Search results matching tags 'Debt' and 'Government'

Debt Be Not Proud

JohnMauldin — Sun, 09 Sep 2012 05:51:00 GMT

How Down Can Be Up If You Create the Rules
The Fed to the Rescue?
The Correlation Between Government Size and Growth
Debt Be Not Proud
Debt Overhangs: Past and Present
Should the Fed Give Us QE3?
Webinars, Chicago, Palo Alto, Atlanta, New York

"In the financial markets, the current economic cycle is still often viewed as if it is comparable to the far shorter cycles we have experienced since World War II. If that was indeed the case, the solution would be to implement fiscal and monetary stimuli now until lending to the private sector and thereby growth rise substantially. However, what is being overlooked is that the total debt/GDP ratio has risen so sharply over the past 75 years that the limit has probably been reached.

"That would mean that the governments and central banks can no longer create high growth; at best they can prevent growth from sliding fast. In addition, the drawbacks for central banks of opening the liquidity taps further are growing, while the effectiveness of the action is waning. Therefore, although we anticipate the Fed to embark on additional easing measures, we believe they will be disappointing in scope and effectiveness. For the ECB, maintaining the EMU and the euro is more important. To achieve that, interest rates in Italy and Spain have to be rapidly reduced. Nevertheless, the measures the ECB recently announced will achieve no more than creating a degree of calm in the financial markets, unless Spain and Italy make substantial structural reforms to their economies. However, there is great resistance to those reforms."

- ECR Research

The unemployment numbers came out yesterday, and the drums for more quantitative easing are beating ever louder. The numbers were not all that good, but certainly not disastrous. But any reason will do, if what you want is more stimulus to boost the markets ever higher. Today we will look first at the employment numbers, because deeper within the data is a real story. Then we look at how effective any monetary stimulus is likely to be.

I am in Carlsbad today at the Casey Research Investment Conference. I got to hear my good friend Dr. Lacy Hunt give a presentation on monetary policy, and he was on fire. I think I persuaded David Galland of Casey Research to give me access to the speech for you, when it is available, and you willwant to listen to it. It was one of the best speeches I have heard on current monetary and fiscal policy in a very long time. In this week's letter I will touch on a few of his points and make a few of my own. Let's jump right in, as there is a lot to cover.

How Down Can Be Up If You Create the Rules

The nonfarm payroll numbers showed an increase of just 96,000 jobs in August. This was almost dead on the average for the last six months, which is 97,000, down from 205,000 the previous six months, echoing the pattern of last year and suggesting the numbers for the next two months will be soft as well, just prior to the election.

Almost all of the growth is in the birth/death number, which this month was 87,000 new jobs. For new readers, this is the number that the Bureau of Labor Statistics creates to account for new businesses created that were not part of the employment survey. The BLS surveys established businesses to get the employment data (thus this survey is called the establishment survey). Since, almost by definition, they can't survey new businesses, and net new businesses are one of the more important parts of the employment picture, BLS makes an estimate based on historical data. Then over time they revise the overall numbers. The direction of the revisions is very important, as it tells us much about the underlying employment trends.

The revisions were all negative this time. That suggests to me that this month's birth/death number is probably higher than it should be, and over time it will get revised down as well. Ugh.

Looking at the data, we find that 28,000 jobs were created in the bar and restaurant business. Those are not exactly high-paying jobs. My anecdotal observation is that more than a few college graduates are taking those jobs.

The average earnings data was flat for the month, as the year-over-year number fell to a +1.7%, which is below inflation. Workers are falling behind. Worse, hours worked fell by one-tenth of an hour. That doesn't seem like a lot, but when you add the hours up, that one-tenth is the equivalent of several hundred thousand jobs, in terms of actual pay, which is of course a drag on consumer spending.

We are down 4.7 million jobs from the pre-recession peak. At less than 100,000 jobs added per month, it would take four more years just to get back to where we were five years ago. Which would not appreciably reduce the unemployment rate, due to the growth in population.

All that was disappointing, but not anything we should be surprised by. No, the thing that caused me to do a double-take was the drop in the unemployment rate from 8.3% to 8.1%. How can only 96,000 new jobs cause a drop in the unemployment rate of 0.2%? That is really a rather large number and should have required closer to 250-300,000 new jobs. In addition, the population actually grew by 213,000.

"The number of unemployed fell by 250,000, and the unemployment rate fell by 0.2 to 8.1%. But those declines were largely the function of labor force withdrawal. Flows data confirm this suspicion: 195,000 went from employed to not in labor force, and 226,000 from unemployed to not in labor force, both very high numbers by historical standards. The number classed as not in labor force but wanting a job rose by 437,000 to 7.0 million, or 2.9% of the population, the highest of the Great Recession/Tepid Recovery cycle." (The Liscio Report)

The U3 unemployment rate has dropped from 9.1% last August to 8.1% this August. How does that square with numbers in the real world? The working-age population has risen by 3.7 million people, and the number of employed people (including part-time) has increased by 2.3 million. How can an increase in the number of people that logically seem unemployed translate into a reduction in the unemployment rate?

To reduce the unemployment rate, the trick is to reduce the number of people in the work force by significantly more than the number of new jobs. Under the rules, 368,000 people were removed this month from the labor force. The labor force is made up of those who are either employed or unemployed, but you are not considered unemployed if you have not looked for a job in the last four weeks, or are in school or…

Now, here is something Lacy told me today in a private conversation, as we were talking about the rather large drop in the labor force, and it surprised me. He noted that you are not considered to be in the labor force is you have not been considered unemployed during the last year. (I must admit I cannot find that on the BLS website. And at 3 AM in the morning, it would be rude to call his room. I will confirm this later today and note that to you next week if I got the details wrong.)

Here is the interesting thing. It used to be that you were in the labor force if you had been looking for work sometime in the last four years, but that was changed to one year in the latter Clinton years. If we used that older and to my mind more reasonable standard, the unemployment rate would be at least 1% higher and perhaps a lot more. I call the old standard more reasonable because it counts discouraged workers who would take a job if they thought they could find one.

Look at this graph from the St. Louis Fed FRED database. The labor force participation rate is in red and the employment-to-population ratio is in blue. The employment-to-population ratio is down to where it was in the late '70s. The participation rate is down to 63.5%, roughly where it was some 30 years ago.

Note that if you are on disability you are not considered to be in the labor force. As of April we have added 5.4 million people to the disability rolls since the beginning of 2009. This is several million above the previous trend. There are now almost 9 million on disability. There are many who drop off each year, but many of them are going from disability to Social Security.

"As the Congressional Budget Office explains: "When opportunities for employment are plentiful, some people who could quality for [disability insurance] benefits find working more attractive ... when employment opportunities are scarce, some of these people participate in the DI program instead."

"The explosive growth in disability enrollment also 'helps explain some of the drop in the labor force participation rate,' noted economist Ed Yardeni on his blog." (Investor's Business Daily)

In 1992, there was one person on disability for every 35 workers. It is now about one for every 16 workers.

If disability had stayed at the pre-recession growth trend, unemployment would be at least 1% higher, and perhaps as much as 2%.

Bottom line is that true unemployment is closer to 10% and perhaps significantly more. We just don't know. Underemployment is still in the range of 16%. And that does not count people who have a job for which they are far overqualified and who are making much less money than they would if they could find a job in their chosen field. I should note to all those people who think I am being overly pessimistic that John Williams at Shadow Stats, who uses the US government methodology from 30 years ago, tells us that U-6 unemployment is around 23%. The difference is in how you create the model. The feds keep changing the rules, and it should be no surprise that with each new rule the number of people officially counted as unemployed drops. And if you can't find a job, whether you are officially unemployed or not, it's no fun.

The Fed to the Rescue?

This ongoing unemployment problem is increasing the pressure on the Fed to "do something." But is more quantitative easing the answer? I am going to quote from three pieces of research brought to my attention by Lacy Hunt this afternoon (directly from his PowerPoint). This all fits hand in glove with the report I highlighted last week from William White, which was on the Dallas Federal Reserve website.

The upshot of these difficulties is that Fed QE policy has lost its effectiveness and may start to be part of the problem. And thatthe solution should focus on controlling government debt.

The Correlation Between Government Size and Growth

"Government Size and Growth: A Survey and Interpretation of the Evidence." Andreas Bergh, Research Institute of Industrial Economics (IFN) Lund University and Magnus Henrekson, Research Institute of Industrial Economics (IFN) Lund University. Journal of Economic Surveys, April 2011. Page 2, http://journalistsresource.org/wp-content/uploads/2011/08/Govt-Size-and-Growth.pdf.)

The first study we'll look at shows a clear inverse correlation between the size of government and growth. This really confirms common sense, as government only takes from private production to fund its spending. And while one can make a case that some government spending is productive, much of government spending, including transfer payments, does not contribute to that case. That is not the same as arguing that those transfer payments should not be made. It simply points out that there is a cost to society to increase the size of government. And that cost is in jobs, hence the ugly employment numbers.

That being said, the authors note that correlation is not causation and that there are other explations for countries with high taxes and higher growth rates. I provide a link to the study for those who are interested, and we may explore those questions in depth in a later letter. Quoting:

"Any conflict between the size of government and economic growth is largely explained by variations in definitions and the countries studied. Bergh and Henrekson write, 'An alternative approach – of limiting the focus to studies of the relationship in rich countries, measuring government size as total taxes or total expenditure relative to GDP and relying on panel data estimations with variation over time – reveals a more consistent picture...' Bergh and Henrekson find a 'significant negative correlation.' Specifically, 'an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.'" (bold emphasis mine)

Debt Be Not Proud

Cristina Checherita and Philipp Rother, "The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area," European Central Bank working paper no. 1237, August 2010. http://www.ecb.int/pub/pdf/scpwps/ecbwp1237.pdf

This ECB paper suggests that governments need to get their fiscal houses in order.

"Checherita and Rother investigated the average effect of government debt on per capita GDP growth in twelve euro area countries over a period of about four decades beginning in 1970. They confirm and extend the finding by Reinhart and Rogoff in their 2010 NBER paper. A government debt to GDP ratio above the turning point of 90-100% has a 'deleterious' impact on long-term growth. In addition, they find that there is a non-linear impact of debt on growth beyond this turning point. A non-linear relationship means that as the government debt rises to higher and higher levels, the adverse growth consequences accelerate. Results across all models 'show a highly statistically significant non-linear relationship between the government debt ratio and per-capita GDP for the 12 pooled euro area countries included in their sample.'

"Moreover, confidence intervals for the debt turning point suggest that the negative growth rate effect of high debt may start from levels of around 70-80% of GDP. Due to these findings, Checherita and Rother write this '…calls for even more prudent indebtedness policies.' Checherita and Rother make a substantial further contribution by identifying the channels through which the level and change of government debt is found to have an impact on economic growth: (1) private saving, (2) public investment, (3) total factor productivity and (4) sovereign long-term nominal and real interest rates."

Debt Overhangs: Past and Present

Carmen M. Reinhart, Vincent R. Reinhart, Kenneth S. Rogoff, National Bureau of Economic Research, working paper 18015. http://www.nber.org/papers/w18015

Then Lacy reviews recent work by our old friends Ken Rogoff and Carmen Reinhart (who wrote the seminal work This Time Is Different).It is further acknowledgement that excessive government debt will retard growth. Again quoting from his PowerPoint:

"Post 1800 Episodes Characterized by Public Debt to GDP Levels Exceeding 90% for At Least Five Years.

"Consistent with other more recent research, the authors confirm that public debt overhang episodes are associated with growth over one percent lower than during other periods. ... duration of the average debt overhang episode across all 26 episodes lasted an average of 23 years.... Growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interst rates. That is, growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.

"The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive.

"At the end of 23 years... Real GDP is 24 percent lower than for the baseline. It is not exactly what T.S. Eliot had in mind when he wrote 'This is the way the world ends, Not with a bang but a whimper' but the general thrust appears to be applicable to the debt-without-drama damages.

"This research documents the first systematic evidence on the association between high public debt and real interest rates. They write: 'Contrary to popular perception, we find that in 11 of the 26 debt overhang cases, real interest rates were either lower or about the same as during the lower debt/GDP years. Those waiting for financial markets to send the warning signal through higher interest rates that government policy will be detrimental to economic performance may be waiting a long time.'"

Should the Fed Give Us QE3?

There seems to be a clear consensus (from the dozen or so items I have read) that the Fed will now give us QE3 at its meeting next week. I do not doubt that more QE is in the works, but I sincerely hope they wait until after the election. To my mind, another round of QE will not produce all that much, though it may possibly make the stock market happy.

It will not stimulate spending or increase the need for more loans or make it easier to buy a house. Rates are already low, and there is excess liquidity in the system. While I acknowledge that the propensity of a central banker is to do something (God forbid that a recovery should happen while they did nothing, so they couldn't take credit for it!), it is unseemly to do so right before a presidential election. There is nothing in this employment report that is any different from what we knew months ago.

I can see no reason not to wait until November. The building is not on fire. Additional QE today is like pouring water on a drowning man.

Please note: I have been consistent on this issue for decades. The Fed must not be seen to be political in any way prior to a presidential election. Caesar's wife and all that stuff. I would be fine with QE after a Lehman-type incident if it happened right before an election, but we do not have a Lehman issue. The economy is still growing, if slowly. The problem is not a monetary problem and cannot be solved by the Fed. The future direction of the country and the shape of the fiscal deficit will be decided in November.

Next week we'll take a look at the election itself, after some time to assess the convention bounces and what this election really means. Let me give you a teaser. I am not worried at all that either the Obama budget or the Romney budget will be enacted as proposed, because the chances are about zero of either being passed. The issue is the direction of the compromise, and on that seeming nuance, the economic future of the republic hangs. Stay tuned.

Webinars, Chicago, Palo Alto, Atlanta, New York

I will be doing an inaugural "Fireside Chat" with Barry Ritholtz on Tuesday, September 11 at 1 PM Eastern. This webinar will be hosted by my friends at Altegris Investments (and moderated by Jon Sundt) and will be available to accredited investors and financial professionals. If you have already registered with the Mauldin Circle (and are in the US), you will shortly be receiving an invitation to attend. If you have not, I invite you to go to www.mauldincircle.comand register today, so you can hear Barry and me discuss the latest news and, of course, touch on the election and what it means for investors.

I am speaking at the Casey Investment Summit in Carlsbad, California, today and tomorrow, and then in Palo Alto Sept. 12-13, at an investment conference again sponsored by Altegris Investments. I am also seeing friends and checking out some really cool projects.

I will be in Chicago on September 19, presenting at the RDA Financial Network Investor Forum, from 6:00 to 7:30 PM. The Forum will be held at the Chicago Marriott Oak Brook. This event is sponsored by Steve Blumenthal and my friends at CMG. If you would like to attend, please email Linda Cianci at Linda@cmgwealth.com .

And I'm speaking October 1 in New York at the 8^thAnnual Value Investing Congress. I'll be joined by many really smart speakers, including Bill Ackman and David Einhorn. I've been able to secure a "friends and family" discount, if you'd like to join me there: $1,500 off the regular price to attend. To take advantage of these savings, register by September 7^th at www.ValueInvestingCongress.com/Mauldinwith discount code N12JM.

My friend Barry Ritholtz is hosting a one day Big Picture Conference in NYC on October 10. There is a killer line-up. Check it out: http://thebigpictureconference.eventbrite.com/?access=Mauldin

I have been meeting with the management team of Mauldin Economics this week. I cannot tell you how happy I am with our results so far, both as a business and as a research service. Sometime next week you will get a letter announcing some very new and significant changes. I am quite excited, as it is going to allow me new freedom to do more research and get better control of my life.

Right now, it is time to hit the send button. I need to get a few hours sleep before my speech. And I have to mention that good friend David Brin, a member of the Science Fiction Hall of Fame, just wrote a killer novel called Existence. I was the first person to read the first draft. One long Word doc. Awesome.

Life is good, as we all are "back in school" and on our routines. Now if we can just get government to stay out of the way.

Your getting ready to dream about my speech analyst,

John Mauldin

subscribers@mauldineconomics.com

The Future of Public Debt

JohnMauldin — Sat, 01 May 2010 04:08:00 GMT

There Had to Be a Short
How Should Our Institutions Invest?
The Future Of Public Debt
The Future Public Debt Trajectory
Debt Projections
Montreal, New York, Connecticut, and Italy

Everyone and their brother intuitively knows that the current government fiscal deficits in the developed world are unsustainable. They have to be brought under control, but that requires some short-term pain. Today we look at a rather remarkable piece of research from the Bank of International Settlements (BIS) on what the fiscal crisis may morph into in the future, how much pain will be needed, and what will happen if various countries stay on their present courses. Some countries could end up paying north of 20% of GDP just on the interest to serve their debt, within just 30 years.

Of course, the markets will not allow that to happen, long before it ever gets to that level. And what makes this important is that this is not some wild-eyed blogger, it's the BIS, a fairly sober crowd of capable economists. We will pay some attention. Then I'll throw in another few paragraphs about Goldman.

But first, I want to bring a very worthy cause to your attention. For my Strategic Investment Conference last weekend, Jon Sundt and I bought some mighty fine wine for our guests. That of course, is to be expected. But each of those bottles also bought a wheelchair for someone in a most needy part of the world. Here's the story.

Gordon Homes at Lookout Ridge Winery in Napa Valley has gotten five cult winemakers to create special wines for him. These are winemakers whose production is sold out well in advance - they're the all-stars of wine (like Screaming Eagle). And while they can't sell them from their own wineries, they blend these special signature wines for Lookout Ridge.

Each bottle sells for $100, well below what it would take to get one of these cult artists' bottles - even if you could get them. And then Lookout Ridge donates the entire amount to buying a wheelchair for someone who can't afford one in a less-developed country. Attendees at our conference bought enough to send 200 chairs to people desperate for mobility all over the world. Part of it was, I am sure, that it is a very worthy cause, and part of it is that the wines are damn good.

The web page is http://www.lookoutridge.com/lookoutridge/index.jsp. Click on "wine for wheels" on the top bar, and then on some of the links on the page that comes up. Look at the smiles on the faces of people who got a chair! And then order a few bottles. You will thank me when you drink it, and someone in need of mobility will thank you. Now, on to the letter.

There Had to Be a Short

Somebody needs to brief Senators before they get on TV and ask irate questions which demonstrate they have no idea what they are talking about. Expressing shock that someone was short on the trade in question shows you don't understand the trade. Let me see if I can offer some clarity.

Normally, you think of a Collateralized Debt Obligation (CDO) as a pool of mortgages. This pool is broken into anywhere from 6 to 15 tranches. The highest-rated tranches get their money back first, and the rating agencies made them AAA. While the lowest level would be called the equity portion and be first in line to lose, in theory it paid a very high yield. It was usually not rated. But the level just above that is BBB (just barely investment-grade), and that was typically about 4% of the total deal, but paid a much higher yield than the "safe" AAA portion.

Now, here is where it gets interesting. Investment banks would take the BBB portions of these Residential Mortgage-Backed Securities, which were not as easy to sell, and combine them in a CDO, which the rating agencies then rated using models based on data provided by the investment banks themselves. Since this combining of BBB tranches supposedly created diversification that the rating firms' models indicated would drastically limit delinquencies and defaults, the AAA tranche of the CDO was jacked up to 75% of the total capital structure, with 12% rated AA. Only 4% was typically considered BBB. So pools of mortgages that probably should have been rated below BBB were miraculously turned into a CDO with 87% of its capital structure rated AAA and AA and only 4% rated BBB, with a chunk as equity. (I wrote about this in January of 2007, based on material from Gary Shilling and others, plus my own research, although I think I wrote about it in an earlier letter as well.)

Who would buy this stuff? Mostly institutions that were reaching for yield in what was, in 2007, a very low-yield world. Yield hogs. And institutions that trusted the rating agencies.

But the CDO in the Goldman case was not this type of CDO. It was hard to find enough BBB pieces to put together a CDO of the type described above, and the demand was high. Remember, everyone knew that housing could only go up. So, what's an investment bank to do? They create a synthetic CDO. Follow this closely. The various investment banks - it was way more than just Goldman; rumors are it was up to 16 of them - would construct an artificial CDO fund based on the performance of BBB tranches in other deals.

Let me see if I can simplify this. It is as if I had a very negative view about a particular industry for which there was no future or index or liquid security. We could go to an investment bank and ask them to create a "hypothetical" index that would mirror the performance of this industry. I would be willing to short that index. But unless the bank wanted to be long that index, they would have to find a buyer who would take the long position. Presumably the buyer would have a different view than me.

Now, by definition there has to be a short for the long, and vice versa. This is a synthetic index. It exists only as a spreadsheet and performs in conjunction with the components it's modeled upon.

Numerous hedge funds did not think the rating agencies knew what they were talking about when it came to the mortgage ratings. They also believed we were in a housing bubble. So they went to a number of investment banks and asked them to construct synthetic (derivative) CDOs that they could short. And there were buyers on the other side who wanted the yield, who trusted the agencies, and who believed that housing could only go up.

As to the Goldman deal, the buyers had to know there was someone short on the other side. By definition there was a short. Besides, they had a guarantee from ACA on the AAA portion (which of course went bad, as I wrote about later that year) - there was a guaranteed AAA yield a few points higher than with normal AAA debt. What could be better? Except of course that it was too good to be true. Learn a lesson, gentle reader. Don't reach for yield.

The hedge funds that shorted the synthetic CDOs took real risk. They had to pay the interest on the underlying tranches to the investors who were long. And if the housing market continued to rise, and the bubble did not burst, they could easily lose a lot, if not all, of their money. No one knows when a bubble will burst. The markets can be irrational longer than you can remain solvent.

Let's be very clear. This was purely gambling. No money was invested in mortgages or any productive enterprise. This was one group betting against another, and a LOT of these deals were done all over New York and London.

The SEC alleges that there was material lack of disclosure. I must admit that I would want to know that the person who was taking the short position had a hand in the creation of the pool of BBB paper I was buying. And if Fabrice Tourre told someone that Paulson was $200 million long when they were actually net short, that could be problematic. Now, if he just said that Paulson bought the equity portion of the synthetic CDO (there has to be one), that will be a different matter.

The prosecutor for the SEC is by all accounts a very solid and serious person who would not move this case forward if he did not think they would win. This is not one the SEC will want to lose. On the other hand, I hope that Goldman takes this to the Second Circuit Court of Appeals (the final decision maker in a long and arduous process), as there are some very interesting aspects to this case that I would like to see resolved, as an individual in the industry. On someone else's legal bill.

I wonder why Goldman's witnesses seemed ill-prepared. Did their lawyers tell them to keep it simple and not get into a spirited defense? My instinct says that a lot more will come out about this case. If it was just this one deal, then Goldman should pay the fine and walk away. Done all the time. I suspect there is more here. Or maybe it was just that they didn't want to explain why they were doing a synthetic CDO. We'll see when someone writes the book.

How Should Our Institutions Invest?

However, the larger and far more critical question is, why were institutions buying synthetic CDOs in the first place? This is an investment that had no productive capital at work and no remotely socially redeeming value. It did not go to fund mortgages or buy capital equipment or build malls or office buildings. It seems to me there is a certain social responsibility when you have institutional capital and manage pensions. It's one thing to buy a gambling stock; it's quite another to be the gambler, especially if it is not your capital at risk, and by being a yield hog you increase your bonuses. The hedge funds were risking their capital. The institutions were risking other people's money. And let's be clear, the counterparties in the Goldman deal, at least, were very knowledgeable players. They knew exactly what they were buying.

OK, enough. Let's move onto the BIS paper.

The Future of Public Debt

For the rest of this letter, and probably next week as well, we are going to look at a paper from the Bank of International Settlements, often thought of as the central bankers' central bank. This paper was written by Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli. (http://www.bis.org/publ/work300.pdf?noframes=1)

The paper looks at fiscal policy in a number of countries and, when combined with the implications of age-related spending (public pensions and health care), determines where levels of debt in terms of GDP are going. The authors don't mince words. They write at the beginning:

"Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability."

Drastic measures is not language you typically see in an economic paper from the BIS. But the picture they paint for the 12 countries they cover is one for which drastic measures is well-warranted. I am going to quote extensively from the paper, as I want their words to speak for themselves, and I'll add some color and explanation as needed. Also, all emphasis is mine.

"The politics of public debt vary by country. In some, seared by unpleasant experience, there is a culture of frugality. In others, however, profligate official spending is commonplace. In recent years, consolidation has been successful on a number of occasions. But fiscal restraint tends to deliver stable debt; rarely does it produce substantial reductions. And, most critically, swings from deficits to surpluses have tended to come along with either falling nominal interest rates, rising real growth, or both. Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if.

"When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways? In some countries, unstable debt dynamics, in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels, are already clearly on the horizon.

"It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk. It will also complicate the task of central banks in controlling inflation in the immediate future and might ultimately threaten the credibility of present monetary policy arrangements.

"While fiscal problems need to be tackled soon, how to do that without seriously jeopardising the incipient economic recovery is the current key challenge for fiscal authorities."

They start by dealing with the growth in fiscal (government) deficits and the growth in debt. The US has exploded from a fiscal deficit of 2.8% to 10.4% today, with only a small 1.3% reduction for 2011 projected. Debt will explode (the correct word!) from 62% of GDP to an estimated 100% of GDP by the end of 2011. Remember that Rogoff and Reinhart show that when the ratio of debt to GDP rises above 90%, there seems to be a reduction of about 1% in GDP. The authors of this paper, and others, suggest that this might come from the cost of the public debt crowding out productive private investment.

Think about that for a moment. We are on an almost certain path to a debt level of 100% of GDP in less than two years. If trend growth has been a yearly rise of 3.5% in GDP, then we are reducing that growth to 2.5% at best. And 2.5% trend GDP growth will NOT get us back to full employment. We are locking in high unemployment for a very long time, and just when some one million people will soon be falling off the extended unemployment compensation rolls.

Government transfer payments of some type now make up more than 20% of all household income. That is set up to fall rather significantly over the year ahead unless unemployment payments are extended beyond the current 99 weeks. There seems to be little desire in Congress for such a measure. That will be a significant headwind to consumer spending.

Government debt-to-GDP for Britain will double from 47% in 2007 to 94% in 2011 and rise 10% a year unless serious fiscal measures are taken. Greece's level will swell from 104% to 130%, so the US and Britain are working hard to catch up to Greece, a dubious race indeed. Spain is set to rise from 42% to 74% and "only" 5% a year thereafter; but their economy is in recession, so GDP is shrinking and unemployment is 20%. Portugal? 71% to 97% in the next two years, and there is almost no way Portugal can grow its way out of its problems.

Japan will end 2011 with a debt ratio of 204% and growing by 9% a year. They are taking almost all the savings of the country into government bonds, crowding out productive private capital. Reinhart and Rogoff, with whom you should by now be familiar, note that three years after a typical banking crisis the absolute level of public debt is 86% higher, but in many cases of severe crisis the debt could grow by as much as 300%. Ireland has more than tripled its debt in just five years.

The BIS continues:

"We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future. As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained.

"The permanent loss of potential output caused by the crisis also means that government revenues may have to be permanently lower in many countries. Between 2007 and 2009, the ratio of government revenue to GDP fell by 2-4 percentage points in Ireland, Spain, the United States and the United Kingdom. It is difficult to know how much of this will be reversed as the recovery progresses. Experience tells us that the longer households and firms are unemployed and underemployed, as well as the longer they are cut off from credit markets, the bigger the shadow economy becomes."

We are going to skip a few sections and jump to the heart of their debt projections. Again, I am going to quote extensively, and my comments will be in brackets [].Note that these graphs are in color and are easier to read in color (but not too difficult if you are printing it out). Also, I usually summarize, but this is important. I want you to get the full impact. Then I will make some closing observations.

The Future Public Debt Trajectory

"We now turn to a set of 30-year projections for the path of the debt/GDP ratio in a dozen major industrial economies (Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, the United Kingdom and the United States). We choose a 30-year horizon with a view to capturing the large unfunded liabilities stemming from future age-related expenditure without making overly strong assumptions about the future path of fiscal policy (which is unlikely to be constant). In our baseline case, we assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 level as projected by the OECD. Using the CBO and European Commission projections for age-related spending, we then proceed to generate a path for total primary government spending and the primary balance over the next 30 years. Throughout the projection period, the real interest rate that determines the cost of funding is assumed to remain constant at its 1998-2007 average, and potential real GDP growth is set to the OECD-estimated post-crisis rate.

[That makes these estimates quite conservative, as growth-rate estimates by the OECD are well on the optimistic side.]

Debt Projections

"From this exercise, we are able to come to a number of conclusions. First, in our baseline scenario, conventionally computed deficits will rise precipitously. Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit/GDP ratio will rise to 13% in Ireland; 8-10% in Japan, Spain, the United Kingdom and the United States; [Wow!] and 3-7% in Austria, Germany, Greece, the Netherlands and Portugal. Only in Italy do these policy settings keep the primary deficits relatively well contained - a consequence of the fact that the country entered the crisis with a nearly balanced budget and did not implement any real stimulus over the past several years.

"But the main point of this exercise is the impact that this will have on debt. The results plotted as the red line in Graph 4 [below] show that, in the baseline scenario, debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in Belgium, France, Ireland, Greece, Italy and the United States. And, as is clear from the slope of the line, without a change in policy, the path is unstable. This is confirmed by the projected interest rate paths, again in our baseline scenario. Graph 5 [below] shows the fraction absorbed by interest payments in each of these countries. From around 5% today, these numbers rise to over 10% in all cases, and as high as 27% in the United Kingdom.

"Seeing that the status quo is untenable, countries are embarking on fiscal consolidation plans. In the United States, the aim is to bring the total federal budget deficit down from 11% to 4% of GDP by 2015. In the United Kingdom, the consolidation plan envisages reducing budget deficits by 1.3 percentage points of GDP each year from 2010 to 2013 (see eg OECD (2009a)).

"To examine the long-run implications of a gradual fiscal adjustment similar to the ones being proposed, we project the debt ratio assuming that the primary balance improves by 1 percentage point of GDP in each year for five years starting in 2012. The results are presented as the green line in Graph 4. Although such an adjustment path would slow the rate of debt accumulation compared with our baseline scenario, it would leave several major industrial economies with substantial debt ratios in the next decade.

"This suggests that consolidations along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades.

"An alternative to traditional spending cuts and revenue increases is to change the promises that are as yet unmet. Here, that means embarking on the politically treacherous task of cutting future age-related liabilities. With this possibility in mind, we construct a third scenario that combines gradual fiscal improvement with a freezing of age-related spending-to-GDP at the projected level for 2011. The blue line in Graph 4 shows the consequences of this draconian policy. Given its severity, the result is no surprise: what was a rising debt/GDP ratio reverses course and starts heading down in Austria, Germany and the Netherlands. In several others, the policy yields a significant slowdown in debt accumulation. Interestingly, in France, Ireland, the United Kingdom and the United States, even this policy is not sufficient to bring rising debt under control.

[And yet, many countries, including the US, will have to contemplate something along these lines. We simply cannot fund entitlement growth at expected levels. Note that in the US, even by "draconian" estimates, debt-to-GDP still grows to 200% in 30 years. That shows you just how out of whack our entitlement programs are.

Sidebar: This also means that if we - the US - decide as a matter of national policy that we do indeed want these entitlements, it will most likely mean a substantial VAT tax, as we will need vast sums to cover the costs, but with that will come slower growth.]

[Long before interest rates rise even to 10% of GDP in the early 2020s, the bond market will have rebeled. This is a chart of things that cannot be. Therefore we should be asking ourselves what is the End Game if the fiscal deficits are not brought under control.]

"All of this leads us to ask: what level of primary balance would be required to bring the debt/GDP ratio in each country back to its pre-crisis, 2007 level? Granted that countries which started with low levels of debt may never need to come back to this point, the question is an interesting one nevertheless. Table 3 presents the average primary surplus target required to bring debt ratios down to their 2007 levels over horizons of 5, 10 and 20 years. An aggressive adjustment path to achieve this objective within five years would mean generating an average annual primary surplus of 8-12% of GDP in the United States, Japan, the United Kingdom and Ireland, and 5-7% in a number of other countries. A preference for smoothing the adjustment over a longer horizon (say, 20 years) reduces the annual surplus target at the cost of leaving governments exposed to high debt ratios in the short to medium term.

[Can you imagine the US being able to run a budget surplus of even 2.4% of GDP? $350 billion-plus a year? That would be a swing in the budget of almost 10% of GDP.]

That is enough for today. We will delve further next week.

Montreal, New York, Connecticut, and Italy
Join Me in Paris

I have to tell you, the conference last week was awesome. The energy in the room was great. The speeches and conversations were amazing. We are working on getting them transcribed so we can share a few of them. You really want to make plans to be there next year. There is not any investment conference in the country that matches it for quality. My thanks to the hard-working staff of Altegris for doing such an outstanding job of making it all go so smoothly. And my apologies to all those who waited to the last minute to sign up and couldn't get in. When I say this conference will sell out, I really do mean it. So, next year, don't procrastinate.

I am home for most of May. I have a 24-hour trip to Montreal to be with Tony Boeckh for his private Club X conference. Tony will be the author of next Monday's Outside the Box, where he will discuss the themes in his new (and should be bestseller) book, The Great Reflation. I also get to go out and party when I land with David Rosenberg. That should be fun!

The next week I am back in New York for a day, then two nights in Stamford, Connecticut, speaking to Pitney Bowes execs, and then home, where I will stay until June 3, when the whole family (seven kids and spouses, grandbabys) takes a vacation to Italy for two weeks.

I am going to stay over and speak at the Global Interdependence Center Conference in Paris June 17th and 18th, with my good friend David Kotok and other luminaries. There will be a lot of central banker types, and if you want to get a feel for what's happening in Europe you should come. Information is at www.interdependence.org.

It is time to hit the send button. It's late and this letter is overlong. Thanks for hanging with me! Have a great week.

Your worried about the debt analyst,

John Mauldin

Government Debt Spirals

JohnMauldin — Tue, 24 Nov 2009 16:57:00 GMT

I have been writing about sovereign debt risk for some time. Japan, Spain, Italy and Portugal are all facing serious fiscal deficits and funding problems within a few years. But Greece may be the first country to hit the wall. In today's Outside the Box, we look at a short column by Ambrose Evans-Pritchard of the London Telegraph on the problems facing Greece. Greece will soon be faced with deciding which bad choice to make among a very small set of really bad, difficult choices.

And then we turn to a piece by Edmund Andrews in the New York Times about the funding problem facing the US. The US is going to have to borrow at a minimum $3.5 trillion in the next three years according to Obama administration officials, and it is likely to be much higher. And rates are likely to be rising. As Andrews notes "Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury's average cost of borrowing would cost American taxpayers an extra $80 billion this year." If interest rates were at the same level as a few years ago, interest costs on the debt this year would be $221 billion more than they actually were.

We are not yet Greece or Japan. But we are working on it given the current direction. At some point the bond market is not going to "go along" for the ride. Read these pieces and think about them.

As I often write, if something cannot happen then it won't. Greece cannot go along the same path they are on. While today we are blithely ignoring the debt problem, the US cannot continue with massive deficits without serious consequences.

With that being said, for those in the US, I wish you a very Happy Thanksgiving. My intention is to write a letter this Friday as usual, assuming I can roll out of bed after the feasting. I am told by very reliable sources that thanksgiving calories do not count, and I intend to take advantage of that.

Your still hopeful we will find a way to Muddle Through analyst,

John Mauldin, Editor
Outside the Box

Greece tests the limit of sovereign debt as it grinds towards slump

By Ambrose Evans-Pritchard, The Telegraph

Greece is disturbingly close to a debt compound spiral. It is the first developed country on either side of the Atlantic to push unfunded welfare largesse to the limits of market tolerance.

Euro membership blocks every plausible way out of the crisis, other than EU beggary. This is what happens when a facile political elite signs up to a currency union for reasons of prestige or to snatch windfall gains without understanding the terms of its Faustian contract.

When the European Central Bank's Jean-Claude Trichet said last week that certain sinners on the edges of the eurozone were "very close to losing their credibility", everybody knew he meant Greece.

The interest spread between 10-year Greek bonds and German bunds has jumped to 178 basis points. Greek debt has decoupled from Italian debt. Athens can no longer hide behind others in EMU's soft South.

"As far as the bond vigilantes are concerned, the Bat-Signal is up for Greece," said Francesco Garzarelli in a Goldman Sachs client note, Tremors at the EMU Periphery.

The newly-elected Hellenic Socialists (PASOK) of George Papandreou confess that the budget deficit will be more than 12pc of GDP this year, four times the original claim of the last lot. After campaigning on extra spending, it will have to do the exact opposite. "We need to save the country from bankruptcy," he said.

Good luck. Communist-led shipyard workers have already clashed violently with police. Some 200 anarchists were arrested in Athens last week after they torched streets of cars in a tear gas battle.

Mr Papandreou has mooted a pay freeze for state workers earning more than €2,000 a month. This has already set off an internal party revolt. "There is enormous denial," said Lars Christensen, emerging markets chief at Danske Bank. "They don't seem to understand that very serious austerity measures are needed. It is a striking contrast with Ireland," he said.

Brussels says Greece's public debt will rise from 99pc of GDP in 2008 to 135pc by 2011, without drastic cuts. Athens has been shortening debt maturities to trim costs, storing up a roll-over crisis next year. Some €18bn comes due in the second quarter of 2010 (IMF).

Modern economies have reached such debt levels before, and survived, but never in the circumstances facing Greece. "They can't devalue: they can't print money," said Mr Christensen.

The tourist trade is withering, down 20pc last season by revenue. Turkey was up. It is hard to pin down how much is a currency effect, but clearly Greece has priced itself out of the Club Med market. Wages rose a staggering 12pc in the 2008-2009 pay-round alone (IMF data), suicidal in a Teutonic currency union. Greece has slipped to 71st in the competitiveness index of the World Economic Forum, behind Egypt and Botswana.

Greece has long been skating on thin ice. The current account deficit hit 14.5pc of GDP in 2008. External debt has reached 144p (IMF). Eurozone creditors – German banks? – hold €200bn of Greek debt.

A warning from Bank of Greece that lenders must wean themselves off the ECB's emergency funding has brought matters to a head. Default insurance on Greek debt jumped 40 basis points last week.

Greek banks have borrowed €40bn from the ECB at 1pc, playing the "yield curve" by purchasing state bonds. This EU subsidy has made up for losses on property, shipping, and Balkan woes.

The banks insist that they are in rude good health. EFG Eurobank has halved reliance on ECB funding. "Greek banks are very liquid: we maintain billions in extra liquidity," it said. Yet markets are wary. Recession has come late to Greece, but will bite deep in 2010. It takes three years for defaults to peak once the cycle turns.

David Marsh, author of The Euro: The Politics of The New Global Currency, said the danger for EMU laggards is that the ECB will begin to tighten before they are out of trouble. It is German recovery that threatens to stretch the North-South divide towards breaking point.

Athens squandered its euro windfall. For a decade, EMU let Greece borrow at almost the same cost as Germany. It was a heaven-sent chance to whittle down debt. Instead, the country dug itself deeper into a hole by running budget deficits near 5pc of GDP at the top of the boom.

Like Labour under Brown, idiot leaders mistook a bubble for their own skill. But the consequences in EMU are more dreadful. Austerity may prove self-defeating, without the cure of devaluation. Greece risks grinding deeper into slump.

The EU can paper over this by transfering large sums of money to Greece. But will Berlin, Paris – and London, also on the hook – feel obliged to bail out a country that has so flagrantly violated the rules of the club, not least by holding Eastern Europe's EU entry to ransom over Cyprus? That is neither forgotten, nor forgiven.

During the panic last February, German finance minister Peer Steinbruck promised to rescue any eurozone state in dire trouble. He is no longer in office. The pledge was, in any case, a bounced political cheque even when he wrote it. Greece can assume nothing.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/6630117/Greece-tests-the-limit-of-sovereign-debt-as-it-grinds-towards-slump.html

Wave of Debt Payments Facing U.S. Government

By Edmund L. Andrews, the New York Times

WASHINGTON — The United States government is financing its more than trillion-dollar-a-year borrowing with i.o.u.'s on terms that seem too good to be true.

But that happy situation, aided by ultralow interest rates, may not last much longer.

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today's low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

With the national debt now topping $12 trillion, the White House estimates that the government's tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means.

The surge in borrowing over the last year or two is widely judged to have been a necessary response to the financial crisis and the deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States' long-term budget crisis is becoming too big to postpone.

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.

The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.

"The government is on teaser rates," said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. "We're taking out a huge mortgage right now, but we won't feel the pain until later."

So far, the demand for Treasury securities from investors and other governments around the world has remained strong enough to hold down the interest rates that the United States must offer to sell them. Indeed, the government paid less interest on its debt this year than in 2008, even though it added almost $2 trillion in debt.

The government's average interest rate on new borrowing last year fell below 1 percent. For short-term i.o.u.'s like one-month Treasury bills, its average rate was only sixteen-hundredths of a percent.

"All of the auction results have been solid," said Matthew Rutherford, the Treasury's deputy assistant secretary in charge of finance operations. "Investor demand has been very broad, and it's been increasing in the last couple of years."

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation's oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government.

"What a good country or a good squirrel should be doing is stashing away nuts for the winter," said William H. Gross, managing director of the Pimco Group, the giant bond-management firm. "The United States is not only not saving nuts, it's eating the ones left over from the last winter."

The current low rates on the country's debt were caused by temporary factors that are already beginning to fade. One factor was the economic crisis itself, which caused panicked investors around the world to plow their money into the comparative safety of Treasury bills and notes. Even though the United States was the epicenter of the global crisis, investors viewed Treasury securities as the least dangerous place to park their money.

On top of that, the Fed used almost every tool in its arsenal to push interest rates down even further. It cut the overnight federal funds rate, the rate at which banks lend reserves to one another, to almost zero. And to reduce longer-term rates, it bought more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages.

Those conditions are already beginning to change. Global investors are shifting money into riskier investments like stocks and corporate bonds, and they have been pouring money into fast-growing countries like Brazil and China.

Articles in this series will examine the consequences of, and attempts to deal with, growing public and private debts.

The Fed, meanwhile, is already halting its efforts at tamping down long-term interest rates. Fed officials ended their $300 billion program to buy up Treasury bonds last month, and they have announced plans to stop buying mortgage-backed securities by the end of next March.

Eventually, though probably not until at least mid-2010, the Fed will also start raising its benchmark interest rate back to more historically normal levels.

The United States will not be the only government competing to refinance huge debt. Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.

Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury's average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education.

But that could seem like a relatively modest pinch. Alan Levenson, chief economist at T. Rowe Price, estimated that the Treasury's tab for debt service this year would have been $221 billion higher if it had faced the same interest rates as it did last year.

The White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government's marketable debt — about $1.6 trillion — is coming due in the months ahead.

To lock in low interest rates in the years ahead, Treasury officials are trying to replace one-month and three-month bills with 10-year and 30-year Treasury securities. That strategy will save taxpayers money in the long run. But it pushes up costs drastically in the short run, because interest rates are higher for long-term debt.

Adding to the pressure, the Fed is set to begin reversing some of the policies it has been using to prop up the economy. Wall Street firms advising the Treasury recently estimated that the Fed's purchases of Treasury bonds and mortgage-backed securities pushed down long-term interest rates by about one-half of a percentage point. Removing that support could in itself add $40 billion to the government's annual tab for debt service.

This month, the Treasury Department's private-sector advisory committee on debt management warned of the risks ahead.

"Inflation, higher interest rate and rollover risk should be the primary concerns," declared the Treasury Borrowing Advisory Committee, a group of market experts that provide guidance to the government, on Nov. 4.

"Clever debt management strategy," the group said, "can't completely substitute for prudent fiscal policy."

http://www.nytimes.com/2009/11/23/business/23rates.html?_r=1&hp

An Uncomfortable Choice

JohnMauldin — Sat, 29 Aug 2009 17:59:00 GMT

An Uncomfortable Choice
What Were We Thinking?
Frugality is the New Normal
And Then We Face the Real Problem
The Teenagers Are in Control
Choose Wisely
Argentina, Brazil, Uruguay, New Orleans, Detroit, and More

We have arrived at this particular economic moment in time by the choices we have made, which now leave us with choices in our future that will be neither easy, convenient, nor comfortable. Sometimes there are just no good choices, only less-bad ones. In this week's letter we look at what some of those choices might be, and ponder their possible consequences. Are we headed for a double-dip recession? Read on.

An Uncomfortable Choice

As our family grew, we limited the choices our seven kids could make; but as they grew into teenagers, they were given more leeway. Not all of their choices were good. How many times did Dad say, "What were you thinking?" and get a mute reply or a mumbled "I don't know."

Yet how else do you teach them that bad choices have bad consequences? You can lecture, you can be a role model; but in the end you have to let them make their own choices. And a lot of them make a lot of bad choices. After having raised six, with one more teenage son at home, I have come to the conclusion that you just breathe a sigh of relief if they grow up and have avoided fatal, life-altering choices. I am lucky. So far. Knock on a lot of wood.

I have watched good kids from good families make bad choices, and kids with no seeming chance make good choices. But one thing I have observed. Very few teenagers make the hard choice without some outside encouragement or help in understanding the known consequences, from some source. They nearly always opt for the choice that involves the most fun and/or the least immediate pain, and then learn later that they now have to make yet another choice as a consequence of the original one. And thus they grow up. So quickly.

But it's not just teenagers. I am completely capable of making very bad choices as I approach the end of my sixth decade of human experiences and observations. In fact, I have made some rather distressing choices over time. Even in areas where I think I have some expertise I can make appallingly bad choices. Or maybe particularly in those areas, because I have delusions of actually knowing something. In my experience, it takes an expert with a powerful computer to truly foul things up.

Of course, sometimes I get it right. Even I learn, with enough pain. And sometimes I just get lucky. (Although, as my less-than-sainted Dad repeatedly intoned, "The harder I work the luckier I get.")

Each morning is a new day, but it is a new day impacted by all the choices of the previous days and years. Tiffani and I have literally interviewed in depth well over a hundred millionaires, and talked anecdotally with hundreds over the years. I am struck by how their lives, and those of their families, come down to a few choices. Sometimes good choices and sometimes lucky choices. Often, difficult ones. But very few were the easy choice.

What Were We Thinking?

As a culture, the current mix of generations, especially in the US, has made some choices. Choices which, in hindsight, leave the adult in us asking, "What were we thinking?"

In a way, we were like teenagers. We made the easy choice, not thinking of the consequences. We never absorbed the lessons of the Depression from our grandparents. We quickly forgot the sobering malaise of the '70s as the bull market of the '80s and '90s gave us the illusion of wealth and an easy future. Even the crash of Black Friday seemed a mere bump on the path to success, passing so quickly. And as interest rates came down and money became easier, our propensity to acquire things took over.

And then something really bad happened. Our homes started to rise in value and we learned through new methods of financial engineering that we could borrow against what seemed like their ever-rising value, to finance consumption today.

We became Blimpie from the Popeye cartoons of our youth: "I will gladly repay you Tuesday for a hamburger today."

Not for us the lay-away programs of our parents, patiently paying something each week or month until the desired object could be taken home. Come to think of it, I am not sure if my kids (15 through 32) have ever even heard of a lay-away program, not with credit cards so easy to obtain. Next family brunch, I will explain this quaint concept. (Interestingly, I heard about a revival of the concept on CNBC radio, coming back from dropping Trey off at school this morning. Everything old is new again.)

As a banking system, we made choices. We created all sorts of readily available credit, and packaged it in convenient, irresistible AAA-rated securities and sold them to a gullible world. We created liar loans, no-money-down loans, and no-documentation loans and expected them to act the same way that mortgages had in the past. What were the rating agencies thinking? Where were the adults supervising the sand box?

(Oh, wait a minute. DThat's the same group of regulators who now want more power and money.)

It is not as if all this was done in some back alley by seedy-looking characters. This was done on TV and in books and advertisements. I remember the first time I saw an ad telling me to call this number to borrow up to 125% of the value of my home, and wondering how this could be a good idea.

Turns out it can be a great idea for the salesmen, if they can package those loans into securities and sell them to foreigners, with everyone making large commissions on the way. The choice was to make a lot of money with no downside consequences to yourself. What teenager could say no?

Greenspan keeping rates low aided and abetted that process. Starting two wars and pushing through a massive health-care package, along with no spending control from the Republican Party, ran up the fiscal deficits.

Allowing credit default swaps to trade without an exchange or regulations. A culture that viscerally believed that the McMansions they were buying were an investment and not really debt. Yes, we were adolescents at the party to end all parties.

Not to mention an investment industry that tells their clients that stocks earn 8% a year real returns (the report I mentioned at the beginning goes into detail about this). Even as stocks have gone nowhere for ten years, we largely believe (or at least hope) that the latest trend is just the beginning of the next bull market.

It was not that there were no warnings. There were many, including from your humble analyst, who wrote about the coming train wreck that we are now trying to clean up. But those warnings were ignored.

Actually, ignored is a nice way to put it. Derision. Scorn. Laughter. And worse, dismissal as a non-serious perpetual perma-bear. My corner of the investment-writing world takes a very thick skin.

The good times had lasted so long, how could the trend not be correct? It is human nature to believe the current trend, especially a favorable one that helps us, will continue forever.

And just like a teenager who doesn't think about the consequences of the current fun, we paid no attention. We hadn't experienced the hard lessons of our elders, who learned them in the depths of the Depression. This time it was different. We were smarter and wouldn't make those mistakes. Didn't we have the research of Bernanke and others, telling us what to avoid?

In millions of different ways, we all partied on. It wasn't exclusively a liberal or a conservative, a rich or apoor, a male or a female addiction. We all borrowed and spent. We did it as individuals, and we did it as cities and states and countries.

We ran up unfunded pension deficits at many local and state funds, to the tune of several trillion dollars and rising. We have a massive, tens of trillions of dollars, bill coming due for Social Security and Medicare, starting in the next 5-7 years, that makes the current crisis pale in comparison. We now seemingly want to add to this by passing even more spending programs that will only make the hole deeper.

Frugality is the New Normal

I could go on and on, but I think you get the point. The time for good choices was a decade ago. It would have been more difficult at the time, so that is not what we did. And now we wake up and are faced with a set of choices, none of them good.

Reality is staring back in the mirror at the American consumer, and especially the Boomer generation. The psyche of the American consumer has been permanently seared. We are watching savings beginning to rise and consumer spending patterns change for the first time in generations. Even as the authorities try to prod consumers back into old habits, they are not responding. Borrowing and credit are actually falling. Banks, for whatever reason, now want borrowers to actually be able to pay them back. Go figure.

Frugality is the new normal. We are resetting the underpinnings of a consumer-driven society to a new level. It will require a major overhaul of our economy. The normal drivers of growth - consumer spending, business investment, and exports - are all weak, and it is only because of massive government spending that the second quarter was not as bad as the two previous quarters and that the coming quarter will be positive.

But what then? How long can we continue with 10%-plus GDP deficits? We have an economy that is in a Statistical Recovery, fueled by government largesse. In the real world, we are watching unemployment rise, and it is likely to do so through the middle of next year. Deflation is in the air. Capacity utilization is near all-time lows. Housing numbers are only bouncing because of the government program of large tax credits for first-time home buyers and lower home prices. It will be years before construction is significant.

We will be faced with a choice this fall and early next year. If you take away the government spending, the potential for falling back into a recession is quite high, given the underlying weakness in the economy. A few hundred billion for increased and extended unemployment benefits will not be enough to stem the tide. There will be a groundswell for yet another stimulus package. Another 10% of GDP deficit is quite likely for next year.

As I (and Woody Brock) have made very clear in these e-letters, deficits that are higher than nominal GDP cannot continue without dire consequences. Good friend Richard Russell writes today:

"The US national debt is now over $11 trillion dollars. The interest on our national debt is now $340 billion. This is about at 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let's say that by some miracle the interest on the national debt in 10 years will still be 3.09%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof."

That would be at least 30% of the national budget. How would your household do, paying that much as interest? How can you operate when interest payments are 30% or more of the budget? Do you borrow to pay the interest? And the Obama administration openly admits to deficits of over a trillion a year for the next ten years, under very rosy growth assumptions. Anyone outside of Washington and rosy-eyed economists think we will grow 4% next year? I am not seeing many hands go up.

And Then We Face the Real Problem

If we do not maintain high deficits, it is likely we fall back into recession. Yet if we do not control spending, we risk running up a debt that becomes very difficult to finance by conventional means. Monetizing the debt can only work for a few trillion here or there. At some point, the bond market will simply fall apart. And it could happen quickly. Think back to how fast things fell apart in the summer of 2007. When perception of the potential for inflation changes, it changes things fast.

The problem is that we are now in a very deflationary world. Deleveraging, too much capacity, high and rising unemployment, falling real incomes, and more are all the classic pieces of the formula for deflation.

Let's look at what my friend Nouriel Roubini recently wrote. I think he hit the nail on the head:

"A combination of higher official indebtedness and monetization has the potential to yield the worst of all worlds, pushing up long-term rates and generating increased inflation expectations before a convincing return to growth takes hold. An early return to higher long-term rates will crowd out private demand, as lending rates on mortgages and personal and corporate loans rise too. It is unlikely that actual inflation will emerge this year or even next, but inflation expectations as reflected in long-term interest rates could well be rising later in 2010. This would represent a serious threat to economic recovery, which is predicated on the idea that the actual borrowing rates that individuals and businesses pay will remain low for an extended period.

"Yet the alternative - the early withdrawal of the stimulus drug that governments have been dispensing so freely - is even more serious. The present administration believes that deflation is a worse threat than inflation. They are right to think that. Trying to rebuild public finances at a deflationary moment - a time when unemployment is rising, and private demand is still contracting - could be catastrophic, turning recovery into renewed recession."

There are no good choices. Nouriel, optimist that he is (note sarcasm), suggests that there is a possibility that the government can manage expectations by showing a clear path to fiscal responsibility that can be believed. And thus the bond markets do not force rates higher, thereby thwarting recovery.

And technically he is right. If there were adults supervising the party, it might be possible. But there are not. The teenagers are in control. Instead of fiscal discipline, we are hearing increased demands for more spending. Please note that the very rosy future-deficit assumptions assume the end of the Bush tax cuts at the close of 2010. But raising taxes back to the level of 2000 does not make the projected future budget deficits go away.

I mean, seriously, does anyone think Pelosi or Reid are going to lead us to fiscal constraint? Obama talks a good game, but he has not offered a serious deficit-reduction proposal, other than further tax increases. And by serious, I mean we need cuts on the order of several hundred billion dollars. The Republicans lost their way and their power (deservedly, in my opinion). Just as at the high school prom, the very few adults are being ignored.

It is the proverbial rock and the hard place. Cut the stimulus too soon and we slide back into a deeper recession. Let the budget spin out of control for a few years and we will see inflation return, with higher rates and a recession. Raise taxes by 1.5-2% of GDP in 2010 and we are shoved back into recession.

There are no good choices. If we do the right thing and cut the deficit, it means very hard choices. Can we keep our commitments to two wars and our massive defense budget? Medicare and Social Security reform are not painless. Education? Research? The "stimulus"? But cutting the deficit by hundreds of billions while raising taxes by even more than is already in the works, is not the formula for sustainable recovery.

Have we grown up? Are there adults in the room? Sadly, I don't think there are enough. We are still a nation of teenagers. We will do whatever we can to avoid the pain today. We will kick the can down the road, hoping for a miracle. Will we grow up? Yes, but the lessons learned will be hard.

There are no statistical signs of an impending recession. We are not going to get an inverted yield curve this time, which made it relatively easy for me to predict recessions in 2000 and 2006. We are in a deflationary, deleveraging world. A far different world than in the past.

I see little room for us to avoid a double-dip recession. It would take the skill and speed of former Cowboys running back Tony Dorsett hitting a very small hole in the line to break us into the open. I see no running back in our national leadership with such ability. As I have outlined above, recession could be triggered again in any number of very different economic environments. It all depends on the choices we make. But the choices lead to the same consequences, at least in my opinion.

As I wrote in August 2000 and August 2006, I write again in August 2009: there is a recession in our future. I was early both of those times and I am early now, maybe two years early, though I doubt it. And as I pointed out both of those last times, the stock market drops an average of over 40% during a recession. When I was on Kudlow in October of 2006, I was given a hard time about my recession call and prediction of a bear market. I think it was John Rutherford who dismissed my bearish vision. And he was right for the next three quarters, as the market proceeded to rise another 20%. I looked foolish to many, but I maintained my views.

You have choices. You can buy and hold (buy and hope?) or you can develop a strategic alternative. The next bear market, as I wrote in 2003 and in Bull's Eye Investing, will likely be the bottom. (It takes at least three of them to really take us to the bottom.) But the next one will change perceptions for a long time. Valuations will drop. Savings will rise even more. And a generation will grow up. The adults will return. Chastened. Scarred. Shaken. But we will Muddle Through. That is what we do. Even my teenagers.

Choose wisely.

Argentina, Brazil, Uruguay, New Orleans, Detroit, and More

Only a month ago my fall schedule looked surprisingly light. And then reality hit. I will be at the Schwab conference in San Diego on September 15. If you are going to be there, drop me a note. That is my only trip in September. But then it gets interesting. I celebrate my 60th birthday the first weekend of October, then fly to New Orleans to be at the annual New Orleans Conference, October 8-11. The speaker line-up is better than ever. I find this to be one of the best conferences I go to very year. I have been attending on and off for over 25 years. You should think about this one. http://www.neworleansconference.com/speaker-eblast-JohnMauldin/

Then I will spend the next weekend in Detroit, then probably go to New York, then Philadelphia for a CMG conference October 20, then down to Houston, over to Orlando, stop to change clothes and pack at home, and then fly off on a whirlwind trip to Argentina, Brazil, and Uruguay, speaking at a series of CFA conferences. Orlando in mid-November ... and nothing else so far. Switzerland and London in January.

I recently did an interview with King World News that was quite frankly one of the best interviews I have ever done. Eric King really got me going. It is in two parts. I give you the link to the first part, and the second is in their archives. There are also interviews with a very serious group of names. I am flattered to be included. Click here.

It is time to hit the send button. I am resisting the temptation to launch into politics, so I need to quit before I do. Suffice it to say, we could see some big changes as we work through our teenage years, back to adulthood.

Speaking of good choices, the wedding last weekend was fabulous. I am delighted with my new son-in-law. Life goes on, even as my kids struggle to get enough hours of work and money. Henry is at UPS, and work hours are way down and they have a new son. Chad finally got a new job, which may give him enough hours to survive, but not a lot of money. For those of you who think I live in an ivory tower, I do have a view into the lives of seven kids who are very real people, as well as those of lots of friends. I am very well aware of how tough it is out there, and realize how blessed I am.

You have a great week. Tomorrow I get to go the Dallas Cowboys game in the new stadium in a suite, courtesy of a friend who got the seats from Jerry Jones himself. Not sure where, but it sounds cool. Sometimes life gives you lucky breaks.

Your amazed to still be writing after all these years analyst,

John Mauldin

Slow Long-Term Growth, And Government's Response

JohnMauldin — Mon, 10 Aug 2009 20:50:00 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. His web site is down being re-designed, but you can write for more information at insight@agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out until the end of the year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

John Mauldin, Editor
Outside the Box

Slow Long-Term Growth, And Government's Response

(excerpted from the August 2009 edition of A. Gary Shilling'sINSIGHT)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we've discussed in pastInsights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow -- so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in pastInsights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis -- U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids' education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices -- the vast majority of most Americans' net worth -- are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we're forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we've discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn't want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes aren't so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won't qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% won't qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We've already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore's huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won't stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It doesn't plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed's lending powers to require the Treasury Secretary's approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don't vote in domestic elections.

As noted earlier, initially this recession was in the financial arena -- the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it's not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country's financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps.

Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand wasn't caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We've consistently predicted the good deflation of excess supply, but we've also said clearly that the bad deflation of deficient demand could occur -- due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation. They've never seen anything but inflation in their business careers or lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we've cited in pastInsights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) -- the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall -- are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply overdemand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it's got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. Meanwhile, prices -- already down 32% from their second quarter 2006 peak -- are likely to fall to reach a total 37% decline we've forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by the unusually large slashing of consumer spending. It's hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That's a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7 ) to 2.1%.

So with the five other inhibitors to growth in coming years -- financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation -- our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We're also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s - mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same longrun phenomenon of past decades that was measured in different ways -- the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption's share of GDP, reflecting what consumers did with the money they didn't save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption's share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we're forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption's share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years -- the saving rate fell from 12% to zero, or 12 percentage points while consumption's share of real GDP rose from 67.5% to 71%.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption's share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation's share of national income falling while corporate profits' share leaped during those years.

In the years ahead, however, it's unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits' share was at its zenith, a big decline in corporate earnings' piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one's share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where's The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it's unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined -- and they hadn't on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future -- which means chronic declines with chronic deflation -- are shattering the scales that blinded homeowners. So they're beginning to separate places to live from investments. That means they'll want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we've run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead -- except for federal government stimuli that's spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California's latest budget stopgap will take, temporarily, $4 billion from local government funds.

We're forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there's no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s -- electrification of homes and factories and mass-produced automobiles -- was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June's 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we're right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising -- absent huge federal intervention. And that intervention is assured since no government -- left, right or center -- can withstand high and rising joblessness for long. And don't forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it won't be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what's left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment -- the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In futureInsights, we'll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, don't expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It's likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.

The Great Reflation Experiment

JohnMauldin — Fri, 31 Jul 2009 15:04:00 GMT

The Great Reflation Experiment
The Debt Super Cycle
Some Background on US Inflation
Implications for Investors
A Beach, New York, and Maine

The question we have been focused on for some time now is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask today, and getting the answer right is critical. This week, we have a guest writer who takes on the topic of the great experiment the Fed is now waging, which he calls The Great Reflation Experiment.

One of my favorite sources of information for decades has been and remains the Bank Credit Analyst. It has a long and storied reputation. One of their enduring themes has been the debt super cycle. Investors who have paid attention to it have been served well. I am taking a little R&R this weekend, but I have arranged for my friend Tony Boeckh to stand in for me. Tony was chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst up until he retired in 2002. He still likes to write from time to time, and we are lucky enough to have him give us his views on where we are in the economic cycles. Gentle reader, we are all graced to learn from one of the great economists and analysts of our times. Pay attention. Central bankers do. You can read his extensive bio at www.boeckhinvestmentletter.com and I will tell you how to get his letter free of charge at the end of this letter. And, he told me to mention that his son Rob is now helping him write, so there is a double byline here. Now, let's just jump in.

By Tony Boeckh and Rob Boeckh

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies. Inflation doesn't stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.

Policymakers, money managers, and most forecasters have argued that the crash was a "black swan" event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

The Debt Super Cycle

The real culprit is the US debt super cycle, which has operated for decades, mostly in a remarkably benign manner. The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the US to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.

Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.

Some Background on US Inflation

Inflation, to be properly understood, should be defined as a persistent expansion of money and credit that substantially exceeds the growth requirements of the economy. As a consequence of excessive monetary expansion, prices rise. Which prices go up and at what rate depends on a number of factors. Sometimes it is the prices of goods and services that are the most visible symptom of inflationary pressures. That was the case in the 1970s when the Consumer Price Index (CPI) hit a peak rate of 14% per annum. Sometimes it is the prices of assets such as homes, office buildings, stocks, or bonds that reflect the inflationary pressure, as we have seen in more recent years.

When inflation becomes pervasive, and other conditions are supportive, it can engulf a whole industry. We saw this in the financial sector in the period leading up to the crash. The supporting conditions or "displacements," to use the terminology of Professor Kindleberger, were financial innovation, deregulation, and obscene profits and salaries. These drew millions of bees to the honey. All great manias are accompanied by malfeasance, in this case the biggest Ponzi scheme in history and many other lesser ones. It is relatively easy to steal when prices are rising and greed is pervasive. Overspending and a general lack of prudence always become widespread when a mania infects the general public. Rational people can do incredibly stupid things collectively when there is mass hysteria.

The origins of post-war inflation go back to the late 1950s and early 1960s, though some would take it back much further. In the 1960s, the US dollar started to come under pressure as a result of US inflationary policy and foreign central banks' ebbing confidence in their large and growing dollar reserve holdings. The US responded with controls and government intervention in a number of areas: gold convertibility, the US Treasury bond market, the Interest Equalization Tax, and, ultimately, intervention on wages and prices. These moves clearly flagged to the world that external discipline would be subjugated to domestic employment and growth concerns. The policy was formalized when the US terminated the link between gold and the dollar in August 1971, essentially floating the dollar and setting the US on a course of sustained inflation. Of course, the dollar floated down, which, among other things, triggered the massive rise in general prices in the 1970s.

The next episode of credit inflation began in the 1980s, paradoxically triggered by the success of Paul Volcker's move to break the spiral of rising general price inflation through very tight money. He succeeded famously, and the CPI headed sharply lower along with interest rates, setting the stage for the massive US debt binge and the series of asset bubbles that followed. It was easy for the Federal Reserve to pursue expansionary credit policies while inflation and interest rates were falling.

The Great Reflation Experiment of 2009

Private sector credit, the flipside of debt, maintained a stable trend relative to GDP from 1964 to 1982 (Charts 1& 2). After that, the ratio of debt to GDP rose rapidly for the 25 years leading up to the crash, and is continuing to rise. The current reading has debt close to 180% of GDP, about double the level of the early 1980s. The magnitude and length of this rise is probably unprecedented in the history of the world. Even the credit inflation that was the prelude to the 1929 crash and the Great Depression only lasted five or six years.

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage - from banks to consumers to supposedly blue-chip companies - and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus - the end of which we won't see for a long time - aborted the meltdown. However, the story is far from over.

The Great Reflation Experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve's balance sheet. Both are unprecedented since World War II. US federal government debt is likely to reach close to 100% of GDP over the next 8 to10 years, according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3). Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, along with an aging population, will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock. Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed's balance sheet and consequent rise in bank reserves - the fuel that could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20%, to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living that could not be attained from regular income alone (Chart 4). They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.

Pensions have been devastated and people's appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20%, depending on term and withdrawal penalties. Reasonable-quality bonds with a five-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate "bullet-proof" stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.

Against this backdrop we offer a few thoughts. First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years, and China will also be important in keeping inflation down. Its capital investment is larger than the US's in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor, means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods. Therefore, investors who need income are probably safe holding reasonably high-quality bonds in the five-year maturity range. A bond ladder is a very useful tool for most people. Holdings are staggered over, say, a five-year time frame, and maturing bonds are invested back into five-year bonds, keeping the portfolio structure in the zero-to-five-year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the US dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The US role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil, and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They don't want more dollars, and yet they don't want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s the US has never subjugated domestic concerns to external discipline. Officials may talk of a strong-dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, "We didn't ask you to buy the dollars." The US has typically seen such buying as currency manipulation to gain an unfair trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, "a balance of financial terror." The most important central banks will continue to hold their noses and buy the dollar to keep it from falling too sharply. However, this is a fragile, unstable situation, and the dollar must fall over time. Investors need to diversify away from this risk. There are three obvious ways.

The first is investing in high-quality US equities that have a majority of their earnings and assets in hard-currency countries.

The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the negative side, it is faced with nonexistent global price inflation, even deflation, and a sharp decline in jewelry demand. On the positive side, concerns over U. monetary and fiscal debauchery will almost certainly heat up. As the odds of the latter increase, gold will be a major beneficiary, and investors should have a healthy insurance position in this asset class.

Third, most foreign currencies will also benefit from these fears, and hence investors can also protect themselves by diversifying into non-dollar assets in the best-managed countries. Some of these are emerging markets like China, which are liquid, in surplus, fiscally stable, and still growing well in spite of the global economic downturn. If and when the world economy begins to recover, and should price inflation stay low, asset bubbles are likely to recur. Where and when is always hard to tell in advance. Good prospects are in emerging-market equities, commodities, and commodity-oriented countries.

So, to sum up, in the next six to 12 months we look for a weak but recovering US economy, a continued deflationary price environment, pretty good asset and commodity markets, and continued narrowing of credit spreads. This view is based on the assumption that the new money created has to go somewhere, a stable to modestly falling dollar, and an anemic world economic recovery next year.

A buy and hold strategy has been bad advice for the past 10 years. The S&P is down 45% from its peak in early 2000. The investment world is likely to remain very unstable in the face of the difficult longer-run problems discussed above. Investors, whether they like it or not, are in the forecasting game, and forecasting is all about time lags. The exceptional circumstances of the current environment make any assessment of time lags extraordinarily difficult, and mistakes will continue to be costly. For that reason, holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth. They are in the unfortunate position of having to wait until the air clears a bit and more aggressive action can be taken with higher confidence. Warren Buffet has properly reminded us on numerous occasions that a price has to be paid for waiting for such a time, but then most of us aren't as rich as he is.

A Beach, New York, and Maine

I want to thank Tony and Rob for writing this week's letter. You can go to their website, www.boeckhinvestmentletter.com and see some of their recent letters, or send an email to info@bccl.ca and get put on their regular list for the free letter.

As you are reading this, I am hopefully reading on a beach, relaxing under an umbrella. Tiffani and Ryan are on a cruise in the Caribbean. They just got back the wedding videos from last year, and they are a hoot. They had one cameraman with an old Super 8 camera, so that video looks like something from the 60s. At some point they will put it on You Tube. Interesting to contrast the old format with the new.

I get back late Monday, and then leave early Wednesday for a quick trip to New York and then on to the Shadow Fed fishing weekend organized by David Kotok. My youngest son, now 15, will be with me for our fourth trip. Maybe this year I can catch more than he does. So far, it has not even been close in either quantity or quality.

Each year, we make small bets (bragging rights are more on the line) on where the markets will be the next year. So far, I am money ahead, as I get a few calls right. Last year the financial markets were just starting to melt down as we met. It will be interesting to see if any of us came close this year. There are some fairly well-known names in the room, so it will be interesting to see who got it right. And even more interesting to try and figure out where we will be next year at this time. I will report back.

And that blank spot that was my fall travel calendar? Looks like I will be going to South America in the fall (Argentina, Brazil, and Uruguay). A few other dates look to be firming up. It has been way too long since I was in South America, and I am looking forward to it.

Have a great week.

Your going to mix in some sci-fi with the economics reading analyst,

John Mauldin

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