The Fed Adds a Third Mandate
A Rational Voice in Dallas
Thinking the Unthinkable
The Threat of the Irish
Has China Found a Miracle Business Cycle?
LA, Winnipeg, Las Vegas, and Thailand
week, in the first part of my annual forecast, I suggested that 2011 would be
better than Muddle Through, with GDP growth in the US north of 2.5%. World GDP
growth should be even better. This week we look at what I see as the real
downside risks to that prediction. Oddly enough, the risks are not in the US
but on the other side of both our oceans, in Europe and China. Plus, we will
visit a few other items, assuming we have space (Bernanke’s recent speech just
screams for some comments).
Two housekeeping items. First, I
will once again be hosting, along with my partners Altegris Investments, our 8th
annual Strategic Investment Conference, in La Jolla April 28-30. Save the date.
Each year the conference gets better. We have as strong a lineup of speakers as
any conference in the country. I will announce when we will take reservations.
It always sells out, so I suggest you do not procrastinate.
Secondly, between finishing my
book and the holidays, I have been rather quiet the past few months in regards
to my Conversations with John Mauldin, but that is getting ready to change.
Over the next few weeks I will be doing conversations with David Rosenberg,
Lacy Hunt (his quarterly will be next week’s Outside the Box), George Friedman
of Stratfor, and John Burns and Rick Sharga to get the latest on the housing
markets; and I am lining up some more very interesting Conversations, so that
subscribers will get more than their money’s worth. Now, let’s jump into the
The Fed Adds a Third Mandate
Fed has two mandates: keeping prices stable and creating an economic climate
for low unemployment. I am sure I was not the only one to listen to Steve
Liesman’s interview of Ben Bernanke this week and shake my head at the spin he
was giving us. First, let’s set the stage.
a paper with Alan Blinder early last decade, Bernanke made the case for the Fed
to target a specific inflation number, and the number that came to be accepted
as his target was 2%. In his famous helicopter speech in late 2002, he assured
us that inflation could not happen “here,” even if the short-term rate was
zero, because the Fed would move out the yield curve by buying large amounts of
medium-term bonds. This would have the effect of lowering yields all along the
upper edge of the curve. This became known as quantitative easing. In Jackson
Hole last summer, he made very clear his intention to launch a second round of
liquidity-injecting quantitative easing (QE2). In that speech, in later
speeches in the fall, and in op-ed pieces he said that such a program would lower
a funny thing happened on the way to QE2: long-term rates began to rise all
over the developed world. As Yogi Berra noted, "In theory,
there is no difference between theory and practice.
In practice, there is." It’s got to be driving Fed types
nuts to see the theory of QE, so lovingly advanced and believed in by so many
economists, be relegated to the trash heap, along with so many other economic
theories (like that of efficient markets). The market has a way of doing that.
Liesman asked Bernanke about one minute into the clip (link below) about the
little snafu that, following QE2, both interest rates and commodity prices have
risen. How can that be a success? Ben’s answer (paraphrased):
have seen the stock market go up and the small-cap stock indexes go up even
Is it the third mandate of the Fed now to foster a rising stock market? I
wonder what the Fed’s target for the S&P is for the end of the year? That
would be an interesting bit of information. Are we going to target other asset
Understand, I am not against a
rising stock market. But that is not the purview of the Fed. And certainly not
a reason to add $600 billion to the balance sheet of the Fed when we clearly do
not understand the consequences. If it looks like they’re making up the rules
as they go along, it’s because they are.
is the clip: http://www.cnbc.com/id/15840232/?video=1742165849&play=1
A Rational Voice in Dallas
Fisher is the president of the Federal Reserve branch in Dallas and a voting
member this year of the FOMC committee. (Also a true gentleman, one of the
nicest guys you could want to meet, and my neighbor, just a few blocks down the
street.) But being a nice guy doesn’t keep him from espousing some strong and
dissenting views about Fed policy. He recently gave a speech to the Manhattan
Institute that should be required reading (link below) for all policy makers at
all levels of government, and not just Fed types. As an anecdote to the
Bernanke spin above, let me quote a few paragraphs:
“The new Congress and the new
staff in the White House have their work cut out for them. You cannot overstate
the gravity of their duty on the economic front. Over the years, their
predecessors — Republicans
and Democrats together —
have dug a fiscal sinkhole so deep and so wide that, left unrepaired, it
will swallow up the economic future of our children, our grandchildren and
their children. They must now engineer a way out of that frightful predicament
without thwarting the nascent economic recovery.
“I have been outspoken about the
limits of monetary policy as a salve for the nation’s fiscal pathology. The Fed
has done much, in my words, to provide the bridge financing until the new
Congress gets to work restructuring the tax and regulatory incentives American
businesses need to confidently expand their payrolls and capital expenditures
here at home.
“The Federal Reserve has held
rates to nil. We have expanded our balance sheet to unprecedented levels. After
much debate — which
included strong concern expressed by one member with a formal vote and others,
like me, who did not have voting rights in 2010
— the FOMC collectively decided in November to temporarily
undertake a program to purchase U.S. Treasuries that, when added to previous
policy initiatives, roughly means we are purchasing the equivalent of all newly
issued Treasury debt through June.
“By this action, we have run the
risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid
that perception, we must vigilantly protect the integrity of our delicate
franchise. There are limits to what we can do on the monetary front to provide
the bridge financing to fiscal sanity. Last Friday, speaking in Germany,
[European Central Bank President] Jean-Claude Trichet said it best: ‘Monetary
policy responsibility cannot substitute for government irresponsibility.’
“The entire FOMC knows the
history and the ruinous fate that is meted out to countries whose central banks
take to regularly monetizing government debt. Barring some unexpected shock to
the economy or financial system, I think we have reached our limit. I would be
wary of further expanding our balance sheet. But here is the essential fact I
want to emphasize today: The Fed could not monetize the debt if the debt were
not being created by Congress in the first place.
“Those lawmakers who advocate
‘Ending the Fed’ might better turn their considerable talents toward ending the
fiscal debacle that has for too long run amuck within their own house. The Fed
does not create government debt; fiscal authorities do. Deficits and the
unfunded liabilities of Medicare and Social Security are not created by the
Federal Reserve; they are the legacy of those who control the purse strings — the Congress,
working with the president. The Fed does not earmark taxpayer money for pet
projects in local communities that taxpayers themselves would never
countenance; only the Congress does that. The Congress and administration play
the dominant role in creating the regulatory environment that incentivizes or
discourages job creation.
A reader of Shakespeare will recall the dialogue between Glendower and Hotspur
in Henry IV. Glendower claims, ‘I can call spirits from the vasty
deep.’ And Hotspur replies, ‘Why, so can I, or so can any man; But will they
come when you do call for them?’
“We shall see if the new Congress
will prove worthy of the power the American people have ‘loaned’ them, and,
together with the president, actually draw the spirits of fiscal reform and
sanity from the ‘vasty deep’ to at long last implement meaningful fiscal and
regulatory policy that incentivizes private-sector job creation here at home
while arresting the hemorrhaging of our Treasury. If they do, then more
Americans will find work and be better off, better paid, and freer to make
their own decisions about the economy.
“If they don’t, then woe to our
children, their children, and the American Dream.”
Let us hope President Fisher
will find support within the FOMC. I commend his speech to you: http://www.dallasfed.org/news/speeches/fisher/2011/fs110112.cfm
. And now on to Europe.
Thinking the Unthinkable
baseline assumption is that Europe kicks the sovereign debt can down the road
for the rest of the year. We have seen Portuguese debt sales go well this week,
even if at a very steep price. Spain looks like it will also do OK. Trichet is
beginning to drum up support for an even bigger fund to stave off the bond
vigilantes. It is unthinkable, we are told in many corners of Europe, that a
sovereign nation would default on its debt or obligations. But, in my
experience, it is the unthinkable things that can rise up to bite you in the
derriere. Sometimes rather viciously. It was unthinkable that US subprime
mortgages would infect the entire planet. Well actually, not entirely, as some
of us did think that very thing in writing, well in advance of the crisis.
is one of my jobs here in Thoughts from the Frontline to sit around and think
about the unthinkable. What is there on page 16, or in some obscure research
paper, that is going to make its way to the top of page one?
asked in interviews what my number one concern is today, I readily answer,
“European sovereign debt and European banks.” (In 2006 it was subprime debt. In
2007 it was bank debt and derivatives. Etc.) That heads a long list of present
concerns, I will admit, but it is clearly at the top.
Spain, Belgium, and Portugal will need to raise over $800 billion this year to
cover rollover debt and new borrowing. Add in Greece, Ireland, and a few other
countries and it quickly gets to a trillion or so. Doable. But is does add a
lot of debt.
posted a piece a few months ago about Belgium. Belgium is not on the “usual
suspects” list when we talk about European debt woes. But this page-16 story
may be making its way to page one over the next few years.
total debt is pushing 100% of GDP and, given its fiscal deficits, probably will
push through that level soon. This is a country of just 10 million people, and
a deeply divided one at that, unable to elect a government. They are making
progress on getting their fiscal house in order, but are not there. And the
market is getting nervous.
good friend and data maven Greg Weldon gives us some details. Belgian interest
rates, while down from the depths of the credit crisis, are once again
beginning to rise, along with those of Spain and Italy. (www.weldononline.com)
is unthinkable that Belgium could have a problem, isn’t it? Except that there
is a very serious and growing contingent of citizens who want to divide the
country into two parts. I am sure cool heads will prevail, but I do pay
attention to Belgium’s politics. I will also be in Brussels in March, so I will
get some first-hand stories.
that is not a 2011 story. No, for this year my concern is the large amount of
Irish sovereign debt on the books of European banks.
The Threat of the Irish
the midst of the credit crisis last year, the Irish government guaranteed not
only the deposits of Irish banks but their bonds. Irish banks, like Icelandic
banks, were larger than the GDP of the country. As it turns out, those
guarantees are going to cost a great deal of money, about 30% of GDP. That
would be the equivalent of over $4 trillion for the US, just for some
perspective. And many of those guarantees are to German, French, and British
banks. Irish taxpayers are in effect bailing out not only their own banks but
banks all across Europe.
“bailout” engineered by the ECB and European authorities will require that that
Irish pay around 10% of their national income in a few years just to service
the debt, according to Barry Eichengreen, professor at U Cal Berkeley. How can
you take 30-50% of your government taxes and pay down such high debt loads at
6% interest? That doesn’t leave much for actual government services. The short
answer is, only with a lot of local pain and none for the bank bondholders,
which again are German, French, and British banks. As Eichengreen writes:
is not politically sustainable, as anyone who remembers Germany’s own experience
with World War I reparations should know. A populist backlash is inevitable.
The Commission, the ECB, and the German Government have set the stage for a
situation where Ireland’s new government, once formed early next year, rejects
the budget negotiated by its predecessor.
Mr. Trichet and Mrs. Merkel have a contingency plan for this?
is the situation economically sustainable. Ireland is told to reduce wages and
costs. It must engage in ‘internal devaluation’ because the traditional option
of external devaluation is not available to a country that lacks its own
the more successful it is at reducing wages and costs, the heavier will be its
inherited debt load. Public spending then has to be cut even more deeply. Taxes
have to rise even higher to service the debt of the government and its wards
such as the banks.
in turn implies the need for yet more internal devaluation, which further
heightens the burden of the debt in a vicious spiral. This is the phenomenon of
‘debt deflation’ about which the Yale economist Irving Fisher wrote in a famous
article at the nadir of the Great Depression.”
is precisely the same phenomenon that I was describing last year when I was
writing about Greece. I deal with it at length in my new book, Endgame, out in early March (I hope).
This debt deflation/devaluation spiral will end in tears. The question is, will
those tears be from Irish eyes?
think what is unthinkable by most Europhiles, but not to Eichengreen or your
the polls indicate that the governing party, which cut the deal to increase the
debt load by some 30% of GDP, will lose the elections, most likely to parties
that are campaigning on repudiating that debt. Irish bank bondholders could
face a haircut of some 80% or more, which is more like a leg amputation than a
party (or parties if there is a coalition) will have a mandate to simply not
guarantee Irish bank debt, which would get their total debt-to-GDP down to a
still-high but manageable 100%. Not good, but something they can grow out of
over time. There are a lot of good things still happening in Ireland, and you
don’t have to look too hard to find some positives.
read a very good blog about Ireland written by Ronan Lyons, whom I hope to
share a pint or two with some day, when I make my first pilgrimage to the Fair
Isle. He gives us eleven reasons to be optimistic about Ireland. Maybe it’s
just the nature of the Irish to find that silver lining, but this comes under
the heading of optimistic realism. Here’s Ronan:
“So, while Ireland faces very significant
challenges, we should not write ourselves off just yet. Yes, our
problems are largely our own fault in not preparing for life in the eurozone.
Yes, the next five Budgets are going to be tough ones for everyone. And yes,
Ireland in 2016 will not be what we might have thought it would in 2006…
“But Ireland in 2016 will probably be a far better
place to live than any of us thought possible in 1996, 1986 or indeed any
previous decade. The
Celtic Tiger was not a mirage. And we have a very real economy that, with a
good bit of hard work and with a fundamental reorganization of how government
raises and spends money, can deliver for us again. That starts in 2011.”
But part of that reorganization may involve some
very tough negotiations. The incoming parties should stick to their mandate.
Why should they back Irish bank debt to the Germans and the French at the
expense of being mired in a depression for a decade or more? At least I think
that is what the political discussion will be.
the ECB, IMF, and the rest of the EU says, “If you don’t take on that debt we
will not buy any more of your debt. You will be shut off from the subsidized
debt markets,” then what? Ireland could answer back, “You want us to pay the
rest of this debt? Go pound sand.” Or whatever the Irish equivalent is. It will
be a very intense and interesting set of negotiations.
while that is happening there is a lot of uncertainty, and markets hate, hate,
hate uncertainty. Will the EU or ECB buy that bad bank debt off the books of
the private banks? (Refer to the graph below to see where the debt is.) Who picks
up the tab? German taxpayers? The Bank of England? Note that nearly $100
billion is owed to US banks. That is NOT chump change.
is particularly exposed. What would it do to the pound if the Bank of England
had to bail out British banks to the tune of almost $200 billion? Note that
Royal Bank of Scotland and Lloyds are almost wards of the state, as it is. And
the euro could come under intense pressure.
eurozone leaders do not act, such a confrontation could spiral out of control
rather quickly. Think November 2007. Think Bear Stearns and Lehman. Interbank
lending could dry up almost overnight.
it happen? No one knows. But it should be on our radar screen. Here’s a side
issue. If Ireland walks away, what does that say to Greek voters? Or to the
Portuguese? Is it a one-off —Ireland just not wanting to back their bank
debt — or could it be the first domino of a general debt restructuring?
This we will need to watch. There. We thought about it.
Has China Found a Miracle Business Cycle?
let’s look over the Pacific Ocean to China. They seem to have repealed the laws
of business-cycle gravity, going from one fabulous growth year to the next.
Most analysts are predicting another solid year of high single-digit growth.
And that is the base-case scenario. But what if the unthinkable happens?
inflation is in the high single digits. Unofficial inflation may be running
closer to 20%. Simon Hunt wrote last year:
“Our friends in Beijing talk
about the daily cost of living rising at an annual rate of around 20%. In
Shanghai gas prices to the home have risen by some 600% in two years and
electricity by over 300%.”
More recently he wrote:
“The large increase in minimum
wages announced after Christmas have two powerful implications. First, de
facto, they suggest that actual inflation is higher than is being shown in the
official CPI data; and, second, that China’s pool of surplus labor is drying
up. The latter has important implications for wage inflation and the structure
“Beijing announced an increase
in minimum wages of 21%, after raising them by 20% in June this year. Across
China every municipal authority has already raised its minimum wage with most
only six months ago. Further hikes are possible early this year. Wage increases
of this size are more than can be warranted by normal living adjustments. They
reflect an abnormal rise in inflation and a tightening labor market.”
The Chinese central bank keeps
raising reserve requirements for banks, and is slowly allowing interest rates
to rise. Can the Chinese central bank engineer a soft landing with inflation so
I am not sure about this year,
but I do know this: no country has ever figured out how to repeal the business
cycle. Eventually there is a recession. And when China has a recession, the
rest of the world will feel it, just as the world responds to a US recession.
Recessions are just nature’s way of wringing out excesses. They are not
permanent. In fact some research suggests that the longer a recession is
delayed, the worse the excesses get. This is yet another situation we will need
to give close attention.
As an aside, I think the
inflation predicament China finds itself in will give the Chinese some reason
and room to gradually allow the renminbi to rise against the dollar. And the
country is to be applauded for recently allowing more free trading of their
currency in the US. Eventually they will float their currency, as it cannot
become a real candidate for a reserve currency until they do. But that is
clearly what they would like to see. It is just a matter of time.
LA, Winnipeg, Las Vegas, and Thailand
you are an investment advisor or broker, meet me in Las Vegas, where I will be
speaking for my partner Steve Blumenthal of CMG on February 3-4. We have a very
solid lineup, including Christopher
Geczy, Ph.D. of Wharton, at the CMG Investment Forum. Go to http://cmgfunds.net/sys/docs/234/Feb%20Las%20Vegas%20Invitation.pdf
to learn more.
fly to LA tomorrow morning for some meetings with the execs at ISCO, and then
attend a fundraiser with good friend Lee Stein for the Professional Baseball
Scouts Foundation. Loads of fun for us baseball fans, with lots of Hall of
Famers in attendance. I will be the groupie tomorrow night.
Next week I fly to Winnipeg,
getting a lot of reading done on the way. Then on to Thailand, where I will be
speaking in Phuket at a meeting of the execs of MGPA, a large real estate
private equity group. After that, I take a few days to be a tourist in Bangkok
with my old friend Tony Sagami, who now lives in Thailand. I have never been
and really look forward to it.
Last week in Cabo was something
special. What a fabulous time. I need more of those moments. I can’t resist
showing a picture of Tiffani, Ryan, my granddaughter Lively, and your humble
analyst. A very contented family that evening. If you look at Tiffani’s baby
pictures when she was one, it is hard to see a difference between her and
Lively. That bodes well.
a great week. And here’s to hoping for a smooth 2011.
Your hoping to keep warm in Canada analyst,
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.
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01-15-2011 12:09 PM