
Outside the Box

The Geopolitics of the United States, Part 1: The Inevitable Empire

August 24, 2011 | 1556 GMT

Editor’s Note: This installment on the United States, presented in three parts, is the 16th in a series of STRATFOR monographs on the geopolitics of countries influential in world affairs.

The North American Core

North America is a triangle-shaped continent centered in the temperate portions of the Northern Hemisphere. It is of sufficient size that its northern reaches are fully Arctic and its southern reaches are fully tropical. Predominant wind currents carry moisture from west to east across the continent.

Climatically, the continent consists of a series of wide north-south precipitation bands largely shaped by the landmass’ longitudinal topography. The Rocky Mountains dominate the Western third of the northern and central parts of North America, generating a rain-shadow effect just east of the mountain range — an area known colloquially as the Great Plains. Farther east of this semiarid region are the well-watered plains of the prairie provinces of Canada and the American Midwest. This zone comprises both the most productive and the largest contiguous acreage of arable land on the planet.

East of this premier arable zone lies a second mountain chain known as the Appalachians. While this chain is far lower and thinner than the Rockies, it still constitutes a notable barrier to movement and economic development. However, the lower elevation of the mountains combined with the wide coastal plain of the East Coast does not result in the rain-shadow effect of the Great Plains. Consequently, the coastal plain of the East Coast is well-watered throughout.

In the continent’s northern and southern reaches this longitudinal pattern is not quite so clear-cut. North of the Great Lakes region lies the Canadian Shield, an area where repeated glaciation has scraped off most of the topsoil. That, combined with the area’s colder climate, means that these lands are not nearly as productive as regions farther south or west and, as such, remain largely unpopulated to the modern day. In the south — Mexico — the North American landmass narrows drastically from more than 5,000 kilometers (about 3,100 miles) wide to, at most, 2,000 kilometers, and in most locations less than 1,000 kilometers. The Mexican extension also occurs in the Rocky Mountain/Great Plains longitudinal zone, generating a wide, dry, irregular uplift that lacks the agricultural promise of the Canadian prairie provinces or American Midwest.

The continent’s final geographic piece is an isthmus of varying width, known as Central America, that is too wet and rugged to develop into anything more than a series of isolated city-states, much less a single country that would have an impact on continental affairs. Due to a series of swamps and mountains where the two American continents join, there still is no road network linking them, and the two Americas only indirectly affect each other’s development.

The most distinctive and important feature of North America is the river network in the middle third of the continent. While its components are larger in both volume and length than most of the world’s rivers, this is not what sets the network apart. Very few of its tributaries begin at high elevations, making vast tracts of these rivers easily navigable. In the case of the Mississippi, the head of navigation — just north of Minneapolis — is 3,000 kilometers inland.

The network consists of six distinct river systems: the Missouri, Arkansas, Red, Ohio, Tennessee and, of course, the Mississippi. The unified nature of this system greatly enhances the region’s usefulness and potential economic and political power. First, shipping goods via water is an order of magnitude cheaper than shipping them via land. The specific ratio varies greatly based on technological era and local topography, but in the petroleum age in the United States, the cost of transport via water is roughly 10 to 30 times cheaper than overland. This simple fact makes countries with robust maritime transport options extremely capital-rich when compared to countries limited to land-only options. This factor is the primary reason why the major economic powers of the past half-millennia have been Japan, Germany, France, the United Kingdom and the United States.

Second, the watershed of the Greater Mississippi Basin largely overlays North America’s arable lands. Normally, agricultural areas as large as the American Midwest are underutilized as the cost of shipping their output to more densely populated regions cuts deeply into the economics of agriculture. The Eurasian steppe is an excellent example. Even in modern times it is very common for Russian and Kazakh crops to occasionally rot before they can reach market. Massive artificial transport networks must be constructed and maintained in order for the land to reach its full potential. Not so in the case of the Greater Mississippi Basin. The vast bulk of the prime agricultural lands are within 200 kilometers of a stretch of navigable river. Road and rail are still used for collection, but nearly omnipresent river ports allow for the entirety of the basin’s farmers to easily and cheaply ship their products to markets not just in North America but all over the world.

Third, the river network’s unity greatly eases the issue of political integration. All of the peoples of the basin are part of the same economic system, ensuring constant contact and common interests. Regional proclivities obviously still arise, but this is not Northern Europe, where a variety of separate river systems have given rise to multiple national identities.

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It is worth briefly explaining why STRATFOR fixates on navigable rivers as opposed to coastlines. First, navigable rivers by definition service twice the land area of a coastline (rivers have two banks, coasts only one). Second, rivers are not subject to tidal forces, greatly easing the construction and maintenance of supporting infrastructure. Third, storm surges often accompany oceanic storms, which force the evacuation of oceanic ports. None of this eliminates the usefulness of coastal ports, but in terms of the capacity to generate capital, coastal regions are a poor second compared to lands with navigable rivers.

There are three other features — all maritime in nature — that further leverage the raw power that the Greater Mississippi Basin provides. First are the severe indentations of North America’s coastline, granting the region a wealth of sheltered bays and natural, deep-water ports. The more obvious examples include the Gulf of St. Lawrence, San Francisco Bay, Chesapeake Bay, Galveston Bay and Long Island Sound/New York Bay.

Second, there are the Great Lakes. Unlike the Greater Mississippi Basin, the Great Lakes are not naturally navigable due to winter freezes and obstacles such as Niagara Falls. However, over the past 200 years extensive hydrological engineering has been completed — mostly by Canada — to allow for full navigation on the lakes. Since 1960, penetrating halfway through the continent, the Great Lakes have provided a secondary water transport system that has opened up even more lands for productive use and provided even greater capacity for North American capital generation. The benefits of this system are reaped mainly by the warmer lands of the United States rather than the colder lands of Canada, but since the Great Lakes constitute Canada’s only maritime transport option for reaching the interior, most of the engineering was paid for by Canadians rather than Americans.

Third and most important are the lines of barrier islands that parallel the continent’s East and Gulf coasts. These islands allow riverine Mississippi traffic to travel in a protected intracoastal waterway all the way south to the Rio Grande and all the way north to the Chesapeake Bay. In addition to serving as a sort of oceanic river, the island chain’s proximity to the Mississippi delta creates an extension of sorts for all Mississippi shipping, in essence extending the political and economic unifying tendencies of the Mississippi Basin to the eastern coastal plain.

Thus, the Greater Mississippi Basin is the continent’s core, and whoever controls that core not only is certain to dominate the East Coast and Great Lakes regions but will also have the agricultural, transport, trade and political unification capacity to be a world power — even without having to interact with the rest of the global system.

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There is, of course, more to North America than simply this core region and its immediate satellites. There are many secondary stretches of agricultural land as well — those just north of the Greater Mississippi Basin in south-central Canada, the lands just north of Lake Erie and Lake Ontario, the Atlantic coastal plain that wraps around the southern terminus of the Appalachians, California’s Central Valley, the coastal plain of the Pacific Northwest, the highlands of central Mexico and the Veracruz region.

But all of these regions combined are considerably smaller than the American Midwest and are not ideal, agriculturally, as the Midwest is. Because the Great Lakes are not naturally navigable, costly canals must be constructed. The prairie provinces of south-central Canada lack a river transport system altogether. California’s Central Valley requires irrigation. The Mexican highlands are semiarid and lack any navigable rivers.

The rivers of the American Atlantic coastal plain — flowing down the eastern side of the Appalachians — are neither particularly long nor interconnected. This makes them much more like the rivers of Northern Europe in that their separation localizes economic existence and fosters distinct political identities, dividing the region rather than uniting it. The formation of such local — as opposed to national — identities in many ways contributed to the American Civil War.

But the benefits of these secondary regions are not distributed evenly. What is now Mexico lacks even a single navigable river of any size. Its agricultural zones are disconnected and it boasts few good natural ports. Mexico’s north is too dry while its south is too wet — and both are too mountainous — to support major population centers or robust agricultural activities. Additionally, the terrain is just rugged enough — making transport just expensive enough — to make it difficult for the central government to enforce its writ. The result is the near lawlessness of the cartel lands in the north and the irregular spasms of secessionist activity in the south.

Canada’s maritime transport zones are far superior to those of Mexico but pale in comparison to those of the United States. Its first, the Great Lakes, not only requires engineering but is shared with the United States. The second, the St. Lawrence Seaway, is a solid option (again with sufficient engineering), but it services a region too cold to develop many dense population centers. None of Canada boasts naturally navigable rivers, often making it more attractive for Canada’s provinces — in particular the prairie provinces and British Columbia — to integrate with the United States, where transport is cheaper, the climate supports a larger population and markets are more readily accessible. Additionally, the Canadian Shield greatly limits development opportunities. This vast region — which covers more than half of Canada’s landmass and starkly separates Quebec City, Montreal, Toronto and the prairie provinces — consists of a rocky, broken landscape perfect for canoeing and backpacking but unsuitable for agriculture or habitation.

So long as the United States has uninterrupted control of the continental core — which itself enjoys independent and interconnected ocean access — the specific locations of the country’s northern and southern boundaries are somewhat immaterial to continental politics. To the south, the Chihuahuan and Sonoran deserts are a significant barrier in both directions, making the exceedingly shallow Rio Grande a logical — but hardly absolute — border line. The eastern end of the border could be anywhere within 300 kilometers north or south of its current location (at present the border region’s southernmost ports — Brownsville and Corpus Christi — lie on the U.S. side of the border). As one moves westward to the barren lands of New Mexico, Arizona, Chihuahua and Sonora, the possible variance increases considerably. Even controlling the mouth of the Colorado River where it empties into the Gulf of California is not a critical issue, since hydroelectric development in the United States prevents the river from reaching the Gulf in most years, making it useless for transport.

In the north, the Great Lakes are obviously an ideal break point in the middle of the border region, but the specific location of the line along the rest of the border is largely irrelevant. East of the lakes, low mountains and thick forests dominate the landscape — not the sort of terrain to generate a power that could challenge the U.S. East Coast. The border here could theoretically lie anywhere between the St. Lawrence Seaway and Massachusetts without compromising the American population centers on the East Coast (although, of course, the farther north the line is the more secure the East Coast will be). West of the lakes is flat prairie that can be easily crossed, but the land is too cold and often too dry, and, like the east, it cannot support a large population. So long as the border lies north of the bulk of the Missouri River’s expansive watershed, the border’s specific location is somewhat academic, and it becomes even more so when one reaches the Rockies.

On the far western end of the U.S.-Canada border is the only location where there could be some border friction. The entrance to Puget Sound — one of the world’s best natural harbors — is commanded by Vancouver Island. Most of the former is United States territory, but the latter is Canadian — in fact, the capital of British Columbia, Victoria, sits on the southern tip of that strategic island for precisely that reason. However, the fact that British Columbia is more than 3,000 kilometers from the Toronto region and that there is a 12:1 population imbalance between British Columbia and the American West Coast largely eliminates the possibility of Canadian territorial aggression.

A Geographic History of the United States

It is common knowledge that the United States began as 13 rebellious colonies along the east coast of the center third of the North American continent. But the United States as an entity was not a sure thing in the beginning. France controlled the bulk of the useful territory that in time would enable the United States to rise to power, while the Spanish empire boasted a larger and more robust economy and population in the New World than the fledgling United States. Most of the original 13 colonies were lightly populated by European standards — only Philadelphia could be considered a true city in the European sense — and were linked by only the most basic of physical infrastructure. Additionally, rivers flowed west to east across the coastal plain, tending to sequester regional identities rather than unify them.

But the young United States held two advantages. First, without exception, all of the European empires saw their New World holdings as secondary concerns. For them, the real game — and always the real war — was on another continent in a different hemisphere. Europe’s overseas colonies were either supplementary sources of income or chips to be traded away on the poker table of Europe. France did not even bother using its American territories to dispose of undesirable segments of its society, while Spain granted its viceroys wide latitude in how they governed imperial territories simply because it was not very important so long as the silver and gold shipments kept arriving. With European attentions diverted elsewhere, the young United States had an opportunity to carve out a future for itself relatively free of European entanglements.

Second, the early United States did not face any severe geographic challenges. The barrier island system and local rivers provided a number of options that allowed for rapid cultural and economic expansion up and down the East Coast. The coastal plain — particularly in what would become the American South — was sufficiently wide and well-watered to allow for the steady expansion of cities and farmland. Choices were limited, but so were challenges. This was not England, an island that forced the early state into the expense of a navy. This was not France, a country with three coasts and two land borders that forced Paris to constantly deal with threats from multiple directions. This was not Russia, a massive country suffering from short growing seasons that was forced to expend inordinate sums of capital on infrastructure simply to attempt to feed itself. Instead, the United States could exist in relative peace for its first few decades without needing to worry about any large-scale, omnipresent military or economic challenges, so it did not have to garrison a large military. Every scrap of energy the young country possessed could be spent on making itself more sustainable. When viewed together — the robust natural transport network overlaying vast tracts of excellent farmland, sharing a continent with two much smaller and weaker powers — it is inevitable that whoever controls the middle third of North America will be a great power.

Geopolitical Imperatives

With these basic inputs, the American polity was presented a set of imperatives it had to achieve in order to be a successful nation. They are only rarely declared elements of national policy, instead serving as a sort of subconscious set of guidelines established by geography that most governments — regardless of composition or ideology — find themselves following. The United States’ strategic imperatives are presented here in five parts. Normally imperatives are pursued in order, but there is considerable time overlap between the first two and the second two.

1. Dominate the Greater Mississippi Basin

The early nation was particularly vulnerable to its former colonial master. The original 13 colonies were hardwired into the British Empire economically, and trading with other European powers (at the time there were no other independent states in the Western Hemisphere) required braving the seas that the British still ruled. Additionally, the colonies’ almost exclusively coastal nature made them easy prey for that same navy should hostilities ever recommence, as was driven brutally home in the War of 1812 in which Washington was sacked.

There are only two ways to protect a coastal community from sea power. The first is to counter with another navy. But navies are very expensive, and it was all the United States could do in its first 50 years of existence to muster a merchant marine to assist with trade. France’s navy stood in during the Revolutionary War in order to constrain British power, but once independence was secured, Paris had no further interest in projecting power to the eastern shore of North America (and, in fact, nearly fought a war with the new country in the 1790s).

The second method of protecting a coastal community is to develop territories that are not utterly dependent upon the sea. Here is where the United States laid the groundwork for becoming a major power, since the strategic depth offered in North America was the Greater Mississippi Basin.

Achieving such strategic depth was both an economic and a military imperative. With few exceptions, the American population was based along the coast, and even the exceptions — such as Philadelphia — were easily reached via rivers. The United States was entirely dependent upon the English imperial system not just for finished goods and markets but also for the bulk of its non-agricultural raw materials, in particular coal and iron ore. Expanding inland allowed the Americans to substitute additional supplies from mines in the Appalachian Mountains. But those same mountains also limited just how much depth the early Americans could achieve. The Appalachians may not be the Swiss Alps, but they were sufficiently rugged to put a check on any deep and rapid inland expansion. Even reaching the Ohio River Valley — all of which lay within the initial territories of the independent United States — was largely blocked by the Appalachians. The Ohio River faced the additional problem of draining into the Mississippi, the western shore of which was the French territory of Louisiana and all of which emptied through the fully French-held city of New Orleans.

The United States solved this problem in three phases. First, there was the direct purchase of the Louisiana Territory from France in 1803. (Technically, France’s Louisiana Territory was Spanish-held at this point, its ownership having been swapped as a result of the Treaty of Paris in 1763 that ended the Seven Years’ War. In October 1800, France and Spain agreed in secret to return the lands to French control, but news of the transfer was not made public until the sale of the lands in question to the United States in July 1803. Therefore, between 1762 and 1803 the territory was legally the territory of the Spanish crown but operationally was a mixed territory under a shifting patchwork of French, Spanish and American management.)

At the time, Napoleon was girding for a major series of wars that would bear his name. France not only needed cash but also to be relieved of the security burden of defending a large but lightly populated territory in a different hemisphere. The Louisiana Purchase not only doubled the size of the United States but also gave it direct ownership of almost all of the Mississippi and Missouri river basins. The inclusion of the city of New Orleans in the purchase granted the United States full control over the entire watershed. Once the territory was purchased, the challenge was to develop the lands. Some settlers migrated northward from New Orleans, but most came via a different route.

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The second phase of the strategic-depth strategy was the construction of that different route: the National Road (aka the Cumberland Road). This project linked Baltimore first to Cumberland, Md. — the head of navigation of the Potomac — and then on to the Ohio River Valley at Wheeling, W. Va., by 1818. Later phases extended the road across Ohio (1828), Indiana (1832) and Illinois (1838) until it eventually reached Jefferson City, Mo., in the 1840s. This single road (known in modern times as Interstate 40 or Interstate 70 for most of its length) allowed American pioneers to directly settle Ohio, Indiana, Illinois and Missouri and granted them initial access to Michigan, Wisconsin, Iowa and Minnesota. For the better part of a century, it was the most heavily trafficked route in the country, and it allowed Americans not only to settle the new Louisiana Territory but also to finally take advantage of the lands ceded by the British in 1787. With the road’s completion, the original 13 colonies were finally lashed to the Greater Mississippi Basin via a route that could not be challenged by any outside power.

The third phase of the early American expansion strategy was in essence an extension of the National Road via a series of settlement trails, by far the most important and famous of which was the Oregon Trail. While less of a formal construction than the National Road, the Oregon Trail opened up far larger territories. The trail was directly responsible for the initial settling of Kansas, Nebraska, Wyoming, Idaho and Oregon. A wealth of secondary trails branched off from the main artery — the Mormon, Bozeman, California and Denver trails — and extended the settlement efforts to Montana, Colorado, Utah, Nevada and California. The trails were all active from the early 1840s until the completion of the country’s first transcontinental railway in 1869. That project’s completion reduced East Coast-West Coast travel time from six months to eight days and slashed the cost by 90 percent (to about $1,100 in 2011 dollars). The river of settlers overnight turned into a flood, finally cementing American hegemony over its vast territories.

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Collectively, the Louisiana Purchase, the National Road and the Oregon Trail facilitated the largest and fastest cultural expansion in human history. From beginning to end, the entire process required less than 70 years. However, it should be noted that the last part of this process — the securing of the West Coast — was not essential to American security. The Columbia River Valley and California’s Central Valley are not critical American territories. Any independent entities based in either could not possibly generate a force capable of threatening the Greater Mississippi Basin. This hardly means that these territories are unattractive or a net loss to the United States — among other things, they grant the United States full access to the Pacific trading basin — only that control of them is not imperative to American security.

2. Eliminate All Land-Based Threats to the Greater Mississippi Basin

The first land threat to the young United States was in essence the second phase of the Revolutionary War — a rematch between the British Empire and the young United States in the War of 1812. That the British navy could outmatch anything the Americans could float was obvious, and the naval blockade was crushing to an economy dependent upon coastal traffic. Geopolitically, the most critical part of the war was the participation of semi-independent British Canada. It wasn’t so much Canadian participation in any specific battle of the war (although Canadian troops did play a leading role in the sacking of Washington in August 1814) as it was that Canadian forces, unlike the British, did not have a supply line that stretched across the Atlantic. They were already in North America and, as such, constituted a direct physical threat to the existence of the United States.

Canada lacked many of the United States’ natural advantages even before the Americans were able to acquire the Louisiana Territory. First and most obvious, Canada is far enough north that its climate is far harsher than that of the United States, with all of the negative complications one would expect for population, agriculture and infrastructure. What few rivers Canada has neither interconnect nor remain usable year round. While the Great Lakes do not typically freeze, some of the river connections between them do. Most of these river connections also have rapids and falls, greatly limiting their utility as a transport network. Canada has made them more usable via grand canal projects, but the country’s low population and difficult climate greatly constrain its ability to generate capital locally. Every infrastructure project comes at a great opportunity cost, such a high cost that the St. Lawrence Seaway — a series of locks that link the St. Lawrence River to the Great Lakes and allow full ocean access — was not completed until 1959.

Canada is also greatly challenged by geography. The maritime provinces — particularly Newfoundland and Prince Edward Island — are disconnected from the Canadian landmass and unable to capitalize on what geographic blessings the rest of the country enjoys. They lack even the option of integrating south with the Americans and so are perennially poor and lightly populated compared to the rest of the country. Even in the modern day, what population centers Canada does have are geographically sequestered from one another by the Canadian Shield and the Rocky Mountains.

As time advanced, none of Canada’s geographic weaknesses worked themselves out. Even the western provinces — British Columbia, Alberta, Saskatchewan and Manitoba — are linked to Canada’s core by only a single transport corridor that snakes 1,500 kilometers through the emptiness of western and central Ontario north of Lake Superior. All four provinces have been forced by geography and necessity to be more economically integrated with their southern neighbors than with their fellow Canadian provinces.

Such challenges to unity and development went from being inconvenient and expensive to downright dangerous when the British ended their involvement in the War of 1812 in February 1815. The British were exhausted from the Napoleonic Wars in Europe and, with the French Empire having essentially imploded, were more interested in reshaping the European balance of power than re-engaging the Americans in distant North America. For their part, the Americans were mobilized, angry and — remembering vividly the Canadian/British sacking of Washington — mulling revenge. This left a geographically and culturally fractured Canada dreading a long-term, solitary confrontation with a hostile and strengthening local power. During the following decades, the Canadians had little choice but to downgrade their ties to the increasingly disinterested British Empire, adopt political neutrality vis-a-vis Washington, and begin formal economic integration with the United States. Any other choice would have put the Canadians on the path to another war with the Americans (this time likely without the British), and that war could have had only one outcome.

With its northern border secured, the Americans set about excising as much other extra-hemispheric influence from North America as possible. The Napoleonic Wars had not only absorbed British attention but had also shattered Spanish power (Napoleon actually succeeded in capturing the king of Spain early in the conflicts). Using a combination of illegal settlements, military pressure and diplomacy, the United States was able to gain control of east and west Florida from Madrid in 1819 in exchange for recognizing Spanish claims to what is now known as Texas (Tejas to the Spanish of the day).

This “recognition” was not even remotely serious. With Spain reeling from the Napoleonic Wars, Spanish control of its New World colonies was frayed at best. Most of Spain’s holdings in the Western Hemisphere either had already established their independence when Florida was officially ceded, or — as in Mexico — were bitterly fighting for it. Mexico achieved its independence a mere two years after Spain ceded Florida, and the United States’ efforts to secure its southwestern borders shifted to a blatant attempt to undermine and ultimately carve up the one remaining Western Hemispheric entity that could potentially challenge the United States: Mexico.

The Ohio and Upper Mississippi basins were hugely important assets, since they provided not only ample land for settlement but also sufficient grain production and easy transport. Since that transport allowed American merchants to easily access broader international markets, the United States quickly transformed itself from a poor coastal nation to a massively capital-rich commodities exporter. But these inner territories harbored a potentially fatal flaw: New Orleans. Should any nation but the United States control this single point, the entire maritime network that made North America such valuable territory would be held hostage to the whims of a foreign power. This is why the United States purchased New Orleans.

But even with the Louisiana Purchase, owning was not the same as securing, and all the gains of the Ohio and Louisiana settlement efforts required the permanent securing of New Orleans. Clearly, the biggest potential security threat to the United States was newly independent Mexico, the border with which was only 150 kilometers from New Orleans. In fact, New Orleans’ security was even more precarious than such a small distance suggested.

Most of eastern Texas was forested plains and hills with ample water supplies — ideal territory for hosting and supporting a substantial military force. In contrast, southern Louisiana was swamp. Only the city of New Orleans itself could house forces, and they would need to be supplied from another location via ship. It did not require a particularly clever military strategy for one to envision a Mexican assault on the city.

The United States defused and removed this potential threat by encouraging the settlement of not just its own side of the border region but the other side as well, pushing until the legal border reflected the natural border — the barrens of the desert. Just as the American plan for dealing with Canada was shaped by Canada’s geographic weakness, Washington’s efforts to first shield against and ultimately take over parts of Mexico were shaped by Mexico’s geographic shortcomings.

In the early 1800s Mexico, like the United States, was a very young country and much of its territory was similarly unsettled, but it simply could not expand as quickly as the United States for a variety of reasons. Obviously, the United States enjoyed a head start, having secured its independence in 1783 while Mexico became independent in 1821, but the deeper reasons are rooted in the geographic differences of the two states.

In the United States, the cheap transport system allowed early settlers to quickly obtain their own small tracts of land. It was an attractive option that helped fuel the early migration waves into the United States and then into the continent’s interior. Growing ranks of landholders exported their agricultural output either back down the National Road to the East Coast or down the Ohio and Mississippi rivers and on to Europe. Small towns formed as wealth collected in the new territories, and in time the wealth accumulated to the point that portions of the United States had the capital necessary to industrialize. The interconnected nature of the Midwest ensured sufficient economies of scale to reinforce this process, and connections between the Midwest and the East Coast were sufficient to allow advances in one region to play off of and strengthen the other.

Mexico, in contrast, suffered from a complete lack of navigable rivers and had only a single good port (Veracruz). Additionally, what pieces of arable land it possessed were neither collected into a singular mass like the American interior nor situated at low elevations. The Mexico City region is arable only because it sits at a high elevation — at least 2,200 meters above sea level — lifting it out of the subtropical climate zone that predominates at that latitude.

This presented Mexico with a multitude of problems. First and most obviously, the lack of navigable waterways and the non-abundance of ports drastically reduced Mexico’s ability to move goods and thereby generate its own capital. Second, the disassociated nature of Mexico’s agricultural regions forced the construction of separate, non-integrated infrastructures for each individual sub-region, drastically raising the costs of even basic development. There were few economies of scale to be had, and advances in one region could not bolster another. Third, the highland nature of the Mexico City core required an even more expensive infrastructure, since everything had to be transported up the mountains from Veracruz. The engineering challenges and costs were so extreme and Mexico’s ability to finance them so strained that the 410-kilometer railway linking Mexico City and Veracruz was not completed until 1873. (By that point, the United States had two intercontinental lines and roughly 60,000 kilometers of railways.)

The higher cost of development in Mexico resulted in a very different economic and social structure compared to the United States. Instead of small landholdings, Mexican agriculture was dominated by a small number of rich Spaniards (or their descendants) who could afford the high capital costs of creating plantations. So whereas American settlers were traditionally yeoman farmers who owned their own land, Mexican settlers were largely indentured laborers or de facto serfs in the employ of local oligarchs. The Mexican landowners had, in essence, created their own company towns and saw little benefit in pooling their efforts to industrialize. Doing so would have undermined their control of their economic and political fiefdoms. This social structure has survived to the modern day, with the bulk of Mexican political and economic power held by the same 300 families that dominated Mexico’s early years, each with its local geographic power center.

For the United States, the attraction of owning one’s own destiny made it the destination of choice for most European migrants. At the time that Mexico achieved independence it had 6.2 million people versus the U.S. population of 9.6 million. In just two generations — by 1870 — the American population had ballooned to 38.6 million while Mexico’s was only 8.8 million. This U.S. population boom, combined with the United States’ ability to industrialize organically, not only allowed it to develop economically but also enabled it to provide the goods for its own development.

The American effort against Mexico took place in two theaters. The first was Texas, and the primary means was settlement as enabled by the Austin family. Most Texas scholars begin the story of Texas with Stephen F. Austin, considered to be the dominant personality in Texas’ formation. STRATFOR starts earlier with Stephen’s father, Moses Austin. In December 1796, Moses relocated from Virginia to then-Spanish Missouri — a region that would, within a decade, become part of the Louisiana Purchase — and began investing in mining operations. He swore fealty to the Spanish crown but obtained permission to assist with settling the region — something he did with American, not Spanish, citizens. Once Missouri became American territory, Moses shifted his attention south to the new border and used his contacts in the Spanish government to replicate his Missouri activities in Spanish Tejas.

After Moses’ death in 1821, his son took over the family business of establishing American demographic and economic interests on the Mexican side of the border. Whether the Austins were American agents or simply profiteers is irrelevant; the end result was an early skewing of Tejas in the direction of the United States. Stephen’s efforts commenced the same year as his father’s death, which was the same year that Mexico’s long war of independence against Spain ended. At that time, Spanish/Mexican Tejas was nearly devoid of settlers — Anglo or Hispanic — so the original 300 families that Stephen F. Austin helped settle in Tejas immediately dominated the territory’s demography and economy. And from that point on the United States not so quietly encouraged immigration into Mexican Tejas.

Once Tejas’ population identified more with the United States than it did with Mexico proper, the hard work was already done. The remaining question was how to formalize American control, no small matter. When hostilities broke out between Mexico City and these so-called “Texians,” U.S. financial interests — most notably the U.S. regional reserve banks — bankrolled the Texas Revolution of 1835-1836.

It was in this war that one of the most important battles of the modern age was fought. After capturing the Alamo, Mexican dictator Gen. Antonio Lopez de Santa Anna marched north and then east with the intention of smashing the Texian forces in a series of engagements. With the Texians outnumbered by a factor of more than five to one, there was every indication that the Mexican forces would prevail over the Texian rebels. But with no small amount of luck the Texians managed not only to defeat the Mexican forces at the Battle of San Jacinto but also capture Santa Anna himself and force a treaty of secession upon the Mexican government. An independent Texas was born and the Texians became Texans.

However, had the battle gone the other way the Texian forces would not have simply been routed but crushed. It was obvious to the Mexicans that the Texians had been fighting with weapons made in the United States, purchased from the United States with money lent by the United States. Since there would have been no military force between the Mexican army and New Orleans, it would not have required a particularly ingenious plan for Mexican forces to capture New Orleans. It could well have been Mexico — not the United States — that controlled access to the North American core.

But Mexican supremacy over North America was not to be, and the United States continued consolidating. The next order of business was ensuring that Texas neither fell back under Mexican control nor was able to persist as an independent entity.

Texas was practically a still-born republic. The western half of Texas suffers from rocky soil and aridity, and its rivers are for the most part unnavigable. Like Mexico, its successful development would require a massive application of capital, and it attained its independence only by accruing a great deal of debt. That debt was owed primarily to the United States, which chose not to write off any upon conclusion of the war. Add in that independent Texas had but 40,000 people (compared to the U.S. population at the time of 14.7 million) and the future of the new country was — at best — bleak.

Texas immediately applied for statehood, but domestic (both Texan and American) political squabbles and a refusal of Washington to accept Texas’ debt as an American federal responsibility prevented immediate annexation. Within a few short years, Texas’ deteriorating financial position combined with a revenge-minded Mexico hard by its still-disputed border forced Texas to accede to the United States on Washington’s terms in 1845. From that point the United States poured sufficient resources into its newest territory (ultimately exchanging approximately one-third of Texas’ territory for the entirety of the former country’s debt burden in 1850, giving Texas its contemporary shape) and set about enforcing the new U.S.-Mexico border.

Which brings us to the second part of the American strategy against Mexico. While the United States was busy supporting Texian/Texan autonomy, it was also undermining Spanish/Mexican control of the lands of what would become the American Southwest farther to the west. The key pillar of this strategy was another of the famous American trails: the Santa Fe.

Contrary to conventional wisdom, the Santa Fe Trail was formed not only before the New Mexico Territory became American, or even before Texas became an U.S. state, but before the territory become formally Mexican — the United States founded the trail when Santa Fe was still held by Spanish authority. The trail’s purpose was twofold: first, to fill the region on the other side of the border with a sufficient number of Americans so that the region would identify with the United States rather than with Spain or Mexico and, second, to establish an economic dependency between the northern Mexican territories and the United States.

The United States’ more favorable transport options and labor demography granted it the capital and skills it needed to industrialize at a time when Mexico was still battling Spain for its independence. The Santa Fe Trail started filling the region not only with American settlers but also with American industrial goods that Mexicans could not get elsewhere in the hemisphere.

Even if the race to dominate the lands of New Mexico and Arizona had been a fair one, the barrens of the Chihuahuan, Sonoran and Mojave deserts greatly hindered Mexico’s ability to settle the region with its own citizens. Mexico quickly fell behind economically and demographically in the contest for its own northern territories. (Incidentally, the United States attempted a similar settlement policy in western Canada, but it was halted by the War of 1812.)

The two efforts — carving out Texas and demographically and economically dominating the Southwest — came to a head in the 1846-1848 Mexican-American War. In that war the Americans launched a series of diversionary attacks across the border region, drawing the bulk of Mexican forces into long, arduous marches across the Mexican deserts. Once Mexican forces were fully engaged far to the north of Mexico’s core territories — and on the wrong side of the deserts — American forces made an amphibious landing and quickly captured Mexico’s only port at Veracruz before marching on and capturing Mexico City, the country’s capital. In the postwar settlement, the United States gained control of all the lands of northern Mexico that could sustain sizable populations and set the border with Mexico through the Chihuahuan Desert, as good of an international border as one can find in North America. This firmly eliminated Mexico as a military threat.

3. Control the Ocean Approaches to North America

With the United States having not simply secured its land borders but having ensured that its North American neighbors were geographically unable to challenge it, Washington’s attention shifted to curtailing the next potential threat: an attack from the sea. Having been settled by the British and being economically integrated into their empire for more than a century, the Americans understood very well that sea power could be used to reach them from Europe or elsewhere, outmaneuver their land forces and attack at the whim of whoever controlled the ships.

But the Americans also understood that useful sea power had requirements. The Atlantic crossing was a long one that exhausted its crews and passengers. Troops could not simply sail straight across and be dropped off ready to fight. They required recuperation on land before being committed to a war. Such ships and their crews also required local resupply. Loading up with everything needed for both the trip across the Atlantic and a military campaign would leave no room on the ships for troops. As naval technology advanced, the ships themselves also required coal, which necessitated a constellation of coaling stations near any theaters of operation. Hence, a naval assault required forward bases that would experience traffic just as heavy as the spear tip of any invasion effort.

Ultimately, it was a Russian decision that spurred the Americans to action. In 1821 the Russians formalized their claim to the northwest shore of North America, complete with a declaration barring any ship from approaching within 100 miles of their coastline. The Russian claim extended as far south as the 51st parallel (the northern extreme of Vancouver Island). A particularly bold Russian effort even saw the founding of Fort Ross, less than 160 kilometers north of San Francisco Bay, in order to secure a (relatively) local supply of foodstuffs for Russia’s American colonial effort.

In response to both the broader geopolitical need as well as the specific Russian challenge, the United States issued the Monroe Doctrine in 1823. It asserted that European powers would not be allowed to form new colonies in the Western Hemisphere and that, should a European power lose its grip on an existing New World colony, American power would be used to prevent their re-entrance. It was a policy of bluff, but it did lay the groundwork in both American and European minds that the Western Hemisphere was not European territory. With every year that the Americans’ bluff was not called, the United States’ position gained a little more credibility.

All the while the United States used diplomacy and its growing economic heft to expand. In 1867 the United States purchased the Alaska Territory from Russia, removing Moscow’s weak influence from the hemisphere and securing the United States from any northwestern coastal approach from Asia. In 1898, after a generation of political manipulations that included indirectly sponsoring a coup, Washington signed a treaty of annexation with the Kingdom of Hawaii. This secured not only the most important supply depot in the entire Pacific but also the last patch of land on any sea invasion route from Asia to the U.S. West Coast.

The Atlantic proved far more problematic. There are not many patches of land in the Pacific, and most of them are in the extreme western reaches of the ocean, so securing a buffer there was relatively easy. On the Atlantic side, many European empires were firmly entrenched very close to American shores. The British held bases in maritime Canada and the Bahamas. Several European powers held Caribbean colonies, all of which engaged in massive trade with the Confederacy during the U.S. Civil War. The Spanish, while completely ejected from the mainland by the end of the 1820s, still held Cuba, Puerto Rico and the eastern half of Hispaniola (the modern-day Dominican Republic).

All were problematic to the growing United States, but it was Cuba that was the most vexing issue. Just as the city of New Orleans is critical because it is the lynchpin of the entire Mississippi watershed, Cuba, too, is critical because it oversees New Orleans’ access to the wider world from its perch on the Yucatan Channel and Florida Straits. No native Cuban power is strong enough to threaten the United States directly, but like Canada, Cuba could serve as a launching point for an extra-hemispheric power. At Spain’s height of power in the New World it controlled Florida, the Yucatan and Cuba — precisely the pieces of territory necessary to neutralize New Orleans. By the end of the 19th century, those holdings had been whittled down to Cuba alone, and by that time the once-hegemonic Spain had been crushed in a series of European wars, reducing it to a second-rate regional power largely limited to southwestern Europe. It did not take long for Washington to address the Cuba question.

In 1898, the United States launched its first-ever overseas expeditionary war, complete with amphibious assaults, long supply lines and naval support for which American warfighting would in time become famous. In a war that was as globe-spanning as it was brief, the United States captured all of Spain’s overseas island territories — including Cuba. Many European powers retained bases in the Western Hemisphere that could threaten the U.S. mainland, but with Cuba firmly in American hands, they could not easily assault New Orleans, the only spot that could truly threaten America’s position. Cuba remained a de facto American territory until the Cuban Revolution of 1959. At that point, Cuba again became a launching point for an extra-hemispheric power, this time the Soviet Union. That the United States risked nuclear war over Cuba is a testament to how seriously Washington views Cuba. In the post-Cold War era Cuba lacks a powerful external sponsor and so, like Canada, is not viewed as a security risk.

After the Spanish-American war, the Americans opportunistically acquired territories when circumstances allowed. By far the most relevant of these annexations were the results of the Lend-Lease program in the lead-up to World War II. The United Kingdom and its empire had long been seen as the greatest threat to American security. In addition to two formal American-British wars, the United States had fought dozens of skirmishes with its former colonial master over the years. It was British sea power that had nearly destroyed the United States in its early years, and it remained British sea power that could both constrain American economic growth and ultimately challenge the U.S. position in North America.

The opening years of World War II ended this potential threat. Beset by a European continent fully under the control of Nazi Germany, London had been forced to concentrate all of its naval assets on maintaining a Continental blockade. German submarine warfare threatened both the strength of that blockade and the ability of London to maintain its own maritime supply lines. Simply put, the British needed more ships. The Americans were willing to provide them — 40 mothballed destroyers to be exact — for a price. That price was almost all British naval bases in the Western Hemisphere. The only possessions that boasted good natural ports that the British retained after the deal were in Nova Scotia and the Bahamas.

The remaining naval approaches in the aftermath of Lend-Lease were the Azores (a Portuguese possession) and Iceland. The first American operations upon entering World War II were the occupations of both territories. In the post-war settlement, not only was Iceland formally included in NATO but its defense responsibilities were entirely subordinated to the U.S. Defense Department.

4. Control the World’s Oceans

The two world wars of the early 20th century constituted a watershed in human history for a number of reasons. For the United States the wars’ effects can be summed up with this simple statement: They cleared away the competition.

Global history from 1500 to 1945 is a lengthy treatise of increasing contact and conflict among a series of great regional powers. Some of these powers achieved supra-regional empires, with the Spanish, French and English being the most obvious. Several regional powers — Austria, Germany, Ottoman Turkey and Japan — also succeeded in extending their writ over huge tracts of territory during parts of this period. And several secondary powers — the Netherlands, Poland, China and Portugal — had periods of relative strength. Yet the two world wars massively devastated all of these powers. No battles were fought in the mainland United States. Not a single American factory was ever bombed. Alone among the world’s powers in 1945, the United States was not only functional but thriving.

The United States immediately set to work consolidating its newfound power, creating a global architecture to entrench its position. The first stage of this — naval domination — was achieved quickly and easily. The U.S. Navy at the beginning of World War II was already a respectable institution, but after three years fighting across two oceans it had achieved both global reach and massive competency. But that is only part of the story. Equally important was the fact that, as of August 1945, with the notable exception of the British Royal Navy, every other navy in the world had been destroyed. As impressive as the United States’ absolute gains in naval power had been, its relative gains were grander still. There simply was no competition. Always a maritime merchant power, the United States could now marry its economic advantages to absolute dominance of the seas and all global trade routes. And it really didn’t need to build a single additional ship to do so (although it did anyway).

Over the next few years the United States’ undisputed naval supremacy allowed the Americans to impose a series of changes on the international system.

The formation of NATO in 1949 placed all of the world’s surviving naval assets under American strategic direction.
The inclusion of the United Kingdom, Italy, Iceland and Norway in NATO granted the United States the basing rights it needed to utterly dominate the North Atlantic and the Mediterranean — the two bodies of water that would be required for any theoretical European resurgence. The one meaningful European attempt to challenge the new reality — the Anglo-French Sinai campaign of 1956 — cemented the downfall of the European navies. Both London and Paris discovered that they now lacked the power to hold naval policies independent of Washington.
The seizure of Japan’s Pacific empire granted the Americans basing access in the Pacific, sufficient to allow complete American naval dominance of the north and central portions of that ocean.
A formal alliance with Australia and New Zealand extended American naval hegemony to the southern Pacific in 1951.
A 1952 security treaty placed a rehabilitated Japan — and its navy — firmly under the American security umbrella.

Shorn of both independent economic vitality at home and strong independent naval presences beyond their home waters, all of the European empires quickly collapsed. Within a few decades of World War II’s end, nearly every piece of the once globe-spanning European empires had achieved independence.

There is another secret to American success — both in controlling the oceans and taking advantage of European failures — that lies in an often-misunderstood economic structure called Bretton Woods. Even before World War II ended, the United States had leveraged its position as the largest economy and military to convince all of the Western allies — most of whose governments were in exile at the time — to sign onto the Bretton Woods accords. The states committed to the formation of the International Monetary Fund and World Bank to assist with the expected post-War reconstruction. Considering the general destitution of Western Europe at the time, this, in essence, was a U.S. commitment to finance if not outright fund that reconstruction. Because of that, the U.S. dollar was the obvious and only choice to serve as the global currency.

But Bretton Woods was about more than currency regimes and international institutions; its deeper purpose lay in two other features that are often overlooked. The United States would open its markets to participating states’ exports while not requiring reciprocal access for its own. In exchange, participating states would grant the United States deference in the crafting of security policy. NATO quickly emerged as the organization through which this policy was pursued.

From the point of view of the non-American founders of Bretton Woods, this was an excellent deal. Self-funded reconstruction was out of the question. The bombing campaigns required to defeat the Nazis leveled most of Western Europe’s infrastructure and industrial capacity. Even in those few parts of the United Kingdom that emerged unscathed, the state labored under a debt that would require decades of economic growth to recover from.

It was not so much that access to the American market would help regenerate Europe’s fortunes as it was that the American market was the only market at war’s end. And since all exports from Bretton-Woods states (which the exception of some Canadian exports) to the United States had to travel by water, and since the U.S. Navy was the only institution that could guarantee the safety of those exports, adopting security policies unfriendly to Washington was simply seen as a nonstarter. By the mid-1950s, Bretton Woods had been expanded to the defeated Axis powers as well as South Korea and Taiwan. It soon became the basis of the global trading network, first being incorporated into the General Agreement on Tariffs and Trade and in time being transformed into the World Trade Organization. With a single policy, the Americans not only had fused their economic and military policies into a single robust system but also had firmly established that American dominance of the seas and the global economic system would be in the interest of all major economies with the exception of the Soviet Union.

5. Prevent any Potential Challengers from Rising

From a functional point of view the United States controls North America because it holds nearly all of the pieces that are worth holding. With the possible exception of Cuba or some select sections of southern Canada, the rest of the landmass is more trouble than it is worth. Additionally, the security relationship it has developed with Canada and Mexico means that neither poses an existential threat to American dominance. Any threat to the United States would have to come from beyond North America. And the only type of country that could possibly dislodge the United States would be another state whose power is also continental in scope.

As of 2011, there are no such states in the international system. Neither are there any such powers whose rise is imminent. Most of the world is simply too geographically hostile to integration to pose significant threats. The presence of jungles, deserts and mountains and the lack of navigable rivers in Africa does more than make Africa capital poor; it also absolutely prevents unification, thus eliminating Africa as a potential seedbed for a mega-state. As for Australia, most of it is not habitable. It is essentially eight loosely connected cities spread around the edges of a largely arid landmass. Any claims to Australia being a “continental” power would be literal, not functional.

In fact, there are only two portions of the planet (outside of North America) that could possibly generate a rival to the United States. One is South America. South America is mostly hollow, with the people living on the coasts and the center dominated by rainforests and mountains. However, the Southern Cone region has the world’s only other naturally interconnected and navigable waterway system overlaying arable land, the building blocks of a major power. But that territory — the Rio de la Plata region — is considerably smaller than the North American core and it is also split among four sovereign states. And the largest of those four — Brazil — has a fundamentally different culture and language than the others, impeding unification.

State-to-state competition is hardwired into the Rio de la Plata region, making a challenge to the United States impossible until there is political consolidation, and that will require not simply Brazil’s ascendency but also its de facto absorption of Paraguay, Uruguay and Argentina into a single Brazilian superstate. Considering how much more powerful Brazil is than the other three combined, that consolidation — and the challenge likely to arise from it — may well be inevitable but it is certainly not imminent. Countries the size of Argentina do not simply disappear easily or quickly. So while a South American challenge may be rising, it is extremely unlikely to occur within a generation.

The other part of the world that could produce a rival to the United States is Eurasia. Eurasia is a region of extremely varied geography, and it is the most likely birthplace of an American competitor that would be continental in scope. Geography, however, makes it extremely difficult for such a power (or a coalition of such powers) to arise. In fact, the southern sub-regions of Eurasia cannot contribute to such formation. The Ganges River Basin is the most agriculturally productive in the world, but the Ganges is not navigable. The combination of fertile lands and non-navigable waterways makes the region crushingly overpopulated and poor.

Additionally, the mountains and jungles of South and Southeast Asia are quite literally the world’s most difficult terrain. The countries in these sub-regions cannot expand beyond their mountain boundaries and have yet to prove that they can unify the resources within their regions (with the India-Pakistan rivalry being the most obvious example of sub-regional non-unity). The lands of the Middle East are mostly desert with the bulk of the population living either near the coasts — and thus very vulnerable to American naval power — or in river valleys that are neither productive enough to support an agenda of power projection nor accessible enough to encourage integration into a larger whole. Only the Fertile Crescent has reliable agriculture, but that agriculture is only possible with capital- and labor-intensive irrigation. The region’s rivers are not navigable, and its lands are split among three different states adhering to three different religions (and that excludes fractious Lebanon).

That leaves only the lands of northern Eurasia — Europe, the former Soviet Union and China — as candidates for an anti-American coalition of substance. Northern Eurasia holds even more arable land than North America, but it is split among three regions: the North European Plain, the Eurasian steppe and the Yellow River basin. Although the developed lands of the North European Plain and the Eurasian steppe are adjacent, they have no navigable waterways connecting them, and even within the North European Plain none of its rivers naturally interconnects.

(click here to enlarge image)

There is, however, the potential for unity. The Europeans and Russians have long engaged in canal-building to achieve greater economic linkages (although Russian canals linking the Volga to the sea all freeze in the winter). And aside from the tyranny of distance, there are very few geographic barriers separating the North European Plain from the Eurasian steppe from the Yellow River region, allowing one — theoretically — to travel from Bordeaux to the Yellow Sea unimpeded.

And there are certainly synergies. Northern Europe’s many navigable rivers make it the second-most capital-rich region in the world (after North America). The fertility of the Yellow River basin gives it a wealth of population. The difficulty of the arid and climatically unpredictable Eurasian steppes, while greatly diminishing the utility of its 106 billion hectares of farmable land, actually brings a somewhat inadvertent benefit: The region’s geographic difficulties force the consolidation of Russian military, economic and political power under a single government — to do otherwise would lead to state breakdown. Among these three northern Eurasian regions is the capital, labor and leadership required to forge a continental juggernaut. Unsurprisingly, Russian foreign policy for the better part of the past two centuries has been about dominating or allying with either China or major European powers to form precisely this sort of megapower.

And so the final imperative of the dominant power of North America is to ensure that this never happens — to keep Eurasia divided among as many different (preferably mutually hostile) powers as possible.

The United States does this in two ways. First, the United States grants benefits to as many states as possible for not joining a system or alliance structure hostile to American power. Bretton Woods (as discussed above under the fourth imperative) is the economic side of this effort. With it the United States has largely blunted any desire on the part of South Korea, Japan and most of the European states from siding against the United States in any meaningful way.

The military side of this policy is equally important. The United States engages in bilateral military relationships in order to protect states that would normally be swallowed up by larger powers. NATO served this purpose against the Soviets, while even within NATO the United States has much closer cooperation with states such as the United Kingdom, Norway, Denmark, the Netherlands, Poland and Romania, which feel themselves too exposed to extra-NATO foes (most notably Russia) or even intra-NATO allies (most notably Germany).

The United States has similar favored relationships with a broad host of non-European states as well, each of which feels physically threatened by local powers. These non-European states include Pakistan (concerned about India), Taiwan (China), South Korea (North Korea, China and Japan), Mongolia (China and Russia), Thailand (China, Myanmar and Vietnam), Singapore (Malaysia and Indonesia), Indonesia (China), Australia (China and Indonesia), Georgia (Russia), the United Arab Emirates and Qatar (Saudi Arabia and Iran), Saudi Arabia (Iran), Israel (the entire Muslim world), Jordan (Israel, Syria and Iraq) and Kuwait (Iran, Iraq and Saudi Arabia).

The second broad strategy for keeping Eurasia divided is direct intervention via the United States’ expeditionary military. Just as the ability to transport goods via water is far cheaper and faster than land, so, too, is the ability to transport troops. Add in American military dominance of the seas and the United States has the ability to intervene anywhere on the planet. The United States’ repeated interventions in Eurasia have been designed to establish or preserve a balance of power or, to put it bluntly, to prevent any process on Eurasia from resulting in a singular dominating power. The United States participated in both world wars to prevent German domination, and then bolstered and occupied Western Europe during the Cold War to prevent complete Russian dominance. Similarly, the primary rationale for involvement in Korea and Vietnam was to limit Russian power.

Even the ongoing conflicts in Afghanistan and Iraq should be viewed in this light. Al Qaeda, the Islamist militant group behind the 9/11 attacks, espoused an ideology that called for the re-creation of the caliphate, a pan-national religious-political authority that would have stretched from Morocco to the Philippines — precisely the sort of massive entity whose creation the United States attempts to forestall. The launching of the war in Afghanistan, designed to hunt down al Qaeda’s apex leadership, obviously fits this objective. As for Iraq, one must bear in mind that Saudi Arabia funded many of al Qaeda’s activities, Syria provided many of its recruits and Iran regularly allowed free passage for its operatives. The United States lacked the military strength to invade all three states simultaneously, but in invading Iraq it made clear to all three what the continued price of sponsoring al Qaeda could be. All three changed their policies vis-a-vis al Qaeda as a result, and the recreation of the caliphate (never a particularly likely event) became considerably less likely than it was a decade ago.

But in engaging in such Eurasian interventions — whether it is World War II or the Iraq War — the United States finds itself at a significant disadvantage. Despite controlling some of the world’s richest and most productive land, Americans account for a very small minority of the global population, roughly 5 percent, and at no time has more than a few percent of that population been in uniform (the record high was 8.6 percent during World War II). While an expeditionary military based on maritime transport allows the United States to intervene nearly anywhere in the world in force in a relatively short time frame, the need to move troops across the oceans means that those troops will always be at the end of a very long supply chain and operating at a stark numerical disadvantage when they arrive.

This prods the United States to work with — or ideally, through — its allies whenever possible, reserving American military force as a rarely used trump card. Note that in World Wars I and II the United States was not an early participant, instead becoming involved three years into each conflict when it appeared that one of the European powers would emerge victorious over the others and unify Europe under its control. Washington could not allow any country to emerge dominant. In the Cold War the United States maintained front-line forces in Western Europe and South Korea in case of hostilities, but it did so only under the rubric of an alliance structure that placed its allies directly in harm’s way, giving those allies as much — if not more — reason to stand against U.S. foes. In many ways it allowed the reapplication of the U.S. strategy in the world wars: allow both sides to exhaust each other, and then join the conflict and collect the winnings with (by comparison) minimal casualties.

The strategy of using its allies as bulwarks has granted the United States such success that post-Cold War Washington has been able to reduce the possibility of regional hegemons emerging. Examples include the backing of the Kosovar Albanians and Bosniacs against Serbia in the 1990s Yugoslav wars and Operation Desert Storm in 1991. Ongoing efforts to hamstring Russia — Ukraine’s 2004-2005 Orange Revolution, for example — should also be viewed in this light.