Thoughts From The Frontline : Crisis

Forecast 2013: Unsustainability and Transition

John Mauldin — Tue, 15 Jan 2013 04:39:00 GMT

Unsustainability and Transition
One Bubble to Rule Them All
The Year of the Windshield
Godzilla Redux: Disaster A or Disaster B
France Is the New Greece
US: The Crisis Games
Entitlement Unsustainability
London, Athens, Geneva, Toronto, and New York

“There are decades when nothing happens and there are weeks when decades happen.” – Vladimir Ilyich Lenin

"People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them." – Jean Monnet

"If something cannot go on forever, it will stop." –Herbert Stein

As we begin a new year, we again indulge ourselves in the annual (if somewhat futile) rite of forecasting the year ahead. This year I want to look out a little further than just one year in order to think about the changes that are soon going to be forced on the developed world. We are all going to have to make a very agile adaptation to a new economic environment (and it is one that I will welcome). The transition will offer both crisis and loss for those mired in the current system, which must evolve or perish, and opportunity for those who can see the necessity for change and take advantage of the evolution.

This is my most-read letter of the year, by the way, and if you’re not yet a subscriber you can join my “one million best friends” and receive both Thoughts from the Frontline and my other weekly letter, Outside the Box, as well as Grant Williams’ rollicking Things That Make You Go Hmmm…, all for free, by simply entering your email address on my site: http://www.mauldineconomics.com/go/bwbsl/CAS

Unsustainability and Transition

Think back to 2001. It was the opening of a new millennium. While that was auspicious enough, several events then ensued that shaped the future for decades to come. China was admitted to the World Trade Organization, leading to a revolution in its production and global trade. The euro was launched with much fanfare – and a minor chorus of criticism. We are now in a midst of a great trial that will determine whether the euro will be a brief experiment or a durable currency. This has dramatic implications not only for Europe but for the world. And, of course, the tragic events of 9/11 shaped a new global perception of what constitutes threats to democracy and security.

Also as the century opened, a secular bear market had just begun, which diminished returns for retirees. Economic activity in the developed world has yet to recover to the pace of the previous century; and many analysts, as we saw in the last letter for 2012, predict an even slower pace of global growth for the rest of this decade. A fear of deflation prompted Alan Greenspan to lower interest rates to levels that eventually created a housing bubble and encouraged Congress, through lower debt costs, to run up huge deficits prior to the economic collapse of 2008. Since then, our deficit and debt have only gotten worse since.

You can read all sorts of economic predictions for this year. Some expect a return to the growth rate of last century and a new bull market. Some see a recession, a major downturn. But no matter what your view of the next 12 months, there is a pervasive sense that the current system of swelling government debt and entitlement promises cannot be sustained. Politicians may persist in kicking the can further down the road, but anyone with third-grade math can see that the system is unsustainable. The US cannot pay an estimated $200 trillion (and growing) in entitlement obligations (Burns and Kotlikoff, The Clash of Generations), although others say that we owe a “mere” $80-plus trillion. Japan cannot continue to borrow 45% of its government budget at 1% when debt is at 230% of GDP and rising over 10% a year. Europe cannot postpone the consequences of an unequal currency union forever.

We live in an unsustainable world. To extend the thought of Herb Stein, we must change the world to one that will be more sustainable. That has been an implicit theme in this letter for years, but this year it will be an explicit theme that we will visit often. That transition to a more sustainable world is going to involve uncomfortable changes for many, if they do not prepare for it.

At the outset, let me state that this “unsustainability” is not a reference to the Malthusian arguments that the world is running out of food, energy, or the other necessary commodities to insure economic progress for a growing world. I reject those arguments. I have a great deal more faith than that in our ability to transition to new forms of food and energy production. I am in fact quite optimistic about the future of the world. No one will want to go back to the good old days of 2013 in 2033. Our age will seem a quaint time of poor health care (“Can you imagine, people died of cancer back in those days?”), scarcity, and a soul-sappingly dreary manufacturing system. The transition we are undertaking to a new world of innovation and technology will be unsettling to many people, but those changes are by and large positive ones, and they will be welcome.

As I was finalizing this letter, my friend Barry Ritholtz at The Big Picture sent this note:

The deficit scolds have been warning for years that hyperinflation is imminent. I have been hearing these ominous warnings my entire adult life. “This is unsustainable! Inflation is about to explode!” But inflation has been rather tame, and we are not experiencing anything remotely like hyperinflation. They keep using that word “unsustainable,” but with all due respect to Inigo Montoya, I do not think that word means what they think it means.

I am definitely in the deficit (and debt!) scold camp, but I give little credence to the US hyperinflation believers. Very different animals. I also believe that we can get the deficit under control if we so choose – or the market may force us to do so.

One Bubble to Rule Them All

The unsustainability I refer to is that of the largest bubble in human history: government debt in tandem with government promises that cannot be fulfilled. And unlike 1993 when only the developed countries of Canada and Sweden had to deal with unsustainable debt, bloated budgets, and unrealistic promises, this time the bubble countries comprise the largest economies and the majority of global GDP.

This is not a short-term matter. There are three distinct economic ecologies that will have to change and will do so on their own timetables. And owing to their size and the significant abilities of a committed establishment to resist change, no matter how inevitable, we are talking years of transition, not months.

The economic ecologies I refer to are of course Europe, Japan, and the United States. One could argue that a fourth center of unsustainability exists: China. However, I am not convinced that anything more than the usual garden-variety recessions are in store for China.(I’m not forecasting Chinese recessions, just pointing out that not even the Chinese can repeal the business cycle forever).

We will not get into detail on each of the three economies mentioned but will touch on each. And I’ll end with a note on where investors should look to make the transition a new era of sustainability. Let’s start with Japan.

The Year of the Windshield

Back in late November and December I commented in several radio and TV interviews that the title for my annual forecast issue would be “The Year of the Windshield.” I changed the actual title only recently as I thought more about the upcoming year in its totality, but perhaps the most dramatic shift this year will be that Japan at last begins its descent into that dark night, from the twilight that has been its economy for 20 years. The subtitle comes from my book Endgame, where I whimsically titled a chapter “Japan Is a Bug in Search of a Windshield.”

The problems, which we will look at briefly in a few paragraphs, are well known. Yet Japan has soldiered on, borrowing yet more massive amounts of money, never bringing its budget into line, spending huge amounts on stimulus and infrastructure, and muddling through with an economy that is no bigger today than it was 20 years ago. Japan’s stock market is still down some 75% (give or take) over the last 23 years, though some were celebrating a 23% move last year. Given the frustration that investors have endured from the Nikkei over that time, I suppose you take solace when and where you can. The chart below is current as of this week. You can get more details on the index performance over the last two decades at http://www.forecast-chart.com/historical-nikkei-225.html.

Japan now has a breathtaking 230% ratio of government debt to GDP (the last estimate I have seen), and it is growing at 10%-plus a year. The government will borrow almost 45% of its budget this year. Has there ever been a more clear disaster in the making? Yet shorting the Japanese bond has been called “the widow-maker.” I think it was Soros who once quipped that you can’t call yourself a global macro trader until you have lost money shorting JGBs (Japanese government bonds).

The new Japanese government, led by Prime Minister Abe and former Prime Minister and now Minister of Finance Aso, have very explicitly demanded that the Bank of Japan target 2% inflation. They have made clear their intention to replace the governors of the current BoJ board with members who agree with this policy. They have the political clout to do so. Whether at the upcoming meeting or after April, when a new head of the BoJ is appointed, that is going to happen. These moves mean there will be a massive printing of yen. In response, the yen has already weakened by over 10%.

You can control the quantity of money or the price of money but not both. (Yes, I know that one influences the other, but I am referring here to large-scale printing of money.) One has to assume that the law of gravity will not be repealed and that investors will want something more than 2% on the ten-year bond if inflation is at 2%. If the ten-year bond were to rise by 2%, Japan would soon be spending over 50% of its tax revenues on the interest carry alone. I submit that this is not a workable business model.

Why now and not sometime during the past ten years? I see a number of factors coming together this year:

1. The Japanese had a 15%+ savings rate in 1990. That is now down below 1%. (Exact numbers are difficult, because Japanese data on this topic has severe lags, and thus my number is an extrapolation but a reasonable one, I think.) Due to the nature of their retirement system, they have channeled the vast bulk of these savings into JGBs. When the savings rate goes negative or is no longer sufficient to buy all the issued debt, the choice will be to monetize the debt or cut spending. The latter choice does not appear to be part of their national conversation. Cutting spending by the amount required will mean a serious recession and further deflation, an option the new government explicitly rejects.

2. Both the trade deficit and the current account have recently turned negative. The vaunted Japanese export machine seems to have hit a wall, and this will limit options in controlling the price of the yen, even if the government wants to. Understand, inflation targeting is also currency-valuation targeting. They clearly want the yen to devalue. I have been writing for years that the yen would eventually be 125, then 150, then 200 to the dollar. It has been 300 in my lifetime, and unless the Japanese change direction, there is no reason it can’t get there again. This means that Mrs. Watanabe will see her energy bills double. This will call into question the Japanese decision to close their nuclear energy plants – something that Abe is already reconsidering.

Think the Koreans will be happy when you can buy a Lexus cheaper than you can buy a Kia? (Disclosure: I love my Japanese Infiniti, the first “foreign” car I have bought, except for a two-month dalliance with a disaster of a Volkswagen 30 years ago.) Think Samsung and LG will be happy when Panasonic and Sony can eat their lunch pricewise? Welcome to the era of real currency wars.

Today this note is worth about $11. In the future? Not so much.

Godzilla Redux: Disaster A or Disaster B

Japan is now committed to either Disaster A or Disaster B. Remember those really bad Japanese “horror” movies of the ’50s and ’60s? Godzilla first released in 1954, and there were dozens of remakes and follow-on movies. It seemed endless. And while the current government policy will not trash downtown Tokyo, it will seriously damage the savings and buying power of two generations. Disaster A is monetization, which is clearly not good when the Japanese want to buy anything not made in Japan (like energy, steel, commodities, a lot of food, etc.) Disaster B is the deflationary depression that budget balancing will yield. Which leads us to the next factor:

3. Once the government is committed to the new strategy, any retreat will cause a market upheaval. This is not a short-term commitment. It seems to me that the Japanese truly believe that their lack of economic growth can be solved through inflation. Their politicians seem to be channeling their inner Paul Krugman, or at the least taking Bernanke’s advice from 2000, when he published a paper called “Japan’s Slump: A Case of Self-Induced Paralysis?”

When your debt and deficit are as massive as Japan’s, the only way to resolve the issue is to inflate away the debt or willingly enter into a depression. They obviously think they can control both the debt and inflation.

This means you should NOT run out and short Japanese government bonds. Repeat, NOT. The only way for the Japanese to make their plan work without having to battle the Godzilla of a destitute bond market is for the BoJ to move out the yield curve and monetize the debt. They will eventually hit all bids on JGBs. For all intents and purposes, the BoJ will become the yen bond market. You will get all the yen they promised when you bought those bonds … but the contract never stipulates what those yen will actually buy.

The plan is evidently that, with a little inflation, they will jump-start the economy; and with growth they can eventually balance the budget and return to a normal bond market. Rots of ruck, guys.

Just a couple years ago this letter seemed as if it was All Greece, All the Time. Since Japan is, say, about 100 times more important than Greece, we will be revisiting it at length in the coming months. But before we move on,three notes:

First, some full disclosure. Even though I have been suggesting that Japan is a “bug in search of a windshield” for almost three years, I have not actually put any money on the table. Until this month. I have now invested a sizeable portion of my pension funds into a short Japan strategy (not simply a short yen and clearly not a short JGB strategy) and will increase that position as time goes on. This is going to be a long-term trade, so no need to rush out and short the yen this morning. Please don’t. Think about this. There is little difference between 90 yen to the dollar and 100 yen, with a target of 200 or more – at least if I am right. If I am wrong, which is quite possible, then the name “widow-maker” will once again be appropriate. I am not suggesting that you do anything, just start your investigation. I will be writing more soon. And for the record, I will be putting this trade on slowly, because the yen market and the Nikkei have moved a lot already. I think this may be one of the most asymmetrical trades I have seen, but this will require endurance, not speed..

Second, the results of this whole Japanese central bank kabuki theater piece will serve as a warning to other governments (especially the US Fed and Congress) not to attempt to reproduce this strategy. Right now, though, it seems to them like a good idea. And this is precisely the policy urged by Paul Krugman. Conveniently, Japan is getting ready to conduct a massive experiment based on Krugman’s ideas. While Krugman has only his reputation on the line, there are 127 million Japanese who have real skin in the game. If Krugman does not think that monetization is appropriate, he should publicly say so now. No Monday-morning quarterbacking allowed. And since I am in Spain tonight, I request that he show some huevos. Go explicitly on the record.

It would be nice to know just how much monetization Krugman thinks is enough. At what point should the Japanese stop? Four percent inflation? Six percent? 200 yen to the dollar? 250 or 300? Should they continue until the economy is growing at 2%? 4%? How should they then withdraw from monetary stimulus? Will withdrawal cause a recession when they do? Do deficits matter at all? Is there a theoretical limit to monetization and stimulus if the economy is sputtering? Of if withdrawal of monetary stimulus is likely to cause a recession and economic hardship, should it be continued past “normal” bounds? What are those boundaries?

If the Japanese strategy (as I think I understand it) is successful, then I will have to lay my right hand on a copy of the General Theory and convert to the gospel according to John Maynard Keynes, as interpreted by his disciple Paul Krugman. If the facts change then I suppose I must change, too. But the jury is out on this one. The world will be watching.

And finally I should note, all humor aside, that I recognize this is not a B-grade disaster movie. This is as real as it gets for Japan and its people. The Japanese are hard-working and clearly brilliant business people. They are not doomed. They will be forced to adapt, but they have done this before, as have many countries. I wish them well, I truly do.

France Is the New Greece

Four years ago I wrote about Greece, and two years ago I wrote about Spain (in detail in Endgame). I was early both times. I was looking at the math of their budgets and only saw the numbers, staring me in the face. For the record, France is on its way to becoming the new Greece. Not in the same way, of course: France will blaze its own path to economic chaos. Hollande seems to have a good mental map for that journey and a good head start. I am early again, but unless something very new and different unfolds, the die is cast.

If Greece causes heartburn for European politicians, what will economic chaos in France mean? There seems to be no polite word for even a soupçon of austerity in the French language.

The French are not going to meet their budget forecasts. They will lose their AAA rating, which they will claim is a conspiracy against them and completely unjustified. And when their interest rates climb by 2% they will demand that the ECB buy their debt, just as the ECB is doing for Spain and Italy. Watch the screaming when their rates climb above 4%. We will be told, “Four percent is clearly a temporary lack of market understanding and simply not rational.”

It is going to be interesting to watch how the Socialist government of Hollande tries to maneuver in the coming months and years. Will they try to cut spending? Where? Agricultural subsidies? Pensions? Move retirement (temporarily, of course) back to 62? (Zut alors!) Try and force the economy to grow with more deficit spending and borrowing and hope the ECB intervenes? Will French workers and farmers quietly accept austerity? Will Germany want to subsidize France? Is France a bridge too far for European solidarity? Stay tuned.

Paris was recently ranked as the most expensive city to live in. I can attest that the city is trop cher. I must admit that Paris is one of my favorite places in the world, especially in spring. I love going to my friend Bill Bonner’s place in Ouzilly, in the deep countryside of France. It is extraordinary. The only good thing that will come out of this debacle the French government is creating is that Paris is going to get a whole lot cheaper. Well, that and the total discrediting of socialist policy.

Europe has its own sustainability issues, which I have chronicled in the past, and we will of course visit them again. This will be a source of serious volatility in the coming year.

US: The Crisis Games

In my opinion 2013 is a make or break year for the US. If we are going to get the deficit on a glide path to balance, then it needs to happen this year. (I should note I have been saying 2013 since 2010.) 2014 is an election year, and it will be muy difícil to get anything of substance done then. Will Obama be any more willing to compromise in 2015? At that point I think it is too late and the bond market, having watched Japan and France and much of Europe descend into chaos, will simply begin to demand higher rates, no matter what the Fed does. If it doesn’t happen even sooner.

This American fiscal issue is first of all going to mean crisis after crisis if the Republicans are serious at all about the deficit. Will they blink, or will they allow the government to shut down? It was shut down twice in the 1990s. The world survived. I wish we had a more collegial system. Who knew we would be nostalgic for the era of Clinton and Gingrich?

Again, this letter is getting long and we all know the problems. I will write more on all this in future letters. But before we leave the issue, let me offer a suggestion to House Republicans and some thoughts on the unsustainability of entitlements.

First, let me humbly suggest that the House pass two budgets. Not one, two. First, pass one that assumes that current tax policy remains intact, but that puts us on a glide path to a balanced budget in seven years. Then pass one with the same goal but with sweeping, pro-growth tax reform. Like a 15% corporate tax but no deductions for anything. Total elimination of tax expenditures. Maybe get crazy and substitute a VAT for the Social Security tax. No halfway measures. Get radical.

Then send both budgets to the Senate with a note that says you will be glad to vote to extend the debt ceiling for a period of time, when they pass a budget the president will sign. After all, they have 55 Democratic senators. They do control the Senate. They have not passed a constitutionally mandated budget for three years. What’s to think they can pass anything? Stop negotiating with yourselves and make them put something on the table that the president publicly agrees with.

The debt ceiling then becomes the problem of the Senate and the president. They can get an increase any time they pass a budget that they can find just five Republicans to vote for. It doesn’t have to be one of your two options, but it does have to be something that is public. The Senate is supposed to be where compromises happen. So let them compromise, and then and only then sit down to talk.

In the meantime pass true immigration reform. Go the extra mile on this one. It is good policy and good politics. Pass any House Democratic proposal that makes even a little sense. Show some true bipartisanship. And no negotiating on the budget until the Senate passes a bill that Obama will sign. Then get serious and get it done.

A few final thoughts on the US. The tax increases are going to add up to more than advertised in the mainstream media, perhaps as much as 1.5% of GDP. This is not going to make for a robust first half. A quarter or two of outright recession is quite possible. At the least, growth will be very weak. And the hidden tax of increased healthcare insurance costs as a result of “Obamacare” will be more than 1% in the latter half of 2013, as insurance companies adjust to rising mandates and costs in 2014. Insurance companies are announcing major increases in premiums. My own company healthcare costs are up an eye-shocking amount. And for labor-intensive businesses? Workers are going to be left to the tender mercies of the new healthcare system.

Obamacare is going to be the mother of all bureaucratic nightmares to implement. I am in sympathy with the need for change in the healthcare system, but how we think we can radically adjust 15% of the US economy with no collateral damage to it is beyond me. On top of the tax increases, Obamacare will mean a very lackluster year for the US economy.

Entitlement Unsustainability

One of the things foremost in my mind is the unsustainability of entitlements, especially healthcare. We all know that Social Security can be resolved rather quickly, but healthcare is going to be difficult. Not the least of the problems is that Americans live manifestly unhealthy lifestyles. Data suggests we are actually 40% sicker than our European counterparts, which explains why healthcare costs so much more here in terms of GDP. Further, healthcare policy was formed in an era of big business and labor unions, and that time is passing.

As I was discussing this with Pat Cox tonight, he mentioned that Michael Barone used nearly those exact words in his op-ed today. I stopped and read it and found myself nodding in agreement. He noted a repeating 76-year cycle in American politics (only modestly forced) that suggests a new era is upon us. Not too far off from Neil Howe’s Generations cyclical thesis. You can read the whole column here. Let me quote from the ending:

The original arrangements in each 76-year period became unworkable and unraveled toward its end. Eighteenth-century Americans rejected the Colonial status quo and launched a revolution, then established a constitutional republic.

Nineteenth-century Americans went to war over expansion of slavery. Early-20th-century Americans grappled with the collapse of the private-sector economy in the Depression of the 1930s.We are seeing something like this again today. The welfare state arrangements that once seemed solid are on the path to unsustainability.

Entitlement programs – Social Security, Medicare, Medicaid – are threatening to gobble up the whole government and much of the private sector, as well. Lifetime employment by one big company represented by one big union is a thing of the past. People who counted on corporate or public-sector pensions are seeing them default.

Looking back, we are as far away in time today from victory in World War II in 1945 as Americans were at the time of the Dred Scott decision from the First Inaugural. We are as far away in time today from passage of the Social Security in 1935 as Americans then were from the launching of post-Civil War Reconstruction.

Nevertheless our current president and most politicians of his party seem determined to continue the current welfare state arrangements – historian Walter Russell Mead calls this the blue-state model – into the indefinite future.

Some leaders of the other party are advancing ideas for adapting a system that worked reasonably well in an industrial age dominated by seemingly eternal big units into something that can prove workable in an information age experiencing continual change and upheaval wrought by innovations in the market economy.

The current 76-year period is nearing its end. What will come next?

I can see multiple paths, but all must inevitably lead to some form of sustainability. Avoid the rush. Go ahead and begin adapting now!

By the end of this decade and probably much sooner we will have transformed the unsustainable current system into something more manageable. The secular bear market will have ended. Healthcare and medicine are due for a radical upgrade, and science-fiction-like technologies await.

The new era (I am searching for a name to call it) will be most welcome if you make plans to transition from where we are to where we are going. And this letter will chronicle the journey. Stay with me. For those of you who are interested in alternative investments to address the kinds of challenges we’ve covered here, I’ve written a piece on the global macro environment, which you can access at http://www.altegris.com/MauldinGlobalMacro. (In this regard I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

London, Athens, Geneva, Toronto, and New York

I am in the Costa del Sol of Spain tonight, where I decided to spend the weekend talking to the locals and exploring. Tuesday I fly to London for meetings and a rather cool gathering that is one of my favorite things to do: a dinner with interesting people. Then I fly off to Athens where I will meet Christian Menegatti, the managing director of research at Roubini Global Economics. We are going to spend three days meeting with business leaders, politicians, bankers, and just regular people, getting a feel for what’s happening on the ground. Drop a note if you want to meet later in the evenings at my hotel in Athens.

All that, coupled with what I learned as the guest of Skagen Funds in our tour of Scandinavia, will be the topic of next week’s letter, which I will write from Geneva, amidst meetings with clients. (Which is why I stayed in Europe rather than going back to Texas just to return to Switzerland a few days later. And this “tour of duty” does not exactly amount to hardship.)

I will be in Toronto on January 28 for a speech with my Canadian partner, Nicola Wealth Management. Lots of media (times later) and meetings with long-time friend Rick Rule and Sprott Management. And of course a lengthy confab with Rosie (David Rosenberg). I will learn a lot, I am sure. Then it’s on to NYC on the 29^th and possibly DC later that week before returning home for a time. You gotta love it.

I was in Sweden speaking to about 200 investors and money managers (lots of pension money) for Skagen Funds over lunch last Friday. Sweden, as noted above, went through its own crisis in 1993. I have talked with many Swedes involved in the markets at the time. I have not met anyone who enjoyed it, although when I asked that question during lunch I did see one person raise his hand. I found out later that he was a government bond trader.

I also asked, “Did anyone here propose in 1988 anything resembling what eventually became the difficult compromises of 1993?” I saw no hands raised this time. And if the US does not make the difficult choices today, then we will be forced to make disastrous choices not very far down the road. Taxes will be raised and healthcare and other spending cut far more than any of us can imagine. That is the time-honored pattern, and there is no reason to think the US is any different.

It is very early in the morning and time to hit the send button. Have a great week. I will take notes and report back to you.

Your feeling the need to learn Spanish analyst,

John Mauldin

subscribers@mauldineconomics.com

Gambling in the House?

John Mauldin — Sat, 28 Jul 2012 19:22:00 GMT

There Is Gambling in the House? I Am Shocked…
Opacity and Credit Default Swaps
No Access for Spain
Denver, Maine, and Carlsbad

Rick: How can you close me up? On what grounds?
Captain Renault: I'm shocked, shocked to find that gambling is going on in here!
– From the classic scene in Casablanca,made in 1942

The latest scandal du jour seems to be about what is now called LIBORgate. But is it a scandal or is it really just business as usual? And if we don’t know which it is, what does that say about how we organize the financial world, in which $300-800 trillion, give or take, is based on LIBOR? This is actually just the second verse of the old song about derivatives, which is a much larger market. Which of course is a problem that was not solved by Dodd-Frank and that has the potential to once again create true havoc with the markets, whereas LIBOR can only cost a few billion here and there. (Sarcasm intended.)

The problem is the lack of transparency. Why would banks want to reveal how much profit they are making? The last thing they want is transparency. This week I offer a different take on LIBOR, one which may annoy a few readers, but which I hope provokes some thinking about how we should organize our financial world.

There Is Gambling in the House? I Am Shocked...

Let’s quickly look at what LIBOR is. The initials stand for London InterBank Offered Rate. It is the rate that is based on what 16 banks based in London (some are US banks) tell Thomson Reuters they expect to pay for overnight loans (and other longer loans). Thomson Reuters throws out the highest four numbers and the lowest four numbers and then gives us an average of the rest. Then that averaged number becomes about 150 other “rates,” from overnight to one year and in different currencies. The key is that the number is not what the banks actually paid for loans, it’s what they expectto pay. Also, please note that the British Banking Association, on its official website, calls this a price “fixing.”

Most of the time the number is probably pretty close to real, or close enough for government work. But then, there are other times when it is at best a guess and at worst manipulated.

Back in the banking and credit crisis panic of 2008 the interbank market dried up. No bank was loaning other banks any money at any price. Thus there was clearly no way for the LIBOR number to be anything butfictitious. Anyone who was not aware of this was simply not paying attention.

The regulators certainly knew on both sides of the Atlantic. All along there were clear records, we now learn, that bankers were telling the FSA (the Financial Services Authority) that they had problems. Regulators were worried about what was happening but were pointing out that there was a large hole in the ship that was already admitting water, and they didn’t want to make it any bigger. Timothy Geithner, then President of the New York Federal Reserve Bank (and now Secretary of the Treasury) wrote a rather pointed letter to the FSA, suggesting the need for better practices.

Some banks reported lower rates, to make it appear they were better off than they were (since no one was actually lending to them), and others might have given higher rates, for other reasons. Remember, this was a British Banking Association number. Whether you personally won or lost money on the probably wrong price information depends on whether you were lending or borrowing and whether you really wanted the entire market to appear worse than it already was.

This was the equivalent of an open-book test where you got to grade your own paper. And we are supposed to be shocked that there might have been a few bad“expectations” here and there by bankers acting in their own self-interest, with the knowledge of the regulators? The more amazing proposition would be that in a time of crisis the number had any close bearing on reality to begin with. Call me skeptical, but I fail to see how we should be surprised.

The larger question that really needs to be asked is how in the name of all that is holy did we get to a place where we base hundreds of trillions of dollars of transactions worldwide on a number whose provenance is not clearly transparent. Yes, I get that the methodology of the creation of the number after the banks call in their“expectations” is clear, but the process of getting to that number was evidently not well understood and looks to be even muddier than my rather cynical previous understanding of it.

It now seems that there will be a feeding frenzy as politicians and regulators hammer the various banks for improper practices. And they are pretty easy targets: there is just no way you can explain this that does not sound bad.

You’re a big banker. The world is falling down before your eyes. No one trusts anyone. If you put out a bad number (whatever “bad” means in a time of sheer utter blind panic) the markets will kill you even more than they already are and you could lose your job. You have got to come up with a number in ten minutes.

“Hey, Nigel, what do you think we should tell Tommie [Thomson Reuters]?”

“I don’t know, Winthorpe, maybe Mortimer has an idea; let’s ask him.”

Simply fining a few bankers is not going to fix the larger problem: the lack of transparency for arguably the most important number in financial markets. A very clear methodology needs to be developed, along with guidelines for what to do in times of crisis when the interbank market is frozen and there really is no number. Having no number might be worse than having a number that is a guess. But having a number that can be fudged by banks for their benefit is also clearly not in the public’s interest.

The point of the rule of law is that it is supposed to level the playing field. But the rule of law means having a very transparent process with very clear rules and guidelines and penalties for breaking the rules.

I had dinner with Dr. Woody Brock this evening in Rockport. We were discussing this issue and he mentioned that he had done a study based on analysis by an institution that looks at all sorts of “fuzzy” data, like how easy it is to start a business in a country, corporate taxes and business structures, levels of free trade and free markets, and the legal system. It turned out that the trait that was most positively correlated with GDP growth was strength of the rule of law. It is also one of the major factors that Niall Ferguson cites in his book Civilization as a reason for the ascendency of the West in the last 500 years, and a factor that helps explain why China is rising again as it emerges from chaos.

One of the very real problems we face is the growing feeling that the system is rigged against regular people in favor of “the bankers” or the 1%. And if we are honest with ourselves, we have to admit there is reason for that feeling. Things like LIBOR are structured with a very real potential for manipulation. When the facts come out, there is just one more reason not to trust the system. And if there is no trust, there is no system.

Opacity and Credit Default Swaps

Which brings me to my next point. We just went through a crisis where derivatives were a major part of the problem, and specifically the counterparty risk of over-the counter (OTC) derivatives.

Taxpayers had to back-stop derivatives sold by banks (and specifically AIG) that were clearly undercapitalized. That cost tens of billions. Yet the commissions and bonuses paid for selling those bad derivatives went on being paid. Congress held hearings and expressed outrage, but in the end Dodd-Frank sold out.

“Efforts to create an exchange-traded futures contract tied to credit-default swaps haven't yet gained traction after 18 months of talks, but banks dealing in the private multitrillion-dollar market for credit derivatives believe such contracts will eventually appear for a simple reason: They should attract new players.

“Credit-default swaps function like insurance for bonds and loans. Investors use them to hedge or speculate against changes in a borrower's creditworthiness. If a borrower defaults, sellers of the protection compensate buyers.

“The swaps – traded over the phone or on-screen, with prices known only to trading partners – are the domain of asset managers and hedge funds with the sophistication and financial wherewithal to take on complex risks.

“Futures, by contrast, are more routine instruments used by institutions and individual or "retail" investors. Futures prices are displayed publicly on exchanges, and customers can trade them directly with other customers – unlike in the swaps market, where a dealer is on one side of every trade.

“Dealers have long been fiercely protective of keeping the status quo in credit-default swaps or ‘CDS’ because they have booked fat profits from customers not being able to see where other customers are trading.”(Market Watch)

And that is the issue. Bankers do not want transparency, because it will seriously cut into their profits. And while I like everyone to make a profit, the implicit partner in every trade is the taxpayer and, last time I looked, we do not get a piece of that trade. Derivatives traded on an exchange were not part of the problem during the last credit crisis; OTC derivatives were.

An exchange makes it very clear where the counterparty risk is and what the price mechanism is. It creates a transparent rule of law and places the risk on the backs of those buying and selling derivatives and not on the taxpayer. Exchange-traded derivatives do not pose a potential threat to the economies of the world, while we don’t know the extent of the threat posed by OTC trades. JPMorgan has lost around $6 billion on the trading of their “London Whale.” If Jamie Dimon and the JPM board couldn’t guarantee reasonable corporate governance, then why should we assume that in another crisis we won’t find another AIG?

Dodd-Frank needs to be repealed and replaced. The last time, the process was too clearly in the hands of those being regulated and has contributed to their profits. Enough already.

Credit default swaps and any other derivative large enough to put the system at risk must be moved to an exchange, to make clear the counterparty risks.

No Access for Spain

Let me close the letter by noting that Spain has clearly lost access to the bond market, absent intervention by the rest of Europe and more specifically the ECB. Spanish 10-year rates jumped over 7.5%. Then Super Mario Draghi said that the ECB would do whatever it takes to defend the euro, and the market rebounded. Why this was news is not clear, but sometimes the market just needs some hand holding.

Now the ECB is going to be forced to follow through or face a rather violent market correction downward. It will be interesting to see how long the markets will exhibit patience without a clear program from the ECB, while Germany would of course prefer that nothing is done until after its Constitutional Court ruling on September 2.

We are getting closer to the moment when European leaders will be forced to act. Spain is going to need a bailout and not just of its banks. Germany and the other northern-tier nations have not yet agreed on a path.

We will delve further into Europe over the next few weeks. The situation is getting increasingly problematic. There is no plan, and the eurozone lurches from crisis to crisis. One country after another is falling into recession and then depression. Austerity without default (or monetization, default’s cousin) produces misery.

I think France is likely to be downgraded within a few months, putting Germany, the Netherlands, and Finland in a very difficult position. Will they put their own balance sheets and ratings at risk? Because that is what will be needed if the eurozone is to hang together. Stay tuned.

Denver, Maine, and Carlsbad

I am in Gloucester, Massachusetts tonight, spending the night in the museum that my economist friend Woody Brock calls his summer home, which is almost hidden at the end of a dirt road and surrounded by trees and enormous granite rocks. The grounds of the estate are an old granite quarry, itself a work of art, with massive, gorgeous works in stone intermingled among the trees and magnificently lit up at night. The quarry lakes are crystal clear, and the reflections of the trees, stone, and profuse flowers blend together like something out of an epic fantasy. It almost makes me want to grow up and become an economist, if they live like this.

Gloucester is an old fishing town and where the movie The Perfect Storm was based. Woody drove me around and showed me the home where he grew up, and where his sister and her husband still live. The town is an interesting contrast to Newport, where the really rich from New York built huge mansions and sailed their yachts. The summer homes of Gloucester are wonderful, fitted into the land and, for the most part, with a real family feel to them.

I was in Newport for the past week for a symposium on behalf of the Department of Defense. The Net Assessment Office brought together the most eclectic, diverse group of people I have ever been associated with to develop some alternative scenarios for the purpose of thinking about what might be needed in the future. My mind is still reeling. I am processing what I learned and will write about it at some point.

Interestingly, for me, some past worries about potential problem areas were laid to rest and other areas became of more concern. Five straight days of early mornings and late nights have me a little tired – thus the short letter tonight.

I head back to Dallas tomorrow and then back out on Monday afternoon for Denver, to be with my Altegris Investments partners at Financial Advisor magazine's Innovative Alternative Strategies Conference. I’ll then fly back Tuesday evening, only to turn around and fly to New York and then on to Maine with my son Trey, for the annual “Shadow Fed” fishing trip run by David Kotok. There will be so many good friends there again. I think this will be the sixth year Trey and I have gone. David Rosenberg will be there, as will Barry Ritholtz (The Big Picture), Martin Barnes, John Silvia (chief economist at Wells) and the usual Fed types. Quite the cast of characters. Bloomberg TV (Mike McKee) will be there, and I am scheduled for an early hit with Tom Keene and perhaps a comment or two on the employment number on Friday morning.

Then I am home for a few weeks, before heading out to Carlsbad, California, to be at an important Casey Research conference called Navigating the Politicized Economy. It has quite the speaker line-up and would be a great way to kick off your fall thought process. You can learn more at http://www.caseyresearch.com/V-2012-fall-summit.

It’s time again to hit the send button. Have a great week. And having thought of Trading Places tonight (maybe my favorite movie), I think I will go buy the DVD and watch it one more time!

Your “feeling good, Louis” analyst,

John Mauldin

subscribers@mauldineconomics.com

The Lion in the Grass

John Mauldin — Sat, 21 Jul 2012 18:45:00 GMT

The Seen and the Unseen
The Lion in the Grass
Black Swan or Hidden Lion?
The Lions of Europe
What If the US Trade Balance Became a Surplus?
The Bug that Roared
Up in the Clouds, or How Do I Stay Connected?
Newport, Gloucester, Denver, and Maine

The Seen and the Unseen

"In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently;they are not seen; we are fortunate if we foresee them.

"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

"Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil."

- From an essay by Frédéric Bastiat in 1850, "That Which Is Seen and That Which Is Unseen"

I have been captivated by the concept of the seen and the unseen in economics since I was first introduced to the idea. It is a seminal part of my understanding of economics, at least the small part I do grasp. The idea was first written about by Frédéric Bastiat, who was a French classical liberal theorist, political economist, and member of the French assembly. He was notable for developing the important economic concept of opportunity cost. He was a strong influence on von Mises, Murray Rothbard, Henry Hazlitt, and even my friend Ron Paul. He was a strong proponent of limited government and free trade, but he also advocated that subsidies (read, stimulus?) should be available for those in need, "... for urgent cases, the State should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions."

Today we'll explore a few things we can see and then try to foresee a few things that are not so obvious. This is a condensation of a speech I gave earlier this afternoon in Singapore for OCBC Bank, called "The Lion in the Grass." The simple premise is that it is not the lions we can see that are the problem; but rather, in trying to avoid them, it is often the lions hidden in the grass that we stumble upon that become the unwelcome surprise.

When I was discussing this concept with Rob Arnott (of Research Affiliates and the creator of Fundamental Indexes) in Tuscany a few weeks ago, he mentioned the following photo, which he took on the savannah in Tanzania a few years ago. I think it is a perfect way to start out our discussion of the Lions in the Grass. In today's letter I will briefly mention a few "lions" we might not be seeing, and perhaps in later letters we can go into more depth, if you like. (I should note that this letter will print longer as there are lots of charts and pictures.) So, here's Rob's photo:

And before we plunge into the tall grass, let me note that I have written a Special Report on a new mutual fund that focuses on managed futures, but with a significant twist. As it happens, that twist is something I have been suggesting for over 15 years. My friends and partners have put this fund together as a regular 40 Act mutual fund, so it is available to all US investors and not just accredited investors. That also means I do not have to limit the distribution. All you have to do to get a copy is fill out a very simple form athttp://www.altegris.com/Landing-Pages/Mauldin-EVO.

For those of you who are looking for a way to diversify and would like to have managed futures in your portfolio, but want the ease and liquidity of a mutual fund, I am very pleased that this option is available. I have been a proponent of managed futures for a long time, for a number of reasons (including diversification), and I think this is something you should investigate. (In this regards, I am president of and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now, into the grass.

The Lion in the Grass

Let's go back and look at Bastiat's first sentence:

I really can't remember when I first began to ponder the concept of the Lion in the Grass, although I have never used it in a letter. But during my Tuscany escape I thought about it a great deal, and I think it is a very useful analogy for today's world, and in the light of Bastiat's insight some 162 years ago.

It is natural to the human condition to focus on the apparent dangers in front of us. That is part of our evolutionary heritage from the time when humans were first dodging lions and chasing antelopes on the very African savannah in Rob's picture. But we soon learned that if we were to survive it was not enough to walk away from and around the lions we could see. We also had to make sure we didn't walk into a lion hidden in the grass. It is the hidden lions that can spring on us suddenly and take an arm or a leg.

Below, I have once again reproduced Rob's picture. I even knew there was a hidden lion and could not find it. But after it was pointed out to me, it is now the first thing I see. And there is a direct analogy there, to both economics and investing.

So, before you look on the next page I suggest you go back and look one more time to see if you can spot it. Just for fun.

I showed this to a friend who is a hunter, and he spotted it almost immediately. But then he has taught himself over the years to look for the hidden game. And as Bastiat noted, it is the skilled economist who looks for the effects that are hidden, the surprises that are unseen. It should be a habit to look at the potential second- and third-order consequences of what we can see happening before our eyes. That way, we not only avoid the lurking lions, we also turn what would hunt us and do us harm into the hunted. Sometimes, the dangers themselves can be turned into a very nice trophy indeed, if you can see and respond in time.

But as I noted, that hidden lion is now the first thing I see. And that is the way with economic lions in the grass. Once someone points one out, it's obvious. So obvious, that we soon convince ourselves that we would have seen the lion without help. How many people told you they "knew" all along that subprime debt was going to end in tears, or that the housing market was a bubble? Or that we would be plunged into the Great Recession?

I remember, in the fall of 2006 I was beginning to talk about the probability of a recession, in this letter, in speeches, and in numerous media interviews. (There is one such episode still up on YouTube.) I was told I was ignoring what the market was telling us, and indeed the market proceeded to go up for another six months. Being early is lonely. Me and Nouriel. ;-)

Today there are a lot of people who tell us they knew there was a recession coming, all along. In fact, the farther we get from 2006, the greater the number of people who remember making that call. It now seems I had no reason to feel so lonely out there on that limb. In retrospect, it seems the limb was rather crowded.

So, with that in mind, let me show you where the other lion is. Then go back and look at the first picture. After a few times you will see the hidden lion almost before you see the two more visible ones. (I just showed it to the stewardess on the plane from Singapore. She spotted it immediately. Oh well.)

Black Swan or Hidden Lion?

I should note that a Lion in the Grass is different from a Black Swan. A Black Swan is a random event, something that takes us all by surprise. Economic Black Swans are actually quite rare. 9/11 and the aftermath was a true Black Swan. Other than Nostradamus some 500 years ago, who saw it coming?

The last recession and the credit crisis were not true Black Swans. There were those who saw it all coming, but few paid attention. They were dancing right along with Chuck Prince to the rousing music of a bull market and swelling profits.

As we know now, a lot of people saw the subprime crisis coming and a few made huge fortunes. Sadly, it generally required one to risk a small fortune to play in that game. But it's different with hidden lions. If you can spot one, and figure out how to stalk it, there can be large profits betting on that which is unseen by the markets.

So, now let's quickly look at a few lions we can see and then try to spot a few that are hidden close by.

The Lions of Europe

Everyone now knows that there are lions roaming all over Europe. When I (and a fast-swelling group of other observers) started writing about Greece, we were at first told that developed countries simply could not default in the modern era. Indeed, European banking regulators had allowed (implicitly encouraged?) European banks to buy peripheral-country bonds and required them to post no reserves against those bonds. It was "free money" to the banks. You could pay a few points on deposits and then leverage them up to 40 times, getting up to 3-4% carry, depending on how far out the yield curve you wanted to go. 100% risk-free returns on your capital. Who wouldn't go for that? And it had to be risk-free, because the regulators said so.

And when Endgame came out in the spring of 2011, we got a lot of pushback for saying that Spain would get in serious trouble and have to "restructure" its debt. How could that be? By that time one had to admit that it was possible Greece might have problems. But Spain? We were told that Spain was a "real country." Real countries did not default. (Forget that Greece, only a few years earlier, had been considered real enough to be admitted to the eurozone.) Spain was different.

I totally guarantee you that Spanish Prime Minister Rajoy will give you a 100% dead-certain guarantee that Spain will never default. Right up until the time it does. Just like he said that Spanish banks were fine and needed no help from Europe, only a week before they asked for help.

(You have to feel sorry for the guy. He is sincere, but he is doggedly riding a very ailing horse as he tilts at the debt windmill. Cue the song "To Dream the Impossible Dream." The line "To fight the unbeatable foe" comes to mind. There is just too much Spanish debt, and the requirement to keep cutting the deficit will just make that hole deeper and the foe even more fearsome when the final battle lines are drawn.)

We can all see the lions, large and small, of Greece, Portugal, Ireland, Spain, Italy, and now Cypress and Malta. The fear of contagion is what keeps European leaders up at night, trying to figure out how to keep Spain afloat. Because if Spain sinks, the focus immediately turns to Italy.

The woes of Greece, Spain, et al. have been chronicled in this letter and indeed almost everywhere. So let's just look at one chart and then move on. This is from my friend Chris Wood, writing in GREED and fear. Notice how much capital is leaving Spain each month. The outflows are now massive.

Chris writes rather pointedly:

"The above suggests that conditions are continuing to deteriorate in Spain which is a further reminder that this is the country most likely to trigger more Eurozone tremors in the short term. The same message is given by the Spanish 10-year bond yield which is back above 7%. Meanwhile, a glance at the Bank of Spain's official statistics shows a record €122bn of capital outflow in the first four months of this year, which is another sign of growing macroeconomic stresses. Clearly, a macroeconomic adjustment is now well under way with Prime Minister Mariano Rajoy announcing further tax hikes last week. Thus, Rajoy announced on 11 July new austerity measures totalling €65bn, including raising the sales tax from 18% to 21%. And, clearly, if Spain is willing to take its medicine in the context of a fixed exchange rate system it can make the necessary adjustment, just like Hong Kong post 1997 or the Baltic states of Latvia and Estonia in recent years. But the question is, of course, whether the society and the politics can take the strain. GREED & fear has severe doubts. The proposal to write off retail investors' holdings of Spanish banks' subordinated debt remains politically explosive not to mention the Bankia IPO, which in terms of sheer cynicism was more egregious in GREED & fear's view than any of the scandals exposed by the US housing crisis."

But enough of the lions we can see. Don't look now, but the lion that lies hidden in the grass is France. Yes, the France that is supposedly a big part of the solution to eurozone woes and Germany's stalwart partner in guaranteeing all that debt. AAA France. Rated that way by the same people who turned the nuclear waste of subprime CDO squareds, composed 100% of the worst sort of BBB junk, into gold.

Now, the rating agencies are using the same alchemical Philosopher's Stone to transmute French debt into ... fool's gold.

France deserves (and will soon get) its own full letter. But while you are waiting, let me highlight a few thoughts. First, let's look at this chart from the IMF, examining the debt prospects of six countries (The entire study was of 18 countries.) The dotted lines are three paths that the debt-to-GDP ratio can follow. The top line is the trajectory without any actions by the individual governments. The middle dotted line is what the debt trajectory would look like with mild reforms to entitlements, and the bottom line is the debt trajectory if very draconian measures are taken. See if you can spot the hidden lion by guessing which country's debt situation looks most like France's.

Yes, the country most like France is Greece. Yes, THAT Greece. The one that just defaulted. The one that everyone agrees is dysfunctional. Also notice that if Greece were to follow the suggested draconian path, it could stabilize its debt. And then notice that if France were to make the same level of draconian cuts, its debt-to-GDP ratio would merely rise to almost 200% within 25 years. Oops.

So, what has been the response of the new French government? It has decided to double down on what was already an irresponsible path. Do you think the average German understands just how bad off their "partner" is? For that matter, do you think the average French politician understands how bad off France is? Certainly not the majority of them, and it is doubtful that their counterparts in Germany do, either. This is going to be a train wreck of truely biblical proportions. Think 12 plagues, not the run of the mill 10.

Hollande evidently has very good political instincts and knows how to work the system. Unfortunately, he has the economic understanding that God gave a goose. Someone should sit him down and make him read all of Bastiat's essays. (It might just be too much to ask a French Socialist politician to read an English or Austrian economist who actually understood how things work.)

Let's look at what Hollande has done in his first month. He lowered the retirement age from the 62 that Sarkozy was barely able to get it up to, back to the ripe old age of 60. He has raised the taxes on those making over €1 million to 75%. He is raising the wealth tax on those whose have a net worth of over €4 million to double what they were expecting. This is called the contribution exceptionnelle sur la fortune. No translation is needed. You think a few people might decide to move to Spain? Or Switzerland? Capital will go to where it is loved and wanted. And those with a little wealth cannot be feeling a lot of love, if they are in France.

Note that the contribution exceptionnelle is on net worth, not on income. But the politicians promise it is just for the current emergency. It can go back down when the crisis is over. Except that France is getting ready to enter a permanent crisis. Can you see which direction this is heading? Can you see which direction the wealthier French citizen is headed? You can get a reservation in a good French bistro these days if you live in London. Just saying...

The newly appointed, radical, and Orwellian-named Minister of Productive Recovery is calling every company that plans to reduce its payroll to avoid losses and telling it that it must negotiate with labor and figure out how to keep losing money. The unions are in the streets. Oh, and large corporations will also have to pay more taxes. And don't even think about moving "French jobs" out of the country.

They raised the minimum wage. Can you find one serious study that suggests that is a way to increase the number of workers?

The list goes on. This flies in the face of the IMF study (and many others) that shows France is at the edge of a fiscal cliff with its entitlement programs. And taxes already consume 50% of GDP. Deficits are high and rising, and raising taxes even more will not result in actually collecting more taxes. Ask England how much they got when the passed a tax surcharge on the wealthy: tax revenues from the rich went down. An increase of only a few percent, and at some point the rich vote with their feet. Ask Maryland.

Germany has almost got its head around the fact that it will have to bail out Spain. Does anyone think German voters will go along with bailing out the French? What happens when the markets realize that France is essentially bankrupt and cannot print its own currency? And that all the policies that this new government wants to enact will only make things worse? And that Hollande will be in power for at least four years?

It won't be this year or even in 2013 (I think), but within a few years we will be writing about France in the same way we are writing about Greece and Spain, et al., today. And French banks are massively larger than French GDP (some four times, or so I seem to recall). France cannot backstop its banks any more than Spain can.

Andy Xie, the irascible Chinese economist who was on the program with me in Singapore, said that when Germany signed the Maastricht Treaty, they thought the rest of Europe would become like Germany. They did not realize that the only solution is for the Germans to become more like the French. (If that happens, I wonder if you will be able to find a good German restaurant in London.)

We will explore this idea in future letters, but I would suggest that if France becomes an economic problem on the order of Spain, it will be very disruptive. Bailing out France may be a bridge too far, even for a stolid europhile like Merkel. Let's quickly move on.

What If the US Trade Balance Became a Surplus?

We can all see that shale oil is a growing business. US oil production is rising, even as consumption is dropping due to more efficient use of oil. You can easily find projections that within 10 years the US could be energy-independent. And if we get some policies that allow more wells to be drilled (which could create another 1 million jobs) it could happen even sooner!

That will narrow the trade deficit but not eliminate it. But...

What if we find a way to take our huge natural gas supply and send it abroad? Natural gas is about $2 today. There are supposedly 10,000 wells that have been capped and very few new wells are being drilled. Natural gas is just too cheap in the US. But it was recently $17 in Japan, and almost that in Europe. Even I can see an arbitrage there. There is certainly enough global demand to allow the US to sell enough natural gas to further reduce or even eliminate the trade deficit (again, depending on the national policies we set).

That is the lion we can see. But what happens if we stop sending our "surplus" dollars into the world? A growing world will need more dollars to finance global trade. And to buy our exports. The lion that is hidden is that the dollar would become seriously strong. Today, everyone and his uncle is predicting the demise of the dollar (along with other fiat currencies). But what if we actually got our deficit act together and combined that with a real energy policy? That sounds rather Pollyannaish today, but it is totally within the realm of possibility.

A strong dollar has all sorts of positive effects if it is accompanied by a trade surplus and a balanced budget. Can you imagine a world where the dollar is the reserve currency because it deserves to be, rather than by default because no other currency can step up to the plate?

But then that creates all sorts of problems when you combine it with the next Lion in the Grass.

The Bug that Roared

It has been said that you can't consider yourself a real global macro trader until you have lost money shorting Japanese bonds. Japan is a bug in search of a windshield – but it keeps dodging. Japan has a debt-to-GDP ratio that is approaching 230% (at a rate of increase of 8-10% a year!). The savings rate (see chart below, courtesy of Kyle Bass and team at Hayman Advisors) is declining rapidly and will soon go negative. At that point, the thought is, Japan will need to seek out foreign investors to buy its bonds. And who will buy a Japanese bond at 1% for ten years? If rates rise only 2%, then Japan would be spending almost 80% of tax revenues on just the interest on its bonds. I would submit that that is not a workable business model.

So traders keep shorting Japanese bonds (JGBs). And they keep losing money. But what if Japanese rates never rose? How could that be, you ask?

Given that Japan will collapse if interest rates rise, I would suggest that interest rates will not be allowed to rise. The Bank of Japan will fire up the printing press for their own version of Operation Twist, but on a scale that will make the other central bankers of the world jealous.

So then Japanese bonds don't revalue (on an internal basis). But the consequence is that the Japanese yen goes seriously south. Can you say 125 to the dollar? 150? 200? Do I hear 250?

At what point will you be able to buy a Lexus cheaper than you can buy a Kia? Think that will make Korea happy? Or any of Japan's Asian neighbors? Think the Japanese care? They will continue to churn out quality products made with robots that will compete very favorably with those of any industrial country. Japanese equities will soar in such an environment (in terms of a depreciating yen), which makes buying cutting-edge Japanese stocks and shorting the yen an interesting trade.

But that is the lion we can see. The lion we are missing is that this triggers a massive currency war, far more significant and costly than anything we have seen in our lifetimes. But that is a story for another day. For now, it is time to close.

Up in the Clouds, or How Do I Stay Connected?

I am asked all the time how I stay connected in all of my travels. I really am connected almost all the time from everywhere, as of late, which is a real productivity boost. Since I am here in Singapore, I thought I would just take a second to give you some details on our newest foray to upgrade my connectivity.

First, by now everyone has heard about cloud computing. I looked at if a few years ago, and it was still too new and expensive for a small company like mine. However, that has changed. We met a young man in Italy last summer (a friend of a business associate) who is with a firm called A3 that helps government organizations and businesses move their computing to the cloud. And what we found out is that we could upgrade everything we do for about the same as I was paying, but get far more service and security.

Our entire team of about seven people has "migrated" to the cloud. That means no more servers in my office and the support they need. All our data is now accessed from the cloud. We simply get online and sign in from whatever computer we are on, and the home page as we last accessed it pops up. And everything is backed up in the cloud (on multiple sites) in real time. I can access my information from my laptop, my iPad, or any other computer. Everything is there. All the software is basically in the cloud, although I do have some special adaptations to allow me to work offline in planes and where an internet connection is not immediately available. But as soon as I get online, everything is immediately and automatically backed up.

My data is now more secure, and it is far harder to "hack" my computer. Crippling virus attacks, which used to occur with sad regularity, are now far, far more difficult to perpetrate. (I would have to be pretty stupid to get a virus now.)

We get 24-hour technical service and cheaper enterprise software, and my staff can now get online from anywhere. My problem now is trying to get them to stop working late at night! They are getting to be just like me – signing on "just to check in." And it doesn't matter whether they are at the office in my home or halfway around the world. The service can grow with me effortlessly – just set up another user.

As a help to the company and its people, let me introduce you. And whether you are very large or small, or if you decide to work with them or another group, you should check out migrating your work to the cloud. It is way cool up here. A3 has a short introductory video, and Andre would be glad to talk with you. Go to www.A3Cloud.

Newport, Gloucester, Denver, and Maine

This very moment I am on a rather bumpy airplane ride somewhere over India. In about 8-9 hours we land in Frankfurt, which is long enough for me to actually hit the send button and make my Chinese translator, Shadow, happy. (I rather like that name, and it is an analog of her Chinese name).

I will get in to NYC about noon and then go to the Loews Hotel and just enjoy a relaxing afternoon. Then tomorrow it will be a late brunch with some like-minded biotech investors. (Like me, except that some of the have been extremely successful. Your humble analyst is hopeful that something will rub off, just being around them.)

Then I am off to Newport for a week I have long been looking forward to. I am going to get to participate in something that I find both very exciting and a unique honor. I have had the privilege of getting to know Andrew Marshall over the last few years, first in small groups and then privately. Mr. Marshall runs something called the Office of Net Assessment for the US Defense Department, and reports to the Secretary of Defense. He was appointed by Nixon in 1973, and every Secretary of Defense and US President since then has reappointed him. He is now 90 years old and shows no sign of slowing down. A few hours with him will get you right up on your toes, as he has worked with such a long list of forward-looking thinkers over the decades that it boggles the mind. He recalls seemingly every conversation. (On the matter of aging and continuing to work and keeping your act together, he is my official hero.) In the futurist world he is legend. The institutional memory he carries with him is beyond value. Essentially, the ONA develops and coordinates net assessments of the standing, trends, and future prospects of US military capabilities and potential, in comparison with those of other countries or groups of countries, so as to identify emerging or future threats or opportunities for the United States. Think of it as an internal planning think tank for the Department of Defense.

Every now and then ONA gathers a small group of thinkers to present analysis on their personal fields of expertise, and then develop a paper based on their findings. This year I have been invited to attend and speak. I will be in Rhode Island for a very full week..

My only request of them was to be able to listen to the other presentations and interact with the presenters in the evenings. They said yes. How could I not go? What kind of idiot would I be to pass this up? I get to sit in one place and listen to experts from very diverse backgrounds, hand-picked by Andy Marshall, speak on topics that will affect the future in ways I have not yet even thought about (and some I have not even considered). We will also deal with the usual topics of all kinds of technologies, geopolitics, etc.; and in the afternoons and evenings we'll gather in small groups. I will be taking notes, and I'll see what it is OK to write about and let you know.

Friday night I travel up to Gloucester to spend the evening with Dr. Woody Brock at his summer home, before catching the plane on Saturday afternoon in Boston to return to Dallas. Somewhere along the line I will need to write this letter. And then it's Denver on Monday night for a conference with my friends at Altegris, run by our friends at Financial Advisor magazine, focusing on alternative investments. And then I'm back in Dallas for a night, before heading off with youngest son, Trey, to our annual fishing week with David Kotok and all our buddies. It is one week I really look forward to. It will be interesting to do it this year just drinking nonalcoholic beer. Sigh.

I got smiles while I was in Singapore from some of the staff. I have learned that most of the ladies who read me are quite aware of the skin crème I mention every now and then, which uses skin stem cells to help your skin come alive. I get letters, and people come up all the time and tell me their stories. I know it is odd for an economist to be talking about skin crème, but when something works for this 62-year-old guy, in the daily battle to stave off the ravages of aging, I just say what the heck and do it. And the staff at OCBC made this last trip to Singapore such a fabulous delight that giving them a few bottles just seemed the right thing to do to express my appreciation. (You can find out more atwww.lifelineskincare.com/ahead-curve.)

I am now in the Frankfurt airport. It really is time to hit the send button. Have a great week, and we will spend some more time on our lion hunt in future letters. Hoped you liked this theme and that it resonated with you.

Your ready to go back to Africa analyst,

John Mauldin

Waving the White Flag

John Mauldin — Sun, 13 May 2012 16:14:00 GMT

Waving the White Flag
Viva Los Rescates Financieros de los Bancos
Contagion is Real
It Doesn’t End With Spain
New York, Atlanta, and Philadelphia

A common mistake that people make when trying to design something completely foolproof is to underestimate the ingenuity of complete fools.

- Douglas Adams, The Hitchhiker's Guide to the Galaxy

For quite some time in this letter I have been making the case that for the eurozone to survive, the European Central Bank would have to print more money than any of us can now imagine. That the sentiment among European leaders was that they were prepared for such a move was clear – except for Germany, which is haunted by fears of a return to the days of the Weimar Republic and hyperinflation.

When Germany agreed to a fixed monetary union and a European Central Bank, it was with the clear understanding that it would be run along the lines of the German central bank, the Bundesbank. The members of the Bundesbank and the German members of the ECB were most outspoken about the need for a conservative monetary policy that would keep a clamp on inflation.

However, as I have previously noted, the Bundesbank was a toothless tiger. Germany has two votes out of 23 on the ECB, and the loud drumbeat from most of Europe, which is experiencing the difficulty of austerity accompanied by too much debt, is for a far more accommodating ECB.

The simple fact is that Mario Draghi, the Italian president of the ECB, created €1 trillion euros to help fund European banks, which promptly turned around and bought their respective countrys' sovereign debt. Germany's Angela Merkel forced the Bundesbank to "play nice" and go along with what was seen as the only way to solve a growing banking crisis in Europe. Everyone breathed a sigh of relief, thinking that this at least bought a year during which things could be sorted out. But it turns out that a trillion euros just doesn't go as far as it used to. The "relief" lasted about a month. The last few weeks have presented yet another budding crisis, as least as large as the last one. Where to get the next trillion?

This week the German Bundesbank waved the white flag. The die is cast. For good or ill, Europe has embarked on a program that will require multiple trillions of euros of freshly minted money in order to maintain the eurozone. But the alternative, European leaders agree, is even worse. Today we will look at the recent German shift in policy, why it was so predictable, and what it means. This is a Ponzi scheme that makes Madoff look like a small-time street hustler. There is a lot to cover.

At the end of the letter I will mention a few upcoming speaking engagements, in Atlanta, Philadelphia, and a webinar I will be doing next week. Now let's jump over to Europe.

Waving the White Flag

It is the world's worst-kept secret: Germany does not want inflation but wants to abandon the European Union even less. And as we will see, the eurozone simply does not have enough money to keep itself together without massive ECB intervention.

"Cry havoc," wrote Shakespeare in Julius Caesar, "and let slip the dogs of war." The military order "Havoc!" was a signal given to the English military forces in the Middle Ages to direct the soldiery (in Shakespeare's parlance "the dogs of war") to pillage and incite chaos.

The cry is much the same in Europe today, though it is not the dogs of war that will ravage the land but the hounds of inflation. The English edition of Spiegel Online today carries a story with the headline "High Inflation Causes Societies to Disintegrate."

Spiegel Online explains:

"'Inflation Alarm!' reads the front-page headline in Bild, Germany's biggest selling newspaper. "How quickly will our money be eaten up?" the paper continues on page 2. "Millions of Germany [sic] are worried: Inflation is returning!" Just in case the message wasn't clear enough, the article is illustrated with a picture of a 1-trillion-mark note from 1923, the high point of German hyperinflation.

"The fact that Bild, arguably Germany's most influential newspaper, chose to run with the story in its Friday edition shows just how deep-rooted Germans' fears of inflation are. Nine decades later, the hyperinflation of the early 1920s still haunts the country.

"The panic-mongering was prompted by a statement by a senior official from the Bundesbank, Germany's central bank, to the finance committee of the German parliament earlier this week. Jens Ulbrich, head of the Bundesbank's economics department, said that Germany is likely to have inflation rates 'somewhat above the average within the European monetary union' in the future and that the country might have to tolerate higher inflation for the sake of rebalancing national economies within the euro zone.

"Ulbrich did not give concrete figures in his statement, saying only that it was important that inflation in the euro zone as a whole continues to remain stable, even if it rises in some countries and falls in others. Observers believe the Bundesbank may be reckoning with an inflation rate of around 2.5 or 2.6 percent."

If only they could be assured that inflation would be so mild. It is already at 2.1% in Germany. On Thursday, Finance Minister Wolfgang Schäuble, heretofore an inflation hawk of the old Bundesbank school, told reporters that inflation could go as high as 3 percent. "As long as we are ... in a corridor between 2 and 3 percent …we are in an area that is still acceptable," Schäuble said.

Bild wrote in the actual editorial:

"For 10 years, the euro was very stable and had lower inflation than the deutsche mark. But now the worst part of the financial and euro crisis is coming: creeping currency devaluation and inflation which could possibly continue for years. That's how counties want to wash away their debts. But it mainly affects (blue-collar) workers, employees and retirees. They are precisely the people who have borne the burden of solving the crisis and who have kept a cool head. That's unfair….

"Inflation gnaws at our trust in money, in our most important institutions, in politicians and in the central banks, which in German are dubbed 'guardians of the currency' for a good reason. Because they experienced it so bitterly, Germans know that in the end high inflation causes societies to disintegrate. It robs the individual of trust in the future, without which no country can thrive."

What brought on such a remarkable display of German forbearance? The threat of a complete eurozone collapse, brought on not just by Spanish banks (the present culprit) but what appears to be the dawining realization that this is about more than just Spain or Greece or Portugal or Ireland.

Viva Los Rescates Financieros de los Bancos

I have been writing for almost two years about the fact that the cajas, or Spanish regional banks, are worse than bankrupt. US banks are shut down when their nonperforming loans are at 5% of their capital. Spanish banks are at 20% and rising rapidly. My coauthor Jonathan Tepper and I spent a whole chapter in Endgame on Spain, at the end of 2010. This week the Spanish government basically nationalized Bankia, the nation's 4^thlargest bank, which had been cobbled together from seven failed cajas and given a large government guarantee and a €3 billion public-offering equity infusion. Only roughly half of its real estate loans are generating returns, and that is the number for public consumption.

"Aside from creating a financially unsound bank, the government also demanded an additional 30 billion euros worth of write-downs on loans – valuing 84 billion euros in total, when combined with the original requirement of 54 billion euros in write-downs. The combined write-down program is, however, unlikely to be sufficient to address the close to 180 billion euros in toxic assets held by Spanish banks. Furthermore, many of Spain's struggling banks will be unable to maintain the core tier-one capital ratio required by EU regulations without the government's assistance. Spanish banks will require an estimated 100 billion-250 billion euros in recapitalization later this year to reach this capital ratio target – a significant percentage of which will have to be shouldered by Madrid.

"The government takeover of Bankia is a clear policy reversal for the conservative administration of Prime Minister Mariano Rajoy, who for months insisted that no additional public funds were needed for the banks. Intervening on Bankia's behalf demonstrates the failure of Spain's banking consolidation strategy." (Stratfor)

We are talking the need for new Spanish-government debt amounting to roughly 25% of GDP that will be needed just this year, and that's if things don't deteriorate beyond present assumptions in their real estate sector. Care to make a wager on how sound those assumptions are? About as sound as Rajoy's assessment, only a few months ago, that no public money would be needed, perhaps?

Let's do some basic math. Spanish banks took down some €352 billion in the LTRO (created by the ECB), or over 1/3 of the total amount. They have about€80 billion left after deposit outflows and buying sovereign debt. Which will be needed to buy yet more Spanish government debt, so they can be bailed out.

As near as I can tell, Spain is guaranteeing about $20 billion of the new IMF funds that will be used for a European bailout. Spain already has $332 billion of liabilities to the ECB, $125 billion to the stabilization fund, another $99 billion for something called the Macro Financial Asset Fund, and various guarantees for other bank and European funds, all of which totals over $600 billion, give or take. Their public debt-to-GDP ratio is only 69%, but add in these other guarantees and commitments and you get over 130% debt-to-GDP. And that is before they start bailing out their banks, and before any additional debt from their fiscal deficit, which is running at 8%.

(Yes, I know they say it will be around 5%; but they are in a deepening recession; unemployment is rising at an alarmingly high rate, which lowers revenues and increases government spending; and their bond costs are rising. Care to take the over/under bet on, say, a 7% fiscal deficit? You get to be the under. Hmmm, I don't see many hands out there.)

Look at this chart of ten-year Spanish bonds:

Notice that rates came down when the LTRO was issued and Spanish banks had the money to buy Spanish government debt. Why would they buy it? Because they got to borrow money from the ECB at 1% for three years and could make a very fat spread. Making a "free" 4% is a tried and true way to garner profits that can be used to offset losses.

Once the LTRO was done, Spanish interest rates began to climb. Note that they only briefly dipped below 5%.

I think I have this straight. Spain wants to guarantee more bank debt that the banks will use to get more money from the ECB, which will in turn be invested in Spanish bonds that will provide the money to run higher deficits, which will…

This is somewhat like a destitute bar patron guaranteeing his friend's tab so his friend will buy him more drinks. The ECB is the bartender. European taxpayers are the bar owners. We know who pays the tab in the end.

Contagion is Real

It seems quaint that only a few years ago the concern in Europe was that there would be "contagion" risk resulting from a Greek default. So worried were they that we had almost-daily pronouncements that Greece would not be allowed to default, that there was no need for a Greek default, the developed countries no longer defaulted, etc. Now that Greece has defaulted, the line in the sand is "That was just Greece; no other country will need to default."

But just in case, European leaders created all sorts of funds, guaranteed joint and severally, to help bail out nations in trouble. First Greece, then Ireland and Portugal. Even with all the money that was raised, it was not enough to prevent a Greek default. And the "new" debt is trading at around 10% of what the original was … as I was predicting two years ago.

The austerity that was forced on Greece has resulted in a backlash from Greek voters. The two ruling parties, basically run by two families, had traded control of the government back and forth for 50 years. Last week they could not even get 33% between them. In fact, no coalition can be cobbled together from any of the splinter parties. There will now be new elections, probably in June. Looking at the early polls, it is probable that a coalition will form that will reject the enforced austerity. Which will of course mean that Greece will not get the European funds it needs to be able to pay for even the austerity programs. Which will make things worse and hasten the departure of Greece from the euro.

Europe and the euro can survive without Greece. They could even make it without Portugal. Ireland will merely default on the debt it incurred from the ECB to bail out its banks, but will want to stay in the eurozone.

But the euro needs Spain, to maintain a credible standing, or so Germany evidently believes.

It Doesn't End With Spain

The next usual suspect is Italy. And indeed Italy will soon be paying 5-6% of GDP just to cover the interest on its debt. If it were not for interest, they would have an actual government surplus. While they are making progress, a European recession is not going to make it any easier.

Let's move on from Italy. Let's consider France. They just had an election, and to no one's surprise they voted a Socialist into the office of president. And it appears likely he will get a majority in the legislative branch as well, giving Hollande control of the government. What he says he will do is get things under control by raising taxes to cover about 40% of the deficit and cutting spending to cover the other needed 60% – although he has not said what he will actually cut. He has pledged higher taxes on business and top earners (75% taxes on earnings over €1 million), subsidies for companies taking on younger and older workers, a partial reversal of the rise in the retirement age to 62, a promise to hire 60,000 new teachers, and he will take longer to get the budget under control than the current agreement with the EU allows.

Brussels issued a rather stern warning today, asserting that France must comply with the agreed-upon budgetary terms, which will require a lot more taxes and/or cuts than Hollande is willing to do. And whatever he decides, he has no easy task. France's acknowledged, official debt-to-GDP is 86%; but when you include their various commitments to the ECB, the ESFS, ESM, EIB, etc., the number rises to about 146%. Not all of that requires France to make the interest payments, but just to cover any losses in case of a default. But that 86% number is rising rather rapidly.

And their problems are not a short-term cyclical issue. They have committed to relatively larger entitlements and pensions than even here in the US! And those bills are coming due in the same time frame as in the US. It does not get any easier, and the French are notoriously unwilling to accept cuts in pensions or labor conditions. Want to touch agricultural subsidies? Want to see more tractors and burning tires on the Champs-Élysées? Just saying.

France has not balanced its budget since 1974. Note that the budget deficits are over 8% for the last few years (but not as bad as US deficits!), and now they have a negative trade balance. (chart from my friends at GaveKal)

Hollande campaigned explicitly on an anti-austerity platform. Angela Merkel campaigned for his opponent, Sarkozy. Not exactly the basis for a lasting friendship. And the rest of Europe is watching closely to see how this all works out. What will Germany do? Louis Gave (living in Hong Kong but still very French) writes:

"Assuming this program [Hollande's pledges to increase spending, raise taxes, etc.] ends badly, then France will need friends. Fortunately, the head of the IMF happens to be French, though this may be a double-edged sword, as Christine Lagarde cannot be seen giving France a privileged deal. In light of this rhetoric, and his promise of more spending, it is hard to think that Hollande and Angela Merkel will become fast friends. Meanwhile, Hollande's promise that his first act will be to pull France's troops out of Afghanistan is unlikely to endear him to the US administration. In short, France will soon need friends, but those may be as rare as an interesting French presidential candidate. Meanwhile, we have to hope that, like Groucho Marx, Hollande is a man who will declare 'These are my principles and if you don't like them, I can change them.'"

The Economist recently wrote:

"Although one ratings agency has stripped France of its AAA status, its borrowing costs remain far below Italy's and Spain's (though the spread above Germany's has risen). France has enviable economic strengths: an educated and productive workforce, more big firms in the global Fortune 500 than any other European country, and strength in services and high-end manufacturing.

"However, the fundamentals are much grimmer. France has not balanced its books since 1974. Public debt stands at 90% of GDP and rising. Public spending, at 56% of GDP, gobbles up a bigger chunk of output than in any other euro-zone country – more even than in Sweden. The banks are under-capitalized. Unemployment is higher than at any time since the late 1990s and has not fallen below 7% in nearly 30 years, creating chronic joblessness in the crime-ridden banlieues that ring France's big cities. Exports are stagnating while they roar ahead in Germany. France now has the euro zone's largest current-account deficit in nominal terms. Perhaps France could live on credit before the financial crisis, when borrowing was easy. Not anymore. Indeed, a sluggish and unreformed France might even find itself at the center of the next euro crisis."

The banks of France are over 4 times the size of French GDP. The markets have been punishing the larger banks, with some of them down almost 90%. Look at this graph for Societe Generale:

While French banks are not the problem that Spanish banks are, they are far larger relative to the size of their home country. Even a small problem can be large for the country. And French banks have very large exposure to European peripheral debt. A default by Spain would push them (and a lot of other European banks) over the edge. Which is one reason that Sarkozy was so loudly insistent that any bank problems should be treated as a European problem and not the problem of the host country. (Interesting idea if you are Irish!) France simply cannot afford to deal with any problems in its banks while it is running such large deficits. And not while it is guaranteeing all sorts of European debt, which is at the heart of the problem. Germany needs France to help shoulder the financial burdens of Europe. And as long as France can keep its AAA rating, Germany has a partner. But if France loses that rating, then any European debt it guarantees clearly loses that rating as well.

S&P has already taken France down one notch to AA+ and still has a negative outlook. Moody's has warned of a possible downgrade to France. Italy now has a BBB+ rating, just below that of Spain. When you look at the actual balance sheet and total debt, France is not all that far from further downgrades, unless it embraces a new budget ethic, which is precisely what Hollande has said he will not do.

That would be a real crisis for the eurozone. German voters might not be willing to shoulder the European burden without a full partner in France. And if France had to guarantee a great deal more pan-European debt, while it continued to run deficits and, God forbid, had a crisis in one or more of its banks, it would be putting its credit rating at risk.

Is there any wonder about the timing of the Bundesbank retreat? They looked at Greek and French elections and then at the ongoing Spanish crisis, which is trending from very bad to awful with a risk of horrific. They glanced at the balance sheets of their own banks and those of French banks vis-à-vis sovereign debt from peripheral Europe, then took a peek at German-voter polls and flipped through their own balance sheet, and decided that the only entity with enough money to stem the crisis was the ECB. And that means a "little" inflation.

I think the vast majority of Germans (and to be fair, the entire world) have no idea how many trillions of euros are going to be needed to keep patching the leaky ship that is the eurozone. It is even possible that most German politicians actually think it might only be 3% inflation.

Spain is too big to save and too big to fail. The only way for Spanish debt to remain at 6% is for the ECB to basically buy it (or lend to Spanish banks so they can buy it, or whatever creative new program Draghi and team can think up). When Spain goes, it is just a matter of time before we lose Italy and then, yes, even France. The line must be drawn with Spain. And the only outfit with a balance sheet big enough that can also do it in a politically acceptable manner is the ECB, and the only way they can do it is with a printing press.

Will it buy time? Yes, but time for what? To fix government deficits? To deal with bank debts? Sovereign debt? To somehow solve the massive trade imbalances between Germany and the European periphery? To force voters to accept a fiscal union? In the midst of a crisis? If there is some conspiratorial cabal that has a secret plan, they have kept it well hidden. Because from here it looks like they are making up the "plan" as they go along.

Their actual intentions are no secret. They will do whatever it takes to keep the European Union and eurozone together. And whatever it takes is a very open-ended plan. But it is going to cost them trillions of euros.

Someone is going to have to pay that bar bill. And there's going to be one helluva hangover.

New York, Atlanta, and Philadelphia

I will be in Connecticut on Monday and Tuesday morning for a Pitney-Bowes corporate meeting . They have a fascinating line-up of speakers to give them some ideas about problems and opportunities as they plan for the future. Then I give a speech Tuesday night and do media and meetings all day Wednesday and Thursday before I head home in time to write another letter to you.

The next week I fly to Atlanta to be with my good friend Cliff Draughn of Excelsia, where I will speak at a noon gathering on May 23^rd. You can learn more at www.excelsia.com. I will be in Philadelphia on June 4-5 with partner Steve Blumenthal of CMG for their annual Advisor Forum. He has assembled an outstanding group of speakers. Details to follow, but if you are an investment advisor you should consider coming. You can call CMG at 610-989-9090.

This has been a whirlwind two weeks. First the Casey conference in Florida, then my own Strategic Investment Conference in California, and then on to Tulsa to watch my daughter Amanda graduate from college, followed by a quick trip to Chicago. I saw so many friends everywhere – and sadly gained a few pounds, with so many great meals and not enough gym time. I will need to work those off soon. And for those who are interested, we are going to make some of the speeches from the SIC available over time. The response from those who attended was overwhelmingly positive.

While back home I got to have dinner with my friend and dentist, Dr. Gary Sanchez, who works in Albuquerque. Gary is the inventor of the Health Chair, which I found in my search for a better chair to help my back. And it has. If you are like me and sit a long time each day, then you might want to take a look at www.thehealthchair.com. He has upgraded his website to be more consumer-friendly (nice video). The chair is not cheap, but I it is definitely one of the better investments I have made.

I am looking forward to Mother's Day. My mother will be 95 this August. She reminds me to stay young at 62! And it is time to hit the send button. The sun is coming up, and I have been sitting too long in this chair, not matter how great it is! Have a great week.

Your ready for a vacation in Tuscany analyst,

John Mauldin

John@FrontlineThoughts.com

The War for Spain

John Mauldin — Sat, 14 Apr 2012 15:17:00 GMT

The War for Spain
Spain Goes “All In”
“We Are Not Greece”
The New Labor Force
A Little Blue Suede Shoe Trouble

I fully intended to ignore Spain this week. Really, truly I did. I had my letter all planned, but then a few notes drew my attention, and the more I reflected on them, the more I realized that the inflection point that I thought the ECB had pushed down the road for at least a year with their recent €1 trillion LTRO is now rushing toward us much faster than ECB President Draghi had in mind when he launched his massive funding operation.So, we simply must pay attention to what Spain has done this week – which, to my surprise, seems to have escaped the attention of the major media. What we will find may be considered a tipping point when the crisis is analyzed by some future historian. And then we'll get back to some additional details on the US employment situation, starting with a few rather shocking data points. What we'll see is that for most people in the US the employment level has not risen, even as overall employment is up by 2 million jobs since the end of the recession in 2009. And there are a few other interesting items. Are we really going to see 2 billion jobs disappear in the next 30 years?

But first, a personal note. My friend and fellow writer/economic blogger Mike "Mish" Shedlock's wife has ALS, better known as Lou Gehrig's disease. I have talked at length with him the past year as the disease progressed. It is a truly evil affliction. Mish has stayed the course, working with his wife, and now the options will soon be down to her communicating with a device that follows her eye movements to choose words on a computer screen. I cannot even imagine the pain of living with a loved one in the condition.

Mish is not asking for anything for his family, but he is sponsoring a raffle for ALS research. Please consider buying one or more tickets, or making a small donation to the Les Turner ALS Foundation. The money will go to research to find a cure, so that someday no one has to go through such pain. Thanks.

The War for Spain

In my book Endgame, co-author Jonathan Tepper and I wrote a chapter detailing the problems that Spain was facing. It was obvious to us as we wrote in late 2010 that there really was no easy exit for Spain. The end would come in a torrent of misery and tears. Tepper actually grew up in a drug rehab center in Madrid – as a kid, his best friends were recovering junkies. (For the record, he has written a fascinating story of his early life and is looking for a publisher.) His Spanish is thus impeccable, and he used to get asked to be on Spanish programs all the time. Until the day came when the government created a list of five people, including our Jonathan, who were basically named "Enemies of Spain," and pointedly suggested they not be quoted or invited onto any more programs.

As it turns out, the real enemy was the past government. We knew (and wrote) that the situation was worse than the public data revealed, but until the new government came to power and started to disclose the true condition of the country, we had no real idea. The prior government had cooked the books. So far, it seems it even managed to do so without the help of Goldman Sachs (!)

In about ten days I will be sending you a detailed analysis of all this, courtesy of some friends, but let's tease out some of the highlights. True Spanish debt-to-GDP is not 60% but closer to 90%, and perhaps more when you count the various and sundry local-government debts guaranteed by the federal government, most of which will simply not be paid. Spanish banks are miserably underwater, and that is with write-offs and mark to market on debts that totals not even half of what it should be. If Spanish housing drops as much relative to its own bubble as US housing has so far (and it will, if not more), then valuations will drop 50%. The level of overbuilding was stupendous, with one home built for every new every person as the population grew. We know that unemployment is 23%, with youth unemployment over 50%. Etc, etc. We could spend 50 pages (which is what I will get you access to) detailing the dire distress that is Spain.

Which brings us to this week. It was only a few weeks ago that most everyone, including your humble analyst, thought that the ECB had bought a little time with its "shock and awe" €1-trillion LTRO. Lots of analysis said there would now be at least a year to put programs in place to deal with the coming crisis.

Yet we may now be fast approaching the Bang! moment when the markets simply refuse to believe in the firepower that whatever governmental entities can muster. It happened with Greece, as it has in all past debt crises. Things go along more or less swimmingly until, as Ken Rogoff and Carmen Reinhart so articulately detail in This Time is Different, we wake up one morning to find that Mr. Market has seemingly lost all interest in funding a country at a level of interest rates that is credibly sustainable. When interest rates ran to 15% for Greece, even arithmetically challenged European politicians could understand that Greece had no hope of ever paying off its debt.

When rates rose last year to almost 7% for Italy and 6% for Spain, before the ECB let loose the hounds of monetization, they were approaching the limits of sustainability. Rates came back down as the ECB either bought directly or engineered the purchase of the bonds of the two countries. But now the LTRO effect appears to have worn off, and yesterday interest rates for Spanish ten-year bonds climbed again to 5.99%. There is a large auction for ten-year Spanish bonds next week, which the market is clearly anticipating with a bit of concern. Meanwhile, Italian interest rates are not rising in lock step, which shows that the anxiety is now clearly directed at Spain. Ho-hum, move along folks, nothing to see here in Rome.

(What follows now is a mix of the facts as I read them and speculation on my part. I admit I may be reading more into the information, as I squint at it at 3 AM, than is justified. But then again, there is a substantial amount of history that suggests I am not totally off base...)

Spain Goes "All In"

I came across this tidbit from typicallyspanish.com, and my antennae started to twitch (hat tip Joan McCullough). The key is the second paragraph. (Hacienda is the common name of the Spanish tax ministry, otherwise known as the Agencia Estatal de Administración Tributaria.)

"Spain led the loss in the number of self-employed workers in Europe in 2011. One in two of the self-employed to lose their jobs in the EU over the year was Spanish. Seven out of ten self-employed in Spain do not employ anyone else. Over 2011 Europe lost a total of 203,200 self-employed workers, 0.6% fewer than in 2010.

"Following the news that cash business transactions over 2500 € are to be banned, Hacienda has said they will not fine anyone who admits that they have been making payments of more than 2,500 € over the previous three months. The cash limit is part of the Governments anti-fraud plans which have been approved today, Friday. Those Spaniards who have a bank account outside the country now face the legal obligation of having to inform Hacienda about the account. The Government hopes its anti-fraud measures will bring in 8.171 billion €."

My fellow US citizens will be saying to themselves, "So what? We have to report our foreign bank accounts, and any large cash transactions are flagged." But gentle reader, this is much different. This is new law for Spain, basically currency control writ large, and bells have to be going off all over Europe.

First of all, note that Greece never tried to require its citizens to report cash transactions or to list foreign deposits. This is the new Spanish government revealing serious desperation. The government's back is to the wall. They have to know they will not collect the taxes they need to generate, but are going to try anyway to demonstrate to the rest of Europe (read Germany) that they are doing everything they can.

In a side note, on Wednesday, Spain's interior minister introduced new measures to thwart plots using "urban guerrilla" warfare methods to incite protests. And the local papers are printing op-eds by economists talking about how the effort to comply with German austerity demands will just make the economy worse, and that the government is not taking into account the resolve of labor unions to oppose them. "Germany is the problem." It pains me to say this (truly it does), but this is what we were writing about Greece, not all that long ago. We are seeing footage of demonstrations, verging on riots. It is a familiar pattern.

Second, let's review what I wrote a month ago. I noted that the LTRO money was being used by Spanish banks to buy Spanish government debt (and Italian banks were buying Italian government debt, etc.). The intention was to help the two countries specifically and Europe in general to finance their debts and allow banks to shore up their capital as part of that effort. But what that does is yield the unintended consequence of making a breakup of the eurozone easier, as it helps get Spanish and Italian debt off the books of German and French banks.

The only reason Germany and France, et al., cared about Greece is that their banks had so much Greek debt on their balance sheets, in many cases more than enough to render them insolvent. Bailing out the banks directly would have been costly, so better (thought the European leaders) to do it with bailouts from funds created with guarantees from the various governments (which is a backdoor way to get it from taxpayers) and the European Central Bank. A crisis was avoided and there was a more or less orderly Greek default – which anybody who bothered to look at the math saw coming well in advance.

A further side note: Spanish-bank borrowing from the European Central Bank doubled last month, "revealing a dangerous dependence on emergency funding that on Friday triggered renewed turmoil in financial markets." (The Telegraph) And the Spanish stock market is down some 30% over the past year.)

So, in the effort to make sure that everyone pays their taxes and to stop tax fraud, the Spanish government is going to find out which of its citizens have moved their money out of Spain. And let's be clear, money has been flying out of the banks of Spain and Portugal (and to some extent Italy) as it did, and still is, in Greece.

And it will be easier to track that offshore money than you think. Some people, I am sure, moved their money into cash and then out of the country. But others simply wired the money, thus leaving a trail. Spanish banking regulators can easily require they be given that information, and what bank will say no to the regulators? Spain does not collect taxes from its citizens if they are residents of a foreign country (as the US does), but it can tax everyone who lives in Spain. And if you live in Spain and decide to diversify your risk among a few other countries? I am not sure of Spanish tax law, but I reasonably assume you are supposed to report all your income from whatever source. (Otherwise there would be no one investing with Spanish banks, brokerages, and investment advisors –if it were legal not to report foreign investments, then everyone would invest outside of the country.)

Let me hazard a modest prediction: We will see a rather sudden and substantial need for physical cash in certain other "peripheral" countries, as now their citizens may not want to leave trails as they go about opening foreign bank accounts. What is to keep Italy from doing as Spain has done? Or Portugal? Or France? Or Germany?

Let me be clear about something. I am not suggesting that people should not pay their taxes. If you choose to live in a country, you should pay the taxes that are required. What Spain is trying to do is simply make sure that all their citizens pay the proper amount of taxes. If there was already 100% compliance, there would be no need for new regulations like Spain's. And the same goes for the US. Our penalties are rather stiff for not paying taxes, more so, I'm guessing, than in most of Europe. I have on more than one occasion noted that the national sport of Italy is tax avoidance.

My friends in Spain tell me a lot of business is done in cash. But that is the case in the US and almost everywhere I go. There are a lot of (ahem) "independent" taxi drivers, services, etc. that do not take anything but cash. Maybe they report everything, but I do not bother to ask. (When I was a waiter in college, did I report all of my tips? I was required to report a minimum amount of income for each hour worked, but did I report everything? Since it has been 40 years and the statute of limitations has run out by now, I might admit to missing a few dollars here and there.)

I imagine there are quite a few Spanish citizens who are not sleeping well this weekend. And more than a few people tossing and turning in other countries as well. If the next month comes and goes without any sign of unusual cash movement in Europe, then I will owe the peoples of peripheral Europe a big apology for doubting their willingness to pay their taxes. Or maybe it will turn out that they were better at "avoidance" than your average American, and planned their movements far in advance...

Let's get back to the central point. Spain is too big to fail and too big to save. The bond markets are clearly getting nervous, much sooner than was planned. Spain is clearly attempting to demonstrate that it will do everything in its power to comply with the new European austerity rules. Yet Prime Minister Mariano Rajoy has warned that the situation has created "a vicious circle that strangles Spain."

Rajoy delivered a strongly worded speech to parliament, insisting that it was "as clear as day" that Spain would not need a Greek-style bailout. But in recognition that the country is losing market confidence, he appealed to other European leaders to be "careful with their comments" and remember that "what is good for Spain is good for the eurozone." (The London Telegraph)

One can look at the amount of money Spain will need to refinance in the coming year and look at their financial ability, then look at how much can possibly be raised by the European community, even under the proposed new structures, and readily come to the conclusion that there is simply not enough money to save Spain if the market goes Bang!

The only possible solution I see is for the European Central Bank to step in with some new program. ECB President Mario Draghi has demonstrated a marked ability to come up with new, creative ways to kick the can down the road. Finding the money to bail out Spain is hopefully in his book of tricks. As fellow central banker Ben Bernanke has noted, Mario has a printing press. And the LTRO showed he knows where it is and how to use it.

"We Are Not Greece"

The German Bundesbank is saying as loudly as it can, "QE? Nein!!" But I count only two German votes among the 23 that compose the board of the ECB. Spain is demonstrating to its European brothers and sisters that it is doing all it can. "We are not Greece" is the clear statement. And "We need and deserve your help." Yesterday, Rajoy pointedly noted again that "What is good for Spain is good for the eurozone."

One should not underestimate the willingness of politicians who are viscerally committed to a certain action (in this case European unity) to spend someone else's money in the pursuit of that action. Especially if that money is a hidden tax in the form of debt monetization.

The markets are moving up the time table on the next large monetization of Spanish (and eventually Italian?) debt. Germans will shout that this is inflationary, and for them it probably will be. But much of the rest of Europe is in the grip of deflation. Spain is clearly in a classic Keynesian liquidity trap. This is what can happen when you have very different economies operating under one monetary roof. This is not simply a banking or sovereign-debt crisis, it is about a massive trade imbalance and huge differences in the productivity of labor. The trade imbalance between the south – Portugal, Spain, Italy, and Greece – and the north (mostly Germany) must be solved before there can be any resolution of the economic crisis. This is Economics 101, which European politicians seem to have slept through.

There will be the attempt to create some sort of fund to buy Spanish debt, but it will prove to not be enough. And given recent market movements, it may not be able to happen fast enough. It will not surprise me if the ECB uses the promise of such a fund as a pretext for acting sooner.

And yes, this will lower the value of the euro. We will have to see how far Europe is willing to push the process. Greece will soon default again (they are in a depression and have a national election in early May), Portugal is still moving toward being bailed out, and the Irish are growing tired of having to repay the British, French, and Germans for bailing out their failed banks. Think bailout fatigue isn't growing among European voters? Stay tuned...

The New Labor Force

I will end this letter with the beginning of what I intended to write originally and hope to finish next week. Work and employment is changing before our eyes in the US and much of the developed world. As the Baby Boomer generation reaches retirement age and finds out that either it cannot afford to retire or does not want to retire, the "trickle-down" effect to younger workers is starting to become apparent in the data.

Let's look at three charts (hat tip to John Hussman, who called this to our attention and got me looking at the details). The first shows the employment level in the US for the last five years. The gray area is the official period of recession. Employment growth since the end of the recession has been only a few hundred thousand jobs a month; but since employment is a lagging indicator, you can claim that we have recovered 4 million jobs since the employment bottom in late 2009 or about 2 million jobs since the 3^rd quarter of 2009. It all depends on where you want to start your count. But we are still down roughly 4.5 million jobs since the beginning of the recession. This has been the slowest "recovery" since the end of WWII.

Now let's look at the next chart. This is the employment level for those over the age of 55. Notice that it kept rising all through the recession and especially after. People over 55 have seen their total employment level rise by about 4 million jobs since the beginning of the recession, and over 3 million jobs since the 3^rd quarter of 2009. Almost any way you look at it, those over 55 have seen their jobs level improve over those who are younger. If you take the end of the 3^rd quarter as your marker, the Boomer generation has seen its jobs level rise by 3 million, while overall jobs rose by just 2 million! Those who are younger are actually falling behind!

And once last chart before we go. Last week we looked at how the civilian participation rate (the percentage of the population who have a job or want a job) for the US has been falling for a decade and especially since the end of the recession. You can attribute a high percentage of the apparent decrease in unemployment to the fall in the participation rate.

Except for one group or cohort. This next chart is the participation rate of those over 65. Their participation rate is rising. The graph is "noisy," but the trend is clear. Whether willingly or out of necessity, older workers are staying longer in the work force. And given the rather lackluster employment growth, they are taking jobs that would normally go to younger workers, which is why we are seeing higher rates of unemployment among the latter. We will go into the why of that next week, but a great deal of it has to do with work skills.

A Little Blue Suede Shoe Trouble

My travel schedule is rather hectic, and I will be on the road some 22 out of the next 26 days. Only in the US, which is easier on my body, but air travel has long lost its romance. Airport security can take the fun right out of travel, not to mention the time. Today I was lost in thought, thinking about this letter as I stood in line. I went through the drill, as I have done hundreds of times, taking out the laptop, taking off the coat and shoes, emptying the pockets, etc. Except this time I forgot the shoes. I went right on through the line with the new body scanners (which for some reason I don't like), then began to collect my gear and noticed my shoes were not in the tray. (And yes, these are the very same blue suede shoes that Swedbank bought me a few weeks ago in Stockholm, when my bags were lost. I have found them to be quite comfortable and stylish travel shoes.)

So I looked down. I was still wearing them. I laughed and remarked about it to the security guy at the tail end of the line and began to leave, when suddenly they stopped everything. Seems I had found a particularly zealous security person. Not only did I have to take off my shoes, but I had to go back through security and get scanned all over again. Next time I will try being funny with a more amenable crowd.

It is time to hit the send button. It is once again late, but I get to sleep a little later here in Frisco, so I can adjust. Have a great week.

Your proud member of the working Boomer generation analyst,

John Mauldin

John@FrontlineThoughts.com

All Spain All the Time

John Mauldin — Sat, 31 Mar 2012 17:27:00 GMT

All Spain All the Time
Structural versus Cyclical Dilemmas
The Mother of All Housing Bubbles
Spanish Banks en Bancarrota
Meanwhile in the Rest of Europe
And Two More Leaked Documents
The Fat Lady Has Not Sung
San Francisco, New York, and Philadelphia

Last Monday I was in Paris and was asked to do a spot on CNBC London. I arrived at the studios an hour early due to a misunderstanding of the time zones, so while trying to catch up on the news I listened to CNBC. I had just written about Spain in last week's letter and guessed that was what they wanted to talk to me about, but for the full hour before I got on it seemed like every guest wanted to talk about Spain. When I had my turn and indeed got the Spain question, I smiled and noted that we were now in a period when it would be "All Spain All the Time," for at least the next year. I should have noted that there would be brief interruptions where we glanced at Portugal and perhaps Ireland, but the real focus would be on Spain.

I fully intended to write about something other than Europe this week, but the events of the last 24 hours compel me to once again look "across the pond" at the problems that not only plague Europe but will be a drag on world growth as well, as Europe goes through its continued painful adjustment as a consequence of trying to adopt a single currency. Since Spain is going to be on the front page for some time, it will be useful to look at some of the problems it is facing, to put it all into context. And what I heard while in Europe in private meetings is troubling.

All Spain All the Time

Spain is in a recession, though only down an estimated 1.7% in 2012, if things go well. Unemployment is at 23%, which is higher than Greece for the latest Greek data that I can find. But more than half of young Spaniards (over 51%) are out of work, creating a lost generation that has been hardest hit by Spain's economic woes. The total number of unemployed has climbed above five million, and Spanish under-25 unemployment has nearly tripled, from 18% just four years ago.

" 'This is the least hopeful and best educated generation in Spain,' said Ignacio Escolar, author of the country's most popular political blog and former editor of the newspaper Publico. 'And it's like a national defeat that they have to travel abroad to find work.' Young Spaniards are now living in the family home longer than ever before, pushing the average age of independence from their parents to well into their thirties." (The Telegraph)

Unions called a general strike on Thursday as the recently elected Spanish government delivered its new austerity budget. While the protests were mostly peaceful, the pictures we see are of youth in partial riot mode. It is eerily similar to the onset of riots in Greece just a few years ago – except that unemployment is higher than when the Greek crisis started. And while Spanish leaders will protest that Spain is not Greece, there are striking similarities .

As an aside, let's remember that Habsburg Spain defaulted on all or part of its debt 14 times between 1557 and 1696 and also succumbed to inflation due to a surfeit of New World silver. Portugal has defaulted on its national debt five times since 1800, Greece five times, Spain no less than seven times. There have been more than 250 sovereign debt defaults since 1800.

Structural versus Cyclical Dilemmas

A country (or a family) can face two different types of crises. A cyclical crisis is typically temporary and due to a business-cycle recession. When the problem that caused the recession is dealt with, the economy comes back and employment returns to normal.

Structural problems are more difficult to deal with. Structural unemployment is a more permanent level of unemployment that's caused by forces other than the business cycle. It can be the result of an underlying shift in the economy that makes it difficult for certain segments of the population to find jobs. It typically occurs when there is a mismatch between the jobs available and the skill levels of the unemployed. Structural unemployment can result in a higher unemployment rate long after a recession is over. If ignored by policy makers, it can then even lead to a higher natural unemployment rate.

Structural unemployment can be created when there are technological advances in an industry. This has happened in manufacturing, where robots have been replacing unskilled workers. These workers must now get training in computer operations to manage the robots and employ other sophisticated technology, in order to compete for fewer jobs in the same factories where they worked before. (about.com)

But structural unemployment may also be caused by government policies that make it difficult or even uneconomic for businesses to hire workers. Typically these policies are put in place by well-meaning if economically ignorant politicians (nobody wants to create unemployment), but the problems are there no matter what the intentions were. Let's look at a few Spanish structural problems.

The first is a rather poisonous employment environment. The graph below was created by The Bank Credit Analyst to discuss structural employment problems in France, but the country that is even higher on the employment protection index is Spain. Note that both countries are higher than 3^rd and 4^thplace Greece and Portugal.

In an open market, the large majority of jobs are created by small businesses. But when you make it difficult and more expensive for small businesses to hire workers, it is not surprising that you get fewer jobs. In the US, our experience is that when the minimum wage rises, youth unemployment rises as well, even in times of recovery. This has been consistent over the last few decades, when statistics have been kept. There are a lot of reasons for this, which we will not go into today, but there is every reason to believe that Spain in particular and Europe in general would be no different in that respect from the US.

The Mother of All Housing Bubbles

Spain had its own housing bubble, in most ways worse than that of the US. In 2006, the Guardian wrote that 50% of new EU jobs had been created in Spain during the previous five years. But in 2011 housing starts were down by 94% and new mortgages by 81% (IMF, 2011). The IMF notes that "The stock of unsold units may take around another four years to clear. The lowest estimates of the stock of unsold units are at close to 700,000 units, with considerable regional variations but with a downward adjustment that has only started at the end of 2010. These only include newly completed units, and do not fully include units repossessed by financial institutions, unsold secondary market houses, or unfinished units."

TheWall Street Journal suggests the number may be more than double that:

"Some 1.5 million unfinished, unsold or unwanted residential units stand scattered across the country, products of a still-deflating housing bubble that threatens to undermine Spain's broader economy for years to come. It is the hangover after an epic fiesta, a period Spaniards now refer to as "cuando pensábamos que éramos ricos"—'when we thought we were rich.'"

Let's put that in context. The US has about 6.5 times more people than Spain. There are 2.43 million existing homes for sale plus shadow inventory in the US, estimates of which vary. Using the WSJ number, this would suggest Spain has the equivalent of 15 million-plus homes for sale. That in a country where unemployment is more than double ours and where population growth and household formation is certainly slower than in the US. Only Ireland can rival Spain for the largest housing bubble.

The number of homes being foreclosed on is estimated to triple in Spain. About 120 evictions take place every day. Those who default on their mortgages cannot walk away from the debt, as in the US. A story is out tonight about one resident who lost her job and is being foreclosed on. She will still owe over about half her debt, or more than €100,000, plus court costs and penalties. From the Huffington Post:

"If the bank manages to sell a foreclosed home, that amount is struck off the remaining debt. But the norm these days is that the property is put up for auction and nobody bids. That has meant the bank then takes over the house for just half its originally assessed value, and wipes the amount off the remaining debt – leaving the borrower still owing a bundle. The legislation passed last week raises the proportion the bank has to effectively pay in the event of non-sale to 60 percent."

Home prices have fallen just 10-20%, as banks cannot afford to write down mortgages (more on that later). Realistic estimates assume a 40-50% total drop is more likely, and anecdotal evidence suggests it could be even more if the economy does not recover soon. And as we will see, that is going to be tough.

Spanish Banks en Bancarrota

I am not sure if the Spanish term for bankrupt is en bancarrota or quebrado, as Google didn't make it clear.

(Sidebar: The former sounds suspiciously Italian, as it is the term for "broken bench," which was the medieval term for what happened when a merchant bank went under. Its bench was literally broken. Our guide pointed to a spot in Sienna where she said the first banks and the term originated. And it is where the English word bankrupt comes from.)

In any event, there is widespread agreement that the regional Spanish banks, the cajas, are bankrupt, as they made massive loans for construction and mortgages. The government has taken some action, forcing 45 caja savings banks that were threatened by bankruptcy due to bad property loans to consolidate down to 14. But although bank regulators have estimated that Spanish banks will need €26 billion in extra capital, many skeptics believe this severely underestimates future losses and that the government may have to step in with a much larger bailout for the financial sector. The Bank of Spain contends that construction debt to banks stands at some €400 billion, of which repayment of€176 billion is questionable, with €31.6 billion of those considered nonperforming. (WSJ)

Spanish private debt is 220% of GDP, dwarfing government debt, which is high and rising. So not only are banks being forced to raise capital and reduce their loan books, consumers and businesses are also overextended. The government wants to increase taxes or reduce spending by 17% to get the deficit down from over 8% to 5.5%, a combination that is not geared for growth.

€12.3bn will be raised in new taxes, with €5.3bn coming from corporations, and €2.5bn is projected to come from a temporary amnesty on tax evasion (you've got to love the optimism). We have seen how such policies worked in Greece. They meant lower, not increased, revenues. Note that Britain also raised taxes on "the rich" and saw revenues fall in that category, not increase as projected.

Further, as we go along this year, watch for "breaking" news that off-balance-sheet guarantees by the Spanish government will be huge, adding multiples of 10% to total debt-to-GDP. Spain's admitted government debt is over 70% of GDP, which in comparison to other European countries is not all that bad. Except that is not the extent of the problem. There is regional debt, bank-guaranteed debt, sovereign guarantees, etc. that take it to roughly 85%.

And then we add the guarantees that Spain has made to the EU for all the stabilization funds, ECB liabilities, etc., at which point Mark Grant suggests that Spanish debt may be closer to 130% of GDP. (Of course, if we count all debt and guarantees, something that a normal bank would make you or me do if we wanted a loan [at least since the subprime debacle], then Italy has over 200% debt-to-GDP. Just saying.)

Spain is going to have an uphill struggle to keep its deficit down to 5.5%. Unemployment is still rising, as Spain is after all in a recession and costs will be up and revenues down. But the current budget buys time and what will amount to good will from the rest of Europe, as Spain will be seen to be trying, conducting yet another experiment in austerity. When those deficits come in higher, then what will Europe do? With each piece of bad news, the problem of funding Spanish debt will grow. Right now, Spanish banks are buying Spanish government debt with everything they can muster, which is to say, ECB loans at 1% for three years, invested in 5.5% bonds. With 30 times leverage. All the while trying to cut losses and reduce their loan books – a trick worthy of Houdini.

Meanwhile in the Rest of Europe

Let's quickly take a turn around Europe. Germany is preparing to reduce its budget, which will reduce inflation and also relative labor costs, which will make it more difficult for peripheral Europe to catch up on their massive trade deficits. In a story tonight in the Telegraph, with the headline "Germany launches strategy to counter ECB largesse," Ambrose Evans-Pritchard notes that "The plans have major implications for monetary union, dashing hopes in Southern Europe that Germany might accept a few years of mini-boom at home to help lift the whole system off the reefs.... 'The Bundesbank does not want to be blamed for making the same mistakes as central banks in Ireland and Spain where they did not address asset bubbles early enough,' said Bernhard Speyer from Deutsche Bank.... The German authorities are in effect preparing a form of quasi-monetary tightening to offset ECB largesse."

I keep noting that the third leg of the euro crisis, the trade imbalance between northern and Southern Europe, must be addressed or there is no real solution, just short-term Band-Aids. Ambrose's column goes on to note that Germany is hoping the rest of the world will do their job to provide a positive trade balance for peripheral Europe, all the while continuing its own massive surpluses. Unless and until the peripheral countries adopt their own currencies, the adjustment will be slow and painful, and the countries will be in recession for years, until wage costs (income to workers) drop by 30% relative to Germany. That is the ugly reality.

Wolfgang Munchau, writing in theFinancial Times, notes that even with the proposed increases in the European bailouts funds (the sources and variety of which are quite confusing, so let's look at them in the aggregate) there is not going to be enough for Spain:

"The current ESM is big enough to handle small countries, but not Spain. I expect Madrid eventually to apply for a programme, specifically to deal with the debt overhang of the Spanish financial sector. But even a minimally enlarged version of the ESM will not be big enough.

"What this stand-off tells us is that we are approaching the political limits of multilateral programmes. If you want to claim funds of such size, you need joint and several liability – ie all eurozone countries need to be jointly liable – not individual liability among member states. Call it a eurobond, call it what you like. If you do not want that either, then you have to accept that there is simply no backstop for Spain. As I said, welcome back to the crisis."

And Two More Leaked Documents

And also tonight, we get two leaked documents from today's meeting of the European finance ministers. (I am not certain why they keep trying to keep these documents secret, as the press typically gets them before the ministers do.)

The first document tells us that€1 trillion in ECB largesse is not enough and has simply calmed the storm. "Contagion may ... re-emerge at very short notice, as demonstrated only a few days ago, and re-launch the potentially perverse triangle between sovereign, bank funding risk and growth," one of the analyses, prepared by the EU's economic and finance committee and seen by the Financial Times, said.

From the Financial Times:

"The second document, which was prepared by the Commission, warned bluntly: 'The euro crisis is not over. Many of the underlying imbalances and weaknesses of the economies, banking sectors or sovereign borrowers remain to be addressed.'

"The paper argued the elements of the recent restoration of confidence – finalising a second Greek bailout, increasing the eurozone's rescue fund, EU-wide bank recapitalisation, new eurozone fiscal discipline rules, and efforts to pass policies to encourage growth – must be fully implemented or leaders risk losing their last chance to act.

" 'If this window of opportunity is not most effectively used ... we might have missed the last chance for a considerable amount of time,' the analysis said."

The Fat Lady Has Not Sung

As I wrote last week, I was at the Global Interdependence Center conference on central banking in Paris. It was the coming out of the GIC Global Society of Fellows, ably headed up by my friend Paul McCulley, formerly of PIMCO. David Kotok, who runs Cumberland Advisors (and who runs the annual August fishing trip in Maine) is the GIC vice-chair. He wrote a short note of his take-aways, and I found it striking and worth a few minutes of your time, as a few years ago he wrote a very bullish book on Europe. His candor, given that former view, is sobering. The rest of the letter is his:

Back from Paris
David Kotok

We are back from Paris. The head is filled with new info. For the publicly available portion of the conference, see the GIC website, www.interdependence.org. The remaining comments will be my personal "takeaways" from both public and private conversations. By Chatham House Rule and Jackson Hole Rule, these words are attributable only to me. All errors are mine.

1. In my view, the situation in Portugal is unraveling. This may be the second shoe to drop in the European sovereign debt saga. Now that Greece has paved the way, the speed of unwind with Portugal may be much faster. I do not believe the markets are prepared for that. Runs are affecting Portuguese banks. Euro deposits are shifting to other, safer countries and the banks that are in those countries. Germany (German banks) is the largest recipient. Remember, deposits in European banks are guaranteed by the national central banks and the national governments, not the ECB. There is no FDIC to insure deposits in the Eurozone.

2. The issue is that Greece was supposed to be "ring-fenced." Notice how European leaders have stopped using that word. Their new word is firewall. If a second country (Portugal) restructures, the sovereign debt issues become systemic rather than idiosyncratic. That becomes the second game-changer. Systemic risk needs big firewalls. We learned that the hard way with Lehman and AIG, which were systemic, vs. Countrywide and Bear Stearns, which were "ring-fenced" – or thought to be ring-fenced at the time.

3. A game-changer was the use (not threat) of the collective action clause by Greece. CAC altered the positions of the private sector. It rewrote a contract after the fact. That is why Portugal's credit spreads are wide: the private-sector holders of Portuguese debt know that a CAC can be used on them, too. The same is true for all European sovereign debt. A re-pricing of this CAC risk is underway.

4. Private holders of Greek debt had several years to get out before the eventual failure. Those that did not get out were crushed in the settlement. Greece is now a ward of governmental and global institutions like the ECB, IMF, and others. It is unlikely to have market access for years. This is another game-changer. In the old crisis days, the strategy was to regain market access quickly and restore private-sector involvement. In the new Eurozone-CAC crisis days, the concept is to crush the private-sector holders, and that means no market access for a long time. Instead, we will have ongoing and increasing sunk costs by governmental institutions. Caveat: government does not know how to cut losses and run. Government only knows how to run up small losses until they are huge. Witness Fannie Mae in the US. Witness the sequence that allowed Greece to fester for years. Government does not know how to take the "first loss," which is usually the smallest lost. Government does know how to run up moral hazard.

5. The term moral hazardmeans the action is done today and the price is determined later, after the chickens come home to roost and crap all over the coop. That is the nature of government everywhere. By the time the chickens return, the political leaders have changed. Those who took the moral hazard risk are gone. Those who inherited their mess are blamed during the cleanup. That is where we are today in Europe. Hence, the political risk is rising daily. Elections could change these governments, and the new governments may repudiate the actions of the old ones. We expect more strikes and unrest. That is how elections can be influenced.

6. European debt-crisis issues are lessons for the US. They belong in the political debate. Both political parties are responsible for our growing debt issues. Bush ran up huge deficits. Obama continued them. Each party blames the other. Neither takes on the responsibility of their actions. We shall see how this evolves between now and November.

I am more pessimistic about peripheral Europe than I have been. All that my co-author Vincenzo Sciarretta and I wrote in our book several years ago is now being reversed by policies. In the beginning, the Eurozone benefited immensely from economic integration and interest-rate convergence. Now it faces disintegration and divergence. Reverse the chapters in the book and play the film backwards.

Can Europe find a stabilizing level and resume growth? Time will tell. Meanwhile, political leaders and central bankers are going to be tested again.

This ain't over. Yogi is correct.

San Francisco, New York, and Philadelphia

It is time to hit the send button, but let me first mention a few important things. I have had a number of readers ask me about the skin care crème I mentioned a few times early last year. As many of you know, I acquired the rights to market a revolutionary new skin crème that contains skin stem cells, and that has showed very positive results. Bottom line, the product works as I said; but it was too much for us to take on and to remain focused on my main mission, which is research and writing about investments and economics. So I gave those rights back to the company, Lifeline Skin Care, a subsidiary of International Stem Cell Corporation.

I still use the crème every day. I also have heard from a LOT of readers who, like me, use it and love it. It does stimulate your skin to grow. Most of my readers may not be interested, but those who are you might look at the following link. Guys, your wives will love you. Trust me on this. And if you are like me, you will like the results as well. You can see a one-minute video of a TV news story and get all the details:http://www.lifelineskincare.com/ahead-of-the-curve.

I am off to San Francisco in a few hours to attend a conference on life extension, where I will catch up with my good friend Pat Cox and (editor of Breakthrough Technology Alert). Pat is introducing me to several biotech executives from the area, and I am going to one of the more important companies anywhere. I will also get to have lunch with Colonel Doner, an old friend and one of the great raconteurs. It is possible that we were separated at birth. I may also get to once again spend extended time with Dr. Mike West, the chairman of BioTime, which I consider to be one of the true leading lights in the rejuvenation world. Mike West has a handle on stem cell technology like none other.

Then it's back to Dallas for a night and then on to New York to speak at an Investorside independent research program cosponsored by Bloomberg. It is at the Bloomberg building on 59^th and Lexington. Attendance is limited. http://www.investorside.org/events/IndependentsDay2012_agenda.html

The next day I do some media spots in the morning, finish up with lunch with Barry Ritholtz, and then hop a plane back to Dallas.

It will be a full week, while trying to get the next book done. Have a great week and make sure you see some old friends who mean a lot.

Your fading fast, too far past midnight analyst,

John Mauldin

John@FrontlineThoughts.com

Unintended Consequences

John Mauldin — Sat, 03 Mar 2012 20:17:00 GMT

Unintended Consequences
Sufficient Unto the Day
What Should Greece Do?
And Then There Is Ireland
New York, Orlando, Sweden, and Paris
Just One Question, Daddy

"Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces."

–Sigmund Freud

Let me introduce Mauldin's Rule of Thumb Concerning Unintended Consequences:

For every government law hurriedly passed in response to a current or recent crisis, there will be two or more unintended consequences, which will have equal or greater negative effects then the problem it was designed to fix. A corollary is that unelected institutions are at least as bad and possibly worse than elected governments. A further corollary is that laws passed to appease a particular group, whether voters or a particular industry, will have at least three unintended consequences, most of which will eventually have the opposite effect than the intended outcomes and transfer costs to innocent bystanders.

This week we wonder about the consequences of the European Central Bank (ECB) issuing over €1 trillion in short-term loans to try and postpone a banking credit crisis and lower sovereign debt costs for certain peripheral countries in Europe. What if, instead of holding the European Monetary Union (EMU or Eurozone) together, that actually makes a breakup more likely? That would certainly fall under the rubric of unintended consequences, and be worth our time to contemplate in this week's letter.

Further, what if the group that oversees credit default swaps declares an actual sovereign debt default not to be a technical default in order to avoid a credit crisis because CDSs would have to be paid? Could that actually undermine the ability of smaller countries to borrow money at lower cost, if they could even borrow it at all? Thus making the eventual outcome even worse? We will explore these perplexing questions and more as we once again turn our attention to Europe.

But first, and quickly, we are now ready to take reservations for the 9^th Annual Strategic Investment Conference, May 2-4, which this year will be in Carlsbad, California for the first time, at a venue that will allow us to take a few more attendees but still keep that intimate feeling. I host the conference, along with my partner Jon Sundt and his team at Altegris Investments.

Each year I wonder how we could make the conference any better, but I think we have done it. I must say that I do not think any conference anywhere has the quality speaking line-up that we do. It is the finest collection of top-notch raconteurs posing as economists assembled anywhere. Each speaker is a headliner in his own right, wherever they go. We have nothing but the best each year.

Look at this line-up: Dr. Woody Brock, Mohamed El-Erian, Marc Faber, Niall Ferguson, Jeff Gundlach, David Harding, Dr. Lacy Hunt, Paul McCulley, David McWilliams (from Ireland), David Rosenberg, Jon Sundt, and your humble analyst. Plus the surprise guests. Seriously, where else can you find all that talent under one roof? I design the conference each year to be the one that I would want to attend. And Sundt and team run as smooth and enjoyable a conference as you will find anywhere.

Signing up will also give you access to exclusive papers and webinars. For example, next week I'll be interviewing Winton Capital Management. For regulatory reasons, you will need to speak with Altegris to verify your accredited-investor status, prior to being allowed to attend. You can learn more and register by going to http://meetings.StrategicInvestmentConference.

I should note that the best feature of the conference is the attendees themselves. You will make new friends and meet old ones. And the speakers are very accessible. The price goes up considerably on March 15, so register early. We always sell out, and I get calls asking to get in at the last minute, and have no way to help. Don't procrastinate. Register now. We are way ahead of last year on the pace of registrations. Again, it will sell out. Do it now.

Unintended Consequences

The ECB injected (created? printed?) €529.5 billion for an annual cost of 1%, more than the €489 billion they issued just last December. This was called a long-term refinancing operation, or LTRO. The total now is over €1 trillion euros (around $1.3 trillion), which can only make Ben Bernanke jealous. That money was technically issued to the various national central banks, who in turn lent it to their various commercial banks for almost any collateral that still had a pulse. Which banks in turn used it to shore up their balance sheets, and any spare change was used to buy more sovereign debt of their countries, thus financing their own government's deficits. And making a nice juicy spread for the next three years, which can help repair that balance sheet.

I can't find a chart I have permission to use and don't feel like spending three hours to make one just to show that the ECB has simply exploded in the last 6 months, swelling almost four times in that period, on a time-adjusted basis. Just imagine a slowly rising line that viciously turns north beginning July of last year. As in a "J" curve.

Did we see a rise in loans to commercial establishments? Easy money for all? Hardly.

The markets were quite happy that a credit crisis has once again been put off. So were the various governments. Did we see a rise in loans to commercial establishments? Easy money for all? Hardly. So what did the banks buy with their new money? (Besides the chance to deposit it back at the ECB?) They bought short-term government bonds, which more or less matched the terms of the money they had borrowed.

Which collapsed shorter-term bond yields. In November, Spanish one-year bonds paid about 5% over similar German bonds. Today it is less than 1% more. Still a nice total spread over 1%. Three-year bonds have dropped from around a 5% spread over the corresponding German bonds to slightly under 3%. Italian debt has dropped from a spread (over German yields) of 6% to 1% for one-year bonds and from over 7% to under 4% for three-year bonds. Nine and ten-year bonds are roughly the same for both countries as three months ago.

Sufficient Unto the Day

So what does a country with deficits and growing debt do? It sells lower-current-cost short-term bonds to help its current deficit (more on that later), rather than take on longer-term debt. It can also buy back more expensive longer-term debt sold last year for much lower short-term rates today.

But that means there is more roll-over risk in the very near future, as you have to borrow to replace those bonds when they mature; but why worry about that today? As my Dad was wont to say when he wanted to ignore the problems cropping up in his future, "Sufficient unto the day is the evil thereof."

I saw a table created by those clever people at Bridgewater. They analyzed the nature of the capital of the banks of various European countries. Not much has changed in the last few years, except that foreign capital is still fleeing and that capital is being replaced (almost euro for euro) by ECB debt. Let us make no mistake, without ECB largesse, European banks would either have to sell equity at fire-sale prices or their governments would have to nationalize them. Otherwise they would be insolvent. And that would in all likelihood mean a credit crisis worse than 2008, as hard as that is to imagine.

And while many applaud Mario Draghi's actions, as they feel he has averted a crisis with his initiation of the LTRO, there are others who are not pleased. This note from yesterday's Financial Times:

"The head of Germany's Bundesbank has launched a powerful attack on Mario Draghi, president of the European Central Bank, in a sign of mounting concern in Europe's biggest economy at measures being taken to try to contain the eurozone financial crisis.

"Jens Weidmann's warning of increasing risk stemming from some ECB policies highlights fears of potential costs for Germany from its role as the eurozone's biggest creditor nation and may spark fresh doubts about the eurozone's ability to deal with the long-running banking and sovereign debt crisis.

"Mr Weidmann, who has an influential voice on the ECB's governing council, said the central bank risked endangering its reputation and called for a quick return to stricter rules on the collateral that the ECB accepts from banksin return for central bank funds. The criticism in a letter to Mr Draghi was revealed on Wednesday by Germany's Frankfurter Allgemeine Zeitung."

Peter Sands, the head of Standard Chartered (a British commercial bank), warns that the new money runs the risk of "laying the seeds for the next crisis." He wonders what happens in three years' time when all that debt needs to be refinanced. That seems a reasonable question, as finding a spare €1 trillion will not be a lot easier in three years.

Former ECB board member (and fellow Italian) Lorenzo Bini Smaghi added to Mr. Sand's concerns. He said that banks may become "addicted to easy financing," creating a disincentive for them to "stand on their own feet once the crisis is over." (the FT)

The concern is that the ECB is now committed to more than just €1 trillion. As noted above, ECB financing, which amounts to almost 8% of peripheral countries' bank financing, has offset foreign (to the home country) debt that is leaving. Since that exodus is accelerating, the word fleeingmay be more appropriate. And foreign investors (mostly banks, as I understand it) have another 14% of funding in peripheral banks.

The concern is that the ECB may have to come up with even larger sums to offset the losses as foreign assets flee. (Foreign in the sense that they are not from in-country sources. As an example, Italian banks have about 6.5% of ECB funding and 12% of foreign– non-Italian – funding.)

There is really no way to know how much will be needed to forestall a further crisis. The ECB has so far signaled it is willing to step up, and the markets seem to see no reason it won't continue to do so.

But therein lies the unintended consequence. In an effort to keep the eurozone from breaking up in the midst of a credit crisis, they may have made it easier for it to break up in the future. To understand why, let's revisit Greece a few years ago.

Was it only three years ago that the market was willing to lend Greece all the money it wanted at rates not far above those of Germany? And then it seemed like, all of a sudden, in the blink of an eye, Greece could no longer sell debt at interest rates that allowed it to credibly have a hope of repaying the debt.

And Europe had to step in and bail them out. But let's be certain of one thing. As I was writing back then, the ONLY reason that Germany, France, et al., were willing to continue to lend Greece money was that their banks had bought so much Greek debt that if they had to write it off all at once it would cost the various governments hundreds of billions. The financing package of €130 million that Greece will get? €100 billion goes right back to private bondholders, mostly banks and institutions (like insurance and pension funds). Just to create the fig leaf that there is no default. So Greek debt actually goes up, even though there is a haircut on current debt. (More on that below.)

If the only banks that held Greek debt had been Greek banks, then Europe would simply have let Greece go under, with its banks. Maybe some token help, but nothing like the amounts that have been funded. Greece would have had no choice but to leave the eurozone and return to the drachma.

I wrote at the time that we would know when German banks had essentially sold their Greek debt, written it down, or were otherwise able to handle a default, because Merkel would no longer be willing to fund Greece. That point was essentially reached a few months ago. Now Europe keeps demanding ever more austerity from Greece, and every time Greece agrees they move the line and ask for more. Greece is now going to have to demonstrate it is willing to cut spending and raise taxes, no matter what.

Greece's economy will experience deflation this year as GDP falls 4.4%, the nation's fifth straight year of recession, according to the European Commission. Greece's economy contracted 6.8% last year and 3.5% in 2010.

As recently as November, the commission forecast the Greek economy would contract just 2.8% this year. But just two weeks ago that estimate was blown away. Fourth-quarter data showed Greece had contracted by almost 7% in 2011. But they had just agreed to massive austerity cuts for the next ten years, totaling as much as their current annual GDP. In an economy where government spending is 40% of GDP. Such cuts will make it even more unlikely they can meet their targets.

Europe will then demand even more cuts when the targets are not reached (or increases in taxes on what's left of the private sector). Everyone realizes the party is over, but no one wants to be the first to leave. It simply will not do for the eurozone to expel a member. The precedent is dangerous. So they make staying in the eurozone so onerous that leaving eventually becomes the best choice (more on that later). "We didn't tell force you to leave; it was your own choice."

So what is happening now is that European banks are slowly shedding their foreign sovereign debt and buying the sovereign debt of their own countries. More Italian debt is coming home to Italy, Spanish debt to Spain, and so on. Given ECB funding, this process will go on for several years.

And at some point, if Spain or Italy decided to partially default, then European banks will be able to absorb the losses. If one of the peripheral countries does not get its budget in order, then it too will have to face the music of austerity and rolling recessions, just as Greece is, in order to get funding from Europe.

If, as an example, Europe decides to no longer fund Spanish debt (at the cost of German and other taxpayers) without draconian austerities, what then? Since Spanish debt will mostly be in the Spanish system (banks, insurance, pensions, etc.), if Spain decides to leave the eurozone it will be much easier on the larger European system.

I think the very fact of allowing (encouraging?) the various countries to bring the debt home to internal banks and institutions is in fact increasing the likelihood of exit from the eurozone, when a future crisis occurs . It's all well and good to talk solidarity, but continuing to fund the peripheral nations at the cost of other taxpayers, with the accompanying damage to the euro, will soon wear thin on voters in those other countries.

Far-fetched? Aren't Spain and Italy getting their act together? Kiron Sarkar makes the following points, with which I agree, so let's jump to him (courtesy of The Big Picture):

"Spain unilaterally set its 2012 budget deficit at 5.8% of GDP, much higher than the 4.4% previously agreed with the EU. The budget deficit came in at 8.5% last year, once again higher than the target of 6.0%. A ‘discussion' between Spain and the EU is inevitable, especially as (to date) the EU has insisted that Spain sticks [sic] its prior commitment. Quite an interesting development, particularly as it has come on the same day that 25 out of 27 EU countries (excluding the UK and the Czech Republic) signed up to the ‘fiscal compact' which, once approved by each country's national Parliament (Ireland will need a referendum), will introduce the German inspired‘debt brake' into their constitutions – basically commits the 25 EU countries to reduce borrowings and, indeed, balance their budget deficits.

"Spanish unemployment rose by a massive +2.4% MoM in February, with youth (under 25) unemployment over 50%, yep that's 50%.

"The EU has a tough task. If it offers concessions to Spain, expect Portugal, Ireland, etc., etc. to submit their own ‘requests.' However, I just can't see how Spain can meet its prior commitment. Officially, GDP is forecast to be -1.0% to -1.7% this year, though in reality the actual outcome will be closer to (indeed may exceed) the more pessimistic forecasts.

"Whilst Spain is facing increasing pressures, Italy announced today that its 2011 budget deficit fell to -3.9% (-4.6% in 2010), better than the -4.0% forecast. 2011 GDP came is a marginally higher at +0.4%, (+0.3% expected). Whilst Italy entered into recession in the last Q of 2011 and its economy is expected to contract this year, Italy has pledged to balance its budget deficit by 2013.

"As I keep banging on, Italy is in far better shape than Spain, in spite of its higher headline debt to GDP. Spanish and Italian bond spreads continue to converge – I remain of the view that Italian bond yields will decline below equivalent Spanish bonds."

With that in mind, let's change the focus a bit.

What Should Greece Do?

This is a hard question. If Greece borrowed money from me, I would want them to pay. But if I am Greek the situation looks different. Let me take a cold-blooded look at what will offer the best long-term economic outcome for Greece, laying aside all the moral arguments about paying one's debts, etc.

The simple arithmetic is that Greece cannot afford to pay its debts. They are getting ready to give debtors close to a 70% haircut, if you figure in the time cost of money. There is no way in Hades, to borrow a Greek term, that they can get back to 120% of debt-to-GDP by 2020, given the massive austerity they have agreed to and which is just the beginning. (Is 120% now the new sustainable level because that is where Italy and Belgium are?)

Forcing debtors to take such a loss is not going to entice future lenders. Greece is effectively shut out of the bond market for a very long time. Their only source of borrowed money is the EU, and that debt is now costing the future of the country for at least a generation.

Most Greeks who are able send their children abroad to study. Given that the unemployment rate for people under age 25 in Greece is nearly 50 percent, it appears few young people are returning from abroad. In September 2011, organizers of a government-sponsored program on emigration to Australia, a program that reportedly attracted only 42 people in 2010, were overwhelmed when more than 12,000 people signed up to attend. (Source: Stratfor)

What is the point of paying back part of the bonds if you don't get access to future bonds? The current program offers no hope, and the people of Greece know that.

Greece should declare an "emergency," along with a bank holiday, and leave the eurozone and return to the drachma. Keep as much hard currency and reserves as you can, so you can buy needed medical supplies and energy until things turn around.

Don't pay one dime of debt to anyone for at least a few months, if not years. Default on every penny. Let the market set a value on the future currency, and only then offer to give two drachmas of debt repayment for the value of one drachma in hard euros in new debt. If you get no euros, then give no drachmas. But be very frugal about making that offer. Run up as little debt as possible in the beginning.

Play the political game, of course. Maybe even promise participation in a better future, when that happens.

Meanwhile, get your budget house in order. Figure out how to eventually run small surpluses, which will be easier if you don't have to pay for that old debt. Fix future growth of government spending to some percentage of GDP growth. Amazingly, you will soon– in just a few years – be seen as a worthy credit and be allowed back into the bond market. Ask Iceland or even Argentina (if ever there was a country that should be shut out of the world bond market, it is Argentina. They have made a national sport of defaulting on debt. Go figure.)

Right now tourism is 15% of your GDP. Make it 25%. Divert resources to make it happen. Make your country the best vacation value in Europe. Get your people, who are naturally hospitable, to get behind the drive for more tourism. Greet each traveler like someone bringing you gold, because that is what they are doing. That hard currency is what will buy you the resources you need (like food, energy, and medicine).

Note: you are not leaving the European Union, just the euro. There are lots of members of the EU that have their own currencies. You will just be another such country.

But since there will be a black market in euros if you try to keep a closed currency, at some point not too long after converting everything in the banking and financial system to drachmas, just go ahead and let people use their euros. Let businesses post two prices, but all government transactions will be in drachmas. Your citizens and businesses must pay their taxes in drachmas. If they take euros, they will need to find the drachmas to pay the VAT or other taxes.

Don't let the central bank go crazy printing money. That will just cause inflation and drop the value of the drachma further, postponing a recovery.

If a business wants to open a factory, then make it happen. Encourage all the foreign direct investment you can. Give them a tax holiday. Look at Ireland and match their tax rates. No government red tape to open a business, just bring your money and jobs. If some of your citizens "magically" find some euros that were in offshore bank accounts and want to bring them back to invest, let them. Declare a tax holiday on all money that shows up. Let them bring their euros back for the market price of the drachma until things stabilize.

Drop your tax rates to the lowest in Europe and then enforce them. The lower you make them, the more money you will raise in taxes. Look at some of the old Warsaw Pact countries. Selectively sell your government-owned businesses to get the currency you need for infrastructure (roads and such) and to remove the annual losses they have from your books. Or simply give most (and in some cases all) of the assets to the employees and unions, for businesses like your railroads.

There are local contingencies and characteristics I am not close to being aware of, I am sure. But structure everything that you can for the future, which will arrive faster than you think. There is a huge Greek diaspora. If they see opportunity, they will invest, if not come back. Make sure they see it.

It will be tough for the first year or two. But then you can grow your way out of the crisis, at first slowly and then more rapidly. There are myriad examples of countries that have done similar things without your natural advantages.

But staying in the euro and trying to pay that debt will just put chains on your children and elderly. You have been in recession for close to five years. Staying in the euro will mean at least another ten. Facing such a bleak future, the young and entrepreneurial will leave, which is what you cannot afford. They are your most precious asset. Without them there is no growth and no future.

Is leaving the euro and returning to the drachma a good choice? No, it will be a disaster. But I think it will be a lesser disaster than staying.

And Then There Is Ireland

What do the Greeks get by staying? My friend the Irish provocateur David McWilliams writes last week about how Ireland should view the Greek deal:

"For Ireland, this [the Greek deal] means that we will get a deal on bank debt most definitely. It might take time because the last thing the ECB wants is a queue of ‘me too' demands from Ireland and Portugal. But it is clear that our hand has been strengthened, if we decide to play it.

"But just in case you think this is a victory for the citizen, let's examine in a bit more detail how it works. There will be no default. Greece will be given a €130bn loan. With that loan it will pay out €100bn to bondholders, who will have seen their bonds fall 53pc in value. After the penal interest Greece has paid on these bonds already, we still see an insolvent country paying bondholders 50pc of face value when they should be getting nothing.

"So Greece gets €100bn written off, but borrows €130bn in order to achieve this, so it is still borrowing more making its overall debt not better but worse in absolute terms.

"Now it needs to grow to bring these figures down and that is going to be impossible. So we are going to be back to square one in a few years except for one crucial thing.

"After all this is done, private creditors to Greece will have been paid by European public money stumped up by the taxpayers of other European countries. The banks have been bailed out again. Without help they would have got nothing. They now get 50pc of their worthless holdings and the subsidy comes from the taxpayer."

David is going to be at the Strategic Investment Conference, as I mentioned at the beginning of the letter. I am going to give him the podium and then put him on a panel with Marc Faber (a [Swiss] Austrian economist) and maybe even the Scot Niall Ferguson, and throw some raw meat up on the stage and see what happens. It will be highly instructive and good fun as well.

You can see what McWilliams is calling "Punk Economics" at www.davidmcwilliams.ie. It is a short video clip but fascinating. He represents a growing populist strain in Europe. And he does so with Irish verve and humor. You've got to love it.

New York, Orlando, Sweden, and Paris

I leave for New York for two days tomorrow. I will be on Tom Keene's show on Bloomberg Radio at 9:30 am or so. That is always fun. And meetings and a fun dinner with friends. Then a quick trip to Orlando the next weekend for a speech. And then I leave for Stockholm to give a talk, spend a day or two simply being tourist, write my letter on the way to Paris, and then play tourist some more for the weekend, along with meeting a few managers that my partner Jon Sundt of Altegris Investments will introduce to me. Then on Monday we will both attend the GIC conference at the Banque de France, with our friend Paul McCulley. The title of the conference isRe-Examining Central Bank Orthodoxy for Unorthodox Times: Inaugural Meeting of The Global Society of Fellows (this is also a link, if you want more information). There are a few spots still left. It will be a most fascinating time to talk about central banking in Europe.

Just One Question, Daddy

I spoke at the Shareholders Service Group conference in San Diego on Thursday, with a lively audience of investment advisors. I made a few comments, something to the effect that "all your models are garbage," and it made the headlines here and there. (http://www.advisorone.com/2012/03/02/fellow-advisors-all-your-models-are-garbage-john-m)

My daughter Melissa was in the audience, as she was in the area attending a writer's seminar and stayed over to listen to Dad, which she has not often been able to do. She had to leave as I was doing Q&A, and I said goodbye from the podium.

She turned around, grabbed the microphone from a gentleman standing there, and said, "Since you mentioned me, is it alright if I ask a question?"

It had been a rather intense speech, even if I did get a few laughs here and there, so I was curious as to what had piqued her interest. Let me say that she does not share Dad's political leanings. (I don't know where I went wrong.) She is also not shy, so I was bracing for a tough question. The audience was on the edge of their seats, waiting to hear what she would ask, as well. And then it came:

"Dad, you said you were going to get a new iPad 3, right?"

"Yes," I said, even as I knew I was being set up. I had mentioned the new iPad in the context of telling them to get one so they could get my book. And I do love my iPad. And I will scramble to get one as soon as the new ones come out. They are way cool.

"Ok then, can I have your old one?"

What can you say? She knows all the brothers and sisters will soon be asking the same question. But you are on stage and she has asked so sweetly. How can you refuse? You just smile and say yes. She has great timing.

(Note to Apple marketing management: You should make sure I can buy one before I leave for Europe. I will show it off everywhere. I am willing to pay for the privilege of advertising your product. I just want one as soon as possible. Please.)

Have a great week. Find a few friends and spend some time with them. It makes it all worthwhile.

Your finding pleasure in the small things analyst,

John Mauldin

John@FrontlineThoughts.com

Collateral Damage

John Mauldin — Sat, 31 Dec 2011 16:26:00 GMT

What Next? Where Next?
A World with Too Much Debt
Debt Restructuring and Write-Offs
The Euro Zone: Pouring Fuel on the Flames
What If… ?
The Year(s) Ahead
Auld Lang Syne

"Whoever cannot seek the unforeseen sees nothing for the known way is an impasse."
― Heraclitus, Fragments

Which path will we take? If we could only grow our way out of our sovereign debt problems. But growing debt creates even more problems if not dealt with, making it even more difficult to deal with; yet getting the debt and deficit under control brings its own form of pain. As I keep pointing out, there are no easy choices left. Some countries must choose between difficult and very bad, and others are faced with either disaster or calamity. Greece simply gets to choose what it wants to be the cause of a depression. Long and slow or fast and deep? Choose wisely.

It's that time of year when we start thinking about what the next may hold for us. I am reading and thinking a great deal about my annual forecast issue next week, taking some time off from my usual Friday missive; so this week we look at what I think is one of the best pieces of analysis I have read in the past few months. It is from a private letter for the Boston Consulting Group, and Dan Stelter graciously allowed me to let my friends read it.

Follow this thinking carefully and then think through their outline of what a country would have to do to leave the euro, which starts at the subhead entitled "What if… ?". Then ask yourself what do you need to do. The short answer from me is that you need to consider more what you already own rather than what you should buy.

At the end of the letter is a link to an in-depth review of what scenarios businesses should be considering, but it will also work for individual investors. Now, let me turn it over to Dan and David.

Collateral Damage

What Next? Where Next?

What to Expect and How to Prepare

David Rhodes and Daniel Stelter

January 2012

This paper covers some familiar ground in order to remind readers of the interplay among the most important economic developments, considers the scenarios for which companies should prepare, and suggests some steps that prudent companies may wish to consider. For those readers who are well acquainted with the economic scenarios described, we suggest that you start reading at "What Should Companies Do to Prepare?" beginning on page 13, below.

The economic travails of much of the West are reaching a decisive stage as the year ends. In 2008, we predicted sluggish recovery and a long period of low growth for the West in a two-speed world. This picture does not now properly reflect the downside risks. The policy of "kicking the can down the road" is failing, as the intensifying crisis in the euro zone and the failure of the G20 summit in late October clearly demonstrate. As to December's European summit, we describe its impact later in this paper.

Such extreme uncertainty is challenging for companies trying to prepare their budgets for next year—or, more fundamentally, trying to plot their strategic course. It helps to have a clear understanding of what may happen and why it may happen. So before we address the question of which scenarios to expect and how to prepare, let us remind ourselves about the root of the problem: the West is drowning in debt.

A World with Too Much Debt

Total debt-to-GDP levels in the 18 core countries of the Organisation for Economic Co-operation and Development (OECD) rose from 160 percent in 1980 to 321 percent in 2010. Disaggregated and adjusted for inflation, these numbers mean that the debt of nonfinancial corporations increased by 300 percent, the debt of governments increased by 425 percent, and the debt of private households increased by 600 percent. But the costs of the West's aging populations are hidden in the official reporting. If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher. (See Exhibit 1.)

Add to this sobering picture the fact that the financial system is running at unprecedented leverage levels, and we can draw only one conclusion: the 30-year credit boom has run its course. The debt problem simply has to be addressed. There are four approaches to dealing with too much debt: saving and paying back, growing faster, debt restructuring and write-offs, and creating inflation.

Saving and Paying Back. Could the West simply start saving and paying back its debt? If too many debtors pursued this path at the same time, the ensuing reduction in consumption would lead to lower growth, higher unemployment, and correspondingly less income, making it more difficult for other debtors to save and pay back. This phenomenon, described by Irving Fisher in 1933 in The Debt-Deflation Theory of Great Depressions, can result in a deep and long recession, combined with falling prices (deflation). This is amplified when governments simultaneously pursue austerity policies—such as we see today in many European countries and will see in the U.S. beginning in 2012. A reduction in government spending by 1 percent of GDP leads to a reduction in consumption (within two years) of 0.75 percent and a reduction in economic growth of 0.62 percent. Saving (or, more correctly, deleveraging) will reduce growth, potentially trigger recession, and drive higher debt-to-GDP ratios—not lower debt levels. Indeed, during the early years of the Great Depression, President Hoover—convinced that a balanced federal budget was crucial to restoring business confidence—cut government spending and raised taxes. In the face of a crashing economy, this only served to reduce consumer demand.

For the private sector and government to reduce debt simultaneously would require running a trade surplus. So long as surplus countries (China, Japan, and Germany) pursue export-led growth, it will be impossible for debtor countries to deleverage. Martin Wolf put it trenchantly in the Financial Times: "The Earth cannot, after all, hope to run current account surpluses with the people of Mars." The lack of international cooperation to rebalance trade flows is a key reason for continued economic difficulties.

Saving and paying back cannot work for 41 percent of the world economy at the same time. The emerging markets would have to import significantly more, which is unlikely to happen.

Growing Faster. The best option for improving woeful debt-to-GDP ratios is to grow GDP fast. Historically, this has rarely been achieved, although it can be done—for example, in the U.K. after the Napoleonic Wars and in Indonesia after the 1997/1998 Asia crisis (although Indonesian debt levels were nowhere near contemporary highs in the West). Attacking today's debt mountain would require reforming labor markets or investing more in capital stock. Neither is happening.

Politicians are unwilling to interfere in labor markets given today's elevated levels of unemployment. Moreover, empirical evidence shows that the initial impact of such reforms is negative, as job insecurity breeds lower consumption.

Companies can afford to invest significantly more, as they are highly profitable. The share of U.S. corporate profits in relation to U.S. GDP is at an all-time high of 13 percent (as are cash holdings), yet corporate real net investment (that is, investment less depreciation) in capital stock in the third quarter of 2011 was back to 1975 levels. But companies are reluctant to invest while demand is sluggish, while existing capacities are sufficient, and while the outlook for the world economy remains highly uncertain.

The aging of Western societies will be a further drag on economic growth. By 2020, the workforce in Western Europe will shrink 2.4 percent, with that of Germany shrinking 4.2 percent.

The inability to grow out of the problem is bad news for debtors. Look at Italy, for example: Italian government debt is 120 percent of GDP. The current interest rate for new issues of ten-year bonds is 7 percent—up from 4.7 percent in April 2011. If Italy had to pay 6 percent interest on its outstanding debt, such a high rate would materially increase the primary surplus (that is, the current account surplus before interest expense) that Italy would need to run in order to stabilize its debt level. If we assume that Italy's economy grows at a nominal rate of 2 percent per year, the government would need to run a primary surplus of 4.8 percent of GDP (calculated as 6 percent interest incurred on its debt minus 2 percent nominal growth multiplied by 120 percent debt to GDP) just to stabilize debt-to-GDP levels; the latest forecasts show only a 0.5 percent surplus for 2011. Any effort to increase the primary surplus through austerity and tax increases runs the risk of creating a downward spiral. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth, and rising interest rates.

Debt in itself makes it more difficult to grow out of debt. Studies by Carmen Reinhardt and Kenneth Rogoff and the Bank for International Settlements show that once government debt reaches 90 percent of GDP, the real rate of economic growth is reduced. This also applies to the debt of nonfinancial corporations and private households. Exhibit 2 shows the current debt level of key economies by sector. In all countries, the debt level of at least one sector is beyond the critical mark. Somewhat perversely, only in Greece are the two private sectors below the threshold. And only in Germany and Italy (in addition to Greece) do private households have a debt level below 70 percent of GDP.

[Note: For those not familiar, the flags represent the US, Japan, Germany, France, Britain, Portugal, Italy, Ireland, Greece, and Spain, in order.– JM.]

Debt Restructuring and Write-Offs

We explored this option in our last paper (Back to Mesopotamia: The Looming Threat of Debt Restructuring, BCG Focus, September 2011). Assuming a combined sustainable debt level of 180 percent of GDP for private households, nonfinancial corporations, and governments, we estimated the debt overhang to be €6 trillion for the euro zone and $11 trillion for the U.S. We argued that (some) governments might be tempted to fund this through a one-time wealth tax of 20 to 30 percent on all financial assets.

The target level of 180 percent can be debated (and was debated by many readers of Back to Mesopotamia), but a level of 220 percent would still imply a debt restructuring of $4 trillion in the U.S. and €2.6 trillion in the euro zone, leading to a one-time wealth tax of 12 percent and 14 percent, respectively. Given the unpopularity of such a tax, we are likely to see less incendiary taxes imposed. This means that politicians must resort to the last option: inflation.

Inflation. Another option to reduce Western debt loads would be financial repression—a situation in which the nominal interest rate is below the nominal growth rate of the economy for a sustained period of time. After World War II, the U.S. and the U.K. successfully used inflation to reduce overall debt levels. In spite of today's low-interest-rate environment, we have the opposite situation: interest rates are higher than economic growth rates. As risk aversion in financial markets increases and a new recession in 2012 looms large, the problem could get even worse.

So the only way to achieve higher nominal growth will be to generate higher inflation. Aggressive monetary easing has barely moved the inflation needle in the U.S. and most of Europe, although the impact on U.K. inflation has been greater. Inflation is not being generated, because the expectation of inflation remains low and because there is still overcapacity and overindebtedness in the private and public sectors. Continued monetary easing could (and will) lead to a substantial monetary overhang that could, if the public loses trust in money, lead to an inflationary bubble. Some argue that inflation is unlikely because of the oversupply of labor and continued competition from new market entrants like China. Certainly we may see continued pressure on wages because of globalization, although the longer low growth persists in the West, the more likely it is that Western governments will resort to increased protectionism, leading to upward pressure on prices. Moreover, some observers believe that the inflation indicators do not give a true reading of the underlying rates of inflation.

It is also a matter of trust. Take, for example, the history of hyperinflation in Germany in the early 1920s. The German Reichsbank funded the government with newly printed money for several years without causing inflation. But once the public lost trust in money, people started to spend it fast. This led to higher demand and an inflationary spiral.Today the velocity of money in the U.S. is at an all-time low of 5.7. If the number of times a dollar circulates per year to make purchases returned to the long-term average of 17.7, price levels in the U.S. would rise by 294 percent over that period—unless the Federal Reserve simultaneously reduced its balance sheet by $1.8 trillion. Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.

There are no easy solutions to the debt problem. At best, we expect a sustained period of low growth in the West. Even this would require the following:

A coordinated effort to rebalance global trade flows, which would require the emerging markets, Germany, and Japan to import more, thereby allowing the debtor countries to earn the funds necessary to deleverage

Stabilizing the overstretched financial sector through recapitalization and slow de-risking and deleveraging—in contrast to today's new rules, which encourage banks to shrink their balance sheets rather than finance commercial activity (it is worth noting that the effect of monetary easing during a period when ultra-low interest rates are below the rate of inflation is essentially to provide additional support to the banking system through the provision of low-cost liquidity)

Reducing excessive debt levels, ideally through an orderly restructuring or higher inflation

Current policies fall short against all these criteria. The coordinated intervention of several global central banks on November 30 could be construed as a positive sign of global cooperation, given that the whole world fears the implications of a (disorderly) breakup of the euro zone. In reality, it was once again merely a case of pulling the only lever left—that of printing money—and so did not address the one fundamental problem facing the world economy. Even China's participation reflected its worries about its biggest export market (Europe) and the risk of another (possibly deep) recession more than a true willingness to support the West by rebalancing trade flows.

Any new recession, given growing and unsustainable debt levels, would increase the risk of short-term defaults and significantly increase the medium-term risk of higher inflation. Companies should therefore prepare for these scenarios. But they also need to consider how the situation in Europe could amplify the problem.

The Euro Zone: Pouring Fuel on the Flames

The crisis of the euro zone makes dealing with the debt overhang even more difficult. The introduction of the euro was followed by two important developments:

Debt grew quickly in most countries of the euro zone because credit became cheap and, in many instances, negative real-interest rates fueled real estate bubbles. Consumers in the countries of the periphery, made confident by newly strong currencies and low interest rates, also embarked on a spending boom.

Competitiveness diverged between Germany and the Netherlands, on the one hand, and the countries of the south (the periphery), on the other, with the countries of the periphery failing to rein in excessive wage increases which, in the past, could be addressed through currency devaluation. Having lost the ability to adjust through exchange rate devaluations, the countries of the periphery can now only resort to painful internal devaluations (in short, salary cuts). (See Exhibit 3.)

December's EU summit was supposed to restore confidence in the future of the euro zone. The European leaders made the following decisions:

The members of the EU will change their respective constitutions and national laws in order to impose limits on allowable budget deficits.

The members of the EU will accept stricter supervision of their budgets by EU institutions (such as the European courts), including quasiautomatic sanctions should their national budget deficits breach prescribed limits (a "structural deficit" of more than 0.5 percent of GDP—reflecting the impact of the business cycle).

The European Stability Mechanism (ESM) will be implemented a year earlier and run for some time in parallel with the European Financial Stability Facility (EFSF). EU leaders increased to a total of €500 billion the financial power that can be deployed to support the weaker countries of the euro zone.

The members of the EU will consider whether to provide funding of €200 billion to the International Monetary Fund (IMF) in order to help countries deal with a liquidity squeeze.

In future debt restructurings, private-sector bondholders will be treated according to the practice of the IMF, with no automatic haircuts. All government bonds will require collective-action clauses to facilitate restructurings.

The summit was predictably vague on the subject of imbalances within the euro zone, although the politicians expressed a wish for more coordination in the future.

With the U.K. opposed to an overall EU treaty change, the other EU leaders (all the euro zone countries, along with most other EU members outside the euro zone) aim to use an intragovernment treaty to implement these changes by March 2012. It remains to be seen if such a "treaty within the treaty" will be feasible in legal terms. Even more important, it is not yet certain that the individual governments will commit to the rules as decided at the summit. We may well see some pushback and efforts to soften those rules in the coming months. And even if the new rules are fully implemented, previous experience with the commitments made under the 1992 Maastricht Treaty does not necessarily give cause for optimism that they will be followed.

Before the summit, the European Central Bank (ECB) announced new measures to support European banks. It lowered the core refinancing rate to 1 percent; offered two new long-term refinancing operations that will last for three years; widened the range of acceptable collateral; and, for the first time, made loans to small and medium-size enterprises acceptable. The ECB also made clear that it does not plan to engage in a broad-scale program to buy up the debt of countries like Spain and Italy. Rather, it sees the responsibility for dealing with the debt crisis as lying with the individual governments of the euro zone. In other words, the ECB does not wish to act as a lender of last resort—the absence of which is one of the underlying causes of the continuing weakness of the combined EU response.

In our view, these are steps in the right direction but they are not sufficient, because they do not address the core issues of the debt overhang and diverging competitiveness. The plan that emerged from the summit is unlikely to be enough to stabilize financial markets. With the U.K. opting out and the uncertainty about legal enforcement, there is valid reason to question the plan's credibility.

Any true solution of the crisis must, at a minimum, accomplish four things: buy time for fundamental reforms by introducing interest relief for the weaker countries of the euro zone, improve relative unit-labor-cost competitiveness, restructure excess debt, and establish a fiscal union. Overall, European leaders, while taking some steps in the right direction, again have not gone far enough.

Interest Relief. First, the financial markets need a credible commitment from the ECB to "ring fence" any member of the euro zone. It has become clear that only the ECB's "big bazooka" (using the unlimited purchase of the debt of troubled countries to keep interest rates down) has the firepower and the credibility to keep interest rates below critical thresholds. The EFSF lacks the firepower to take on the refinancing needs of Spain and Italy over the next two years. Starting the ESM a year earlier and running it in parallel with the EFSF will increase the funds available, as will the potential provision of additional funding for the IMF. But even then, the available funds will not be sufficient to cover the weaker countries long enough to allow for fundamental reforms.

Even if the ECB stepped in, it could only buy time: in a "benign" scenario of only 4 percent interest on Spanish or Italian government debt, the debt-to-GDP ratio would continue to grow, from 60 percent in Spain and 119 percent in Italy today to 65 percent and 131 percent, respectively, in 2015. Any attempt to stabilize debt levels would lead to the vicious circle already described.

Diverging Competitiveness. The summit did not address the issue of diverging competitiveness and the resulting trade imbalances within the euro zone. The countries of the periphery (as well as France) have to regain competitiveness by lowering their unit-labor costs and introducing more flexibility into the labor markets. Gold-plated pensions (particularly in the public sector) and rigid job-security laws make progress here very unlikely.

In the case of Spain, unit labor costs would have to be reduced by more than
25 percent to restore competitiveness. In a system of fixed exchange rates, this can only be achieved by significantly increasing productivity (by requiring more working hours per week or making capital investments) and/or lowering salaries. Lower incomes would make it more difficult to service and reduce the high levels of debt (less revenue from taxes with which to pay back government debt and lower personal incomes with which to fuel growth or pay off private debt). Falling incomes, reduced tax revenues, and austerity programs would reduce growth and further reduce debt sustainability—leading to higher risk premiums in the capital markets.

The social cost of such an internal devaluation would be high and few people would accept it. A recent article in The Economistcompared the implied adjustments for the periphery of Europe with developments during the 1930s leading to the Great Depression. Back then, adherence to the constraints of the gold standard prevented an adjustment, and Germany had to achieve an internal devaluation to regain competitiveness. Although very few expect a repetition of the tragedy of the 1930s, it is obvious that a strategy of saving our way out of the crisis will not only fail but will run the risk of triggering significant tensions in Europe.

The Debt Overhang. The summit made it clear that the governments of the periphery are expected to introduce austerity programs in order to balance their budgets and reduce their debt levels. Because many countries suffer from too much government debt and elevated private-sector debt (as shown in Exhibit 2), it is obvious that any attempt to deleverage both simultaneously will lead to a deep and long recession, as described above. We continue to believe that some kind of debt restructuring—and not only of public debt—is necessary to lay the foundation for future growth.

Establishment of a Fiscal Union. At the summit, European leaders moved toward closer fiscal coordination to ensure the euro zone's future. A fiscal union would ultimately allow for the issue of joint Eurobonds and so enable the periphery to shelter behind the stronger north. This may be one cornerstone for a long-term solution to the euro zone's problems, but it does not address the issues of diverging competitiveness and the debt overhang. Capital markets would rightly question whether the countries of the periphery would accept losing control of their budgets and of key political decisions.

Political tensions can be expected if Brussels—or even worse, Berlin—is to decide on retirement ages and pension levels. But one can also question the willingness of Germany and other countries of the north to continually fund the south. Will the German electorate accept higher taxes to support the countries of the south? And more important, will the capital markets? Some observers took the failed auction of ten-year German bonds in late November as an early-warning signal. And indeed, the German economy is not as healthy as is generally assumed. With government debt at 87 percent of GDP and interest rates of 3 percent, Germany needs nominal growth of 3 percent just to keep debt levels stable (assuming no primary surplus)—no easy task given the negative impact of demographics on future growth. The additional costs of rescue operations within the euro zone could cause the day of reckoning to arrive sooner than is generally expected.

In summary, the existing initiatives fall short. The new agreements essentially put in place some additional improvements to the existing stability and growth pact, which has not been successful to date. The politicians did not increase the size of the ring fence—the "big bazooka" necessary to avoid the viral spread of the sovereign-debt risk; there was no progress on debt mutualization through the issuance of common Eurobonds; there was no forceful monetary easing plan for the ECB; there were no tough calls made on how to address the problems of diverging competitiveness; and no strategy was articulated for reigniting growth in the euro zone—the absence of this last element perhaps not so surprising given that this is all about containment. Whatever our readers' views on the stance adopted by the U.K., we can't help but believe that the leaders of the other countries were thankful for the distraction provided by the U.K.'s position, which diverted attention from the lack of sufficient substantive progress on some of the most pressing issues.

The euro zone needs a comprehensive plan to deliver a combination of higher inflation (to reduce real debt and address diverging unit-labor costs), deleveraging in the periphery, and higher consumption in the northern countries. Employees in Italy, Spain, and Portugal—and also in France—would have to accept wage increases below the rate of inflation, while employees in Germany and the Netherlands would enjoy real-wage increases. Politicians in the north would also need to lower taxes and introduce stimulus programs to support domestic consumption. In addition, any successful strategy would need to include a restructuring of excess debt (partial defaults). Some observers believe that Germany would be unwilling to pursue such a strategy given fears of higher inflation and the moral hazard of overly indebted countries benefiting from broader cost sharing within the euro zone. We are more optimistic. We believe that Germany will—after long resistance—support such a strategy as the only way the euro zone can survive in its current form. The only real alternative, the breakup, would have major negative repercussions.

What If… ?

For some commentators, it is not a question of whether the euro zone will break up but of how and when it will break up. There is undoubtedly an increased risk of at least some (potentially disorderly) fracture in the euro zone. And some governments are rumored to be preparing just in case—by, for example, securing sufficient capacity to print new supplies of money. Not surprisingly, we have engaged with many clients to discuss this scenario and prepare for it. A country leaving the euro zone would need to do the following:

Announce and immediately impose capital controls.

Impose immediate trade controls (because companies would otherwise falsify imports in order to get their money out).

Impose immediate border controls (to prevent a flight of cash).

Implement a bank holiday (to stop citizens from withdrawing their money and running before the devaluation) and—although this is somewhat hard to imagine—stamp every euro note in the country, converting it back to the national currency.

Announce a new exchange rate (presumably not floating at the beginning, given capital and exchange controls) so that trade could continue.

Decide how to deal with existing outstanding euro-denominated debt, which would probably entail a major government and private-sector debt restructuring (that is, default). This might be easier in the case of government debt, which tends to be governed by domestic law, in contrast to the debt of major corporations, which is normally governed by U.K. law (but we would assume enactment of laws declaring a haircut here, as well).

Recapitalize the (insolvent) banks to make up for losses from defaults.

Determine what to do with the nonbank financial sector, the stock and bond markets, and every company account and commercial contract in the country.

Any breakup would lead to significant turbulence in financial markets—just think about the number of credit default swaps outstanding—and a worldwide recession. The OECD has warned that a breakup of the euro zone would lead to "massive wealth destruction, bankruptcies and a collapse in confidence in European integration and cooperation," leading to "a deep depression in both the existing and remaining euro area countries as well as in the world economy." Exhibit 4 describes a breakup scenario and its potential implications.

According to UBS, the economic costs of a breakup would be huge. Depending on whether the country leaving the EU is a "weak" or a "strong" country, the costs would range from €3,500 to €11,500 per inhabitant per year. Besides these implications for the countries of the euro zone, the world economy would be severely affected, with negative implications for the U.S.—amplifying existing recessionary and potentially deflationary pressures—and also for the emerging markets that depend on exports to the West.

The Year(s) Ahead

As they go into 2012, business leaders need to prepare for a difficult year, and perhaps for several difficult years. They should consider at least four scenarios:...

And with that, we close the year, as the letter would be too long otherwise. You can read their suggested scenarios at The Years Ahead Report. I strongly suggest you do. They made me think a lot about my own business and investments.

Auld Lang Syne

Music plays an important part in most of our lives. I grew up listening to gospel quartets and Irish tenors (my father's favorite). Believe it or not, in my youth I sang as a high tenor with the Fort Worth Opera Chorus, in 1968. I had the privilege of being ten feet from Beverly Sills, the reigning operatic diva of the '60s and '70s as she sang the Mad Scene in Lucia di Lammermoor, the role for which she was best known. The next month we had some new Spanish tenor from the New York Opera, a guy named Placido Domingo, doing La Traviata.The most beautiful sound I have ever heard from a human voice was Domingo singing the death scene in soft, lilting head tones during the dress rehearsal, to save his voice. It was magical, and those of us who were privileged to be close have never forgotten that moment. Of course, he soon rocketed to fame.

I sang with folk groups, did some musicals, sang the tenor solos in The Messiah, tried to do a little rock and roll (I played guitar very badly), and joined various chorales. I could have had a voice scholarship, but wisely realized I would never be anything other than mediocre. I still feel a special thrill when I hear solid harmony and a beautiful tenor, but my repertoire of what I like has expanded. "Give me the beat, boys, and free my soul. I wanna get lost in your rock and roll, and drift away."

I leave you with three links. The first is a short retrospective on the music of those who left us this last year. http://www.nytimes.com/interactive/2011/12/22/magazine/the-music-they-made.html?ref=magazine

And as we close out another year tonight, this barbershop version of "Auld Lang Syne" will convey my sentiments for a truly Happy New Year for you and yours.

http://www.youtube.com/watch?v=LdlN6Mc2iYA&feature=related

And I leave you with a very bright note. Turn the sound up, and let 14-year-old Liam McNally of Britain simply take your breath away. That humans can make such wondrous sounds… If your soul does not soar with this, hasten to your soul doctor for a checkup. http://www.youtube.com/watch?v=utfkGocmCiE&feature=related

Let me express my deep and heartfelt appreciation for you, my friends, as you give me the privilege of coming into your world each and every week. Because of you, I live a dream life that I could never have imagined would be possible. I am truly grateful.

Your wishing I could still hit that high note analyst,

John Mauldin

John@FrontlineThoughts.com

Where is the ECB Printing Press?

John Mauldin — Sat, 12 Nov 2011 21:15:00 GMT

Where Can I Find €3 Trillion?
When Leverage Comes Back to Haunt You
The German Dilemma
So How Do We Solve the Eurozone Problem?
Where Is the ECB Printing Press?
DC, Cleveland, and New York

Europe remains the focus of markets, and rightly so. But the picture is not as clear as one would like. Different analysts point to different problems – if only this one problem could be solved, then all this would go away, they tend to say. Sadly, it is not one problem but three that must be solved, and none of them is easy. In today’s letter I try and offer a basic primer on the problems facing Europe. My challenge to myself is to do it in a short piece rather than the book-length tome it could easily become. Thus, in the pursuit of brevity, we will not be as in-depth as usual, but I think it helps us to step back a few feet and look at the larger picture before we focus on minutiae.

Where Can I Find €3 Trillion?

First, for the record, the European issue is not a crisis of confidence, as Merkel and Sarkozy, et al., keep telling us. It is structural. And until the structural issues are dealt with, the problems will not be solved.

The first problem facing Europe is the glaring sore thumb: there is simply too much sovereign debt in Greece, Ireland, Spain, Italy, Portugal, and Belgium. That is not news. What has yet to be absorbed by the markets is that the cost of bailouts, present and potential, is likely to be in the €3 trillion range, talking an average of the estimates I have seen (with the Boston Consulting Group suggesting €6 trillion). €3 trillion is not pocket change. Indeed, it is a number that is inconceivable in scope.

Greece has been told that they can write off 50% of their debt held by private entities, but not that owed to the IMF, ECB, or other public entities. This means something more like a 20-30% haircut on total debt. Sean Egan suggests that eventually Greece will write off closer to 90%. That is a number that cannot be contemplated in polite European circles, as it is plenty enough to cause a serious banking crisis.

And that is before we get to the rest of the problem children. Portugal will need at least a 40% write-off (probably more!). The Irish are going to walk away from the bank debt they assumed in the banking crisis. While on paper Spain looks like it may survive, in reality it has significant problems in its banking sector. If they move to insure the solvency of their banks, their debts become unmanageable, not to mention that their debt grows each and every month from the rather large deficits they run and seem totally unwilling to try to reduce. The Spanish government deficit is likely to be at least 7% next year, well above their target of 6%. The“semi-autonomous regions” are in deep trouble, and their citizens are leveraged due to excessive real estate exuberance. Unemployment across Spain is 21%, and for the young it is over 40%.

The Spanish government has adopted the rather novel idea that if it doesn’t pay its bills then its deficit will not be as large and therefore they can get closer to meeting their targets. Yields on Spanish debt are about 1% lower than on Italian debt, but give them time.

And then there is Italy. Italy is simply too big to save. Yes, it looks like Berlusconi is leaving, but he is not the real problem. The problem is a 10-year bond yield at 7%, when your debt is 120% of GDP and growing. Italy is likely to be in recession soon, which will only make the problem worse. A drop in GDP while deficits rise means that debt-to-GDP rises faster. That means interest-rate costs are rising faster than (the lack of) growth in the economy. The deficit is a reported 4.6%. By contrast, Germany’s is 4.3%. But the difference is the debt. The market realizes that if you grow debt by 5% a year, it will not be but a few years until Italy is at 150%. There is no retreat without default from such a number, and the markets are saying, “We’ve seen this movie before and the ending is not a happy one. We think we’ll leave at intermission.”

The ONLY reason that Italian yields have dropped below 7% is that the European Central Bank has been buying Italian debt “in size.” Any retreat by the ECB from buying Italian debt and Italian yields shoot to the moon. Italy will need to raise close to €350 this year, including new debt and rollover debt. The higher rates will put even more pressure on the deficit.

Debt, whether it is with an individual, a family, a city, or a country, always has a limit. Debt cannot grow beyond the ability to service the debt. That is the clear lesson of Rogoff and Reinhardt’s epic work, This Time Is Different. When that limit is reached, the debt must be restructured in some way, either with better terms or through some sort of default.

Mediterranean Europe simply borrowed more than it could pay, given the cash flows of the various countries. And now we are at the Endgame. How can one deal with the debt?

The best solution is to figure out how to grow your economy faster than the growth of debt. Over time, debt service becomes a smaller part of the economy. But Southern Europe does not seemingly have that option. Certainly not Greece, Portugal, or Spain; and this week we learned that Italian production was off 4.8%. Europe, even Germany, is slipping into recession.

Germany is in the position of wanting the problem countries to cut their deficits through something called austerity. And living within your means is hardly a novel idea. It makes a great deal of sense. But when you are a country in recession and have to cut back, it only makes the recession worse for a period of time. Asking Greece to cuts its deficit by 4% a year for 4 years to get to something closer to balance means that the Greek economy will shrink by at least 10%, if not more. Tax revenues, never on solid footing, will shrink, making the deficit worse. How do you ask people to willingly enter into a pepression for a rather long time in order to pay back the banks, even if the debts were freely taken on by the government and the money spent on the populace, and even if the haircuts are 50%?

Yes, if Greece leaves the euro that means they will also have a depression. No one will lend them money for at least three years. Their banks will be insolvent, their pension funds destroyed. Their ability to buy needed materials (like oil, medicines, etc.) will be limited to the amount of goods they can produce and sell. Government employees will be forced to leave jobs, as there will be no money to pay them. Those on government pensions will get a fraction of what they were promised. Going back to the drachma will be painful in the extreme. Just as staying in the euro will be painful. Greece has no good choices.

There are those who suggest that Europe is demonstrating the failure of the socialist welfare state. And there is some reason to say that. But I don’t think the socialist welfare state is the cause of the debt crisis. One can have a welfare state without debt, if you are willing to run a sensible budget. Think of the Scandinavian countries.

And you can have countries without much social welfare get into debt problems. There are plenty of examples in history. Amassing large amounts of debt is a national problem that has as much to do with character as anything else. That is true for families or for countries. It is wanting to spend for goods and services today and pay for them in the future.

Debt has its uses. Properly used, it can be of great benefit to societies and families. People can buy homes and tools that can be used for the production of goods, build roads and other infrastructure, etc. But debt cannot be allowed to become the master of the budget or the source for current spending, again whether for families or countries. And Greece and its fellow countries have used debt to fund current spending and now have run up against the inability to borrow more at sustainable levels.

The easy answer is to cut spending. But when you cut back spending, even borrowed spending, it is going to affect GDP. It is something that may have to be done, but it is not without consequence. Ireland, a small country of 4.2 million people, just paid close to€1 billion to service debt that it owes for taking on the debts of its banks that went bankrupt. That is hugely unpopular in Ireland, and it will not be long before the Irish government simply says no. If the current one does not, then there will be a new one that does. Unless the Irish renegotiate their debt, they will be paying on it for decades. Debt that was private debt and paid to European banks (who lent to Irish banks) is now public debt. And it is a punitive and crushing debt.

We can go to each problem country and home in on its own particular situation, and the answer almost always seems to be that the debt must be dealt with in some manner that either directly or indirectly amounts to default. (Even if the Eurozone leaders say that a 50% haircut by a bank is “voluntary.” Yeah, right. European leaders have a different understanding of voluntarythan I learned in school.)

But that is the problem. The European Commission is trying to figure out how to find €1 trillion to use to bail out southern Europe and Ireland. They so far cannot, and the market recognizes that fact and that the needs are actually much higher. European leaders cannot (at least publicly) fathom how to find €3 trillion. But whether or not they can “find” another few trillion, that debt will have to be restructured or defaulted. Once you go down that path, as they have with Greece, it is just a matter of time before you have to do the same for Portugal and Ireland; and are Spain and Italy close on their heels?

When Leverage Comes Back to Haunt You

European regulators allowed their banks to leverage up to 450 to 1 on their capital, on the theory that sovereign nations in an enlightened Europe could not default, and therefore no reserves need to be kept for “investing” in government debt. And with those rules, banks borrowed massively and invested it in government debt, making the spread. It was an awesome free profit machine. Until Greece became a road bump. Now it is a nightmare. Even if you only invested 4% of your bank’s assets in Greek debt, if that is more than your capital then you are bankrupt.

Irish banks were foolish and invested in Irish real estate that was in a bubble. They went bankrupt. Spanish banks were even more heavily leveraged to real estate, but have yet to write down their debt. They assume that houses will only lose about 15%, rather than the 50% that the real world is suggesting. And you can get away with that for a time if you own the agencies that rate the real estate debt, as the Spanish banks do. But most of the rest of European banks are going to go bankrupt the old-fashioned, tried-and-true, proven-over-the-centuries way: by buying government debt. Somehow they want to be seen as rational in leveraging up government debt.

As I told the Irish crowd last week, don’t worry about your bank debt; all you have to do is wait a little while. When French and Italian banks (and most of the other banks in Europe) are publicly insolvent and have to go to their respective countries and the ECB for capital, the relatively small amount (by comparison) of Irish bank debt will not even be noticed when you default. I was trying for a little humor, but there is a core of truth in that glib remark.

France cannot afford to bail out its banks. As we have seen this week, they are already in danger of losing their AAA rating, as a false (premature?) press release from S&P suggested. (Someone is in trouble for that one! Seriously, you think S&P is not ready for this? There is reason to believe, I hear, that this was a draft for use later. We’ll see.) France will want the Eurozone to bail out their banks, and that means the ECB. If France gets such a deal, Ireland will certainly demand – and get – one, too.

The German Dilemma

And that brings us to the third problem, which has two parts: (1) the massive trade imbalances in Europe, where Germany and a few others export and the rest of Europe buys, And (2) the fact that German labor is far cheaper on a relative basis than Greek or Portugal labor (or that of most of the rest of the Eurozone). German workers have seen very little rise in their incomes, while Southern Europe labor costs have risen to over 30% higher.

I won’t go into the details (I have written about this before), but there is a basic rule in economics. You can reduce private debt and you can reduce public debt and you can run a trade deficit. But you can only do two of the three at the same time. The total of the three must balance.

Greece runs a massive trade deficit. They are also attempting to reduce their government debt, and private debt (that borrowed by business and consumers) is being forcibly reduced, as the banks are in full retreat.

Greece must therefore endure a large reduction in its labor costs if it wants to reduce its government deficit. Sell that one to the unions. (By the way, Irish public unions took a large reduction, as did pensioners. Different political climate and country.) Germany seemingly wants the rest of Europe to behave like Germans, except that they also want them to continue to buy German products and run trade deficits, while Germany exports its way to prosperity.

In the “old days” of a decade ago, a European country could simply devalue its currency and adjust the relative value of labor that way. But with a fixed currency there is no adjustment mechanism other than reduced pay or large unemployment numbers, which eventually translates into lower wages.

Essentially, the southern part of Europe is on an odd sort of “gold standard,” with the euro being the fixed standard. And the adjustments are painful. There are no easy answers if you stay with the euro. And leaving is its own nightmare.

So How Do We Solve the Eurozone Problem?

Let’s quickly look at options for solving this.

1. The Germans (and the Dutch and Finns, et al.) can simply take their export surplus and taxes and savings and pay for the deficits in the southern zone until such time as they can be brought under control. Or they can bail out all the banks. Not just their own but throughout Europe, as a customer without a banking system cannot buy your products. That seems to be a political non-starter.

2. The problem countries can make the extremely painful adjustments, cut their deficits, and enter into a lengthy pepression. That also seems to be a political non-starter.

3. The Eurozone can forgive enough debt to get the various countries back to a place where they can function, nationalizing the banks that hold the debt, which would lead to a Europe-wide deep recession. Possible if the Eurozone leaders can sell it, but it is a tough sell.

4. A few countries (2? 3? 4?) can leave the Eurozone. If this is not done in an orderly fashion, the chaos will reverberate around the world.

All of the above paths (or some combination of them) mean a banking crisis and chaos and long-term recessions. These are not pretty paths. But the above options assume that the ECB remains true to its Bundesbank core. Which brings us to the next “solution.”

Where Is the ECB Printing Press?

It is hard for us in the US to understand, but the commitment of European leaders to a united Europe is amazingly strong. They will do whatever they think they must do (and/or can sell to the voters) to maintain the European Union.

As a way to think about it, the US fought its most bloody war over the question of whether or not to remain a union. I think you have to call that commitment. While I am not suggesting that Europe is getting ready to start a civil war, I think it is helpful to remember that commitments to an ideal can drive people into situations that others have a hard time understanding.

Let’s summarize. There is too much debt in many southern countries; and while I have not yet mentioned it, France is not far from having its own crisis if they do not get back into balance. And if they lose their AAA rating, then any EFSF solution is just so much bad paper.

The banks and banking system are effectively insolvent. There are large trade imbalances that make it almost impossible for the weaker Eurozone countries to grow their way out of the problem.

The path of least resistance, and I use that term guardedly, is for the ECB to find its printing press. Perhaps they can borrow one from Bernanke. Yes, I know they are buying sovereign debt now, but they are “sterilizing” it, meaning they sell euro paper to offset the monetary base effects (large oversimplification, I know).

But the money to solve the crisis does not exist. The only way to find it is for the ECB to print money and print in size, enough to lower the value of the euro and make exports cheaper (which gives southern Europe a chance to grow out of its problems). Which is of course something the Germans vehemently oppose, as it goes against their core DNA coding.

But the choice is print or let the euro perish. I see no other realistic solution, aside from massive austerity, willingly accepted by Europeans everywhere, along with the nationalization of their banks, etc., as described above. I think there is even less willingness to endure all that.

It is a hard choice, I know. If you held a gun to my head and asked, “What do you think they will do?” I would have to say, “I think the ECB prints.” But not without a lot of rancor and solemn pledges and maybe a rewriting of the treaty in order to get Germany to go along.

The choice is between a much lower euro or one that is far different from today’s, with a number of countries having left it. There are no good or easy choices.

As a closing aside, a lower euro means lower US and emerging-market exports (Europe is China’s biggest customer!) to Europe and more competition from Europeans in what the rest of the world sells to each other. It will be the beginning of serious trade issues and when coupled with the collapse of the Japanese yen, circa 2013, will usher in currency wars and protectionism. This will be a decade we will be glad to leave in 2020.

DC, Cleveland, and New York

I leave on Sunday for a few days to go to DC to speak at the UBS national wealth management conference. I hope to see my friend Art Cashin there, as well as finally meet Ken Rogoff, for whom I am an admitted groupie. Next weekend I will take a day trip to Cleveland and the Cleveland Clinic for some medical work. Mike Roizen is going to see what he can do to keep this 62-year-old body going for a few more decades. It is getting stiff! Then Thanksgiving, my favorite holiday, followed by a very quick trip to NYC with Tiffani for some business, media, and friends.

I had great fun in Atlanta this week. Hedge Funds Care raised over $100,000 to help abused children, a very worthy cause. Last Monday I was with my daughter Melissa for her 31^st birthday dinner. I was sitting across from her, and some of her friends asked where I was going next. “Atlanta,” I said.

“What are you doing there?”

“I am going to speak at a fundraiser for Hedge Funds Care,” was my short answer. They were aghast.“There’s a charity for hedge funds? That’s just wrong!”

I couldn’t resist. I went with it. “Absolutely. Not a lot of people know or care, but a lot of hedge funds went bankrupt in the crisis in 2008. The managers lost their jobs and everything. Think of their kids! They had to leave their private schools, give up their cars and vacations, and lost their credit cards. It has been hard on them. Someone has to help, and we need to take care of our own.” I totally sucked them in. It was fun until Melissa burst out laughing And teased them for being gullible.

Trips in the US somehow don’t seem all that bad any more. Just a few hours on a plane, reading and writing. It is the long international trips that wear and tear the body, I am thinking. Tomorrow I sleep in, trying to catch up.

By the way, be on the lookout for a very special note from me later next week. I am working on a special offer of some of the best business marketing advice I have ever seen (which has sold for tens of thousands of dollars as seminars, papers, books, etc.), and I have arranged for my readers to get it totally free. My little way of trying to help. And now I will hit the send button and relax for the rest of the night. Have a great week!

Your still having fun analyst,

John Mauldin

John@FrontlineThoughts.com

European Summit: A Plan with No Details

John Mauldin — Sat, 29 Oct 2011 19:31:00 GMT

A Definite Plan (Minus Those Sticky Details)
Dear Mario
When Leverage Is the Kind-of Answer
Meanwhile Back in Portugal
Let’s Just Change the Rules
San Francisco, Kilkenny, Atlanta, DC … and the World Series Loss

Where is the peace dividend that was supposed to come after the end of the Cold War? Where are the fruits of the amazing gains in efficiency that technology has afforded? It has been eaten by the bureaucracy that manages our every move on this earth. The voracious and insatiable monster here is called the Federal Code that calls on thousands of agencies to exercise the police power to prevent us from living free lives.

It is as Bastiat said: the real cost of the state is the prosperity we do not see, the jobs that don't exist, the technologies to which we do not have access, the businesses that do not come into existence, and the bright future that is stolen from us. The state has looted us just as surely as a robber who enters our home at night and steals all that we love.

- William "Bill" Bonner

Exactly what happened in Europe yesterday? The market reacted like it was the Second Coming of the Solution to End All Solutions. No problem here! The European debt crisis is solved! But if you look deeply (almost always dangerous when it comes to Europe) there is more to the market "melt-up" than simple euphoria and relief. What you find is a very disturbing unintended consequence that will come back to haunt us, as, sadly, I have written about in the past. The finger points to our old friends derivatives and credit default swaps. This week, as I recover from a rather nasty bug, we look at gamma and delta and other odd entities that may be behind the real reason for the market response, as we march inexorably toward the final chapters of the Endgame. Let's see how far out on a limb I can go.

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I have long been involved in the commodity-trading advisor space (some 20 years) and am a proponent of CTAs as a way to diversify portfolio risk. I have written a detailed report on this fascinating sector in relation to the fund, and it is available for free at http://www.altegrismutualfunds.com/landing/mauldinreports1.aspx, along with more information on the fund (including the offering memorandum and important risk disclosures, which are also included at the end of this letter).

The fund has been very well received since its launch and has grown rapidly to almost $1 billion. There has been very active interest in the professional community, as advisors and brokers are looking for simple and realistic ways to diversify their clients' portfolio risk in a manner that is truly noncorrelated to typical stock funds and many other asset classes. Whether you are a professional or individual, you really should take the time to research what I think is a very solid fund. My partners at Altegris have decades of experience in the CTA space, with the largest available database of CTAs and long-term relationships with many of the managers (I actually started my investment career in the commodity fund space, so I have more than a passing knowledge of the arena). Given the potential for volatility in the global markets, I think it makes sense to have some exposure to funds that can go both long and short (depending on their models). I urge you to read my report:

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A Definite Plan (Minus Those Sticky Details)

Tonight there are so many moving parts it is hard to know where to start, so in the interest of time we will briefly scan a number of facts and opinions and see if we can come to something like a conclusion.

First, let's look at what came out of Europe. Before the summit, German Chancellor Angela Merkel went before her parliament and, in an impassioned speech, basically declared that unless the parliament approved the expansion and leverage of the EFSF the European Union would collapse, along with the decades-long peace that has prevailed. And the Bundestag went along with her – with an important caveat. They made their approval conditional on the European Central Bank continuing to comply with Article 123 of the Treaty of Lisbon, which says that the ECB cannot print money (or words to that effect). The Germans are obsessed with an independent ECB that will maintain the value of the euro – something to do with Weimar being embedded in their collective psyche.

Contrast this "obsession" with Martin Wolf leading the chorus for incoming ECB president Mario Draghi (an Italian) to ignore the Germans. Here are some choice paragraphs from his recent piece:

"Dear Mario,

"Congratulations and commiserations: next week, you will take up one of the most important central banking jobs in the world; but you will also bear a frightful responsibility. The European Central Bank alone has the power to quell the eurozone crisis. You must choose between two paths: the orthodox one leads towards failure; the unorthodox one should lead towards success.

"The eurozone confronts a set of complex longer-term challenges. But the members will not get the chance to make needed adjustments and implement required reforms if it does not survive. The immediate requirements include putting Greece on a sustainable path; avoiding a meltdown in public debt markets of several large countries; and preventing a collapse of banks. Of these, it is the last two that matter. Any effort by the ECB to be the lender of last resort that members need will start a firestorm of protest. People will argue that the central bank may lose money, exacerbate moral hazard and stoke inflation.

"….To the first of these objections, the right response is: so what? The central bank's aim is to stabilize economies, not make money. Indeed, it is far more likely to lose money through half-hearted interventions than through forceful interventions that succeed.

"….The eurozone risks a tidal wave of fiscal and banking crises. The European financial stability facility cannot stop this. Only the ECB can. As the sole eurozone-wide institution, it has the responsibility. It also has the power. I am sorry, Mario. But you face a choice between pleasing the monetary hawks and saving the eurozone. Choose the latter. Explain why you are making the choice. And remember: fortune favours the bold."

Martin Wolf is by no means alone in his call for the ECB to aggressively shore up the European sovereigns and bank markets. There is a very long line of establishment types throughout Europe who are doing so, though there is a notable lack of German figures.

Indeed, from what I read, the ECB seemed to indicate that after the summit it would continue to buy Italian and Spanish debt. But that commitment was rather vague. As is much of what came from the summit. Italian paper was just north of 4% in July. Today Italian interest rates rose to 5.88%, even with apparent ECB buying. More on the reason for the rise later.

They did agree at the summit that private bondholders should lose 50% on their Greek debt. This mostly means banks, pension funds, and insurance companies, along wih the €35 billion owed to the Greek pension system, which promptly declared, "Any solution on the long-term viability of public debt will be accompanied by measures that do not just sustain but visibly improve the current level of the assets of the Greek pension funds.… We are answering the concerns of pensioners and those insured by the system."

We should note that the summit decided that the Greeks should also privatize another €15 billion in national assets, on top of the €50 billion they are already supposed to have done, but on which no progress has been made. All the while finding €17.5 billion to fix the hole in their pension funds, which was already so deep that no daylight could seep in.

Right, if I was a Greek pensioner I would feel soooo relieved. I mean, if you can't trust the Greek government to do what it says it will do… OK, let's not go there.

When Leverage Is the Kind-of Answer

The Europeans also agreed to leverage the EFSF by some amount, but they were unclear on the details as to what that actually meant. The concept is that they will guarantee the first 20% of losses on any newlyissued debt. It was left unstated whether that includes the loans committed to Ireland and Portugal but not yet issued, or just new commitments. Remember, they started with €440 billion but have committed €278 billion already (if memory serves), so that leaves only €170 billion (give or take) that can be leveraged (maybe). If everyone goes along.

Somehow, by a mechanism not revealed, this is to be leveraged up to about €1 trillion, which is about half of the lowest estimate I have seen of what is needed. Thus the desperate hope that the ECB will step in, because that is the only real source for the money that will be needed.

I am not going to go into great historical detail, as I would lose the most patient of readers, but guaranteeing 20% of a government bond is rather pointless. This has been done in the past, and at most it drops a small amount from the interest rates. Nothing meaningful, as the market assumes that it is an 80% bond and rates it accordingly. Further, whatever rating is conferred by the market is an amalgam of total Eurozone credit ratings. That would include guarantees by Greece and Portugal, et al., on their portion of the debt. Think about that for a second. (Those guarantees are supposedly where the privatization of Greek assets comes in, if I read the tea leaves right.)

Further, if you are a market participant thinking of investing in sovereign debt, and not a total rookie, when was the last time you saw a sovereign country write down less than 20% of its debt? (Greece is starting with 50%. On its way to what I suspect will be something far closer to 90%.)

Keep searching. If a sovereign debt goes south, it's for a whole lot more than 20%. It seems to me that whatever the EFSF guarantees is almost certain to turn into a loss. What self-respecting country would write off less, if the hit is taken by entities that have no votes in the national parliament? 20% becomes the starting point, and then the fun begins. There will be lots of screaming and shouting and gnashing of teeth when those losses come home.

Merkel and Co. are selling the whole proposition on the premise that the problem is simply one of confidence, and that if the EFSF restores confidence in the various nefarious government debt schemes, then all is saved. Well, except for Greece. Which has already been flushed.

The problem is that it is not a lack of confidence, nor even a lack of hubris. It is a lack of solvency. The simple arithmetic says there is too much debt in Greece and Ireland and Portugal and Spain and Italy. And ultimately France, though Merkel is too polite to say so and knows that she needs their signature, at least for now. Meanwhile, back at the ranch, no one is paying attention to poor Portugal.

Meanwhile Back in Portugal

"Data released by the European Central Bank show that real M1 deposits in Portugal have fallen at an annualized rate of 21pc over the past six months, buckling violently in September.

" ‘Portugal appears to have entered a Grecian vortex and monetary trends have deteriorated sharply in Spain, with a decline of 8.4pc,' said Simon Ward, from Henderson Global Investors. Mr. Ward said the ECB must cut interest rates ‘immediately' and launch a full-scale blitz of quantitative easing of up to 10pc of eurozone GDP. [Shades of Martin Wolf!]

"The M1 data – cash and current accounts – is watched by experts as a leading indicator for the economy six months to a year ahead. It has been an accurate warning signal for each stage of the crisis since 2007." (The Telegraph)

Portugal is rapidly descending to Greek status. Yet another banking crisis looms.

And then there is Ireland. I wrote a few weeks ago that there is a universal assumption in Ireland, at all levels of society and from all sides of the political spectrum, that the country will get debt relief. That is a €60-billion hole in the ECB balance sheet. From Businessweek.com:

"In Dublin, pressure is building on [prime minister] Kenny to seek more debt relief after the government injected about 62 billion euros into the Irish financial system.

"Why is it acceptable to write down Greek debt, when the Irish pay private bankers' debts?" Gerry Adams, leader of Sinn Fein, said in parliament on Oct. 25. Kenny told Adams he's seeking debt reduction on a ‘number of fronts.'

"The IMF said on Sept. 7 it estimates Ireland's government debt will peak at 18 percent more than the country's gross domestic product in 2013, equivalent to almost 200 billion euros. That's up from 25 percent of GDP in 2007.

"The government has already signaled it may seek to shift some of the costs of bailing out the banking system to Europe, relieving the burden on the taxpayer. [And putting it squarely on European taxpayers as a whole!]

"The Irish government has a legitimate claim that there should be some sort of burden-sharing on a European level." [said Kenny]

Think that will sell to Spain, when they have to figure out how to back their banks, which are for the most part basically insolvent? What about Italy?

Let's see, what else did they do? Oh, yes. European banks will have to come up with€106.5 billion (don't you just love exact figures?), which will bring their Tier 1 capital up to 9%. Never mind that Dexia was supposedly at 12% right before it went bankrupt. Tier 1 in Europe is a meaningless construct, as they don't require haircuts for sovereign debt.

International Monetary Fund (IMF) chief Christine Lagarde royally annoyed European leaders when she called last August for a €200-billion-euro bank recapitalization. I wonder how they felt when the IMF upped its figure to €300 billion two weeks ago. Nouriel Roubini is an optimist, by comparison – he thinks it will only take €280 billion. And Sarkozy wants the EFSF to bail out the banks, especially the French banks. Which would blow through most of the EFSF's assets, even leveraged. Of course, if each government has to bail out its own banks, then France will likely lose its AAA rating, which will make the EFSF lose its AAA rating, which… Are we having fun yet?

Let's Just Change the Rules

I've always had a soft spot for Bunker Hunt. Yes, I know, he was a voracious manipulator who tried (and did) corner the silver market back in 1980, but boys will be boys. Maybe it's a fellow-Texan thing. He went bankrupt because they changed the rules on him. Lesson for all of us: Never assumes the rules are what you think they are just because they are written down, if someone else can change them. You can only push so far and then the peasants revolt.

And that is the final thing that happened at the summit. The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." Cue the theme from The Godfather.

And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default – capiche?

And that smooth move, dear reader, triggered a rather significant unintended consequence, which resulted in the market "melt-up." Let me see if I can walk you through this rather bizarre world of derivative exposure without exposing too much of my own ignorance.

Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if (say) Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested.

But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS? Time to cover. And then the shorts get covered.

Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.

And it just cascades. The high-frequency-trading algo computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost.

Let's go back to where I noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk?

Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away.

(OK, this is just my conjecture; but I have speculated before – with reason –that a major writer of sovereign CDS were German Landesbanks. Think Merkel didn't have that report? As did Sarkozy, on French exposure? It was a very high-stakes poker game they were playing this week. But one side of the table could rewrite the rules.)

Now, I know I am greatly oversimplifying the CDS situation. Even so, a great deal of the volatility of recent times can be laid at the feet of the CDS market, because it is so opaque. There is no way to prove or disprove my speculations, because there is no source that can really plumb the true depths of the situation. And that is the problem.

I am not against CDS. We need more of them. But they should all be moved to a very transparent exchange. If I buy an S&P derivative (or gold or oil or orange juice), I know that my counterparty risk is the exchange. I don't have to hedge counterparty risk. The exchange tells whoever is on the other side of the trade that they need to put up more money, as the trade warrants. Or tells me if the trade goes against me.

The banks lobbied to keep CDS "over the counter." The commissions are huge that way. If they are on an exchange the commissions are small. This was a huge failure of Dodd-Frank. And we all pay for it in ways that no one really sees. As the Bastiat quote at the beginning said, there is what you see and what you don't see.

Equity markets are supposed to help companies raise capital for business purposes, not be casinos. Investors want to and should be able to buy and sell stocks with a long view to the future. And increasingly there is the feeling that this is not the case. When I talk to institutional investors and managers, it is clear that they are very frustrated.

I am not arguing against hedge funds here. There is a need for short sellers in a true market. But that selling should be transparent. In a regulated exchange, you can see the amount of short interest. Everyone knows the rules. But without an exchange, things happen for reasons that are not apparent. An event like the Eurozone summit changes an obscure rule with some vague clauses about triggering a credit event – and the market reacts. This time it was a melt-up. Next time it could be a meltdown, as it was in 2008.

CDS markets should be moved to an open regulated exchange. And while we are at it, high-frequency trading should be stemmed. This could be done easily by requiring all bids or offers to last for at least one second, instead of a few microseconds. You make the offer, you have to honor it for a whole second. What a concept. That would not hurt liquidity, but it would cut into the profits of the exchanges (especially the NYSE) – but I thought these were public markets and not the playground of the privileged few.

If it weren't so cold here in New York, I might just wander down and join Occupy Wall Street and see if I could enlighten a few minds. If those kids only knew what they really should be protesting.

San Francisco, Kilkenny, Atlanta, DC, and the World Series Loss

As noted above, I am in New York tonight (where I spoke at the Van Eck conference, who were wonderful hosts), in my warm hotel, writing away and hoping to skip town tomorrow before a fluke snowstorm hits. Tuesday I leave for the Schwab conference in San Francisco, to be there with my Altegris partners (see you at their booth, where I will be signing books); and then I jump to Kilkenny, Ireland, to join in the fun at the Kilkenomics festival. I am told that my friend Bill Bonner is coming, as well as all sorts of surprise guests. David McWilliams puts on a great show, and it is (fire up Irish brogue here) sure and begorra to be a fun time. (http://www.kilkenomics.com/)

Then I am back for a day or two and then off again to Atlanta for the Hedge Funds Care fund-raising dinner, where I will speak. You should come. http://hedgefundscare.org/event.asp?eventID=74. Then the next week I am at the UBS conference outside of DC, and then home for most of the next nearly two months – or at least that's the plan. I am looking forward to putting in some time in my own bed!

I am indeed recovering from some nasty variant of flu. I so rarely get sick (for which I am grateful) that this one really kicked my derriere. I am still somewhat weak, but at least can type and talk and expect to get back into the gym soon. I miss it.

Last night was tough. Alone in my room, I watched the Rangers blow two opportunities to win a World Series. Twice we were within one strike. Just one lousy strike. TWICE. And tonight we were clearly not in it. I am getting reports on my phone from my kids as I write (I can't bear to watch while we are way behind). Oh well. Wait till next year!

It is time to hit the send button and get some shuteye. Sunday will be a family brunch, where we will console ourselves about the World Series, and just enjoy ourselves. Have a great week!

Your looking forward to Ireland analyst,

John Mauldin

John@FrontlineThoughts.com

Twist and Shout?

John Mauldin — Sat, 17 Sep 2011 18:59:00 GMT

Bailing Out Europe’s Banks
WWGD?
What Is the Fed Really Risking?
What Will the Fed Do Next Week?
Twist and Shout?
Europe, Houston, NYC, and South Africa

What in the wide, wild world of monetary policy is the Fed doing, giving essentially unlimited funds to European banks? What are they seeing that we do not? And is this a precursor to even more monetary easing at this next week’s extraordinary FOMC meeting, expanded to a two-day session by Bernanke? Can we say “Operation Twist?” Or maybe “Twist and Shout?” Not many charts this week, but some things to think about.

But first, I have had readers ask me about my endorsement of Lifeline Skin Care and whether I was still pleased. Quickly, let me say that I am more than pleased. I have not mentioned it recently, as the company had to deal with supply issues (partially, from too many orders, which is a good thing) but those have been handled. I read a lot of positive letters from people who use the cream with excellent results. I can clearly see a difference in my own skin. If you use it correctly you will get results

But a very interesting endorsement came by way of my cynical daughter Tiffani, who was in Europe recently for 6 weeks. She did not take her Lifeline with her but used another (very) high-end product. She came back and was complaining about how her skin looked. After switching back to Lifeline for two weeks, she notes that she can already see a difference, and the “feel” is improving. Many of the re-orders are coming from men (which is not surprising, as the bulk of initial orders came from my readers), almost the reverse of industry standards.

Basically, Lifeline uses patented stem-cell technology in its cream, and it promotes a visible rejuvenation of the skin in about 3-6 weeks (depending on the individual’s skin, how often you use it, etc.) I encourage readers who are (ahem) of a certain age, or simply want to keep their skin looking younger, to click on the link to see a new, very short video; and if you like, you can order at the website. I and a number of friends are enthusiastic users. If you are interested in your appearance, you might want to consider becoming a Lifeline user. And you can use the code WAVE1 to get a $40 discount! www.lifelineskincare.com/page/46/Video.html. Now to the letter!

Bailing Out Europe’s Banks

Yesterday the Fed announced that along with the central banks of Great Britain, Japan, and Switzerland it would provide dollars to European banks that have lost their ability to access dollar capital markets (basically each other and US-based money market funds that are slowly letting their holdings of European bank commercial paper decrease as it comes due. And if they are “rolling it over,”they are buying very short-term paper, according to officials at the major French bank BNP Paribas.

Are US taxpayers on the hook? We will deal with that in a minute. The more interesting question is, why do it at all and why now? Was there a crisis that we missed? Why the sudden urgency?

One of the little ironies of this whole Great Recession is that the central banks of the world rolled out this policy on the 3^rd anniversary of the Lehman collapse. The Fed acted AFTER that crisis to provide liquidity. And we know the recession and bear market that followed.

The only reason for this move must certainly be that they are acting to prevent what they fear will be another Lehman-type crisis. Otherwise it makes no sense. They can give us any pretty words they want, but this was not something calculated to make the US voter happy. To do this, you have to be convinced that “something evil this way comes.” And to recognize the costs of not doing anything, and try to head them off.

My guess (and it is that, on a Friday night) is that the European Central Bank made a presentation to the other central bankers of the realities on the ground in Europe, and the picture was plug ugly. It should be no surprise to readers of this letter that European banks have bought many times their capital base in sovereign debt. The Endgame is getting closer (more on that in a minute).

Let’s look at just one country. French banks are leveraged 4 times total French GDP. Not their private capital, mind you, but the entire county’s economic output! French banks have a total of almost $70 billion in exposure to Greek public and private debt, on which they will have to take at least a 50% haircut, and bond rating group Sean Egan thinks it will ultimately be closer to 90%. That is just Greek debt, mind you. Essentially, French banks are perilously close to being too big for France to save with only modest haircuts on their sovereign debt. If they were forced to take what will soon be mark-to-market numbers, they would be insolvent.

Forget it being simply French or Greek or Spanish banks. Think German banks are much different? Pick a country in continental Europe. They (almost) all drank the Kool-Aid of Basel III, which said there was no risk to sovereign debt, so you could lever up to increase profits. And they did, up to 30-40 times. (Greedy bankers know no borders – it comes with the breed.) For all our bank regulatory problems in the US (and they are legion), I smile when I hear European calls for US banks to submit to Basel III. Bring that up again in about two years, when many of your European banks have been nationalized under Basel III, at huge cost to the local taxpayers.

Next, let’s look at the position of the ECB. They are clearly seeing a credit disaster at nearly every major European bank. As I keep writing, this could and probably will be much worse for Europe than 2008. So you stem the tide now. But for how long and how much does it cost? A few hundred billion for Greek debt? Then Portugal and Ireland come to mind. If bond markets are free, Italy and Spain are clearly next, given the recent action in Italian and Spanish bonds before the ECB stepped in.

Could it cost a half a trillion euros? Probably, if they have to go “all in.” And that is before the ECB starts to buy Italian and Spanish debt (Belgium, anyone?), which no one in Europe is even thinking that the various bailout mechanisms (EFSF, etc.) could handle, which leaves only the ECB to step up to the plate. The ultimate number is quite large.

WWGD?

What Will Germany Do? That has to be the question on the mind of the new ECB president, Mario Draghi, who takes over in November, just in time for the next crisis. I believe German Chancellor Angela Merkel at her core is a Europhile and wants to do whatever she can to hold the euro experiment together. But for all that, she is a politician, who knows that losing elections is not a good thing. And the drum beat of the German Bundesbank and German voters grows ever louder in opposition to the ECB printing euros. Can she explain the need for this to her public?

As my friend George Friedman wrote today, Europe is complex. Speaking about Geithner going to the Eurozone finance meeting this weekend in Poland, he says:

“Geithner’s presence is particularly useful for two reasons. First, despite the vitriol that is a hallmark of American domestic politics, American monetary policy is remarkably collegial. The transitions between Treasury secretaries are strikingly smooth. Geithner himself worked for the Federal Reserve before coming into his current job, and Geithner’s partners in managing the U.S. system – the chairmen of the Federal Reserve and the Federal Deposit Insurance Corporation – are typically apolitical. Geithner holds the United States’ institutional knowledge on economic crisis management.

“Second, what Geithner doesn’t know, he can easily and quickly ascertain by calling one of the chairmen mentioned above. This is a somewhat alien concept in Europe, which counts 27 separate banking authorities, 11 different monetary authorities, and at last reckoning some 30 entities with the power to carry out bailout procedures.

“Getting everyone on the same page requires weeks of planning, a conference room of not insignificant size and a small army of assistants and translators, followed by weeks of follow-on negotiations in which parliaments and perhaps even the general populace participate in ratification procedures. The last update to the European Union’s bailout program was agreed to July 22, but might not be ready for use before December. In contrast, the key policymakers in the American system can in essence gather at a two-top table for an emergency meeting and have a new policy in place in an hour.

“Geithner will undoubtedly point out that the European system is not capable of surviving the intensifying crisis without dramatic changes. Those changes include, but are hardly limited to, federalizing banking regulation, radically altering the European Central Bank’s charter to grant it the tools necessary to mitigate the crisis, forming an iron fence around the endangered European economies so that they don’t crash everyone else, and above all recapitalizing the European banking sector to the tune of hundreds of billions (if not trillions) of euros – so that when trouble further intensifies, the entire European system doesn’t collapse.”

That is the standard Europhile leader’s line. I talked this week with a leader of that faction, and that could be his speech. But again, that is not what Germany signed on for. They thought they were getting open markets and an ECB that would behave like the Deutsche Bundesbank. And it did for ten years. Now, in the midst of crisis, the rest of Europe is talking about needing a less restrictive monetary policy. That means potential inflation, which still strikes fear in the hearts of proper German burghers.

If George is right, Geithner will be speaking to (mostly) a receptive audience. But he is a central banker talking, not a politician. And his message will not play well in Bavaria, or in any country that still thinks of itself as a country, which is to say all of them. Remember this, in order to get the European treaty passed in France and in the Netherlands, they had to remove the parts about the flag and other symbols of unity. It is still 27 countries in a free trade zone, with different languages.

What Is the Fed Really Risking?

This will be where I lose a few readers. The actual answer to the above question is,“Not much.” The Fed is not lending to European banks or even to the various national central banks. Its customer is the ECB, which will deposit euros with the Fed to get access to dollars. Making the safe assumption that the Fed knows how to hedge currency risk (fairly easy), the only risk is if the ECB and the euro somehow ceased to exist. And these are swaplines. This is not a new concept; it has been authorized since May, 2010. The real difference is that previously it has been used only for loans with 7-day maturity, and now that is extended to 3 months. This gives the ECB the ability to lend dollars for 3 months, which they must think will entice US money-market funds back into at least short-term commercial paper. (Just stay one step ahead of the ECB and the Fed, and your loan is “safe.” We will see how enticing this is.)

Now, this is not without costs. It is effectively another round of QE, although theoretically less permanent than the last rounds, as the swap lines have a finite and rather short-term end. And those banks need the money for existing business, so it should not flood the market with new dollars. If that were to happen, the Fed should withdraw the lines or withdraw dollars from the system on its own. Allowing their balance sheet to expand through a back-door mechanism like this is not appropriate monetary policy and would draw deserved criticism.

Why do it? It is not for solidarity among central bankers. The cold calculation is that a European banking crisis would leak into the US system. Further, it would throw Europe into a nasty recession, when growth is already projected (optimistically) to be less than 0.5%. That means the market that buys 20% of US exports would suffer and probably push us into recession, too (given our own low growth), making a far worse problem for monetary policy in the not-too-distant future.

Finally (and this is one I do not like), if the ECB was forced to go into the open market for dollars, the euro would plummet. As in fall off the cliff. Crash and burn. Which would make US products even less competitive worldwide against the euro. While I think we need a stronger dollar, that is not the thinking that prevails at higher levels. You and I don’t get consulted, so it pays us to contemplate the thought process of US monetary leadership and adjust accordingly.

Finally, I think that the end result of lending to the ECB will be to postpone the problem. The problem is not liquidity, it is insolvency and the use of too much leverage by banks and governments. This action only buys time. And maybe time is what they need to figure out how to go about orderly defaults, which banks and institutions to save and which to let go, which investors will lose, whether some countries must leave the euro, etc. Frankly, the world needs Europe to get its act together.

What Will the Fed Do Next Week?

Bernanke has taken the highly unusual step of adding an extra day to next week’s FOMC meeting. While that raised my eyebrows, I thought his monetary policy movements would continue to be constrained. Given yesterday’s announcement of coordinated policy with the ECB, I am not so sure now. These things do not happen overnight or in a vacuum. The phone lines must have been open to Europe. The Jackson Hole meeting seemed innocuous enough, but I bet there were some very deep private conversations. This is something they have seen coming for some time. It is not like the whole euro problem is a surprise. Now, Bernanke has to bring his fellow FOMC members along for the next round.

Operation Twist seems to be priced into the market. The original Operation Twist was a program executed jointly by the Federal Reserve and the (freshly elected) Kennedy Administration in the early 1960s, to keep short-term rates unchanged and lower long-term rates (effectively “twisting” the yield curve). The US was in a recession at the time, but Europe was not and thus had higher interest rates. The equivalent of hedge funds back then (under the Bretton Woods system) would convert US dollars to gold and invest the proceeds in higher-yielding assets overseas. Billions of dollars worth of gold was flowing into Europe each year. (Incidentally, President Kennedy announced Operation Twist on February 2, 1961, which basically corresponded to the business-cycle trough.)

The notion behind Operation Twist was that the government would encourage housing and business investment by lowering long-term rates, and at least not encourage gold outflows, by maintaining short-term rates. Mechanically, the Federal Reserve kept the Federal Funds rate steady while purchasing longer-term Treasuries. The Treasury reduced its issuance of longer-term debt and issued mostly short-term debt. (self-evident.org)

Before I comment, let’s look at what Bill Gross had to say in the Financial Times:

“The front end of the curve has for all intents and purposes become inert and worst of all flat as opposed to steeply positive. Two-year yields are the same as overnight fund rates allowing for no incremental gain – a return that leveraged banks and lending institutions have based their income and expense budgets on. A bank can no longer borrow short and lend two years longer at a profit…

“By flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming Operation Twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process. The further out the Fed moves the zero bound towards a system-wide average maturity of seven to eight years the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.”

Bernanke made it clear in his infamous November 2002 “helicopter” speech that moving out the yield curve was in the Fed’s bag of tricks. By that, I mean they could do what Gross fears. They put a ceiling on the price of (say) the 10-year bond at 1.5%, in hopes of bringing banking and mortgage rates down, thereby theoretically spurring the economy and boosting the housing market. And in a normal business-cycle recession such a policy might work. But in a normal business cycle, it has never been necessary.

Twist and Shout?

The main point of Bernanke’s speech was that the Fed had many policies it could use, even if interest rates were at zero, if it needed to fight inflation. It was a nice academic speech given to professional economists. But it offers some insight into his thinking.

First, that was then and this is now, as my kids like to remind me. Then, deflation was an issue on the minds of many. Now, this week’s CPI data suggest that, at least for the near future, deflation is not the issue. The Consumer Price Index rose 3.8% for the month, compared to a year earlier. That's up from 3.6% in July and is the highest reading since September 2008. On a month-to-month basis, prices rose 0.4% in August, twice the rate of increase forecast by economists surveyed by Briefing.com. (CNN.com)

Real yields (after inflation) are already sharply negative. A 10-year bond is only 2.05%. Five-year TIPS are a negative 0.83%! Three-month rates are 0%! How much lower can it get? Yes, they can go (briefly) negative, but that is not a sign of a healthy economy. See the chart below from Bloomberg.

Second, high rates are not the problem with the housing market. Rates are already historically low. The “problem” is that bankers now want 20% equity at reduced prices to grant a mortgage. Imagine, bankers wanting to get paid back! Even very creditworthy refinancings cannot get done, because borrowers must bring cash to the table, even as their home values have fallen.

The same holds for business borrowing. The latest NFIB survey shows the vast majority of small businesses have access to all the lending they want or need. The survey shows the #1 problem they face is sales.

Do consumers need lower rates? Consumer spending is now an almost-record 71% of GDP. Consumers are repairing their balance sheets and reducing debt. (Personal anecdote: next month I will buy a new car, as my youngest son will claim possession of my present car (which has only has 100,000 miles on it and is in very good shape. Checking out new cars, I find that rates are anywhere from 0% to a high of 3%. While I am happy about that, if I did not have to get another car, no matter how low rates went, I would not buy. Auto sales are not even at replacement level in the US. We are clearly driving our cars longer.)

And retirees are being savaged by low interest rates on their savings. Do we really want retirees increasing their risk by seeking more yield? Just as we are going (in my opinion) into recession? That is precisely the wrong policy to pursue. I know rates would naturally be low as the economy slows, but pushing them down further and for longer is not helpful in a world where core inflation is over 2%.

This next Fed meeting will likely produce a very interesting statement at its conclusion. If the Fed does nothing, you do not want to be long. If they go“all in” you do not want to be short. Guessing what they will do is very serious business, so let’s go back to another Bernanke speech from October of 2003, called “Monetary Policy and the Stock Market” (hat tip, David Rosenberg). You can read the whole speech at www.federalreserve.gov/boarddocs/speeches/2003/20031002/default.htm, but let me highlight a passage to give us a preview of this week’s FOMC meeting:

“Normally, the FOMC, the monetary policymaking arm of the Federal Reserve, announces its interest rate decisions at around 2:15 p.m. following each of its eight regularly scheduled meetings each year. An air of expectation reigns in financial markets in the few minutes before to the announcement. If you happen to have access to a monitor that tracks key market indexes, at 2:15 p.m. on an announcement day you can watch those indexes quiver as if trying to digest the information in the rate decision and the FOMC's accompanying statement of explanation. Then the black line representing each market index moves quickly up or down, and the markets have priced the FOMC action into the aggregate values of U.S. equities, bonds, and other assets.

“On occasion, if economic conditions warrant, the FOMC may decide to make a change in monetary policy on a day that falls between regularly scheduled meetings, a so-called intermeeting move. Intermeeting moves, typically agreed upon during a conference call of the Committee, nearly always take financial markets by surprise, at least in their precise timing, and they are often followed by dramatic swings in asset prices.

“Even the casual observer can have no doubt, then, that FOMC decisions move asset prices, including equity prices. Estimating the size and duration of these effects, however, is not so straightforward. Because traders in equity markets, as in most other financial markets, are generally highly informed and sophisticated, any policy decision that is largely anticipated will already be factored into stock prices and will elicit little reaction when announced. To measure the effects of monetary policy changes on the stock market, then, we need to have a measure of the portion of a given change in monetary policy that the market had not already anticipated before the FOMC's formal announcement.”

From that speech, Bernanke clearly believes that stock prices are a tool of monetary policy. He goes so far as to say that the Fed should not try to “prick” what might be perceived as a bubble, because “… attempts to bring down stock prices by a significant amount using monetary policy are likely to have highly deleterious and unwanted side effects on the broader economy.”

But a rising market is evidently not a problem. He uses all sorts of statistical research that shows a seemingly clear correlation between stock prices (risk assets) and monetary policy. I would argue that correlation is not causation. The data is basically over the last 60 years and does not include a balance-sheet/deleveraging recession like we are now in. The underlying economic tectonic plates have shifted. Ask Japan how much an easy monetary policy helps stock prices.

There has been some chatter that the Fed move to coordinate with the ECB will provoke Tea Party criticism, not to mention Governor Perry’s. I hope not, as that would be foolish, and show that whoever takes that tack is not thinking seriously or simply does not get the broader macro environment. To think that policy would be any different under a Republican means you are not paying attention. This should not be that controversial.

But if the Fed does indeed pursue an Operation Twist or “moves out the yield curve,”then vehement criticism is more than warranted. I will be shouting myself!

Europe, Houston, NYC, and South Africa

I have enjoyed being home for the last nearly two months. But next Friday my“vacation” ends and I go “on the road again.” I have an aggressive travel schedule, where I am gone for about 40 of the next 50 days. I think I will add close to 70,000 miles to my airline mileage.

I leave Friday for a whirlwind trip to Europe (London, Malta, Dublin, and Geneva) and then back. A quick trip to Houston for an excellent conference with very good speakers (www.webinstinct.com/streettalkadvisors), and then I fly to New York for the weekend, where I will be speaking at the Singularity Summit, October 15-16. You can learn more at www.singularitysummit.com/. And then I’ll fly to South Africa for two nights, and head back home.

We are already planning next summer. Tiffani has once again arranged for us to rent a small villa in the village of Trequanda, in Tuscany, Italy. It will be our third year, and it is a slice of heaven. You can pick you own fresh vegetables and herbs from the garden. Walk to fabulous restaurants. Have gourmet chefs come in and cook. All at very reasonable prices. (If you are interested in the villa, you can go to www.ifiordalisi.com/)

And this next time we intend to go to Il Palio in Sienna, something we have wanted to do for a long time (http://en.wikipedia.org/wiki/Palio_di_Siena). It is quite the spectacle. It is far more than a simple horse race.

This Sunday the award-winning design team of Bob and Dylan from Fahrenheit Studio come for a few days of much-needed strategy. There is so much going on. If you like my website, you can see more of their work at www.fahrenheit.com, or call them at (310) 282-8422. They will plunge into a raucous Mauldin family brunch, with guests and sundry hangers on.

This is a night for firsts. I got up from writing to go to Tiffani’s house for a Shabbat (long story). It was the first one for her on her own, and she wanted me there. It was also the first time I interrupted a letter in progress on a Friday evening. And this is the latest I have ever stayed up writing a letter. It will be 5 AM before this is off, but it is my privilege to come into your homes each week. And tonight, I just kept editing and adding! But I’m ready to call it a morning and hit the send button.

Have a great week! Trade carefully out there! And I hope you have wonderful fall weather! Something should go right this week!

Your looking forward to Ireland analyst,

John Mauldin

John@FrontlineThoughts.com

Preparing for a Credit Crisis

John Mauldin — Sat, 10 Sep 2011 20:33:00 GMT

The Consequences of Austerity
Euro Break-Up – The Consequences
Welcome to the Hotel California
The Slow March to Recession in the US
Preparing for a Credit Crisis
What Can You Do About the Weather?
Europe, Houston, New York, and South Africa

“I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”

- Romano Prodi, EU Commission President, December 2001

Prodi and the other leaders who forged the euro knew what they were doing. They knew a crisis would develop, as Milton Friedman and many others had predicted. They accepted that as the price of European unity. But now the payment is coming due, and it is far larger than they probably thought.

This week we turn our eyes first to Europe and then the US, and ask about the possibility of a yet another credit crisis along the lines of late 2008. I then outline a few steps you might want to consider now rather than waiting until the middle of a crisis. It is possible we can avoid one but, as I admit, whether we do (and the extent of such a crisis) depends on the political leaders of the developed world (the US, Europe, and Japan) making the difficult choices and doing what is necessary. And in either case, there are some areas of investing you clearly want to avoid. Finally, I turn to that watering-hole favorite, the weather, and offer you a window into the coming seasons. Can we catch a break here? There is a lot to cover, so we will jump right in.

The Consequences of Austerity

The markets are pricing in an almost 100% certainty of a Greek default (OK, actually 91%), and the rumors in trading circles of a default this weekend by Greece are rampant. Bloomberg (and everyone else) reported that Germany is making contingency plans for the default. Of course, Greece has issued three denials today that I can count. I am reminded of that splendid quote from the British ’80s sitcom, Yes, Prime Minister: “Never believe anything until it’s been officially denied.”

Germany is assuming a 50% loss for their banks and insurance companies. Sean Egan (head of very reliable bond-analyst firm Egan-Jones) thinks the ultimate haircut will be closer to 90%. And that is just for Greece. More on the contagion factor below.

“The existence of a ‘Plan B’ underscores German concerns that Greece’s failure to stick to budget-cutting targets threatens European efforts to tame the debt crisis rattling the euro. German lawmakers stepped up their criticism of Greece this week, threatening to withhold aid unless it meets the terms of its austerity package, after an international mission to Athens suspended its report on the country’s progress.

“ ‘Greece is “on a knife’s edge,”’ German Finance Minister Wolfgang Schaeuble told lawmakers at a closed-door meeting in Berlin on Sept. 7, a report in parliament’s bulletin showed yesterday. If the government can’t meet the aid terms, ‘it’s up to Greece to figure out how to get financing without the euro zone’s help,’ he later said in a speech to parliament.

“Schaeuble travelled to a meeting of central bankers and finance ministers from the Group of Seven nations in Marseille, France, today as they face calls to boost growth amid increasing threats from Europe’s debt crisis and a slowing global recovery.” (Bloomberg: see http://www.bloomberg.com/news/2011-09-09/germany-said-to-prepare-plan-to-aid-country-s-banks-should-greece-default.html)

(There is an over/under betting pool in Europe on whether Schaeuble remains as Finance Minister much longer after this weekend’s G-7 meeting, given his clear disagreement with Merkel. I think I take the under. Merkel is tough. Or maybe he decides to play nice. His press doesn’t make him sound like that type, though. They are playing high-level hardball in Germany.)

Anyone reading my letter for the last three years cannot be surprised that Greece will default. It is elementary school arithmetic. The Greek debt-to-GDP is currently at 140%. It will be close to 180% by year’s end (assuming someone gives them the money). The deficit is north of 15%. They simply cannot afford to make the interest payments. True market (not Eurozone-subsidized) interest rates on Greek short-term debt are close to 100%, as I read the press. Their long-term debt simply cannot be refinanced without Eurozone bailouts.

Was anyone surprised that the Greeks announced a state fiscal deficit of €15.5 billion for the first six months of 2011, vs. €12.5 billion during the same period last year? What else would you expect from increased austerity? If you reduce GDP by as much as Greece attempted to do, OF COURSE you get less GDP and thus lower tax revenues. You can’t do it at 5% a year, as I have pointed out time and time again. These are the consequences of allowing debt to get too high. It is the Endgame.

[Quick sidebar: If (when) the US goes into recession, have you thought about what the result will be? A recession of course means lower GDP, which will mean higher unemployment. That will increase costs due to increased unemployment and other government aid, and of course lower revenues as tax receipts (revenues) go down. Given the projections and path we are currently on, that means even higher deficits than we have now. If Obama has his plan enacted, and if we go into a recession, we will see record-level deficits. Certainly over $1.5 trillion, and depending on the level of the recession, we could scare $2 trillion. Think the Tea Party will like that? Governments have less control than they think over these things. Ask Greece or any other country in a debt crisis how well they predicted their budgets.]

The Greeks were off by over 25%. And they are being asked to further cut their deficit by 4% or so every year for the next 3-4 years. That guarantees a full-blown depression. And it also means lower revenues and higher deficits, even at the reduced budget levels, which means they get further away from their goal, no matter how fast they run. They are now in a debt death spiral. There is no way out, short of Europe simply bailing them out for nothing, which is not likely.

Europe is going to deal with this Greek crisis. The problem is that this is the beginning of a string of crises and not the end. They do not appear, at least in public, to want to deal with the systemic problem of too much debt in all the peripheral countries.

Without ECB support, the interest rates that Italy and Spain would be paying would not be sustainable. I can see a path for Italy (not a pretty one, but a path nonetheless) but Spain is more difficult, given the weakness of its banks and massive private debt. These are economies that matter.

How do they get out of this without a debt crisis on the scale of 2008? By coming to grips with the problem. Germany is apparently doing that this weekend, by preparing to use the money it was going to pour into Greece to shore up its own banks. That is a much better plan. But as a well-researched report (by Stephane Deo, Paul Donovan, and Larry Hathaway in the London office – kudos, guys!) from UBS shows, solving the problem will be very costly. The next few paragraphs are from their introduction.

Euro Break-Up – The Consequences

“The Euro should not exist (like this)

“Under the current structure and with the current membership, the Euro does not work. Either the current structure will have to change, or the current membership will have to change.

“Fiscal confederation, not break-up

“Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries cannot be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such a move.

“The economic cost (part 1)

“The cost of a weak country leaving the Euro is significant. Consequences include sovereign default, corporate default, collapse of the banking system and collapse of international trade. There is little prospect of devaluation offering much assistance. We estimate that a weak Euro country leaving the Euro would incur a cost of around €9,500 to €11,500 per person in the exiting country during the first year. That cost would then probably amount to €3,000 to €4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.

“The economic cost (part 2)

“Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalization of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around €6,000 to €8,000 for every German adult and child in the first year, and a range of €3,500 to €4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over €1,000 per person, in a single hit.

“The political cost

“The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s ‘soft power’ influence internationally would cease (as the concept of ‘Europe’ as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.”

Welcome to the Hotel California

Welcome to the Hotel California
Such a lovely place
Such a lovely face
They livin’ it up at the Hotel California
What a nice surprise, bring your alibis
Last thing I remember, I was running for the door
I had to find the passage back to the place I was before
“Relax,” said the night man, “We are programmed to receive.
You can check out any time you like, but you can never leave!”

- The Eagles, 1977

You can disagree with the UBS analysis in various particulars, but what it shows is that there is no free lunch. It is not a matter of pain or no pain, but of how much pain and how is it shared. And to make it more difficult, breaking up may cost more than to stay and suffer, for both weak and strong countries. There are no easy choices, no simple answers. Like the Hotel California, you can check in but you can’t leave! There are simply no provisions for doing so, or even for expelling a member.

The costs of leaving for Greece would be horrendous. But then so are the costs of staying. Choose wisely. Quoting again from the UBS report:

“… the only way for a country to leave the EMU in a legal manner is to negotiate an amendment of the treaty that creates an opt-out clause. Having negotiated the right to exit, the Member State could then, and only then, exercise its newly granted right. While this superficially seems a viable exit process, there are in fact some major obstacles.

“Negotiating an exit is likely to take an extended period of time. Bear in mind the exiting country is not negotiating with the Euro area, but with the entire European Union. All of the legislation and treaties governing the Euro are European Union treaties (and, indeed, form the constitution of the European Union). Several of the 27 countries that make up the European Union require referenda to be held on treaty changes, and several others may choose to hold a referendum. While enduring the protracted process of negotiation, which may be vetoed by any single government or electorate, the potential secessionist will experience most or all of the problems we highlight in the next section (bank runs, sovereign default, corporate default, and what may be euphemistically termed ‘civil unrest’).”

Leaving abruptly would result in a lengthy bank holiday and massive lawsuits and require the willingness to simply thumb your nose in the face of any European court, as contracts of all sorts would have to be voided. The Greek government would have to “conveniently” pass a law that would require all Greek businesses to pay back euro contracts in the “new drachma,” giving cover to their businesses, who simply could not find the euros to repay. But then, what about business going forward?

Medical supplies? Food? – the basics? You have to find hard currencies for what you don’t produce in the country. Greece is not energy self-sufficient, importing more than 70% of its energy needs. They have a massive trade deficit, which would almost disappear, as who outside of Greece would want the “new drachma?” Banking? Parts for boats and business equipment? The list goes on and on. Commerce would slump dramatically, transportation would suffer, and unemployment would skyrocket.

If Germany were to leave, its export-driven economy would be hit very hard. It is likely that the “new mark” would appreciate in value, much like the Swiss Franc, making exports from Germany even more costly. Not to mention potential trade barriers and the serious (and probably lengthy) recession that many of their export and remaining Eurozone trade partners would be thrown into. And German banks, which have loaned money in euros, would have depreciating assets and would need massive government support. (Just as they do now!)

Can a crisis be avoided? Yes. But that does not mean there will be no pain. We can avoid a debt debacle in the US, but doing so will mean reducing debt every year for 5-6 years in the teeth of a slow-growth economy and high unemployment. It will require enormous political will and mean many people will be unemployed longer and companies will be lost.

Ray Dalio and his brilliant economics team at Bridgewater have done a series of reports on a plan for Europe. Basically, it involves deciding which institutions must be saved (and at what cost) and letting the rest simply go their own way. If they are bankrupt, then so be it. Use the capital of Europe to save the important institutions (not shareholders or bondholders). Will they do it? Maybe.

The extraordinarily insightful and brilliant John Hussman recently wrote on a similar theme. He is a must-read for me. Quoting:

“The global economy is at a crossroad that demands a decision – whom will our leaders defend? One choice is to defend bondholders – existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

“The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties – but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.

“In game theory, there is a concept known as ‘Nash equilibrium’ (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, ‘I drive on the right / you drive on the right’ is a Nash equilibrium, and so is ‘I drive on the left / you drive on the left.’ Other choices are fatal.

“Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.

“We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring. While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about ‘global financial meltdown.’ But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.”

See (http://hussmanfunds.com/wmc/wmc110905.htm for the rest of the article.)

You think the world’s central banks and main institutions are not worried? They are pulling back from bank debt in Europe, as are US money-market funds. (Note: I would check and see what your money-market funds are holding – how much European bank debt and to whom? While they are reportedly reducing their exposure, there is some $1.2 trillion still in euro-area institutions that have PIIGS exposure.)

Look at the following graph from the St. Louis Fed. It is the amount of deposits at the US Fed from foreign official and international accounts, at rates that are next to nothing. It is higher now than in 2008. What do they know that you don’t?

The Slow March to Recession in the US

Until there is a real crisis in Europe, the US will continue on its path of slower growth. Economists who base their projections on past history will not see this coming. Analysts who base their earnings estimates on recent performance are going to miss it (again.) Note: analysts, as I have written numerous times in this letter, are so very, very bad as a group at predicting future earnings that I am amazed people pay attention to them; but they seemingly do. They consistently miss tops and bottoms. That is the one thing they are very good at.

John Hussman, in the same report, offers the chart below, which is a variant on themes I have highlighted in past issues, but with his own personal twist. It is a combination of four Fed indices and four ISM reports. And it has been reliable as a predictor of recessions – one of which it strongly suggests we are either in or heading into.

And recent revisions to economic data suggest that companies are going to have even more trouble making those powerhouse earnings that are being estimated. As Albert Edwards of Societe Generale reports this week:

“… at the start of 2011, productivity trends took a remarkable turn for the worse – especially compared to what was initially reported. An initial estimate that Q1 productivity grew by 1.8% was transformed to show a decline of 0.6%. A slight 0.7% rise in Q1 ULC (unit labor costs) was transformed to show a staggering surge of 4.8%! In addition to that 4.8% rise, ULC rose a further 2.2% in Q2. But the news gets even worse Last week the BLS revised the ULC rise in Q2 up from 2.2% to 3.3% QoQ. US non-farm business unit labor costs are now rising by 2% yoy. That is very bad news for profits. Bad news for equities. And because the pace of ULC is a key driver of inflation (upwards in this instance), it is bad news for an increasingly criticized and divided Fed.”

Preparing for a Credit Crisis

There is so much that could push us into another 2008 Lehman-type credit crisis. As I say, it is not a given, but the possibility should be on your radar screen. Lehman may have been the straw that broke the camel’s back, but there were a lot of other problems. Prior to 2008, we had seen several large companies in the financial world simply disappear. REFCO comes to mind. Not a whimper in the markets. But Lehman was one of a dozen problems all over the world resulting from the larger subprime crisis. Howard Marks of Oaktree writes about simultaneous problems in the markets and what happens:

“Markets usually do a pretty good job of coping with problems one at a time. When one arises, analysts analyze and investors reach conclusions and calmly adjust their portfolios. But when there’s a confluence of negative events, the markets can become overwhelmed and lose their cool. Things that might be tolerable individually combine into an unfathomable mess whose extent and ramifications seem beyond analysis. Market crises are chaotic, not orderly, and the multiplicity and simultaneity of contributing causes play a big part in making them so.”

I did an interview with good friends David Galland and Doug Casey of Casey Research yesterday. They are decidedly more bearish than I am, so wanted an “optimist” to sit on their panel. But they forced me to admit that some of my optimism depends on the probability of US political leaders doing the right thing. Depending on your opinion about that, you are more or less prone to think there is a crisis in our future. And while I like to think it is not me showing a home-town bias, I think Europe has worse problems and a tougher situation than the US. A crisis there is more likely, I think.

But whether you want to make it 50-50 to 70-30 or (pick a number), there is a reasonable prospect of another credit crisis. So what should you do?

First, think back to 2008. Were you liquid enough? Did you have enough cash? If not, then think about raising that cash now. When the crisis hits, you have to sell what you can for what you can get, not what you want for reasonable prices.

I am personally raising more cash in my business. I usually invest money as soon as I can. Now, I am still investing, and you too should still put money to work in places that you think have the potential to do well in a crisis. Go back and see what worked in 2008 and buy more of it! Long-only funds did not work. Those that were more nimble did.

In the next crisis, opportunities to buy assets on the cheap will grow, so having some cash will make it easier to buy things you want to own for the next 10-20 years, whether income-producing or just something you want for fun.

Think through your portfolio. In 2008 I watched investors liquidate solid funds, or sell off assets at fire-sale prices, because that was the only way they could raise cash, when that was the time to invest more, not redeem. Make sure you are the “strong hand.”

Understand, I am not saying sell your conviction stocks. I have some and am buying more. But no index funds, no long-only, unhedged funds. I make very specific choices when it comes to long-only investments that I am looking to hold over and beyond a ten-year horizon. And those are risks I want to take (at least today).

I do not want to own anything that looks like an index fund or long-only mutual fund. Think 2008. I want funds and managers that have an edge and have a hedge, preferably both.

I would not be long money-center bank stocks or bonds, not in the US and especially not in Europe. I have had private off-the-record conversations with Republican leaders. There is simply no willingness to do another TARP-like bailout of bondholders and shareholders. I believe them. As Hussman suggested, this time bondholders will lose. I just don’t know which ones will be ready, and there are lots of other places to deploy assets. If you feel you have some special insight, then be my guest; but I just see too much risk for the potential reward, especially in large bank bonds that pay so little. That is not to say they are all equally bad – certainly not the regionals with less exposure to Europe. But do your homework.

(Caveat: I do think even the GOP leaders will have to cave in and allow the government to be “debtor-in-possession” of the too-big-to-fail banks we allowed to exist under the really bad financial bill called Dodd-Frank, which needs to be repealed and replaced. We have to preserve the system, but not shareholders and bondholders, who will lose this time.)

Think through your business. Banking relationships are not what they used to be. Spend time now getting commitments. Remember the odd spike in 2008 in bank lending? It was from credit lines being drawn down. But no one got new lines at the time. What can you do if sales get tough? What can you do to increase market share when your competitors start to pull back? The winners in 2008-09 were the companies that increased innovation and did not pull back (according to a Boston Consulting Group survey).

If you plan correctly, the next crisis will be an opportunity for you and not a personal crisis. And you will be better able to help those who need it.

A special note. In a few weeks I will be sending out an email that will contain a link to a totally free treasure trove of business and marketing ideas you can use to keep your business at the cutting edge, whether you are established are just starting out. It is one of those things I can do that costs me very little, but that sometime may mean a lot to you. I am just glad to be in the position to help a little.

I know I sound rather stark at times, but I really don’t want you to dig a hole and get in and cover yourself up. I do not. While we are perhaps somewhat more cautious, we are also looking for ways to grow and be more aggressive here at my business. I will keep repeating: look for the opportunities. They are there. Just gauge your risk appropriately.

What Can You Do About the Weather?

The answer is, not very much, but you can prepare. I have arranged for my readers to get the latest copy of the Browning Newsletter, written by Evelyn Browning Gariss, who I think of as one of the world’s greatest climatologists. Her letter is a monthly must-read for me, and it is a steal at $250 a year. You need to read it for a few months to get the feel for it, as you may find it full of new terms, but you’ll soon get the hang of it. There are in fact patterns. And this winter we are sadly being set up for what may be a repeat of last year’s weather in the Southern Hemisphere, and rain at the wrong time in the US, during harvest. You can read the latest issue at my website, http://www.johnmauldin.com/frontlinethoughts/browning-newsletter-0911. (You will need to type in your email address to get it.)

Europe, Houston, New York, and South Africa

I leave in a few weeks for a whirlwind trip to Europe (London, Malta, Dublin, and Geneva) and then back. A quick trip to Houston for a conference (https://www.webinstinct.com/streettalkadvisors/) and then I fly to New York for the weekend, where I will be speaking at the Singularity Summit, which is October 15-16. This is an outstanding conference, and I am honored to be asked to speak. It is really a bunch of wild-eyed futurists (like your humble analyst) getting together to think about what the future holds for us. For two days I get to be an optimist, if only in the longer term! Ray Kurzweil is the guiding light, and he has assembled an all-star cast. You can learn more at www.singularitysummit.com/. For those who can make it, I think you will come back amazed and more positive about the future of our world. And you can see videos of previous conference presentations at their website – well worth an evening or two or three, and the price is right. But if you can make the conference, you will enjoy the experience and meet new friends. And then I’ll fly to South Africa for two nights, and head back home.

It is good to have Tiffani back in Dallas and home and in the office. She has been in Europe for most of the summer, staying with friends and working from there. Even with Skype, it’s just not the same. And she did bring the granddaughter back with her! And one of the twins and her husband have moved back to Dallas, so 6 of 7 are now local. The other is coming soon, I hope! Dad likes to have his kids near.

It has been a very hectic week. Can I get busier? And computer issues have been a plague. To deal with it, we purchased two new HP laptops, and one will now be a mirror, so I will not go down if my computer fails. It is just too cheap not to do it, and lost time is frustrating and costly. I am amazed at what you can get for $1250: 8 gigs of RAM, a terabyte of memory – more power than I can use – cool 17-inch screens, a fingerprint reader camera, and I think there is even a grill attachment somewhere.

And speaking of grills, we did get a new one for Labor Day. About 30 people were here, and I spent most of the day cooking. It was time for fun and family and friends. I need more times like that to remind me of the real values in life, and why we will get through all this hassle. The future was in my home, and what a future it will be! My plan is to hang around a long time to see them enjoy it.

This Sunday Rich Yamarone (of Bloomberg) will be here to brave a family brunch gathering. Then Barry Habib shows up on Wednesday for a day-long planning session on a new venture, ending with a great meal somewhere. (This food theme keeps recurring!) Have a great week. And find some great food of your own! Enjoy life’s pleasures!

Your actually losing weight in spite of the great food analyst,

John Mauldin

John@FrontlineThoughts.com

The End of the World, Part 1

John Mauldin — Sat, 27 Aug 2011 15:17:00 GMT

What Is the CBO Seeing (or Smoking?)
The End of the World, Part 1
Who Will Rescue the Rescuers?
The Problems of Debt in the Eurozone
Thoughts on Jackson Hole
Some Thoughts on Getting Older

Fine, then. Uh oh, overflow, population, common food, but it'll do to

Save yourself, serve yourself. World serves its own needs,
listen to your heart bleed – dummy with the rapture and
the revered and the right, right. You vitriolic, patriotic, slam,

fight, bright light, feeling pretty psyched.
It's the end of the world as we know it.
It's the end of the world as we know it.
It's the end of the world as we know it and I feel fine.

R.E.M. song from 1987

It’s not really the end of the world, but to read some of the analysis and data over the past week, it’s hard not to wonder if it’s not the beginning of the Endgame at the very least. There is more to cover than I can really do justice to, but we will just start. We HAVE to look at the US data first (briefly) and then on to Europe, where it will may be the end of the euro experiment, depending on two voting populations. Can you spell “Banking Crisis,” gentle reader? A nod to Bernanke’s finger-pointing speech, some links on the scourge of high-frequency trading, and we end on a positive note about the Boomer generation growing older. And, I answer the question that is burning in your brain: “How many years of US corn production will China’s dollar reserves buy?” Write your answer down now. This letter may print out longer than usual, as there are plenty of charts. Let’s skip the “but firsts” and jump right in.

What Is the CBO Seeing (or Smoking?)

Last week I finally stopped being wishy-washy (with my 50-50% chance of a recession call) and said the US would be in recession within 12 months. And suggested that you consider moving to the sidelines your longer-term equity investments, except your conviction stocks. (I have some of those in the biotech space and simply intend to buy more if the prices go down. But remember, I am looking out ten years and expect an eventual bubble, so I don’t care if I am early for some of my high-risk money.) Stocks typically go down about 40% or more in a recession. David Rosenberg estimates that we have seen 27% of a typical bear-market move, so that would suggest the possibility of another 30% downdraft (give or take).

None of the data this week makes we want to change my opinion on recession. Rich Yamarone (Bloomberg Chief Economist) and I traded emails as we got new data this morning, comparing notes. He does better charts than I do, so we will use his. (I hear, by the way, that he is being addressed as Lord Vader in the halls of Bloomberg. Come to think of it, his voice is rather raspy.)

As he points out, when GDP year-over-year drops by more than 2%, we have always had a recession. So with today’s second-quarter revision (first revision of many) down to just 1% (technically 0.99%, but we are among friends here), where are we? At 1.5% year-over-year. Here is the chart:

The normally bullish staff at economy.com gave us this rather dismal paragraph tonight as a summary to the week:

“The last week of the summer brings a rare Northeast hurricane and a heavy load of data that will show the economy running close to stall speed. Second quarter GDP was revised down to 1%, and the slight improvement in growth we expect for this quarter assumes no new financial shocks. Upcoming indicators for August will bear the mark of steep declines in stock prices. The employment report will be the headliner; nonfarm payrolls are expected to rise just 30,000, and the unemployment rate likely will tick up 0.1 percentage point to 9.3%. We think the ISM manufacturing survey dipped into contraction territory for the first time in two years, and auto sales and consumer confidence likely also fell during the month. There will also be significant interest in the minutes of the August Federal Open Market Committee meeting, especially given Chairman Ben Bernanke's omission of details regarding policy easing options in his Jackson Hole speech.”

Ugh. More on the Bernank later.

The Michigan Consumer Sentiment number was just awful. It dropped 8 full points (which is huge for this index) to 55.7. The index has fallen nearly 20 points in three months. In the chart below, note the close previous correlation between sentiment and GDP. Which do you think is more likely to happen: sentiment to rise or GDP to fall?

Unemployment claims are back up over 400,000, to 417,000. If the employment gain is really just 30,000, that bodes poorly for any recovery. So, exactly how does that square with the recent Congressional Budget Office (CBO) projections? Quoting:

“CBO expects that the recovery will continue but that real (inflation-adjusted) GDP will stay well below the economy’s potential—a level that corresponds to a high rate of use of labor and capital—for several years. On the basis of economic data available through early July, when the agency initially completed its economic forecast, CBO projects that real GDP will increase by 2.3 percent this year and by 2.7 percent next year. Under current law, federal tax and spending policies will impose substantial restraint on the economy in 2013, so CBO projects that economic growth will slow that year before picking up again, averaging 3.6 percent per year from 2013 through 2016.”

Let me work you through the numbers. We grew at less than a total of 1.4% for the first six months of 2011. To get to 2.3% as an average for the year, we would need to grow by (back of the napkin) 3.2% for the last half of the year. We could reduce the deficit by a lot if we could sell what these guys are smoking to engender such optimism. I think demand would be strong, especially on Wall Street. (Note: these are the same people that told us in 2000 that all government debt would be gone by 2010. Just saying.)

Their projections are likely based on assumptions about recoveries from past recessions. But since 1945, all recessions have been business-cycle recessions. We are now in a deleveraging/balance-sheet/post-credit-crisis recession for which we have no modern analogs, except maybe Japan. And that hasn’t turned out too well, as in, two decades of going nowhere. Yet we are applying the same methodology (massive debt and deficits along with zero interest rates) that did not work there, and will soon bring Japan to ruin.

We have a fundamentally different economic scenario than at any time for the last 66 years. Why then should we expect the same outcome? EVERY indicator (employment, GDP, ISM, sentiment, etc.) is far below its average result two years after the official end of a recession. That should speak volumes.

So why does what the CBO says mean anything? Because Congress is making projections for future deficits, based on what appear to be wildly optimistic assumptions. That means future deficits are likely to be worse than expected. If we enter recession, as I expect, then revenues will be down (as unemployment will be up and profits down) and expenses will go up. That de minimis deficit reduction currently being negotiated by the “Gang of 12” will disappear in a cloud of smoke and maze of mirrors. This will mean that more pain in the terms of future spending cuts and/or tax increases will be needed. (I know a fair number of congressional staffers read this letter. Please pay attention here – your bosses need to be given a“heads up.”)

If we are in for a slow-growth, Muddle Through decade, then the deficit projections by CBO are dismally off. Get the spreadsheets. Factor in slower growth and higher unemployment and two recessions by the end of the decade (typical for the aftermath of a banking/debt crisis), and see what those deficit projections look like.

Given the large amount of data coming next week, as the month ends, I will stop here and get back to the US next week.

The End of the World, Part 1

In trying to decipher Europe it is hard to know where to start, but let’s begin with some assumptions:

For the euro to survive, one of two things must happen. Either the Germans (and the Dutch and Finns and French) decide to back the concept of some sort of eurobond financing of the balance sheets of the peripheral countries, OR there need to be massive write-downs of insolvent-country debt and the various countries need to backstop their banks, because bank losses will be massive.

The former needs buy-in from German voters. Polls show Germans are against the idea of eurobonds by something like 5-1 (75% against, 15% for). (More on Germany below.) The latter option assumes the peripheral countries will lose access to the private bond markets, thus forcing sudden and enormous austerity (read Depression levels or worse). Will they simply throw in the towel and leave the euro on their own, remaining in the free-trade zone but with their own currencies, much as Denmark, the Czech Republic, or Sweden are now? Or opt to suffer and remain in the euro?

Germany could decide not to back the peripheral country debt, and leave the Eurozone. But this would be painful for Germans. If you think the Swiss franc trade is crowded (and way overvalued) because people are looking for a safe haven, what would a new Deutschmark look like to investors? Switzerland is a country (and one of my favorite in the world, so no slight intended – I will be in Geneva for my birthday in October) of just over 7 million people, only somewhat larger than the population of the greater Dallas-Fort Worth, Texas area where I live (although with much better weather!).

Germany, on the other hand, is the world’s 4th largest country by GDP, with a population of over 82 million. It is well-run and respected. The new mark would climb to far higher levels against the remaining euro countries and other currencies, which for an export-driven nation would not be very helpful. Mercedes and BMWs cost a lot now (and don’t forget tool parts and other things Germany excels in making). Double the value of your currency in a short time? Watch your market share drop. Painful is perhaps an inadequate word.

So, what to make of the remarks this week by respected German leaders? Let’s fire up a few quotes here (http://www.telegraph.co.uk/finance/financialcrisis/8720792/Germany-fires-cannon-shot-across-Europes-bows.html):

“German President Christian Wulff has accused the European Central Bank of violating its treaty mandate with the mass purchase of southern European bonds. In a cannon shot across Europe’s bows, he warned that Germany is reaching bailout exhaustion and cannot allow its own democracy to be undermined by EU mayhem.

“ ‘I regard the huge buy-up of bonds of individual states by the ECB as legally and politically questionable. Article 123 of the Treaty on the EU’s workings prohibits the ECB from directly purchasing debt instruments, in order to safeguard the central bank’s independence,’ he said. ‘This prohibition only makes sense if those responsible do not get around it by making substantial purchases on the secondary market,’he said, speaking at a forum of half the world’s Nobel economists on Lake Constance to review the errors of the profession over recent years.

“Mr Wulff said the ECB had gone ‘way beyond the bounds of their mandate’ by purchasing €110bn (£96.6bn) of bonds, echoing widespread concerns in Germany that ECB intervention in the Italian and Spanish bond markets this month mark a dangerous escalation.’” (London Telegraph)

Who Will Rescue the Rescuers?

From the same article: “The blistering attack follows equally harsh words by the Bundesbank in its monthly report. The bank slammed the ECB’s bond purchases and also warned that the EU’s broader bail-out machinery violates EU treaties and lacks ‘democratic legitimacy’. The combined attacks come just two weeks before the German constitutional court rules on the legality of the various bailout policies. The verdict is expected on September 7.”

Yet“Nobel laureate Joe Stiglitz told the forum that the euro is likely to fall apart unless Germany accepts some form of fiscal union. ‘More austerity for Greece and Spain is not the answer. Medieval blood-letting will kill the patient, and democracies won’t put up with this kind of medicine.’ ”

His solution? Germany will either have massive banking losses (see below) or assume some debt. Why give up the dream of a united Europe over a few trillion and your credit rating? Yet (Ambrose Evans-Pritchard writing in the Telegraph):

“Marc Ostwald from Monument Securities said Germany is drifting towards a major constitutional crisis. ‘This has all the makings of the revolt that unseated Helmut Schmidt [in 1982], and indeed has political echoes of the inefficacy of the Weimar regime,’ he said.

“Mr. Wulff said Germany’s public debt has reached 83pc of GDP and asked who will ‘rescue the rescuers?’ as the dominoes keep falling. ‘We Germans mustn’t allow an inflated sense of the strength of the rescuers to take hold,’ he said.

“ ‘Solidarity is the core of the European Idea, but it is a misunderstanding to measure solidarity in terms of willingness to act as guarantor or to incur shared debts. With whom would you be willing to take out a joint loan, or stand as guarantor? For your own children? Hopefully yes. For more distant relations it gets a bit more difficult,’ he said.”

The final option is for the peripheral nations to eschew austerity and leave the Eurozone, launching their own currencies again. This would mean long and painful bank holidays and massive losses for European banks and local citizens, depending on how many countries left. And the lawsuits would last for decades – nothing short of a full-employment act for lawyers all over the world.

And Merkel was not helped by her own Labor Minister, Dr. Ursula von der Leyen. Rather than simply hand over further loans to Athens – money many Germans believe they will never see again– Dr. von der Leyen suggests Berlin should ask for collateral. Gold, preferably. From the Irish Times:

“One month after euro zone leaders agreed a bailout reform package, and a month before the package goes to vote before national parliaments, a senior German minister appeared to be calling for a renegotiation.

“On an aircraft back from Belgrade, a thin-lipped chancellor Angela Merkel reportedly told advisers: ‘I’m going to have to have a word with Ursula.’

“Even before she landed, German officials were in full damage limitation mode, working the phones and issuing statements denying the minister spoke for the government. ‘This is sub-optimal,’groaned a senior government source. ‘No one is amused.’ ”

Some back-bench minister? Hardly. Dr. von der Leyen, a 52-year-old mother of seven, is one of Dr. Merkel’s most ambitious ministers and one of two names regularly mentioned as a possible successor.

But she only reflected a rather contentious Bundestag meeting this week, in which one after another representative voiced opposition, invariably noting that the voters disapproved.

Of course, none of this is helped by Finland negotiating a side collateral deal as part of their conditions for approving their portion of the next loan to Greece. And a chorus of countries have jumped on that wagon. How do you explain to YOUR voters that the Finns got actual in-the-bank collateral and you got nothing but Greek promises? But if everyone gets collateral, the whole deal will fall apart. What’s the point if you give back a large chunk of your loan? It just means you need even more!

The Problems of Debt in the Eurozone

Let’s look at some charts. This first one is the amount of principal debt in terms of GDP from July 2011 to July 2012 (plus budget deficits, in red) needed by ten European countries. Note that France and Italy are well over 20%! Source: Peterson Institute of International Economics (hat tip, Simon Hunt!)

“From the same report this chart illustrates how Germany could become the banker for the Euro Zone. The question is will it? The question will be more clearly defined in September when Germany’s Constitutional Court will rule on the legal complaints against the Euro Zone rescue packages. If the comments being made by the Bundesbank and by the country’s President are a hint as to the outcome of the court then a negative ruling is a real risk. Who then will take the losses?” (Simon Hunt)

Note in the chart that Germany holds the largest percentage of net debt.

Claims of Euro Area members from netting of Euro System cross-border payments (in billions of Euros):

And then there are the interest-rate issues. Rates were rising rapidly in Spain and Italy until the ECB stepped in. Everyone knows Greece, Ireland, and Portugal are on life support and cannot get debt on their own. The ECB inserted an IV into Spain and Italy and started them on a slow drip. The real question of the moment is, can they get off that support and stand in the markets on their own? The answer a few weeks ago was starting to look like “No.”

And look at the massive growth in ECB lending to Italian banks, which are getting shut out of the “normal” market. It has literally more than doubled in a few months:

Credit spreads at French banks are blowing out. Review how much France has to borrow in the next 12 months, in the first chart. Then look at their deficit-to-GDP (above 10%, according to Charles Gave) and realize that there is no reason why S&P should not downgrade them as well. How do they cut spending? Taxes are already at 50% of GDP. Wealthy French have voted with their feet by moving away.

The list of country woes is long in Europe. Massive unemployment in Spain and Portugal. Deficits everywhere. Voting populations in both creditor and debtor nations are upset.

It is only a matter of time until Europe has a true crisis, which will happen faster – BANG! –than any of us can now imagine. Think Lehman on steroids. The US gave Europe our subprime woes. Europe gets to repay the favor with an even more severe banking crisis that, given that the US is at best at stall speed, will tip us into a long and serious recession. Stay tuned.

Thoughts on Jackson Hole

Jackson Hole often provides fireworks and significant speeches. Bernanke came up with neither this week, which I think is a good thing. But he did forcefully point out that the Fed has done about all it can do and that the forces of civil government need to step up to the plate with credible actions. It was as close to finger pointing as a Fed Chairman can do, and parts of the speech actually sounded as if he was trying to channel his inner Richard Fisher (Dallas Fed President). Basically, he said the Fed has done what it can with as easy a monetary policy as is possible and prudent. Quoting from Joan McCullough’s remarks on the speech:

“Yeah, the Fed underestimated the severity of our ills and so this recovery is gonna take longer than expected. But underneath it all, the US still has the capability of generating growth. Here are the precise words with which he threw responsibility back at Congress and the Administration; he starts out kind of slow:

“ ‘… Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if – and I stress if – our country takes the necessary steps to secure that outcome.’

“Just in case they didn’t understand that they had just been handed the baton, he continued with this:

“ ‘… most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”

“With this closing castigation cum zing:

“ ‘… Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.’ ”

As I said, for a Federal Reserve Chairman, that is as close to reading the riot act as you are going to get.

Some Thoughts on Getting Older

I turn 62 on October 4 while in Geneva. I don’t feel that old, and hope I don’t look it, but the birth certificate verifies the age. I should note that my mother turned 94 last week and is still quite active. I was talking with a Rice University classmate (of ’72) and old friend, John Benzon, who has recently retired from Price Waterhouse and is trying to figure out what “Act 2” will be. I realized that when we graduated, we had barely lived 1/3 of the lives we now have.

So with that on my mind, two items hit my inbox today. The first was from Lance Roberts of Streettalk Advisors. The San Francisco Fed did a report recently that suggested that we aging Boomers will be a drag on the stock market as we sell to support our retirement (shades of Harry Dent!). From the report:

“The baby boom generation born between 1946 and 1964 has had a large impact on the U.S. economy and will continue to do so as baby boomers gradually phase from work into retirement over the next two decades. To finance retirement, they are likely to sell off acquired assets, especially risky equities. A looming concern is that this massive sell-off might depress equity values.”

You can read his short piece and the link to the Fed piece at http://www.streettalklive.com/financial-blog/253-boomers-are-going-to-be-a-real-drag.html.

I am not so sure, though. I think the Boomer generation is a little different from previous generations. I remember going to my grandmother’s in my early years, when my aunts and uncles were the age I am now. Even though active – and most lived well into their 90s – they had a far more sedentary lifestyle than many Boomers do today. Boomers are more active and, whether for financial reasons or simply because they don’t want to retire (that would be me!), they are going to work longer than previous generations. In fact, the only cohort that has seen their employment rates rise is workers over the age of 55! Good for them (although tough on my young kids, who need those jobs).

Then I got this picture from Jon Sundt, the president of Altegris, a close friend, and my business partner. He is 50, at the tail end of the Boomer Generation. This is a wave he caught at the Mentawai Island Chain, 80 miles off the coast of Sumatra, Indonesia. He goes there every summer. They go into the middle of the Indian Ocean to find these large waves. And it is mostly Boomer surfers. (I’m not sure how much I like the guy who’s responsible for a large part of my monthly cash flow taking these risks, but that’s another story!)

Go to a gym or running trail: it is not just kids out there any more. There are lots of people my age where I work out. Some of the trainers are over 50! We all have friends who are pushing the envelope – climbing mountains, biking, etc.

And the new biotech that will come out within the next five years is going to offer cures for many of the things that kill us sooner than we simply wear out. Cancer, Alzheimer’s, sclerosis of the liver, viruses are all on the short target list. I was talking about this with Scott Burns, noted author and long-time newspaper columnist (and a long-time friend). He calls it “catastrophic success”in his next book, as living longer is a “success,” but it makes our collective pension, Social Security, and Medicare problems even worse. Maybe MUCH worse. I smiled and told him there are worse problems than living longer. I intend to be writing and traveling for a few more decades.

And as my Dad used to say (he made it to 86), “God willing and the creek don’t rise” I intend to do 62 pushups on October 4^th, which will be a personal best. I can’t do much about getting older (I will be very disappointed if I do not get a whole lot older!), but I don’t have to go quietly into that dark night. And neither do you, gentle reader. So, make sure you are around to read my musings a whole lot longer, as well. If you hang around long enough, you will even see me turn bullish! It won’t be that long, I promise. It will seem like just a few weeks from now.

And while I was having lunch with Scott, he asked me the question, “How many years of US corn production would the dollar reserves of China buy?” I mused, maybe 40. Wrong. It is only 12. And that is just corn. Not soybeans, wheat or rice or cattle, hogs or chickens. Think about that and stand back in awe at the productivity of the American farmer.

It is time to hit the send button. I stupidly forgot to save this letter and had an unexpected “hard” crash. I thought I lost almost the entire e-letter; but checking the Web, I found a back door to the temporary files where most of it was still store, so only lost a few hours re-creating it – but now it is late, 2 am). That means this letter might not be there Saturday morning, and for that I apologize. Have a great week!

Your looking forward to the next third of this life analyst,

John Mauldin

John@FrontlineThoughts.com

Time to Get Outraged

John Mauldin — Sat, 11 Jun 2011 09:52:33 GMT

Is It Time to Buy a House?
Time to Get Outraged by the Banks
We Need a Mulligan
A Congressional Investigation Is Needed
How We Get Out of This
20 Policies to Implement to Create Jobs
Tuscany, Kiev, Geneva, and London

This week we look at data from the Bank of International Settlements, by which (if someone does a lot of work) you can figure out how much US banks have written in credit default swaps to banks in Europe on Greek, Irish, and Portuguese debt. The details should not make you happy. I meditate on whether one should buy a house now, and then discuss “the way out” of all this mess and why we will Muddle Through. Oh, and I’ll ask you for help on yet another book project, on creating jobs. And all while trying to finish early enough to go to dinner. So let’s get started.

Is It Time to Buy a House?

The answer to that question is not simple, but let’s start with my own personal experience. I bought a home in the early ’80s in Arlington, Texas for what we thought was a fair price; but the mortgage was back-loaded, so I was not buying back much equity, just paying a lot of interest. But we had a growing family and the need for space, so we made the move. I must confess I was not the savviest loan customer 30 years ago. I am now aghast.

About eight years later we had the savings and loan crisis in Texas. Real estate became cheap, in some cases real cheap. Our family was growing again and we needed more room. One home we looked at was large and on a golf course. It had also been abandoned for a year and had some damage. The RTC (Resolution Trust Corporation) owned it (the government agency that took all the debt from the failed savings and loans). At one point, it was appraised for $810,000. The loan was (I think) about $690,000.

I had been watching friends buy apartments and loan portfolios from the RTC for a dime on the dollar. True story. The RTC would set out piles of manila folders of loans on a table. You could look the folders and then bid on them. Some of the folders had actual checks from the people who had borrowed money and were still trying to pay on cars, boats, condos, whatever. There were people who would bid the value of the actual “cash” in the folders and get the bid, as the people running the RTC were just trying to get through the mess as quickly as possible. Of course, the taxpayers made up the difference.

If you had cash, you could get apartment buildings and be on positive cash flow on day one. One friend would buy older apartments, turn them into government subsidized homes for the elderly, and get his money back within a few years. For active entrepreneurs with cash, it was a good time. If you owed money or needed money, it was very bad.

In Houston, they were auctioning off homes from the courthouse steps and people were paying for them with credit cards, they were so cheap (some 3-bedrooms went for like $6,000). The economy in Houston was imploding. The joke was,“Will the last person to leave Houston please turn out the lights?”

Anyway, we fell in love with the house in Arlington. My business had (finally!) started to do better and we could afford to “move up.” But given the real estate crash, I was still under water after eight years of making payments on my current house, by about 15% or somewhere in the mid-$20,000 range (I try to forget, as it is painful).

The home we wanted to buy was up for bid. As I said, it needed lots of work. Fire ants had eaten most of the outside wiring. There was no lawn on an almost one-acre property, as it had died the last summer from lack of water. The pool was green slime. And so on.

I put in a bid for $285,000, which was much less (maybe half) than it had cost to build, but I put down a large cash deposit with the bid and offered to take it “as is, where is.” My realtor told us we would not get it, as there were bidders who were offering as much as $50,000 more, but with some requirements. I decided to hold my ground. While this was a dream home for a country boy from a small Texas town, there were other houses going on the block regularly.

As it turned out, the next week we got a call saying the RTC had accepted the bid. When we asked why, we were told they simply did not have the time or people to oversee any “fix this”bids. Even though by a financial analysis there were better bids, it had become a matter of moving that folder off the desk, as there were roomfuls still be dealt with. And having been burned once on a mortgage, I was a lot smarter this time about interest rates and terms. (I had also been in the investment world for nine years, so had learned a few things.) About ten years later, for personal reasons, I sold the home at a nice profit, and this time had paid down the mortgage quite a bit, so I had some equity.

Since then I have leased homes or condos, and still do. I now lease because it makes sense for me, given where I am in my life. I am not sure where I’ll be in five years, or what my business will look like. The world is changing so fast. (Although I could have said that at almost any time for the last 60 years and been right.) Also, the home I lease is quite nice but would cost me about three times in monthly payments to buy it as to lease it. Does the lease price go up at renewal? Of course. But it is still a lifestyle and cash-flow decision.

Buying a home is a personal and lifestyle choice. The owners of the villa we are staying in here in Tuscany have five homes, all over the world. They buy homes that need a lot of work, make them spectacular, and then rent them out, which more or less covers their costs and return on capital; and then they stay in them when they want to. They get people to do the work, other people to pay for it, and they “live large.” Nice life.

Jeremy and Carol Leonard are friends from Canada who are here with us this weekend. He bought a home in Hawaii, where one of his businesses is. He got it for a lot less than it would cost to build, so he was not too worried about the price. He and his family now live there, and he commutes back to Edmonton from time to time for his other business (more on that later).

All that to say is that if you are in a place where you want to buy a home, now may be the right time to start thinking about it. The banks and government are simply overwhelmed with homes that have been repossessed, and it looks like there might be as many as 2 million more homes to come onto the market. Prices in many areas are going to continue to fall, and if you can get credit, mortgage rates are quite low.

If I were buying, I would want to meet agents or bankers who are in the “deal flow.” The anecdotal stories of people getting homes for what seem like very good prices, in this depressed market, are all over the internet. There are homes that are certainly below replacement costs in some areas (and not just in the US but in certain parts of Europe as well). While I think home prices should go somewhat lower, we are out of bubble territory. There are starting to be values in the housing market for savvy shoppers. Which of course is what help creates a bottom. Which I have been writing for many years should happen in 2012-13. So you can be patient, but if you want a home, put in a bid that will make you smile if you get it accepted. No rush. And there are certainly deals for people who can use a little leverage and buy rental property.

And I must admit, if there is another crisis in Europe and prices of vacation homes like the one I am staying in drop a lot? I might just jump in. I like owning stuff. But at the right price.

Time to Get Outraged by the Banks

Long-time readers know I continuously pound the table that credit default swaps need to be put on an exchange. The Frank-Dodd bill failed in so many ways to deal with the last crisis and prevent the next one, it is hard to start a list. But an analysis by economist Kash Mansori, at http://streetlightblog.blogspot.com/2011/06/betting-on-pigs.html, tears apart the mind-numbing 146-page report from the Bank of International Settlements, which is just one long set of tables and data. I spent an hour with it and almost went blind. (For data masochists, it is at http://bis.org/publ/qtrpdf/r_qa1106.pdf.)

Kash had to do a lot of work to come up with his tables, which show how much exposure Europe and the US have to Greece, Ireland, and Portugal. (He very politely answered some questions when I emailed him.) There is a lot of useful information buried in the data, showing us who is exposed to the risk of sovereign defaults in Europe. I have openly speculated that US banks were selling CDS to Europe but had no idea how much. Now we do.

From Kash’s blog:

“Observation #1. Default Insurance Matters.

“First, the BIS data very helpfully breaks exposures into two pieces: direct exposures, which basically means creditors who own bonds issued by one of the PIGs; and indirect exposures, which for the most part means agents who sold default insurance to creditors, primarily through credit default swaps. As summarized in the following table, it seems that approximately 30% of total potential exposures to debt from the PIGs are covered by default insurance (see the figures in red). Put another way, if one of the PIGs defaults, creditors who actually hold bonds from that country will absorb about 70% of the losses, while agents (primarily banks and insurance companies) that sold insurance against the possibility of default will have to cover the remaining 30%. That's not a trivial amount. (All figures below are in billions of USD, as of the end of 2010.)

“Observation #2. Direct Exposure in Europe, Indirect in the US.

“The table above also hints at striking differences between how European and US creditors would be hit in the case of default by one of the PIGs. If Greece were to default, for example, approximately 94% of the direct losses would fall on European creditors, and only 5% would fall on US creditors. However, US banks and insurance companies would have to make about 56% of the default insurance payouts triggered by such an event, while European agents would make only 43% of those payouts.
“The next table illustrates this difference even more starkly. In the case of Greece and Portugal, the vast majority of the losses that would be borne by creditors in Europe would be direct losses. In fact, French and German creditors would almost certainly be substantial net recipients of default insurance payments. (That's less clear in the case of Ireland.) Meanwhile, US financial institutions would have to make substantial net default insurance payments, which would account for between 80% and 90% of all losses borne by the US in the case of default (see the figures in red below).

“Observation #3. Similar Overall Exposures in Europe and the US.

“Finally, it's worth noting that once you account for the substantial payouts that US agents will have to make to European creditors in the case of a default by one of the PIGs, financial institutions in the US have roughly as much to lose from default as those in France and Germany. (See the figures in blue in the table above.) The apparent eagerness of US banks and insurance companies to sell default insurance to European creditors means that they will now have to substantially share in the pain inflicted by a PIG default.

“Implications

“This has some important implications. First, US and European financial institutions are likely to have very different incentives as negotiations regarding debt restructuring and reprofiling proceed. US banks and insurance companies are surely delighted with the "soft restructuring" that is currently being discussed. Such a partial default would probably not trigger default insurance payments, and so the pain would be borne almost exclusively by European institutions. On the other hand, some time soon it seems likely that European creditors will begin to prefer a "hard restructuring" that would require default insurance payouts from the US institutions that sold such insurance. Given how strikingly one-sided the net default insurance payments will be (from the US to Europe), it's easy to imagine how that could shape future negotiations over debt relief for the PIGs.

“Second, there's an interesting puzzle here. Why have European and American financial institutions behaved so differently when it comes to the PIGs? Specifically, why have American firms been so willing to sell default insurance to the Europeans, though they have not bought much PIG debt? And conversely, why have the Europeans systematically been so eager to buy insurance for their PIG debt, even at the very high price such insurance now commands? In essence, European firms have been betting that a PIG default will happen sooner rather than later, while US firms have been betting that default would happen later or not at all.”

If I read those tables correctly, that means US banks have sold some $120 billion of credit default swaps to European banks. Let’s think about that for a minute.

When, not if, Greece defaults, US banks are going to have to dip into capital to pay those commitments. Capital that should be available for loans to businesses but will have to be paid to European banks instead. Will it be a 100% Greek default, or only 50%? If it is a default, do you have to pay all or just the defaulted portion, and when?

Why, oh why, are banks putting American taxpayers at risk, as these too-big-to-fail banks certainly are? And make no mistake, if several major banks were to collapse, our government would need to step in. The largest banks are too big for the FDIC to handle. Now, shareholders would be wiped out this time and bond holders would face haircuts. No question. But why are investment banks allowed to mix the risk with their commercial banks?

We Need a Mulligan

I occasionally golf, more in past years than today. I am a very bad golfer. I would often negotiate in friendly games a few extra “mulligans” before we started. (A mulligan is where you get to replay the ball without taking a penalty stroke.) I was actually doing my playing partners a favor by moving the game along rather than trying to find lost balls in tall grass.

I and so many other people were all for repealing Glass-Steagall back in 1998. Sometimes we just need to admit that we make mistakes, and this was a big one. We need a national mulligan, a major do-over! We should reinstate Glass-Steagall and separate investment banking from commercial banking. Yes, I know that hurts profits and maybe makes banks less competitive, but I really don’t care. When our tax dollars are risked it is just wrong.

Further, I will bet you that bank chiefs will say they have hedged their risk on European debt. OK, I would like to know, with which counterparty? AIG? Is there another AIG looming out there, selling risk insurance? Who is paying attention?

A Congressional Investigation Is Needed

Frankly, all this needs to come out in the open. Who sold this stuff to whom and for how much, and is the risk hedged, and if so to whom? Why did someone think that betting $34 billion on the ability of Greece to pay its debts was a good idea? And are the Irish CDS sold for government debt or are they bank debt? Note that we have over $100 billion in exposure to Irish debt. Long-time readers know that I think the Irish will at some point tell the ECB to stuff it on the bank debts they assumed as taxpayers. Does this put at risk all Irish debt? It’s all in those contracts.

Maybe I am overreacting (it has happened in my life), but I simply find it outrageous that banks can risk so much with so little to lose if things go bad. Just as in the subprime debacle, they make their bonuses and salaries until the end, and the public picks up the risk. Dodd-Frank was a joke. It did not solve the real problems, and has so many unintended consequences. It should be torn up and we should start over. But first we reinstate Glass-Steagall. At a very minimum, we require that banks that want to sell credit default swaps separate that division from the rest of the bank and capitalize it separately. Investors who buy from them must know that the full capital of the bank does not stand behind the CDS. I don’t care if that cuts into profits. I just don’t want the private risk and profits to become public losses.

How We Get Out of This

A good friend of ours, Jeremy Leonard, has come over from Canada to visit us for a few days. He is (among other things) in the pump business, with an office in Hawaii and in Edmonton, Alberta, Canada. He just launched the Canadian branch 14 months ago. He has figured out a way to make a pump in Canada that is superior to the competition in the mining and the oil sands businesses. When we met last December he was up to ten employees. Now he is at 50 and growing. His staff in Hawaii has doubled from 5 to 10 over the last year. He has also figured out how to solve a major environmental problem in the oil sands region, and that business is growing nicely.

Over dinner tonight, we started talking about other businesses. Dr. Mike Roizen (of “You”books and Oprah fame) is coming to stay a few days next week, and he has started lots of businesses, creating over a hundred jobs. And my partners at Altegris and CMG have doubled their staffs in the last five years.

We get out of this conundrum because a million people like Jeremy figure out how to do something faster, cheaper, and better and then actually make it happen. They aren’t sitting around waiting for Greece to default first. If they are smart, they avoid doing something that will be affected by that, and they plough ahead.

And if government gets out of the way, or actually implements policies that help, the economy and employment eventually right themselves. Texas was a basket case 20 years ago. I was fortunate that my business did not depend on the local economy. I had many friends who suffered, who lost jobs and businesses. That’s part of the process. But you get back up and do what you have to do. You figure it out.

And when a nation of entrepreneurs, all working on their individual plans, get it all figured out, the economy is back on track.

In one sense, now is the best time to start a business if you can find the capital, because you can access quality help, get equipment cheaper, lower rents, etc. Challenges? Of course. That comes with the territory of starting a business, and they never end. If you decide to sit back and coast, the world will go on and swallow you up.

20 Policies to Implement to Create Jobs

Maybe I am thinking about employment because I just agreed to do a small book with Dr. Bill Dunkelberg, good friend and fishing buddy, who is also the chief economist of the National Federation of Independent Businesses. It will be on employment in the US and what the government should do to help create jobs. Bill and I have our ideas, but we are also going to “crowd source.”

We will ask our respective readers for their ideas. My bet is that we’ll get a lot better ideas than ones we come up with on our own. The plan is to have it done in time to hit the stores in January, before the political debates really heat up. Whether it will be 10 or 20 or 30 ideas, we don’t know. Not even sure of a title, but Wiley said they would publish it. It will be a fun project and is something I hope can contribute to the “cause” of growing our economy. I believe we have a bright future and want to make sure my kids have the same chances I had.

And now it is late and time to hit the send button. And when you see your congressperson, ask them to look at the credit default swaps debacle that is brewing.

Tuscany, Kiev, Geneva, and London

Tuscany is a slice of heaven. We have already booked the villa for three weeks next year. Next Thursday Trey and I leave to go to Kiev and meet with about 20 classmates from an executive course I did two years ago at Singularity University, who are flying in from all over the world. We will spend three days talking about our businesses and the future. Two years ago we spent nine days (12 hours a day) listening to the real industry leaders talk about where their tech was going, and it was totally worth it. They have another conference in October. If that type of thing interests you, you should do it. http://singularityu.org/

Then Sunday Trey and I go to Geneva, where we meet with friends and business partners, do a speech, visit CERN on Wednesday for a private tour (in exchange for a few hours of my time) and then fly on to London. On Thursday I will be a guest host on CNBC London Squawk Boxand then do a few meetings and catch a plane back to Dallas. Whew! Then I’ll be home for a while.

One of the delights of having 1,000,000 closest friends read your letter is that you get to meet them from time to time. Simone Pallessi hosted us Wednesday night at a fabulous resort 20 minutes from here, put together by one of the members of the Ferragamo family. 4,500 acres, a large winery, some of the finest villas and apartment/suites/rooms, and an unbelievable golf course, all built on a 900-year-old estate with the castle tower still standing. Simone runs the place and was a very gracious host. The Brunello they make is outstanding. www.castigliondelbosco.com.

And yesterday as I was outside writing, I saw a gentleman come up to the back gate (on the road) and ask if I was John Mauldin. I said yes. Story is that last night he was driving with his wife, saw the name Trequanda, remembered Il Conte Matto, and decided to change his plans. He later got a room and came by to say thanks for the recommendation and ask me to sign my book. Turns out he owns a car dealership in California. And since he brought wine, how could I say no? Life’s little pleasures.

Time to go now, as I have guests and had to finish this after we came back from dinner. Have a great week. I am behind on my rather ambitious plans to get things done while here, but I am enjoying life. And you should too!

Your watching time pass so quickly analyst,

John Mauldin

Muddle Through, or Crisis?

John Mauldin — Sat, 07 May 2011 16:25:00 GMT

In This Issue:

Enemy of Spain
The Endgame, Part 2
Muddle Through, or Crisis?
Philadelphia, Boston, Trequanda, Kiev, Geneva, and London

This week I finish the two-part letter on the Endgame and give you my thoughts on the economy and how it all plays out over the next five years. This is the second part of a speech I gave last week at the Strategic Investment Conference in La Jolla. It is a rather bold forecast, and fraught with peril and likely errors, but that is my job here. Damn the torpedoes, etc. I must offer one large caveat! If the facts change so will my forecast, but this is the view into my very cloudy crystal ball as I see it today. As always, remember that those of us in the forecasting world are often wrong but seldom in doubt. Read accordingly.

But before we get there, two quick things. I want to really show my strong appreciation for the work done by my co-hosts, Altegris Investments, at the 8^thannual Strategic Investment Conference. We had a packed house with almost 500 people come to see what I think was the best line-up at an investment conference this year. Each year we say there is no way to get any better, and each year we somehow manage to do so. And that is due in no small part to the considerable effort of the team at Altegris. I am proud to be associated with them. This year we did video many of the speakers and panels, and over time we will figure out how to make some of this available. I will keep you posted.

Enemy of Spain

Second,Endgame continues to do well, so thanks to those who have purchased it, and if you haven’t already got your copy you should go to www.amazon.com/endgameand do so! And quick kudos to my co-author, Jonathan Tepper, brilliant young Rhodes scholar and head analyst at Variant Perception. Apparently, he’s on a small but prestigious list of enemies of Spain, according to El Mundo, one of the biggest Spanish newspapers, for the sin of pointing out that Spain is in a crisis (we have a whole chapter on Spain on the book). Their article appeared in print in the weekly finance edition, but is not online. Other papers have been called by government officials and asked not to quote him. Oddly, the people who helped inflate the enormous construction bubble and the incompetent government officials who denied for years there were any problems are not enemies of Spain. Go figure. I guess if you have to be on an enemies list, you could do worse than Spain (where, oddly enough, Jonathan spent most of his childhood growing up in a drug-rehab facility). Congratulations, young man! (Oh, and a publisher in Korea picked up the EndgameKorean-language rights, so we will soon be in bookstores in Seoul.)

And now to the second part of the Endgame. And for those who want to review the first part, you can read it at http://www.johnmauldin.com/frontlinethoughts/the-endgame-headwinds/.

The Endgame, Part 2

There is an argument that the US should pursue a strong growth and jobs policy as its #1 goal and that growth, along with spending cuts and/or tax increases (depending on your views), will bring us out of the current doldrums and help us solve the budget deficit. I set the table in both the book and last week’s letter that the US is going to be growth challenged for years to come. Let me review a few items in brief and add a few more, then we will get to my predictions of what the next five years will look like. Don’t jump ahead. Without understanding the elements that are lining up to retard growth, the forecast will not make much sense.

First, job #1 MUST be to reduce the deficit below the nominal growth rate of GDP. Period. The level of debt threatens to overwhelm everything else, and at some point can produce a crisis like those evolving in Europe and Japan. I have outlined the reasons for this in depth, so here I merely make the assertion.

As I explained at length, if you increase government spending it will increase GDP IN THE SHORT TERM. The economic literature suggests this effect lasts about 4-5 quarters. Further, tax cuts will produce a growth in GDP of roughly 1 to 3 times the total amount of the cut over the next few years (depending on whose research you read, but the consensus is clearly that tax cuts make a difference). It sadly follows that increasing taxes will have a negative effect of roughly the same amount.

Now, basic economic accounting shows that if you reduce government spending you are going to reduce GDP over the short term by a rough equivalent (GDP = Consumption (C) + Investments (I) + Government Spending (G) + (Net exports)).

Therefore, the first headwind to economic growth over the next five years is the reduction of the deficit. While there is a longer-term difference between tax cuts and tax increases, in the short term (4-5 quarters) there is a simple drag effect. And we are going to need to cut government spending by about 1.5% of GDP per year every year for five years (allowing for some growth) to get the deficit to a manageable level.

Below is a chart I used last week that is from my friend Rob Arnott at Research Affiliates (and to whose annual conference I am flying to as I write this letter), but it bears looking at again. The chart needs a little set-up. It shows the contribution of the private sector and the public sector to GDP. Remember, the C in the equation is private and business consumption. The G is government. And G makes up a rather large portion of overall GDP.

The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has come from government spending. Private-sector spending is where it was almost 13 years ago, accompanied by no growth in median real income and no growth since 2000 in the actual number of jobs, even as population grew by 30 million.

As we bring government spending down, unless it is accompanied by private-sector growth, we will see overall real GDP shrink. That is just the how it works. Now, in the fullness of time (or a few years), the smaller government expenditures and deficit will mean more money for private-sector investment and productivity growth, but the process of simply getting the deficit under control is going to mean slower growth. Wrap your head around that. While Republicans (including me) want to control Congress and the presidency in 2012, the policy choices made in 2013 will not be met with a robust return to 4% growth and immediate jumps in employment levels. It is going to take a lot of education to convince voters that there is no magic in spending cuts (or even tax increases) and that we will need to stay the course, even while there is a general malaise in the economy. My advice to my fellow Republicans? Do not sell the concept that voting Republican will provide a quick fix. It will get you slaughtered in 2014. More on why below, in the conclusions.

Let’s quickly list other headwinds.

· The next headwind we will face, in 2012, is a tax increase of about 2% for almost everyone, as we lose the reduction in Social Security taxes that was passed to 2011 as part of the Bush tax cut extension. This means less money in the pockets of everyone making below about $100,000, which is significant in terms of the drag on GDP.

· The stimulus package of 2009 is fading from view. There is little reason to think any of it will come back. Look at that graph again and see how much worse GDP would have been without it. But for all that, we are watching growth soften of late, with the economy now down to 1.8%. We didn’t get the organic growth in the economy that the Keynesians promised. Where is that multiplier effect? It actually seemed to be a negative multiplier, which Austrian economics suggested it would be. Score one for von Mises and Hayek.

· QE2 is stopping in June. The hope at the Fed is that the economy can take over from there. But the last time QE was stopped, in 2010, the results were not impressive; and now we can look across the pond to England to see what is happening as they are about 6 months further along in their ending of QE. It is hard to get encouraged from the data, as it looks like growth in England has slowed. And the real effects of their new austerity pursuits have not really been felt. Can the Fed start up again? Or more apropos might be the question, “Will the Fed start another round of QE?” My answer is that, when they see the economy slip into recession, they will use the only real tool they have left, and that is to inject liquidity into the economy.

· A McKinsey study on the aftereffects of debt crises (in numerous countries) that require deleveraging in one form or another, is that for the first two years there is a significant slowing of GDP, and the slower growth does not dissipate for 4-6 years. We have not started deleveraging as a nation. The real work now looks like it will be done in 2013; and thus the real pain, the study suggests, is in our future.

· Unemployment is back at 9%, rising this morning another 0.2%. The real level is easily above 10% if you count people who were in the work force as recently as 2008. Five percent of the nation’s workers are not paying income, Social Security or Medicare taxes. Many of them are on food stamps and unemployment, which are driving deficits at the federal and state levels higher. It is hard to imagine a robust economy that does not somehow figure out how to drive the unemployment level down, yet economic growth of 3% or more is required. We are simply not there.

· I noted above that private-sector jobs have gone nowhere for 11 years. But transfer payments as a percentage of private-sector income and wages have risen inexorably for the past 50 years. Below is a chart from Madeline Schnapp, the chief economist of Trimtabs. Let me quote from the email she sent me along with the chart:

“Here is the graph which generated a HUGE amount of controversy when published awhile back. For lack of a better term, I called the ratio the "TrimTabs Dependency Ratio." What it is, using BEA data, is a ratio of ‘BEA's government social benefits to persons’ divided by‘BEA's wages and salaries.’

“While wages and salaries are about 50% of total personal income (other sources of personal income are benefits, interest, dividends, etc.), it is the largest bucket of income that produces revenue for the government via our tax structure. Therefore wages and salaries are currently the engine of support for the government’s social programs.

“FYI, the BEA's definition of government ‘Social Benefits to Persons’ includes Social Security, Medicare, Medicaid (the biggies), unemployment insurance, supplemental nutrition (SNAP, formerly food stamps), veteran's benefits, etc.

“For the ratio to go back to something sustainable, e.g. 20%, either wages and salaries need to rise, benefits need to be trimmed, or taxes need to go up.

“Be careful not to confuse ratio with proportion. In this chart, I am comparing the size of one thing to the size of another (backpacker analogy); it is not a proportion, e.g. one thing as a part of another.

“Another useful analogy is:

“There is the engine (wages and salaries) pulling rail cars up a hill. In those cars are the Defense Department, the EPA, government social benefits to persons, etc. Since 1960, the size of the social benefits rail car has grown from 10% the size of the engine, to now 35%. The ‘Little Engine that Could’ is rapidly becoming the ‘Little Engine that Couldn't.’”

· I showed two charts and research last week that clearly demonstrates that at some point the size of government becomes a drag on the economy. That may seem contradictory to my first point in this letter (reducing government spending will reduce GDP), but it is not. The first point was a short-term effect, and the size of government is a longer-term effect. We now have a government that is too large, and it acts as a headwind to growth.

· The research of Rogoff and Reinhart clearly shows that, as the debt-to-GDP level of a country approaches 90%, there seems to be a slowing of potential GDP growth by about 1%. This is an observation of the data, not a theory. And this graph from David Walker suggests we are getting there. Notice it does not include state and local debt, which it should. We are very close to this level, if not there already.

Muddle Through, or Crisis?

Betting against the power of the free-market economy in the US is generally a bad idea. Yet when I suggested back in 2003 that we would see a slow-growth Muddle Through Economy for the remainder of the decade, it turns out I was right. We only grew at 1.9% last decade, which was the worst performance since the Depression. Ugh.

So where are we for the next five years?

I think we have two choices as a country. We can elect to deal with the deficit proactively, or wait until there is a crisis and react. And make no mistake, there is a an approaching Endgame, with regard to how much debt the market will let us have. We don’t know that point now, but if it happens it will be quite a“surprise!”

What happens if we make the choice to get the deficit under control? What that really means is that we have to decide how much health care we want and how we want to pay for it. Let’s forget for the moment how that happens. Let’s just be optimistic and say we do make those decisions.

For me, that is the best-case scenario. But it means a slow-growth, Muddle Through Economy for quite some time, perhaps as long as 5-6 years, though getting better as time goes on. It also means it is highly likely we will have at least one recession during that period, as growth will be close to “stall speed” and any exogenous shock could tip us into recession. Recessions mean higher unemployment, lower tax revenues, and an even deeper hole that will require more fiscal discipline and work. It will make maintaining corporate earnings growth at today’s expected levels more difficult, which puts a headwind to the US-based equity markets. Of course, a recession will mean (on average) a 40% retrenchment of US equities. It will also mean another deflation scare and a likely QE3. Bernanke can bring back and polish his “helicopter” speech, but this time he will be able to tell us what happened.

Then there is the crisis scenario. Let’s assume we do not deal with the deficit in any meaningful way. Eventually the debt will rise to epic, Greek proportions. The bond vigilantes arise from the dead and start to push up interest rates. Interest as a percentage of government spending rises, crowding out other government expenses or increasing the debt still further.

Then we have a crisis. We are FORCED by the bond market to get the deficits under control, but now we are doing so in a crisis. Health care will have to be slashed by far more than it would in a more controlled scenario. Tax increases will be brutal. You think Social Security is untouchable? Not in this crisis world. Means testing and spending freezes will be the rule of the day. Military cuts will seem draconian. Our allies who depend on us for a defense shield will not be happy. Education? On the chopping block. The economy will not be Muddle Through, but Depression 2.0. Unemployment will go north of 15%.

What’s my basis for this? History. This movie has played over and over again in various countries in modern history. While we may be the world’s superpower, we are not immune from the laws of economic reality.

In such a scenario, I expect QE 3-4-5-6. Could the Fed literally monetize the debt and then “poof” it? When our backa are against the wall, don’t assume that what has been seen as normal will be the reigning paradigm.

Let me jump out on a real limb. I was having dinner last Monday with Christian Menegatti, the #2 economist at friend Nouriel Roubini’s economic analysis shop. We were comparing notes (imagine that), and he said their opinion is that the US has until 2015 before the bond market really calls the deficit hand. Knowing that Nouriel is seen as the ultimate bear, it makes me nervous to put out my own even more bearish analysis.

I think the crucial point will be reached in late 2013. If the bond market sees a serious move to control the deficit, I think they let us “skate.” Then we Muddle Through. But if not, I think we begin to see some real push-back on rates then.

Why so early? Because bond investors are going to be watching the slow-motion train wreck that is happening in Europe and especially Japan. It is one thing for Greece to default (which they will in one form or another, with lots of rumors flying this morning), yet another for Japan to do so. Japan is big and makes a difference. Japan could start to go as early as the middle of 2013. As I have said, Japan is a bug in search of a windshield. Whenever this happens, 2013 or a year or so later, it is going to spook the bond market. The normal indulgence that a superpower and reserve-currency country would be accorded will become much more strained. It will seemingly happen overnight. Think Lehman Brothers on steroids.

I think the chances we will deal with this potential crisis are about 75%. Not doing so is such a horrific outcome that I think politicians will do the right thing. See, I am an optimist. (What was it Winston Churchill said? “You can always depend on the Americans to do the right thing, after they have exhausted all the other possibilities.”)

And let me note that I have had some rather at-length, high-level (but very off-the-record) discussions with politicians on the right in recent weeks. More and more of them are really getting it. But as one said to me, “John, I can’t run on that platform.” And that is the reason that I give it a 25% chance that we’ll wait until a crisis hits us. If the “good guys” (my view, not yours, gentle reader – I know many of you are of the more liberal persuasion) need a real push to act correctly, we are not in good shape.

I totally recognize it will not be easy to fix it. It will probably mean tax increases, which will not be good for the economy. And spending cuts that will be painful. I get all the consequences. I have written about them. But the goal is to get rid of the cancer of the deficit. It could truly destroy our economic body. Sometimes, if you have cancer, you take very ugly chemicals into your body, which have very serious side effects. The prospect does not make me happy at all, but we have made bad choices as a country for decades, and now we have to pay the price.

Just a few more thoughts. Republicans should demand a total restructuring of the tax code in return for any tax increase. I would opt for lower corporate rates to help make us competitive (say 10-15%) and include all foreign corporate income, and get rid of the mass of exemptions. Lower personal rates and a consumption tax would suit me just fine, as both an economist and a businessman; but I know that’s not some people’s cup of tea. Just saying. I like David’s Walker’s thoughts about $3 of spending cuts for every $1 of tax increases. And can we get rid of some of the “tax expenditures,” like mortgage interest deductions? We all pay 4% in income tax so that a minority can have interest-rate deductions. (I have written about efforts we need to undertake that would more than offset any hit to real estate.) At least reduce it for mortgages over $1 million. If you can afford a mortgage that big, you don’t need the deduction.

Every one of those tax expenditures is someone’s else tax break that is vital to the future of the Republic, but if we got rid of all tax expenditures in one massive move (or over time) we could simplify the tax code and come within a few hundred billion of balancing the budget. Walker says the breaks total $1.2 billion. Basically, these are goodies that Congress hands out to get votes. Get rid of them all, I say. It will be politically difficult, but we need drastic action.

And I might suggest that Democrats should come to the table this year rather than waiting until 2013. If unemployment is north of 8% next election, as I think likely, you will lose more seats and (probably) the White House, given today’s polls. Why not negotiate now when you have the Senate and can get what you can? Maybe “my guys” are being obstinate, but the sooner we do this the sooner we get through it.

And that is my point. We do get through it, either as adults or forced to do so by the bond market. One way or another, by the latter part of this decade, in the fullness of time, this too shall pass.

The eternal optimist in me wants to quickly point out that neither scenario is the end of the world. Yes, we may have to tighten our belts, some more than others, but life goes on. We all figure out our own paths. While investing has been more difficult the last five years, we are all still alive, celebrating birthdays and grandchildren. New businesses that will dramatically change our lives are being formed every day. There are lots of opportunities for business and investment, perhaps just not the traditional ones we are used to. Maybe gold goes to $5,000, but I hope it goes to $500. Either way I will still buy some physical gold every month as insurance, with the dream that I’ll give it to my great-great grandchildren as a novelty from the days when we thought gold had value. But I will still buy, just in case. I simply don’t completely or naively trust the &*%@^&’s who are running the place.

Seriously, I expect that, beginning later this decade we will see the secular bear crawl back into hibernation and a roaring secular bull market cycle come charging out. We will all get to once again be geniuses.

The book I am starting to write this month (finally!) will be called The Millennium Wave, in which we’ll look at what our world may be in 2032. The journey there will be bumpy, but what a world it will be! So, over the next few months and quarters, we will keep our eye on the politicians and see what happens. I will be looking for good hedges and places to invest that don’t depend on Washington DC or the other capitals of the world. And I will keep on writing to you, gentle reader, every week.

Last thought: I encourage you to get involved in the process in whatever way you deem correct. This is going to be the most important national conversation we have had in a long time, and you should be a part of it. Make your voice and vote count!

Philadelphia, Boston, Trequanda, Kiev, Geneva, and London

I am in Laguna Beach at the Montage this afternoon for Rob Arnott’s annual client conference. He has an outstanding lineup of speakers: Lacy Hunt, Jim Bianco, Professors Burton Malkiel of Princeton and Nobel laureate Harry Markowitz, along with Rob and his associate Jason Hsu. They are known for the creation of Fundamental Indexes. This has become a (deservedly) amazing story of growth over the last few years. I remember writing about it and saying something like“This would be the fastest idea to grow to $100 billion in assets in history.”They are over halfway there, taking assets from what the research and results say is the inferior performance of cap-weighted indexes.

I fly back on Sunday and am home for two whole weeks in my own bed, then I fly to Philadelphia for a conference with the Global Interdependence Center. To find out more you can go to http://www.interdependence.org/Event-05-24-11.php. Then it’s to Boston for some business and a little relaxation, before flying on Sunday to Italy to stay for three weeks in a small village in Tuscany called Trequanda, where most of my kids will be for the first week or so, and then it will be a working vacation with Tiffani, while friends come to see us. Vacation for me is being in the same place for a few weeks. Then I’m off to Kiev for the weekend for a reunion of my classmates at Singularity University, then to Geneva for a few days and London for one day, where I will guest-host CNBC Squawk Box, which is always a few hours of fun. Then back home, and I’ll get to be in Texas for most of the summer– at least that’s how it looks now.

I feel somewhat awkward of late, going through airports and meetings wearing a large cast on my right foot, trying to keep it immobile to let the inflammation go down from doing too many lunges and straining the tendon. I can feel it helping, but it there is a long way to go.

This next week should be fun, as I will be taking a girls championship softball team to see the Texas Rangers. Most of them have never been to a professional game. Then good friend Cliff Draughn is in town, then (maybe) game six of the Mavericks-Lakers series, more family, and no alarm clocks. I need the rest. This last week, with cancelled flights and early mornings, has frankly been tiring. I really must get the schedule under better control.

Speaking of “brutal,” it is time to hit the send button. Rob’s conference starts with a soiree on the lawn and always features some mighty fine wine. I must go and indulge, while promising to get to bed early! Have a great week!

Your quite sure we get through all this analyst,

John Mauldin