Search results matching tags 'GDP' and 'Government Debt'

The Unsustainable Meets the Irresistible

JohnMauldin — Sat, 22 Jan 2011 21:15:00 GMT

The Unsustainable Meets the Irresistible
State and Local Spending
QE Policy Meets the Tea Party
A Bug in Search of a Windshield
Miami, Vegas, Thailand, and Some Needed Help

This week’s letter is a result of two lengthy conversations I had today, which have me in a reflective mode. Plus, I finished the last, final edits of my book, all of which is causing me to mull over the unsustainability of the US fiscal situation. There is a true Endgame here, and it may happen before we are ready.

The first conversation was with Kyle Bass, Richard Howard, and Peter Mauthe, over lunch (more on Peter, who has come to work with me, below). Kyle is the head of Hayman Advisors, a very successful macro hedge fund based here in Dallas. Then I recorded a Conversation with David Rosenberg and Lacy Hunt, which is one of the best we have ever done. Subscribers will be very happy. The new Conversation with George Friedman is now online, too. You can learn more about Conversations with John Mauldin at www.johnmauldin.com/conversations/ . Now, to this week’s letter. My goal is to make this one a little shorter than normal. We’ll see how I do.

The Unsustainable Meets the Irresistible

Kyle, Lacy, and David are typically pushed into the bearish category, but (not surprisingly to me) their forecast for the next few quarters is rather strong. None of us would be surprised by a high-3% number for GDP this quarter, and 4% is not out of the question. And we all see GDP tailing off as the year winds down. Inventory builds begin to slow, and in 2012 the 2% payroll holiday goes away. Plus, as I have written and David has noted, the pressure on state and local spending is getting larger with every passing day.

State and local spending is the second biggest component of the economy. The chart below, from David’s letter this week, gives us a visual image of just how large it is. Note that budget deficits at the state and local levels total more than 1% of GDP. Revenues, though, are still off 10% (on average) from where they were at the peak. The “fiscal stimulus” from the US government has run out and states and local communities are having to balance their budgets the old-fashioned way – through spending cuts and increased taxes.

As this budget cutting works its way through the economy, and as inventories are no longer being built (they are already at adequate levels), the growth from the current stimulus (both QE2 and payroll and federal government expenditures) the economy will have to stand on its own in terms of organic growth. And as the year wears on it will become apparent there is less true organic growth than currently meets the eye.

State and Local Spending

A few more thoughts on state and local spending. First, Congress needs to go ahead and authorize a bill allowing states to file for bankruptcy. At the very least, this send s very clear message to the states that the federal government will not come to their aid. It is not fair to ask states that have done what they need to do to keep their fiscal houses in order, to support states that have overspent, typically by trying to fund their pensions and run other well-intentioned but underfunded programs.

Second, states need the ability to force public unions to come to the table. Many states have overpromised, and they are simply in a very deep hole and need concessions. Private workers have had to take the brunt of the recent crisis, and meanwhile government workers get far more on average than private employees.

There is an interesting table in a USA Today story from last year, comparing the compensation of federal and private employees. I am going to put the whole table in this letter and let you quickly scroll down through it. The link to the article is at the end. (Notice that government economists make more than private ones!) Now let me say that I begrudge no one their income. What I am saying is that the disparity, when budgets are tight, between what the private sector must deal with and what the public sector has on its plate, should not be as great as it is.

Job	Federal	Private	Difference
Airline pilot, copilot, flight engineer	$93,690	$120,012	-$26,322

Broadcast technician	$90,310	$49,265	$41,045

Budget analyst	$73,140	$65,532	$7,608

Chemist	$98,060	$72,120	$25,940

Civil engineer	$85,970	$76,184	$9,786

Clergy	$70,460	$39,247	$31,213

Computer, information systems manager	$122,020	$115,705	$6,315

Computer support specialist	$45,830	$54,875	-$9,045

Cook	$38,400	$23,279	$15,121

Crane, tower operator	$54,900	$44,044	$10,856

Dental assistant	$36,170	$32,069	$4,101

Economist	$101,020	$91,065	$9,955

Editors	$42,210	$54,803	-$12,593

Electrical engineer	$86,400	$84,653	$1,747

Financial analysts	$87,400	$81,232	$6,168

Graphic designer	$70,820	$46,565	$24,255

Highway maintenance worker	$42,720	$31,376	$11,344

Janitor	$30,110	$24,188	$5,922

Landscape architects	$80,830	$58,380	$22,450

Laundry, dry-cleaning worker	$33,100	$19,945	$13,155

Lawyer	$123,660	$126,763	-$3,103

Librarian	$76,110	$63,284	$12,826

Locomotive engineer	$48,440	$63,125	-$14,685

Machinist	$51,530	$44,315	$7,215

Mechanical engineer	$88,690	$77,554	$11,136

Office clerk	$34,260	$29,863	$4,397

Optometrist	$61,530	$106,665	-$45,135

Paralegals	$60,340	$48,890	$11,450

Pest control worker	$48,670	$33,675	$14,995

Physicians, surgeons	$176,050	$177,102	-$1,052

Physician assistant	$77,770	$87,783	-$10,013

Procurement clerk	$40,640	$34,082	$6,558

Public relations manager	$132,410	$88,241	$44,169

Recreation worker	$43,630	$21,671	$21,959

Registered nurse	$74,460	$63,780	$10,680

Respiratory therapist	$46,740	$50,443	-$3,703

Secretary	$44,500	$33,829	$10,671

Sheet metal worker	$49,700	$43,725	$5,975

Statistician	$88,520	$78,065	$10,455

Surveyor	$78,710	$67,336	$11,374

Source: Bureau of Labor Statistics, USA Today analysis http://www.usatoday.com/news/nation/2010-03-04-federal-pay_N.htm

You can see in the next graph that this differential has built up over time. It used to be that a federal government job paid less but was more secure. Now it is still more secure but pays about 44% more on average (35% higher wages and 69% higher benefits). (source: Reason magazine)

Further, while there has been a clear drop in private employment, we have seen 10% growth in federal employment (state and local employment was flat through the middle of last year, but is likely to fall this year, with budget cuts).

That clearly implies there is room at the federal level for some “austerity.” The calls for a rollback to the budget and employment levels of 2007 will become more vocal as the set of facts we will address in a moment become evident.

Before we get to that, however, I want to take a side trip. Illinois recently passed a very real tax increase as a way to start the process of dealing with its massive deficits. It did so in a lame duck session of its state legislature, even though the voters had clearly elected a far more fiscally conservative legislature that would not have passed the tax increases.

The response of the governors of Indiana and Wisconsin, their closest neighbors? They immediately suggested to Illinois businesses that they are welcome to come to their states and set up shop and pay less taxes.

Higher taxes are hardly a cure. Look at the migration of businesses from high-tax states to low-tax states. Over the last ten years it has been pronounced. For those who argue that higher marginal taxes don’t make a difference, the facts clearly overrule you. Oregon decided to tax the wealthiest 2% of its citizens. They collected 40% less than they projected, and over 25% of the people they expected to tax somehow “disappeared.” And that is just in the first year. At some point, the “rich” get tired of being in the crosshairs of politicians and repair to more favorable climes.

This is all part of the national conversation we need to have on taxes and spending. That we need a complete tax overhaul, a thorough rethinking of how we raise the monies we need, should be obvious. To hear the “this is dead on arrival” conclusions of the various federal deficit commission reports, from the left and even from Republicans, is disheartening, at least to me. There are a lot of things I do not like in those reports, but they are a starting point for a much-needed national conversation. We are soon going to find ourselves in very deep kimchee, if the report Kyle showed me today is close to right.

QE Policy Meets the Tea Party

Kyle shared with me a presentation by the Lindsey Group called “QE Policy Meets the Tea Party.” It was wide-ranging in scope, but what caught my eye was the table I print below. Larry Lindsey is one of the better economists in the country, a former Fed governor with stints at the White House. I have not met him, but his associate Marc Sumerlin is whip-brilliant. (http://www.thelindseygroup.com/)

America, they assert, is in a fiscal trap due to the low interest rates we currently enjoy. What if I told you we could cut defense and discretionary spending by 20%, put in a two-year pay freeze on federal employees, and go ahead and let the Bush tax cuts on the “rich” expire. Wouldn’t that go a long way to fixing the deficit? The answer is, sadly, likely to be no.

As the table shows, if interest rates go back to their long-term historical average, spending could rise by $800 billion in just 8 years. Even under the more optimistic assumptions of the Congressional Budget Office, it is still $500+ billion. The government debt held by the public would be around 120% of GDP (back of my napkin), or close to what I said last week was completely unsustainable by the Irish. It will be no less so for the US. Spend a few moments with the table, and see how even deep cuts and freezes have so little impact. That is not to say they are not necessary, but this just shows that a much different approach is needed.

What approach might that be? Dealing with entitlements, of course. The very item that most politicians give lip service to but have no real solutions for. But that is a topic for another month’s worth of letters.

The takeaway is that we are on an unsustainable path. Absent something more serious even than what the Lindsey Group has outlined, long before we get to 2019 the bond markets will have taken away our ability to finance our debt at low rates.

Peter Orszag wrote a column in the Financial Times today. (Orszag was the Director of the Office of Management and Budget under President Obama.) His closing paragraph:

“The bottom line is that there may well be U.S. public debt tremors this year, both during federal debate over raising the debt ceiling and with at least a limited number of crises in local and city governments. The bigger problem, though, lies beyond 2011, as the unsustainability of the federal government’s fiscal trajectory becomes increasingly clear. I hope it does not ultimately require a crisis to restore fiscal sustainability at the federal level, but I fear it will.”

A Bug in Search of a Windshield

One of my speech lines that usually gets a laugh (although I am not sure how it will go over in Japan next month) is that Japan is a bug in search of a windshield. In today’s FT there is an article quoting an interview with the new Japanese finance minister, a rather surprise appointment from the opposition party and a budget hawk. Quote:

“ ‘We face a dreadful dream that one day the long-term interest rate might rise,’ Kaoru Yosano, the new minister for economic and fiscal policy, told the Financial Times. Japan has hit a ‘critical point’ where it risks losing investor confidence if politicians fail to reach agreement on how to rein in the ballooning national debt, a cabinet minister has warned.”

Greece. Ireland. Japan. They are coming to the end of their ability to raise debt at an affordable level. There will be defaults in one form or another. Whether you call it restructuring or adjustments or printing money, it will happen.

If the US does not get its act together, we will soon be trying to avoid the windshield of the bond market, which will be coming at us faster than we can swerve to avoid it.

On a more optimistic note, I have just returned from giving a speech in Winnipeg. In the mid-’90s, Canada was in much worse shape than the US is in today. They made the tough choices and have since done very well. So has Sweden. We do not have to become Argentina or what will soon be Japan. Let us hope that we make the tough choices and avoid that windshield. The world does not want to suffer through a crippled US economy and government. That is almost unthinkable. So we must start to think the unthinkable and hedge our bets. Just in case.

Miami, Vegas, Thailand, and Some Needed Help

We are in the final stages of planning our annual Strategic Investment Conference. You do NOT want to miss this. It is going to be our biggest and best ever. It will be April 28-30 in La Jolla. Save that date.

Next week I go to Miami to speak at the Tiger 21 Conference. I am on a panel with former Majority Leader Richard Gephardt and former head of the GAO David Walker, following a speech by Newt Gingrich, rounded out by a serious assortment of financial types. I think they bring your humble analyst in as the comic relief, but I have fun all the same.

The next week I am off to Vegas for a day at Steve Blumenthal of CMG’s conference, then it’s on to Thailand. I sing for my supper in Phuket, but will then go to Bangkok for four days with my long-time friend Tony Sagami for some vacation and sightseeing time (although I plan to write a letter from there).

I am racking up the airline miles the first quarter of the year. I have to say that wifi on the plane is one of the greatest things since sliced bread. It is tough to keep up, but that helps.

I am MOST PLEASED to announce that Peter Mauthe has joined Millennium Wave Investments. Peter is well-known in the investment industry, having run some very well-established firms. He is a management professional. He is also a very savvy investment professional, as he is a recent past president of the American Association of Professional Technical Analysts. He really is a master of technical analysis, and I intend to sit at his feet and learn. Over time, you will see some of that wisdom creep into my writing.

Most importantly, if you go to LinkedIn, you will see that Peter has taken the title Chief Implementation Officer (yet another CIO title, but this one is a real description of his role). We have so many opportunities coming at us that Tiffani or I just do not have time to deal with. We are swamped. We have never been busier. We need someone who can manage that process and make things happen. And it has to be someone we can trust implicitly, as he will speak for us in so many business situations.

This is a true new era here at Millennium Wave Investments. I feel we are taking it to a whole new level this year, and I am excited. There are more and even better things coming, down the road. But this letter will still be in your inbox each week. The reason for everything is you, gentle reader, and I am reminded of that every day. Thanks for your support over the years.

Now, have a great week. I see some family time in my weekend and a hectic schedule next week. But I am having way more fun than the law allows.

Oh, and my throwaway line at the annual CFA Forecast Dinner in Winnipeg? It was minus 12 degrees Fahrenheit that night. “Seriously, you should show some sympathy to your speakers. Why not schedule your forecast dinner for July? You would be ahead of everyone else and the forecasts would be just as accurate.” Which is to say, not so much. But I try, gentle reader, I try.

Your needing to stop so his shadow can catch up analyst,

John Mauldin

The Center Cannot Hold

JohnMauldin — Sat, 08 May 2010 02:17:00 GMT

The Risks from Fiscal Imbalances
The Challenge for Central Banks
Bang, Indeed!
The Center Cannot Hold
A Decent Employment Report
Montreal and New York and Italy

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the center cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

- William Butler Yeats

Last week we focused on the first half of a paper by the Bank of International Settlements, discussing what they characterized as the need for "Drastic measures ... to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability." As I noted, you don't often see the term drastic measures in a staid economic paper from the BIS. This week we will look at the conclusion of that paper, and then turn our discussion to the fallout from the problems they discuss, initially in Europe but coming soon to a country near you.

But first, what a week in the markets! I'm sure more than a few investors felt like they had a severe case of whiplash. We will discuss the volatility a little more below.

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If you are not an accredited investor, I work with CMG in Philadelphia. We have created a platform of money managers who specialize in the alternative management space. By this I mean they do not need a bull or bear market in order to have the potential for profits. (Past performance is not indicative of future results.) You can go to http://www.cmgfunds.net/public/mauldin_questionnaire.asp and quickly read about the past performance of a manager we recently added to the platform, and then sign up to get more information.

If you are an investment advisor or broker, all of my partners can work with you in providing your clients exposure to alternative-style investments and managers. Obviously, if your clients are high-net-worth individuals, then you will want to work with Altegris, ARP, or one of my other international partners; and if your clients need lower minimums, then you should work with CMG. And if you have any feedback or comments, feel free to write me. Now, on to the letter.

The Risks from Fiscal Imbalances

Today we are going to return to 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."

Let me briefly sum up last week's letter. They wrote: "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?"

I reproduced graphs that projected interest-rate payments as a percentage of GDP rising rather dramatically over the next 30 years, to levels that, quite frankly, cannot be tolerated by the markets. Long before we get to the place where we in the US are paying 20% of our GDP in interest (which would be about 80% of our tax collections, even with much higher tax rates) the bond market, not to mention taxpayers, will revolt.

The paper's authors clearly show that the current course is not sustainable. And to get back to a level of debt-to-GDP that countries "enjoyed" as recently as 2007 requires such massive structural surpluses as to boggle the mind. And that is with rather optimistic growth assumptions that, as I will show in a few pages, are not very likely.

You can read last week's letter at http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2010/04/30/the-future-of-public-debt.aspx. The discussion of the BIX paper is in the last half of the letter.

Now, we come to the section where they talk about the risks associated with the fiscal deficits. And by the way, we should note that 25 of 27 European countries are running deficits in excess of 3% of GDP. Ireland has a deficit of 14.3%. Portugal is at almost 10%. Greece is almost 14%.

Here is a table from my friends at Variant Perception in London, from data from The Economist. Notice that France is over 8%. Germany is almost 6%. Wow. We'll look at the implications of this later.

The first risk is of course, higher interest rates brought about by what they term increased risk premia. In essence, investors want to get paid more for their increased risk. Interest on Greek debt for 5-year bonds is now 15%. There is no way for them to grow their way out of the problem if interest rates are at 15%, up almost fourfold in less than a year. Rates are rising for other European peripheral countries as well.

The second risk "... associated with high levels of public debt comes from potentially lower long-term growth. A higher level of public debt implies that a larger share of society's resources is permanently being spent servicing the debt. This means that a government intent on maintaining a given level of public services and transfers must raise taxes as debt increases. Taxes distort resource allocation, and can lead to lower levels of growth. Given the level of taxes in some countries, one has to wonder if further increases will actually raise revenue.

"The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital.

"This not only lowers the level of output but, since new capital is invariably more productive than old capital, a reduced rate of capital accumulation can also lead to a persistent slowdown in the rate of economic growth. In an open economy, international financial markets can moderate these effects so long as investors remain confident in a country's ability to repay. But, even when private capital is not crowded out, larger borrowing from abroad means that domestic income is reduced by interest paid to foreigners, increasing the gap between GDP and GNP."

This squares solidly with the work done by Rogoff and Reinhart, showing that when the debt of a country reaches about 100% of GDP, there is a reduction in potential GDP growth of about 1%. As I have written elsewhere, government debt and spending do not increase productivity. That takes private investment. And if government debt crowds out private investment, then there is lower growth. And that is what the Rogoff and Reinhart study clearly shows.

And finally, the BIS authors note the risk that a government cannot run deficits in times of crisis to offset the affects of the crisis, if they already are running large deficits and have a large debt. In effect, fiscal policy is hamstrung.

The Challenge for Central Banks

Interestingly, the authors worry that one of the real problems central banks may face is that inflation expectations may become unanchored in the absence of a willingness on the part of the government to show fiscal constraint. Without some evidence of that willingness, monetary policy could lose any ability of be effective.

In other words, no matter how much the people at the Fed might like to help in a crisis, they may not be able to do anything effective if the US government does not deal with its deficits.

"A second mechanism by which public debt can lead to inflation focuses on the political and economic pressures that a monetary policymaker may face to inflate away the real value of debt. The payoff to doing this rises the bigger the debt, the longer its average maturity, the larger the fraction denominated in domestic currency, and the bigger the fraction held by foreigners. Moreover, the incentives to tolerate temporarily high inflation rise if the tax and transfer system is mainly based on nominal cash flows and if policymakers see a social benefit to helping households and firms to reduce their leverage in real terms. It is, however, worth emphasising that the costs of creating an unexpected inflation would almost surely be very high in the form of permanently high future real interest rates (and any other distortions caused by persistently higher inflation)."

The head of the European Central Bank, Jean-Claude Trichet, made it very clear this week that the ECB is not going to be buying Greek bonds. In my recent discussion with Richard Fisher, president of the Dallas Fed, it was also made clear that the current leadership of the Fed knows it cannot print money. So who is the BIS looking at when they talk about the temptation to inflate?

The Bank of England comes to mind. Also Japan. And a number of smaller European central banks. Countries that would not mind their currencies falling, especially if the euro continues to slide. As the BIS notes, the temptation is going to be large. But there is no free lunch. Such things can spiral out of control and either end in tears or in a Paul Volker wrenching the economy into serious recession. I think the final sentence of the paragraph quoted above serves as a warning that such a policy dooms a country to even worse nightmares.

Now we come to the conclusion of the paper. Normally, I do not like to quote at length, but these next six paragraphs deserve it (again, all emphasis mine):

"Our examination of the future of public debt leads us to several important conclusions. First, fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today's long-term fiscal planning.

"It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly.

"Second, large public debts have significant financial and real consequences. The recent sharp rise in risk premia on long-term bonds issued by several industrial countries suggests that markets no longer consider sovereign debt low-risk. The limited evidence we have suggests default risk premia move up with debt levels and down with the revenue share of GDP as well as the availability of private saving. Countries with a relatively weak fiscal system and a high degree of dependence on foreign investors to finance their deficits generally face larger spreads on their debts. This market differentiation is a positive feature of the financial system, but it could force governments with weak fiscal systems to return to fiscal rectitude sooner than they might like or hope.

"Third, we note the risk that persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term potential growth. Although we do not provide direct evidence of this, a recent study suggests that there may be non-linear effects of public debt on growth, with adverse output effects tending to rise as the debt/GDP ratio approaches the 100% limit (Reinhart and Rogoff (2009b)).

"Finally, looming long-term fiscal imbalances pose significant risk to the prospects for future monetary stability. We describe two channels through which unstable debt dynamics could lead to higher inflation: direct debt monetisation, and the temptation to reduce the real value of government debt through higher inflation. Given the current institutional setting of monetary policy, both risks are clearly limited, at least for now.

"How to tackle these fiscal dangers without seriously jeopardising the incipient recovery is the key challenge facing policymakers today. Although we do not offer advice on how to go about this, we believe that any fiscal consolidation plan should include credible measures to reduce future unfunded liabilities. Announcements of changes in these programmes would allow authorities to wait until the recovery from the crisis is assured before reducing discretionary spending and improving the short-term fiscal position. An important aspect of measures to tackle future liabilities is that any potential adverse impact on today's saving behaviour be minimised. From this point of view, a decision to raise the retirement age appears a better measure than a future cut in benefits or an increase in taxes. Indeed, it may even lead to an increase in consumption (see eg Barrell et al [2009] for an analysis applied to the United Kingdom)."

Bang, Indeed!

I had a discussion today with Jonathan Tepper of Variant Perception in London. We agree that the risk that no one talks about is the level of foreign investment in some of these countries and the consequent rollover risk. By this we mean that when a bond comes due, you have to roll over that bond into another bond. If the party that bought the original bond wants cash to invest in something else, or just does not want your bond risk anymore, you have to find someone to buy the new bond. Greece has a large number of bonds coming due this year. It is not just the new debt; they have to find someone to buy the old debt. And that is why they need so much money.

But it is not just a Greek problem. About 45% of Spain's debt is owned by non-Spanish, and they need to roll over old debt and new debt of 225 billion euros this year alone. That is bigger than the entire GDP of Portugal. Spain cannot finance this internally. But will foreigners buy 100 billion euros and, if so, at what price if they are not convinced that Spain will enact serious austerity measures?

Listen to ECB Governing Council President Jean-Claude Trichet (hat tip to Greg Weldon):

"As regards fiscal policies, we call for decisive actions by governments to achieve a lasting and credible consolidation of public finances. The latest information shows that the correction of the large fiscal imbalances will, in general, require a stepping-up of current efforts. Fiscal consolidation will need to exceed substantially the annual structural adjustment of 0.5% of GDP set as a minimum requirement by the Stability and Growth Pact....

"The longer the fiscal correction is postponed, the greater the adjustment needs become and the higher the risk of reputational and confidence losses. Instead, the swift implementation of frontloaded and comprehensive consolidation plans, focusing on the expenditure side and combined with structural reforms, will strengthen public confidence in the capacity of governments to regain sustainability of public finances, reduce risk premium in interest rates and thus support sustainable growth."

This is a man who wants some serious austerity. No garden-variety cuts here and there. And that brings us to the heart of the problem. That chart a few pages above showed the large fiscal deficits involved. If those are tackled seriously, it will put many countries into outright recessions and reduce the growth in others. Some, like Greece, will be in what can only be called a depression.

The entire eurozone is in for a double-dip recession, if it is not there already. And one country after another is going to have to convince foreigners to buy its debt. But if they make the cuts, their GDP will fall, ironically increasing their debt-to-GDP ratio and making investors demand even higher rates, which becomes a very vicious spiral.

And the banks that do own that debt will suffer liquidity problems unless the ECB steps forward with a new program in a massive way - which Trichet is currently resisting.

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

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

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

The Center Cannot Hold

Sovereign debt was a good idea only a little while ago. Take cheap money, lever up, and make a nice spread. And now, not so much a good idea. Credit spreads are widening all over Europe. Interest rates are rising for the European periphery.

We once again find ourselves on a Minsky Journey to a rather fraught Minsky Moment. Hyman Minsky famously taught us that stability breeds instability. The more things stay the same, the more complacent we get, until Bang! We always seem to think this time is different, and it never is.

The Minsky Journey is where investment goes from what Minsky called a hedge unit, where the investment is its own source of repayment; to a speculative unit, where the investment only pays the interest; to a Ponzi unit, where the only way to repay the debt is for the value of the investment to rise.

Greece is now at its Ponzi moment of financing. As John Hussman pointed out this week, if interest rates are at 15% when you roll over debt, and your country is not growing, you have no way to actually service the debt. And thus, the Minsky Moment when the markets walk away. Bang! From Hussman's letter:

"The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

"Without the transversality condition, the price of a security can be anything investors like. However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won't be delivering enough payments to justify the price.

"Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. Moreover, to bail out Greece for anything more than a short period of time, the rules of the game would have to be changed to allow for much larger budget deficits than those originally agreed upon in the Maastricht Treaty."

And if Greece has further problems, the market will look at Spain (and Portugal and Ireland). In order for Spain to continue to get financing, the market must believe they are going to make a credible effort at austerity measures. And because they need so much foreign financing, that moment may be sooner than we now think, as their rollover risk is massive. If Spain gets slapped, then who will be next?

There are examples of countries that have worked their way out of even worse problems and have done so without default. But those examples always came with currency devaluation and higher inflation. The eurozone countries cannot devalue their currencies. The risk in Europe is that the austerity measures bring about deflation, which makes the debt an even greater burden.

Look, I want the eurozone to succeed. I love Europe and look forward to my family vacation in Italy this June. But I think we have to be realistic and acknowledge that the European leadership has a very tough set of problems. As does Japan, as does Great Britain, as does the US, etc.

To argue that the US can decouple from Europe's problems doesn't hold water with me. We are clearly in recovery, but we are going to need all the help we can get. And a Europe falling into what could be a serious recession is not a Europe that buys our goods. And with the euro on the way to parity (along with the pound) we will have to compete with their exporters. The latter half of this year, I think the US slows down. Then the 2011 tax hikes kick in.

I still think there is at least a 50-50 chance of renewed recession, and with it a serious bear market and rising unemployment. I hope I am wrong but, as I have been writing for some time, you should see this as a trader's market and, with a few exceptions, be wary of being long only.

Montreal and New York and Italy

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 of his new (and should-be bestseller) book, The Great Reflation. I also get to go out and party when I land there with David Rosenberg. That should be fun!

The following 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, grand-babys) 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.

We have been planning (or Tiffani has) for the Italy trip. I really can't wait, as it's going to be a ton of fun. It has been over 25 years since I was in Italy, and that was just a few days in Rome and Venice. This time it's two full weeks, with a week in Rome and Venice and then a week in Tuscany, then to Paris, and then back to Tuscany and Milan.

Your ready for a vacation analyst,

John Mauldin

If This Is Recovery…

JohnMauldin — Sat, 14 Nov 2009 05:31:00 GMT

If This is Recovery, Where Are the Taxes?
Last Business Standing
Stimulus, What Stimulus?
The Reality of Unemployment
Let the Good Times Roll
The Quick Double-Dip Scenario
Phoenix, New York, and Thoughts on the Internet

No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting.

If This is Recovery, Where Are the Taxes?

I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let's look at sales taxes first.

First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we're in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010.

There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%.

On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf.

The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com)

Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising?

Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them.

Last Business Standing

Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business."

Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter's creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors.

So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%.

Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out?

And the answer is that we won't know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report)

But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes:

Stimulus, What Stimulus?

"Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating?

"The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market."

The Reality of Unemployment

All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts.

In August, I did an interview with CNBC from Leen's Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.

That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we've lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000.

Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom.

Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade.

I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios.

All three scenarios are based on assumptions, so let's see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result.

You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below.

For those interested, you can read Mish's very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let's look at his assumptions:

Job losses are likely to continue for a minimum of another year.
When job gains start, they will be very slow at first, then pick up.
An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs.
A falling participation rate (boomers retiring) will continue to mask reported unemployment.
Starting in 2013 the labor pool will start decreasing because of Boomer demographics.
The noninstitutional population will rise by 2.5 million workers a year.

The spreadsheet below needs a little explanation. Let's start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number.

By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike's blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let's look at scenario 1.

This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario.

Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession.

Let the Good Times Roll

What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let's be optimistic.

And the graph below shows the unemployment numbers for the Good Times Scenario.

Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner.

The Quick Double-Dip Scenario

When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession.

I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax.

Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept.

Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn't look like that will be the case. So, let's quickly see what a double-dip scenario might look like. Let's be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives.

Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph.

Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right.

We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario.

The letter is getting long and it's getting late, so let me close with a few thoughts.

First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years.

Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other.

Third, the only way out of this morass is to create an environment where small business can thrive. As I've noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that.

Phoenix, New York, and Thoughts on the Internet

Next week I take a quick one-day trip to Phoenix, then back to do a satellite-remote speech to a South African hedge fund conference. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org). Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

The 7 kids, spouses, and grandkids are starting to gather. We will all have brunch Sunday and then a shower for Tiffani. She has another 6 weeks before she is due, and she is really uncomfortable. Walking is literally a pain.

Permit me to reminisce. A little over 9 years ago I started this letter on the internet with about 2,000 email addresses. It was a new version of what had been a print letter, as that was the business I knew. The internet was still a new thing to me, but it seemed like a good idea at the time. Little did I know.

I am still amazed at the growth and the direction my business and life have taken. My letters are sent out by various publishers and affiliates to over 1.5 million readers and posted on dozens of web sites, and the numbers have been growing rapidly of late. I am grateful. But I wonder what would happen if I started it today. Ten years ago there was little in the way of free economic letters. Not a lot of competition.

Today, there is so much free information that it's staggering. There have to be thousands of blogs and hundreds of free letters, some with very large circulations. It seems a new star is born every few months. While much of it does not add to the level of conversation, some of it is quite excellent. I think I am lucky to have started when I did.

And I am grateful for the kind attention you give me. As I turn 60, I note that this has been a rather overwhelming last ten years. A lot of changes for me, and almost all of them very good. But there are more to come. The last two flights I was on I was connected to the internet at 35,000 feet. I sense a lot more changes coming. I am thinking a lot about how to keep up and not get left behind, how to make sure that you, gentle reader, continue to get my best. That is what, at the end of the day, drives me.

Have a great week. I know I shall. Dad loves it when his kids (from 15 to 32) and spouses and grandkids are all under one roof.

Your amazed at it all analyst,

John Mauldin

The Glide Path Option

JohnMauldin — Sat, 07 Nov 2009 04:54:00 GMT

The Present Contains All Possible Futures
The Ugly Unemployment Numbers
Argentinian Disease
The Austrian Solution
The Eastern European Solution
Japanese Disease
The Glide Path Option
Philadelphia, Orlando, and Phoenix

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we're headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.investorsinsight.com and search for terms I am writing about. And I will start out by briefly touching on today's ugly unemployment numbers, with data you did not get in the mainstream media.

But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.investorsinsight.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don't know, I write a brief monthly column for them.

The Ugly Unemployment Numbers

The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month's. It is an improvement that we are not falling as fast.

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

Let's look at the real number in the establishment survey. If you don't seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg:

"Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual 'change' in the underlying labor market situation ... in which case, October's figure of 817,000 represents the fourth LARGEST yet, behind last month's (September's) second largest figure of 1,021,000 ... for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer 'in' the Labor Force ...

"... the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

"Bottom line ... basis this measure AND the 'Total Unemployment Rate,' we could conclude that not only is there NO 'improvement' in the labor market, but moreover, that it continues to DETERIORATE, intently."

There are plenty more implications in the data, but let's turn to the topic of the day.

The Present Contains All Possible Futures

Like teenagers, we as a US polity have made a number of bad choices over the past decade. We allowed banks to overleverage and, in the case of AIG (and others), sell what were essentially naked call options of credit default swaps, based on their firm balance sheets, far in excess of their net worth; and that put our entire financial system at risk. We gave mortgages to people who could not pay them, and did so in such large amounts that we again brought down the entire world financial system to the point that only with staggering amounts of taxpayer money was it brought back from the brink of Armageddon. We assumed that home prices were not in a bubble but were a permanent fixture of ever-rising value, and we borrowed against our homes to finance what seemed like the perfect lifestyle. We did not regulate the mortgage markets. We ran large and growing government deficits. We did not save enough. We allowed rating agencies to degrade their ratings to a point where they no longer meant anything. The list is much longer, but you get the idea.

Now, we are faced with a continuing crisis and the aftermath of multiple bubbles bursting. We are left with a massive government deficit and growing public debt, record unemployment, and consumers who are desperately trying to repair their balance sheets.

If present trends are left unchecked, we will need to find $15 trillion in the next ten years, just to pay for US government debt, let alone state, county, and city debt. And perhaps some loans for business will be needed? Where can all this money come from? The answer is that it can't be found. Long before we get to 2019 there will be an upheaval in the market, forcing what could be unpleasant changes.

We are left with no good choices, only bad ones. We have created a situation that is going to cause a lot of pain. It is not a question of pain or no pain, it is just when and how we decide (or are forced) to take it. There are no easy paths, but some bad choices are less bad than others. So, let's review some of the choices we can make. (Again, I am being very general here. You can go to the archives for more specifics. This is a summary letter.)

Argentinian Disease

One way to deal with the deficit is to do what Argentina and other countries have done: simply print the money needed to cover the deficits. Of course, that eventually means hyperinflation and the collapse of the currency and all debt. There are writers who think this is an inevitable outcome. How else, they ask, can we deal with the debt? Where is the political willpower?

One large hedge-fund manager in Brazil humorously remarked that Argentina is a binomial country. When faced with two choices (hence binomial) they always made the bad choice. Could it happen here?

Hyperinflation is not an economic event; it is a political choice. I think last Tuesday's election is a sign that the voter population is beginning to pay attention to the need for something more than talk of change. There is growing discomfort with the size of the deficits. Further, the Fed would have to cooperate in order for there to be hyperinflation, and I think there is only a very slight (as in almost zero) chance of that happening. Could Congress change the rules and take over the Fed? Anything's possible, but I seriously doubt there is any appetite in saner Democratic circles for such a thing to happen.

I think the chances of hyperinflation in the US are quite low. It would be the worst of all possible bad choices.

The Austrian Solution

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

The Eastern European Solution

As it turned out, Niall Ferguson (last week I wrote about his brilliant book, The Ascent of Money) was in Dallas last night, and I was graciously invited to hear him. He gave a great speech and signed books, and then we went to a local bar and proceeded to solve the world's problems over Scotch (Niall) and tequila (me), and went farther into the night than we originally intended. He's a very fun and knowledgeable guy.

As we were talking about possible paths, he brought one to mind that I hadn't thought of. He reminded me of the period after the fall of the Berlin Wall, as the nations of Eastern Europe broke from the former Soviet Union. They started with very weak economies and simply overhauled their entire governments and economies in a rather short period of time, though not in lockstep with one another. Privatization, lowered taxes, etc. were the order of the day.

We here in the US are always talking about the need for reform. We need to reform health care or education or energy. In Eastern Europe they did not reform in the sense that we use the word. In many cases they simply started from scratch and built new systems. They had the advantage that there was general agreement that things did not work the way they had been, so there was more room for change.

Today in the US there are large constituencies that resist change. We only get to tinker around the edges, when real structural change is needed. Sadly, we agreed that here there is not much chance of major change. We can't even get the obvious changes needed in the financial regulatory world.

Sidebar: I am outraged at the paltry proposed financial "reforms." Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don't care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

Japanese Disease

I have written a lot over the past year about the problems facing Japan. Their population is shrinking, as is their work force. They are running massive fiscal deficits and have done so for almost 20 years. Government debt-to-GDP is now up to 178% and projected to rise to over 200% within a few years. They started their "lost decades" with a savings rate of almost 16%, and are now down to 2% as their aging population spends its savings in retirement. They have had no new job creation for 20 years, and nominal GDP is where it was 17 years ago.

As bad as our problems are here in the US, their bubble was far more massive. Values of commercial property fell 87%! Their stock market is still down 70%. They had twice as much bank leverage to GDP as the US. (Think about how bad off we would be if bank lending was twice as large and had even worse defaults and capital shortfalls!)

And yet, they Muddle Through. Productivity has kept their standard of living reasonable. Up until recently their exports were strong. The trading floors of the world are littered with the bodies of traders who have shorted Japanese government debt in the belief that it simply must implode. While I believe that it eventually will, if they stay on the path they are on, Japan is a very clear demonstration that things that don't make sense can go on longer than we think.

Richard Koo (chief economist of Nomura Securities, in Tokyo) argues passionately that Japan had a balance-sheet recession, and that the only way for Japan to fight it was to run massive deficits. Banks were not lending and businesses were not borrowing, as both groups were trying to repair their balance sheets, which were savaged by the bursting of the bubble. It is said that at one time the value of the land on which the Emperor's Palace sits in Tokyo was worth more than all of California. Clearly this was a bubble that puts our housing bubble to shame.

So, I understand the point that there are differences between Japan and the US . But there are also similarities. We too have had a balance sheet recession, although here it was mostly individuals and financial institutions that have had to retrench and repair their balance sheets.

Japan elected to run large deficits and raise taxes. As I wrote in the October 16^th letter (http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/10/17/muddle-through-r-i-p.aspx), "Savings equal Investments:

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

I don't want to go on at length again, but basically, the literature I quoted suggests that government stimulus and deficits have no long-run positive effect on GDP. In fact, the work done by Christina Romer, Obama's chairman of the Council of Economic Advisors, shows that tax cuts have a three-times-greater positive effect on GDP, and tax increases have the same level of negative effect.

In the equation above, if you increase government spending it will have a positive effect in the short run on GDP, but not in the long run. In essence, the increase in "G" must be made up by savings from consumers and businesses and foreigners.

But "G" does not enhance overall productivity. Government spending may be necessary but it is not especially productive. You increase productivity when private businesses invest and create jobs and products. But if government soaks up the investment capital, there is less for private business.

And that is Japanese disease. You run large deficits, sucking the air out of the room, and you raise taxes, taking the money from productive businesses and reducing the ability of consumers to save. Then you go for 20 years with little or no economic or job growth.

This is the path we currently seem to be on. The Japanese experience says that it could last a lot longer than people think before we hit the wall; because if savings rise in the US, and if banks, instead of lending, put that money on deposit with the Fed, as they are now doing (in order to repair their balance sheets), the US could run large deficits for longer than most observers currently believe.

We will need 15-18 million new jobs in the next five years, just to get back to where we were only a few years ago. Without the creation of whole new industries, that is not going to happen. Nearly 20% of Americans are not paying anywhere close to the amount of taxes they paid a few years ago, and at least ten million are now collecting some kind of unemployment benefits or welfare.

Choosing large deficits does not reduce the amount of pain we will experience, it just seemingly reduces it in the short term and creates the potential for a serious economic upheaval when the bond market finally decides to opt for higher rates. This path is a bad choice, but sadly, in reality it is one we could take.

The Glide Path Option

A glide path is the final path followed by an aircraft as it is landing. We need to establish a glide path to sustainable deficits (could we dream of surpluses?). That is because at some point there will be recognition, either proactively or forced upon us by the bond market, that large deficits are unsustainable in the long term.

If Congress and the president decided to lay out a real (and credible) plan to reduce the deficit over time, say 5-6 years, to where it was less than nominal GDP, the bond market would (I think) behave. Reducing deficits by $150 billion a year through a combination of cuts in growth and spending would get us there in five years.

The problem is that there is real pain associated with this option. Remember that equation above. Absent a growing private sector, if you reduce "G" (government spending) you also reduce GDP in the short run. You have to take some pain today in order to do that. But you avoid worse pain down the road: a bubble of massive federal debt that has to be serviced will be very painful when it blows up, as all bubbles do.

The Glide Path Option means that structural unemployment is going to be higher than we like (which is actually the case with all the options). And the large tax increases that come with this option will by their very nature be a drag on growth (and cause a double-dip recession in 2011). We can debate tax increases all we want, but I sadly think we will soon have a VAT tax. There are no good options. I just hope that we cut corporate taxes enough when we do create a VAT, that it will make our corporations more competitive, which will be a boost for jobs.

That's pretty much it. This is not a problem we can grow ourselves out of in the next few years. We have simply dug ourselves into a huge hole. This is not a normal recession. There is not a "V" ending to this recession. We are going to have deal with the pain. It will be the pain of reduced returns on traditional stock market investments, a lower dollar, low returns on bonds, European-like unemployment, lower corporate profits over the long term, and a very slow-growth environment. But if we choose this path, we will get through it in the fullness of time.

And of course, then we will eventually have to deal with the $70 trillion in our off-balance-sheet liabilities in Medicare and Social Security and pensions. Sigh. But that's for another time.

Philadelphia, Orlando, and Phoenix

I really am more optimistic than this letter makes me seem. But if you ignore reality, then you have no chance to figure out how to make the best of your situation. It is the efforts of hundreds of millions of individuals trying to make their own lot a little better than will get us back to a robust economy.

Monday I fly to Philadelphia and then the next day to Orlando for two speeches, and then the following week a quick trip to Phoenix, then home to start to plan for Thanksgiving. I will be in New York the first weekend of December (the 4^th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org/), Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

Tiffani has been out the last two days of this week. She is due in seven weeks or less, and her hips are expanding. The pain is too much right now for her to walk up the stairs to the office, so she is working from home. The doctor says this is the one time that her pain is not a sign of something bad. She is being a trooper and not taking any pain meds.

It has been 30 years since I was around a pregnant lady for more than a few hours, and it does bring back some memories. Watching her grow and change has brought back the sense of awe over how our bodies are designed.

Ryan and Tiffani have decided on the name Lively for my first granddaughter, to add to the two new grandsons this year. From zero to three grandkids in just six months! Kind of makes me dizzy.

I really enjoyed my time in South America. Rio is quite beautiful and I want to go back and spend some time.

Have a great week. There will be enough good friends and family that I know I will. And tomorrow night I finally get to go to a Dallas Mavericks game. We may have a real team this year.

Your always optimistic at the beginning of the season analyst,

John Mauldin

Muddle Through, R.I.P?

JohnMauldin — Sat, 17 Oct 2009 19:50:00 GMT

Muddle Through, R.I.P?
Savings Equal Investments
Japanese Disease
Who Will Buy the Debt?
The New Muddle Through Economy
On the Road Again

I first wrote about the Muddle Through Economy in 2002, and the term has more or less become a theme we have returned to from time to time. In 2007 I wrote that we would indeed get back to a Muddle Through Economy after the end of the coming recession. If you Google the term, at least for the first four pages more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle through middle is comfortable to me.

Last week I expressed my concern that we as a country are taking actions that could indeed "Kill the Goose" of our free-market economy. I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I have given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.

But first, two housekeeping items. I want to welcome the 150,000 members of the National Association of the Self-Employed to this letter. They have asked me to be a special consulting economist to their group, and they will send this letter each week to their members. Since its beginning in 1981, the National Association for the Self-Employed has pioneered support for micro-businesses and the self-employed, and been a forceful advocate for small business in this country. (www.nase.org) I am honored. I am pleased to add you to my 1 million closest friends. I hope you find it useful.

Second, I will be going to South America at the end of next week, to Buenos Aires, Montevideo, Sao Paulo and Rio. I will be speaking in those cities and traveling with my new Latin American partner, Enrique Fynn of Fynn Capital (based in Uruguay). If you would like to find out about this tour or what services he can help you with, you can go to www.accreditedinvestor.ws and sign up and Enrique will get in touch with you. And as always, if you are an accredited investor, you can go to that website and one of my partners in the world will get back to you. (In this regard, I am president of and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

Muddle Through, R.I.P.?

I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.

I am not surprised about the response of the Fed to the current recession and credit crisis, whether it's the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there is nothing that would make me think we do not eventually recover, albeit at a very slow Muddle Through pace, with a jobless recovery that lasts for several years. It will not be pleasant, but we'll survive.

However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.

And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics.

Savings Equal Investments

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

(For the wonks out there, GDP is usually termed "Y".)

You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.

This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it is not a guess or an approximation. It is simple reality.

Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.

In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth.

Japanese Disease

Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can't we be like Japan? And my answer is that it is possible, but the cost that Japan has paid has been high.

In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management's latest letter (last week's Outside the Box):

"The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370).

"This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output."

For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President's Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.)

In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it is 373%. We have added over $15 trillion in debt, yet total employment today is roughly where it was 9 years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I am sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease - a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).

Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.

The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have will not go into the investments we need, but into government debt.

Who Will Buy the Debt?

Now, let's go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they do not disappear. They can only go back into a dollar-denominated investment. Up to now, that has typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.

Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate?

The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks' lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.

So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.

And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we will see over 400 banks fail in this cycle.

One quick chart to further highlight the problem that banks are facing. I have been writing for several years that commercial real estate loans will be the next shoe to drop. Moody's calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they are going to have to make. And my bet is they put those reserves they are not lending into government debt.

Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral.

The New Muddle Through Economy

This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won't happen next year, and it's unlikely in 2011.

I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a "New Normal," then I can decide that we are going to a "New Muddle Through Economy." Just not one as benign as I used to think.

In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.

As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.

On the Road Again

I am writing tonight from Detroit. Tomorrow I will be in New York watching the Yankees/LA game. I will be the guy in the second row behind home plate in the Dallas Cowboys jacket. I will be on Yahoo Tech Ticker on Monday morning, so you should be able to go to Yahoo and see me later that afternoon. Then Philadelphia on Tuesday, speaking at my partner Steve Blumenthal's CMG conference for investment advisors. They have a very interesting platform of trading advisors. You can see them at http://cmgfunds.net/public/mauldin_questionnaire.asp

I had a great deal of fun at the New Orleans conference, being with old friends and meeting new ones. David Tice (of the Prudent Bear Fund) was an exceptional host for dinner at Emeril's. I was surprised that Karl Rove actually remembered me after nine years. I thoroughly enjoyed spending some quality time with my friend Ron Paul. We share a lot of concerns about the future of the Republic. I was pleasantly surprised by how thoughtful Howard Dean was. And very personable.

I go to Houston on Wednesday, Orlando on Thursday, and then South America on Saturday. I will be doing a lot of writing from hotel rooms, but all in all it will be fun. You have a great week, and remember that in 10 years none of us will look back and want to return to 2009. 2019 will be better than we can possibly imagine. We just have to make sure we all get there!

Time to hit the send button and find an adult beverage. All the best,

Your going to miss the Old Muddle Through analyst,

John Mauldin

Quarterly Review and Outlook - Third Quarter 2009

JohnMauldin — Mon, 12 Oct 2009 20:32:18 GMT

I look forward at the beginning of every quarter to receiving the Quarterly Outlook from Hoisington Investment Management. They have been prominent proponents of the view that deflation is the problem, stemming from a variety of factors, and write about their views in a very clear and concise manner. This quarter's letter is no exception, where they once again delve into the history books to bring up fresh and relevant lessons for today. This is a must read piece.

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And now let's jump right in to the essay.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - Third Quarter 2009

Ponzi Finance

The Federal Reserve reported that as of June 30, 2009 total U.S. debt was $52.8 trillion. Total U.S. debt includes government, corporate and consumer debt. Importantly, however, it does not include a few trillion in "off balance sheet" financing, contingent unfunded pension plans for corporate and state and local governments, or unfunded liabilities of the U.S. government for such items as Medicare, Social Security and other programs. Currently GDP stands at $14.2 trillion, so there is approximately $3.73 in debt for every dollar of output in the United States, a level unprecedented in our history (Chart 1). Normally, debt levels as a percent of GDP would be uninteresting and immaterial; however, the current level of debt is unique in two ways. First, the asset side of the balance sheet purchased by the debt is falling in price. Second, the money that was borrowed to purchase those assets was often fraudulently expended. Neither the borrower nor the lender really expected the debt to be serviced. Rather, each party expected the asset price to rise extinguishing the debt.

This type of financial arrangement was correctly analyzed by the famous American economist Hyman Minsky in his paper, "Financial Instability Hypothesis", in which he described three phases of debt financing. The first is "hedge finance", where the lender expects a return on both principal and interest. The second is "speculative finance" where the lender expects to get interest on the loan but perhaps not the principal. The third case, where the lender expects neither the principal nor interest to be returned, is referred to as "ponzi finance". This was typified in the last business cycle by loans issued without documentation, no down payment home loans, extremely low cap rates on commercial real estate, and the high leverage borrowing ratio of private equity funds. Even ponzi finance works as long as asset prices are rising. But once the bubble is pricked, the debtor is left with declining asset values that preclude the rollover of their obligations.

Presently, in this worst of all post-war recessions we are witnessing the collapse of asset prices that were inflated by the speculation of earlier years. The aftermath of that speculation and its impact on the economy has been thoroughly studied prior to our present business cycle by the economists of yesteryear who marveled at the mania in the collective mindset of private citizens and their elected representatives who produced such bubbles. The most famous of these economists was Irving Fisher (1867-1947), who in 1933 wrote about this problem of over-indebtedness (Irving Fisher, 1933, Econometrica, "The Debt-Deflation Theory of Great Depressions"). He stated flatly that over-indebtedness was the difference between normal business cycles (recessions), which occur frequently through "over-production, inventory misjudgment, or commodity price fluctuations" and extreme business cycle fluctuations (depressions). Based on his analysis of the great depressions of 1837, 1873, and 1929 he outlined a pattern of economic developments that will take place when the debt cycle is broken. Seemingly old news, but it is interesting to apply his sequence of events to today's economic developments as there are disturbing similarities.

A Downward Spiral

Fisher posited that debt liquidation leads to distress selling, contracting bank deposits and declining velocity of money, all of which contribute to the fall in price levels. This accurately describes today's circumstances. Distress selling is rampant, with home foreclosures reaching all-time highs. Additionally, rapidly rising foreclosures in commercial real estate are causing the closing of financial institutions and the liquidation of their portfolios. Money supply (M2), an imperfect measure of bank deposits, is essentially flat over the last six months even though the monetary base is 100% higher than it was a year ago (Chart 2). Further, the velocity of M2 has contracted at a 12.7% rate over the past two years. The Personal Consumption Expenditure Deflator (goods purchased by consumers) has fallen from a 2.7% growth rate 12 months ago to a yearly increase of only 1.3% presently, and appears to be heading for a zero reading in 2010. GDP has recorded its greatest contraction since the 1930's, and probably is not yet at its lowest level for this cycle.

Fisher then noticed that this distress selling would lead to a fall in the net worth of businesses, a decline in profits, and a reduction in employment. Fisher may have been talking about 1929 and the 1800's, but that is precisely our present situation. Despite a 19% gain in stock prices this year, the S&P 500 has declined about 30% from its peak and stands lower than it was a decade earlier. Corporate profits are down approximately 13% on a year over year basis, and in 2008 S&P 500 profits fell for the first time since 1933. The net worth of hundreds of banks and other large corporations has fallen below zero, with some surviving only because of a massive rescue effort by the federal government. Despite these efforts, consumer net worth has fallen, price levels of homes are down about 30% from their peak levels, and business net worth has been impaired by an almost 39% decline in commercial real estate from its peak levels. Industrial production is down 13.3% since its peak, the largest 20 month decline in the post war period (Chart 3). Including potential revisions, the U.S. has lost eight million jobs in this recession, and currently 17% of the labor force is either underemployed, partially employed, or out of work seeking employment.

Fisher seems to be not so historical as prescient. He states that all the above problems create disturbances in the rate of interest, particularly the fall of nominal money rates and the rise of real interest rates. The federal funds rate is now effectively zero, and yet with the steady downward movement in price indices, real interest rates are rising. This, of course, is of concern to debtors.

The uncomfortable conclusion of Fisher's analysis is that major business cycle fluctuations are, in fact, caused by over-indebtedness and the fall in asset prices. Our present situation appears to mirror the exact sequence of events that have occurred in previous depressions. This suggests that our current "great recession" may morph into a more serious and elongated downward business cycle.

The Impossible Promise

The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370). This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.

From a fiscal policy perspective the outlook for economic growth appears to be one of stagnation for several years due to the size of the federal debt, which is expected to rise 35.7% from 2008 levels to 76.5% of GDP over the next ten years according to the Office of Management and Budget (Chart 4). This exercise in government spending is, of course, an exact replica of the Japanese experience from 1989 to the present. Their debt to GDP ratios have gone from about 50% in 1988 to about 178% today, and yet their nominal GDP is no higher than it was 17 years ago, and their employment stands at twenty year ago levels. It is somewhat unsettling that as of the last employment report the United States employed 131 million people, a level that was first reached in 2000, which means the United States has had no net job gains for almost ten years. Indeed, it appears that the fiscal chain around the free market neck is sufficiently onerous to restrain growth for several years. The promise of the government to revive growth through increased indebtedness is, indeed, an impossible promise.

The Hesitant Fed

As Fisher stated, the write-down of debt and distress selling tends to destroy money deposits and lower the velocity of money. Despite the historical evidence of that fact, our current Fed authorities appear to be oblivious to the lessons of the past. Their initial reaction to the liquidity crisis has to be applauded for their heavy work in insuring the liquidity of the financial system. Similarly, the expansion of their bank balance sheet to $2.1 trillion from $1 trillion was the precise reaction needed to counter the emerging deflation of asset prices. However, their actions increased inflationary expectations, and they have encountered a plethora of critics. In responding to this criticism the most recent statistics suggests they are beginning to lose the fight against the deflationary impulses. Consider that the monetary base rose 1000% in the three months ending December 2008, but has been held essentially flat since then (Chart 5).

The Fed's purchases of assets to increase this base automatically created deposits that positively charged the money supply growth to a 15.2% six-month growth rate (Chart 2). If the economy were operating near full capacity, a healthy banking system would take these deposits and multiply them roughly nine times; that circumstance could be inflationary. Unfortunately the banking system is not healthy, as evidenced by the fact that we have closed 95 banks this year, more than the cumulative total of the past 15 years, and another 416 banks are on a list destined to become extinct. With consumers' asset prices falling so rapidly and banks increasingly afraid of failure, banks are more interested in collecting loans than in lending. So with fewer consumers now credit worthy, loan volumes are collapsing. As loans are paid off, deposits are destroyed, and the money multiplier that should stand at nine has gone to zero. This is evidenced by the fact that the six-month change in M2 has fallen to a 1% growth rate, meaning that monetary stimulus is on hold. Get set for negative GDP in 2010.

Dollar Weakness

The inflation outlook from the monetary and fiscal standpoint looks truly deflationary, yet some believe that dollar weakness will reverse this circumstance and create inflation. This is unlikely. First, our imports are about 13% of GDP, and even if the dollar were to halve in value, the price of imported goods would not only have to compete with U.S. producers, but also their price adjustment would have to offset the other 87% of factors included in the pricing indices. Second, unlike the 1930's a 50% decline in the dollar would be difficult to engineer. Fisher recommended to Roosevelt that the U.S. should exit the gold standard, which he did in April of 1933. That was a fixed exchange rate system, and within three months the dollar lost more than 30% against the gold block countries and fell to 60% of its former value within the next five months. This spurred our exports and provided some price inflation (2.9% per year, GDP deflator) for the next four years. Then, in 1937 the tax increases (the next policy mistake) reversed the positive growth rate of the economy and drove price levels and economic activity downward again. However, even with that small period of price increases the overall price level never recovered from the 25% decline that occurred from 1929 to 1933, and thus deflation reigned. Today the declining dollar is a good thing in terms of our trade balance, but the modest change will be insufficient to offset the negative forces of insufficient domestic demand.

Next year the core GDP deflator will fall to zero, with the possibility of negative levels. Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary environment. Currently the Japanese ten-year note stands at 1.3% with their thirty-year bond yielding 2.1%.

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

Is America On The Road To Financial Ruin?

GaryHalbert — Tue, 23 Jun 2009 19:53:11 GMT

IN THIS ISSUE:

Obama's Government Takeover Continues
Editorial: "Too Big to Fail, Or Succeed"
Americans More Concerned About Deficits
Economy May Have Seen the Worst of It
Conclusions

Introduction

The more I think about it, I believe that last week's E-Letter which revealed President Obama's plans to double the national debt over the next decade was one of the most important e-letters/newsletters I have ever written. If by chance you did not read last week's E-Letter, you need to click on the link above and do so now, since Obama's planned explosion in US debt will be a continuing theme in these weekly E-Letters for some time to come.

I sincerely believe that if our current $11.4 trillion national debt doubles over the next 10 years (and possibly even sooner), it will bankrupt America and send us into an even worse financial and economic crisis. President Obama's plans to run trillion dollar annual budget deficits for at least the next few years are almost certain to wreck the US dollar, which in turn will be very bad news for the stock and bond markets, not to mention the long-term inflation implications.

I have warned for over 25 years that politics are intimately intertwined with the course of the economy, the markets and thus our investments. This argument has never been clearer than today, and more and more Americans are coming to realize this. A Wall Street Journal/NBC News poll late last week found that 58% of respondents now believe that Obama's trillion dollar deficits are a greater concern than the recession in the economy. Maybe I'm making some progress!

President Obama has made public statements in recent weeks that he would prefer a smaller government had he not "inherited" this recession and financial crisis from George W. Bush. He has also said that he does not want to run (own) companies like AIG, GM and Chrysler. Yet his administration continues to promulgate new regulations that will make it even more likely that the government will eventually own much larger stakes in the private sector.

Obviously, Obama's plan to have the government take over national health care is a prime example of his intentions to greatly expand an already bloated, inefficient government and run unprecedented trillion dollar budget deficits. I have not chosen to weigh-in on the healthcare debate so far, partly because polls show that a majority of Americans want major healthcare reforms. All I will say at this point is, be careful what you wish for.

Last week President Obama announced sweeping regulatory changes that will dramatically affect the financial and investment markets for years to come. These so-called "reforms" could result in the government and/or the Fed owning some of our big banks and financial institutions that are deemed to be "too-big-to-fail." While the recent financial crisis suggests that some reforms are needed, having the government own or control many of our largest financial institutions is not the answer.

I will discuss these sweeping new financial regulations as we go along. I will also discuss the latest economic indicators which remain mixed, along with my thoughts on the investment markets. It's a lot to cover, so let's get started.

Obama's Government Takeover Continues

Last Wednesday, President Obama announced the most sweeping financial industry reforms since the Securities and Exchange Commission was created in 1934. Obama unveiled new proposals that would refashion the federal rules governing almost every corner of finance, and will push the government and the Federal Reserve much more deeply into banks and the private markets. The administration's 85-page "white paper" on financial reform sounded the opening salvo in a likely overreaching regulatory process that could expand for several years.

Most importantly, government supervision of all financial firms that are deemed to be big enough to threaten overall economic stability ("systemic risk") will be consolidated under, and be regulated by, the Federal Reserve. We're not just talking about banks here – the new regulations will allow the Fed to oversee any private or public companies that are deemed to pose systemic risks (ie- "too-big-to-fail").

These entities will be required to hold more capital and liquidity than other firms, and will face other regulatory requirements as deemed appropriate by the Fed and/or the Treasury Department. Firms that cannot meet the Fed's requirements can be taken over, partly or wholly, by the government – as was the case with insurance giant AIG, or simply shut down – as was the case with Lehman Brothers. This is scary!

Obama's regulatory net is also being cast over the credit markets whose growth contributed to the financial crisis. Those who package loans together for sale in securitizations (including mortgages) will have to disclose more and will be required to keep 5% of any deal to encourage sounder underwriting. Likewise, the new plan calls for payment of their fees to be spread over time and reduced if the loans go bad. Frankly, these specific regulations may actually make sense, while others are simply unnecessary government intrusions in the private sector.

The president's new reforms also include the creation of a Consumer Financial Protection Agency (CFPA). In theory, this new government agency will safeguard against mortgage, credit card and other abuses that may have contributed to the current crisis. In reality, this new agency may ultimately be the arbiter of who can – and cannot – get a home mortgage, what interest rates lenders and credit card companies can charge, etc., etc. Concern is already mounting that the new agency will take an overly restrictive view of permissible financial products, limiting access to credit and curbing good as well as bad innovation.

What follows are excerpts from an Investors Business Daily editorial published last Friday that fairly, I think, points out the assessment of those who will oppose Obama's sweeping regulatory reforms:

"Many on Wall Street have been stunned by a plan that subjects America's free-market capitalism to the controlling whims of bureaucrats, newly appointed czars and congressional committees headed by anti-business liberals such as Rep. Barney Frank.

‘We intend to take our case to Congress to explain why we believe adding new layers to a broken regulatory system is not the answer,' David Hirschmann, who heads the U.S. Chamber of Commerce's Center for Capital Markets, told the Los Angeles Times. Indeed, there are lots of objectionable things in the plan.

…We hope Wall Street — banks, investment houses, hedge funds, private investors — continues to speak up. The Democrats' plan slips the government's fingers around the economy's neck, choking off the risk-taking that is the very essence of America's capitalist success. Bold risk-takers will be replaced with risk-averse bureaucrats, and the dynamic growth engine that feeds our ever-expanding standard of living will be shut down.

This in turn will create a permanent bailout culture — one that will deem certain companies ‘too big to fail' and subsidize their failure with taxpayer money, while burdening small, entrepreneurial companies with unnecessary and costly regulatory oversight."

The IBD editors hit on only a few of the potential problems with President Obama's sweeping new regulatory reforms included in his 85-page report released last week. Analysts are still sorting out the details and considering the long-term implications. Certainly, some of the reforms will be welcomed by many Americans, especially those who believe that the government should control the private markets. But with any such government intervention, freedoms are sacrificed and free markets are restricted. A June 18 Wall Street Journal editorial makes the best argument I have seen regarding Obama's sweeping regulatory reform proposals.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

QUOTE: TOO BIG TO FAIL, OR SUCCEED
Everyone will want to become big enough to enjoy 'systemic risk' protection.
by Peter Wallison (senior fellow at the American Enterprise Institute)

In a speech at the White House yesterday, President Barack Obama outlined what he envisions for future regulation of the financial system. He called his plan "a new foundation for sustained economic growth . . . a transformation on a scale not seen since the reforms that followed the Great Depression." Indeed it is.

His plan, if adopted, will fundamentally change the nature of our financial system and economy. The underlying concerns and assumptions are clear, and they are made clearer by considering other ways that his administration has dealt with the consequences of competition -- particularly the faux bankruptcies of General Motors and Chrysler and the impending change in antitrust policy. Although the president said in his speech that he supports free markets, these initiatives confirm that the administration fears the "creative destruction" that free markets produce, preferring stability over innovation, competition and change.

According to the administration white paper circulated prior to the president's speech, the Federal Reserve would be authorized to create a special regulatory regime -- including requirements for capital, leverage and liquidity -- for any firm "whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed." In addition, if a large financial firm is failing, the Treasury is to be given the power -- in lieu of bankruptcy -- to appoint a conservator or receiver to "stabilize" it.

Designating particular financial firms for this kind of special regulatory treatment clearly signals to the markets that these institutions are too big to fail. It will reduce the perceived risk of lending to them, enabling them to raise funds at lower cost than their smaller competitors.

In other words, the administration's plan would create what are essentially government-sponsored enterprises like Fannie Mae and Freddie Mac in every sector of the financial economy -- insurers, securities firms, finance companies, bank holding companies, and hedge funds -- where these specially regulated firms are to be designated. The result will be devastating for competition. Larger firms will squeeze out smaller ones and aggressive small companies will have less opportunity to overcome the government-backed winners.

Moreover, the administration's proposal to provide a special bailout mechanism for large firms confirms the likelihood that these firms will never be closed down or liquidated. Citing the market turmoil that followed Lehman's collapse, the administration will argue that failures like this are "disorderly." But failure comes from risk-taking -- the very source of our economy's strength -- and it is ultimately risk-taking and its consequences that the administration's plan is intended to prevent.

The turmoil following Lehman's failure occurred because market participants expected, after the rescue of Bear Stearns, that any larger firm would also be rescued. When Lehman wasn't, all market participants were required to recalibrate the risks of dealing with all others, causing a freeze-up in lending and hoarding of cash. Lehman's failure itself did not cause any substantial losses, and within two weeks of its bankruptcy filing, Lehman's trustee sold its brokerage, investment banking, and investment management businesses to four different buyers.

Contrast this with AIG, the administration's paradigm, which was saved by the government because it was allegedly too big to fail. That firm is gradually wasting away under government control, with the taxpayers footing the bill.

The administration's fear of competitive outcomes is not reflected solely in financial-sector policies. Consider General Motors and Chrysler. They were defeated in the marketplace. Simply put, they failed to build automobiles [that] enough Americans wanted to buy.

Their disappearance would not have threatened the stability of the financial system, although it would undoubtedly have been disruptive for suppliers, dealers and employees. Yet the administration wouldn't allow them to fail, either. Despite all the talk about credit priorities, the fundamental point is that the administration used taxpayer money to overturn the market's verdict. If we want a preview of what the administration will do with the resolution authority it wants for large financial companies, we need look no further.

The same pattern with regard to competitive markets can be seen in the Justice Department's new antitrust policy. Christine Varney, the new assistant attorney general in charge of antitrust policy, has said that U.S. policy should be more like Europe's. Until now, U.S. antitrust policy has tried to protect competition. Europe attempts to protect competitors. Protecting competitors means blunting the skills of superior players, allowing inferior managers and business models to remain in business and thus preventing better managements and business models from emerging. Again, stability wins out over change and progress.

The president has said on several occasions, including in yesterday's speech, that "I've always been a strong believer in the power of the free market." But his administration's prescriptions tell a different story. In AIG, GM, Chrysler, Fannie Mae and Freddie Mac we can see the future that the administration envisions for our economy -- a sclerotic and unchanging structure of big companies working with, protected by, and relying on big government.
END QUOTE

I could not agree more with Mr. Wallison's analysis above. Yet most Americans have no idea what President Obama's sweeping regulatory changes really mean, much less how they may negatively affect competition and the free markets. Most Americans only hear the media sound-bites which leave the impression that the Obama administration reforms will "fix" the financial markets once and for all.

Were some changes in regulation of the financial markets in order? Certainly. Subprime loans, "no-doc" loans and "liar" loans allowed millions of Americans to purchase homes they could never afford. Likewise, credit rating agencies allowed investment bankers to create AAA-rated bonds secured by these questionable mortgages, which greatly broadened the impact of the subprime debacle.

These and other abuses ultimately led to the housing crisis, the credit crisis and the most severe recession since the Depression. So, changes to the financial regulatory system were needed.

As I noted above, some of Obama's new regulations on mortgage lenders make a lot of sense and will help to curb abuses. But many others are nothing less than purposeful government intrusion in the private markets in ways that will stifle competition. In many ways, these new rules look more like nationalization than regulation.

Americans More Concerned About Deficits

While President Obama continues to enjoy high (but falling) approval ratings overall, the public is growing much more concerned about Obama's record-large budget deficits and government intrusion in our lives, as noted in this week's SPECIAL ARTICLES below. In particular, a new Wall Street Journal/NBC News poll published last Thursday had some surprising findings.

For example, a solid majority – 58% – were more concerned about the budget deficit than they are about the economy. Specifically, they said that the president and Congress "should focus on keeping the budget down, even if it takes longer for the economy to recover."

When asked about the expanding role of government (e.g. ownership stake in GM, executive compensation, health care, etc.) a whopping 69% said they were very concerned (49% answered "a great deal" and 20% answered "quite a bit").

On the issue of Obama's health care plans, the WSJ poll results suggest that the president still has a lot of convincing to do. 33% think it's a good idea, 32% think it's a bad idea, and 35% have no opinion. Put differently, 67% either think government run health care is a bad idea, or they're not sure.

The New York Times also released its latest poll last Thursday. It also revealed that the public is growing more wary of the expanding role of government. When asked if the government is doing too much or too little, the result was: 56% too much versus 34% too little.

These surprising poll results suggest that more and more Americans are realizing just how dangerous it will be for America to double the national debt in a decade or less, as I discussed in detail last week.

Economy May Have Seen the Worst of It

Barring a major negative surprise, I think we have likely seen the worst of this recession. The Commerce Department will release its final estimate of 1Q GDP on Thursday, and most forecasters expect it to be in the -5.5% to -5.7% range (annual rate), which is at least mildly less negative than the -6.3% plunge in the 4Q of last year. Together, these two quarters should prove to be the worst of the most severe US recession since the Great Depression.

There is a broad consensus that the US economy has continued to contract during the 2Q, with most suggesting a decline of 2-3% in GDP over the last three months. From there, though, forecasts vary widely as to what will happen in the economy during the second half of the year. While I continue to believe that GDP will remain in negative territory all year, a growing number of analysts believe that GDP could actually go positive in the 4Q.

We have had more good economic news in the last couple of weeks. Most importantly, the Index of Leading Economic Indicators (LEI) rose a better than expected 1.2% in May, following a 1.1% gain in April. These were the first back-to-back monthly increases in almost three years.

The Commerce Department reported on June 11 that retail sales rose 0.5% in May, the first increase in three months. However, the report indicated that much of the rise in sales was due to the significant increase in gasoline prices.

On the manufacturing front, the latest reports were mixed. The ISM Index rose modestly to 42.8 in May versus 42.3 in April. Remember that any reading in the ISM below 50 indicates an economy that is still contracting. Industrial production fell another 1.1% in May, while the factory operating rate slipped to 68.3% in May, down from 69% in April.

On the housing front, there was a bit of encouraging news. Housing starts rose sharply in May, thanks in large part to the federal home tax credit that expires in November. Building permits were also up modestly in May. However, the inventory of unsold homes remains at a record level with over 11 months' supply on the market. Home prices nationally plunged 19.1% in the 1Q and are down 32% from the peak in 2006. So the housing slump is far from over.

The US unemployment rate continues to spike higher, rising to 9.4% in May, up from 8.9% in April. A recent Wall Street Journal survey of economists found a consensus opinion that the unemployment rate will hit at least 9.9% by the end of this year. The continued rise in the unemployment rate is almost certain to keep consumers on the defensive.

While we are seeing signs that the worst of this recession is behind us, that does not mean the economy will move into positive territory by the end of this year. Consumer spending is still lagging and is likely to stay below trend for some time to come. The personal savings rate jumped to 5.7% in April (latest data available), the highest level in more than 14 years, and this trend is likely to continue.

The combination of declining housing and stock-market values with the heavy debt loads Americans took on during the housing boom has inflicted significant damage on household finances. The Federal Reserve's latest "flow of funds report" earlier this month showed that household net worth fell $1.1 trillion in the 1Q from the 4Q of last year to $50.4 trillion, putting it $13.9 trillion below its 2007 peak. Collectively, homeowners held 41.4% of the equity in their homes, the lowest level since records have been kept and down from 53.9% two years earlier.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Conclusions

As noted above, we have seen some encouraging signs in the economy. If you watch any of the financial channels, you will find that there is a great deal of optimism that the recession will be over before the end of this year. Sorry, but I just don't buy it. I continue to believe that the economy will still be in negative territory at the end of the year, as measured by GDP. I hope I am wrong.

As for President Obama's sweeping financial regulatory reforms he announced last week, we would hope to be implementing new regulations that should prevent anything similar to the sub-prime meltdown and the credit crisis from ever happening again. However, I believe that most of Obama's proposed regulatory changes are over-reaching and onerous. But Congress is likely to pass most or all of them, despite the long-term market implications.

On a positive note, I am very encouraged that more Americans are becoming increasingly concerned about the mammoth level of spending and deficits planned by the Obama administration over the next decade. Doubling the national debt in the next decade (or less) will have extremely negative consequences for the economy and stocks and bonds.

I feel that more of the public is coming to realize just how much exploding federal deficits will affect the future of their children and grandchildren. Perhaps we have come to realize just how large a sum one trillion dollars is, how long it could take to pay it back and who will be required to make those payments. More people want the government to do what every family must do - make tough decisions on which expenditures are most important and which can be deferred.

Finally, I believe that the public is picking up on the fact that capitalism's very structure is changing. Specifically, the government has switched from a role of economic supporter and regulator to owner and controller. This is a fundamental shift in the very nature of capitalism and could have ramifications far into the future. To me, this is the most disturbing of all of the recent events that have come to pass.

Let's hope that our representatives in Washington get the message that the recent polls are sending – that Obama's incredible spending and bigger government plans will wreck our economy over time. If not, it could be a very bleak future that we leave to our heirs. Sorry to end on a negative note, but it is what it is.

Wishing you a great summer,

Gary D. Halbert

SPECIAL ARTICLES

Independent voters worried about Obama's spending
http://online.wsj.com/article/SB124570175501838333.html

More polls show growing concern over Obama's deficits
http://www.nydailynews.com/opinions/columnists/goodwin/index.html

Public confidence in Obama stimulus plan is falling
http://www.washingtonpost.com/wp-dyn/content/article/2009/06/22/AR2009062202000.html?hpid=moreheadlines

The End Game Draws Nigh - The Future Evolution of the Debt-to-GDP Ratio

JohnMauldin — Mon, 18 May 2009 21:38:20 GMT

Nearly everyone I talk with has the sense that we are at some critical point in our economic and national paths, not just in the US but in the world. One path will lead us back to relative growth and another set of choices leads us down a path which will put a very real drag on economic growth and recovery. For most of us, there is very little we can do (besides vote and lobby) about the actual choices. What we can do is adjust our personal portfolios to be synchronized with the direction of the economy. The question is "What will that direction be?"

Today we are going to look at what I think is a very clear roadmap given to us by Dr. Woody Brock, the head of Strategic Economic Decisions and one of the smartest analysts I have come in contact with over the years. This week's Outside the Box is his recent essay, "The End Games Draws Nigh." For those who have the contacts in government, I urge you to put this piece into the correct hands so that Woody's very distinct message gets out. I think this is one of the most important Outside the Box letters I have sent out.

Woody normally does not allow his work to go beyond the circles of his clients, but I suggested to him that this piece was quite macro in cope and important for both individuals and policy makers everywhere to understand. In my own simple terms, trees cannot grow in some unlimited manner to the sky. Families cannot grow debt without limit beyond the growth of their incomes. And countries have the same constraints. While growth of debt in the short term is viable, growth of debt faster than the growth of GDP is not viable over the long run. This is not debatable. It is a simple fact. Therefore, as Woody says, it is important that you get the growth side of the equation right as you increase the debt side. Without the proper balance, you are heading for disaster.

From his intro:

"We weave these three concepts together so as to make possible an extension and generalization of "macroeconomic policy" as normally understood. Central to this extension is the need for policies that drive down the nation's Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time. Doing so not only points to a new set of policies for exiting today's quagmire, but also permits an appraisal of the Obama administration's current policy proposals. Regrettably these proposals do not fare well with respect to growth. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere."

This is longer than the usual Outside the Box, and will require you to put on your thinking cap. But you need to digest this, and especially the conclusions. But it is very important that you understand the principles and concepts Woody discusses. We are at a very critical juncture, and the paths we choose will have profound impacts on our lives and fortunes. I cannot overemphasize the point. If we choose a path of growing debt faster than we can grow GDP, the negative implications for many traditional asset classes are enormous.

Let me again thank Woody for allowing me to send this on to you. And for those who post this letter on various sites, just be sure to include a link to Woody's website, www.sedinc.com. For those interested in his subscription service you can contact Woody at woody@sedinc.com or visit his website.

Thanks,

John Mauldin, Editor
Outside the Box

The End Game Draws Nigh – The Future Evolution of the Debt-to-GDP Ratio

By Horace "Woody" Brock, Ph.D.

Preface: In this new report, we link together three quite different concepts that have been discussed in these publications during recent years. First, the problems posed for classical fiscal and monetary policy when extremely large deficits must be financed; second, the critical importance of the rate of economic growth as primus inter pares of all economic variables; and third, the all-important concept of "incentive-structure-compatibility" introduced by Leonid Hurwicz in the 1960s, and recognized in the award to him in 2007 of the Nobel Memorial Prize.

We weave these three concepts together so as to make possible an extension and generalization of "macroeconomic policy" as normally understood. Central to this extension is the need for policies that drive down the nation's Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time.

Doing so not only points to a new set of policies for exiting today's quagmire, but also permits an appraisal of the Obama administration's current policy proposals. Regrettably these proposals do not fare well. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere.

A. Introduction and Overview

In our 2008 research programme, we focused on three issues. First, what exactly caused the worst credit crunch the nation has arguably experienced since the depression of the 1930s? Second, how did the downturn in the US morph into a collapse in Planet Earth's GDP rate from nearly 5% in June 2008 to -0.5% in winter 2009? Third, can traditional macroeconomic policy suffice to turn around the economy? More specifically, will a killer application of classical fiscal and monetary policy truly restore the economy to a stable growth trajectory? Or is there an internal contradiction within macroeconomic policy that could prevent it from succeeding this time around?

To explain the "perfect storm" in the credit market, we drew extensively on the new Stanford theory of endogenous risk to demonstrate that there are three jointly necessary and sufficient conditions to predict and explain the perfect storm we have experienced: (i) A mistaken market forecast of some exogenous event that impacts security prices (in this case, a vastly higher than expected default rate on mortgages); (ii) A high level of Pricing Model Uncertainty bedeviling bank assets (the true cause of the "toxicity" of those complex securities that have clogged the

arteries of the banking sector); and (iii) An unprecedentedly high degree of leverage in the financial sector (money center banks had off-and-on balance sheet leverage of about 40:1 in contrast to the socially optimal leverage of 10:1). The reader can tack "greed" and "incompetence" onto this triad, although doing so diverts attention from the real causes of today's crisis.

To explain the collapse of economic growth worldwide in an astonishingly short period, we utilized a game theory model that explained how the cessation of inter-bank lending amongst the principal money center banks of the world precipitated the first known case of global credit market emphysema: The availability of credit dried up almost everywhere in the course of six months, from Auckland to Iceland. We stressed that this credit contraction had little to do with "globalization" as properly understood, and had no counter-part in history.

To explain the potential failure of fiscal and monetary policy in restoring growth, we demonstrated how the financing of exceptionally large government deficits usually causes a sharp rise in longer-term real interest rates—a rise that bites back and offsets the GDP impact of the fiscal stimulus being applied. The logic leading to this conclusion is reviewed just below in the context of Figure 2.

B. The Good News — A World of Greatly Reduced Uncertainty

A year ago, even six months ago, the great debate centered on whether the credit market crisis would precipitate either a US or global recession. A majority predicted a manageable recession in the US, but nowhere else with the possible exception of the UK. Uncertainty was great, and kept increasing until recently—but no longer. The good news today is that this uncertainty has disappeared. For we now know with probability 1 that everything sucks everywhere. Welcome to a risk free world!

To wit, the G-7 economies are all in recession, and more astonishingly the economy of the planet earth is growing at about -1% or even less. Earnings are crumbling, global trade has decreased by nearly 10%, rising global unemployment foretokens social unrest in many quarters, industrial production has dropped more than ever before, and excess capacity is rising in almost all manufacturing sectors globally. Stephen Roach of Morgan Stanley believes that the "world output gap" could reach a mind boggling 8%–10% by year end. All in all, we have witnessed problems that originated within the US give rise to global scenarios that were virtually unthinkable as recently as the summer of 2008, and do so with blinding speed.

Within the US, there are two parallel problems. First, the nation faces a hitherto unprecedented growth of Federal debt, over both the short and long run. Second, there is the severity of the recession itself. Figure 1 offers a simple way of understanding what killed growth in the US economy. The variables shown remind us of the old adage that "History rhymes, but does not repeat."

History Rhymes: More specifically, the contents of the figure will disturb those seeking to identify today's US recession with earlier ones in 2001 or 1991 or 1981 or 1973 or even 1931. No such identification is possible since the three developments highlighted in the chart and their improbable synergies are different from anything we have seen before. This sui generic nature of today's crisis explains why traditional theories of recessions and "debt super-cycles" possess little explanatory and predictive power.

For example, according to standard business cycle theory, "pent-up demand" on the part of consumers is a principal driver of recovery—but it will not be this time around. The shift towards less consumption and more savings due to the implosion of household balance sheets and to demographics is most probably permanent. If so, this bodes poorly for hopes of a pent-updemand-driven recovery.

History Repeats: While the context of today's crisis differs from those in the past, history repeats itself in that the common denominator of this and all other debt crises has been excess leverage—our mantra in these pages for three years. Our greatest fear was that the all-important role of leverage would be sidestepped in the rush to assign blame and reform the financial system. In this regard, it is dismaying that, whereas we have now vented our anger at bankers and capped bonuses, we have not capped leverage. To be sure, there are calls for "improved bank capitalization" and related reforms, but the crucial role of excess leverage in bringing down the global financial system has not been properly recognized. Instead, excess "greed" has been the principal focus.

Then again, from a game theoretic viewpoint, it may not be surprising that the role of leverage has been underplayed. For leverage is precisely what is required for financiers to reap those huge incomes needed to fund both political parties in Washington, not to mention those "blockbuster" exhibitions we all love so much at the Metropolitan Museum of Art in New York. Stay tuned for Loophole Analysis 101.

C. The Bad News — Two New Uncertainties

Two new uncertainties are now rising to the fore. First, will traditional fiscal and monetary policy suffice to restore economic growth—and in the process restore the viability of the financial sector? Without the latter, there is little hope of revived growth. Our concerns about the inadequacy of traditional macroeconomic policy were discussed at length in our February 2009 PROFILE, and are summarized in Figure 2 taken from that analysis. The flattening out of the stimulus curve in the figure reflects that, when fiscal stimulus exceeds a certain level (e.g., 7% on the horizontal axis), the financing of deficits is likely to cause a sharp increase in real longer-term interest rates. Importantly, this holds true regardless of whether the huge deficits are monetized for reasons we carefully articulated. Higher real yields in turn neutralize the original fiscal stimulus, thus causing the curve to flatten out.¹

We concluded that the risks of policy failure in today's context are disturbing. Moreover, even if traditional policies do prove successful in the shorter run, there is a genuine risk that the huge amount of debt that accrues and must be serviced in the future could transform the US into a "banana republic" in the much longer run. This risk is heightened by the need to fund soaring Social Security and Medicare "entitlements," as record numbers of baby-boomers retire during the next two decades. Moreover, as time goes on, it is precisely these longer-term risks that will matter most to the market, and will increasingly be discounted. Investors of every stripe will be impacted.

The second new uncertainty focuses on whether new and different fiscal and monetary policies can help salvage matters, and guarantee a happier ending.

If the effectiveness of traditional macroeconomic remedies is in doubt, can its arsenal of policies be expanded so as to restore strong longer-term equilibrium growth? The answer is yes, and it is the purpose of this new essay to sketch such an extension of classical macroeconomics.

D. The Critical Dynamics of the Debt-to-GDP Ratio

There is nothing new about a nation running into trouble and running up large amounts of debt in bailing itself out. There is also nothing new about attempting to monetize (via "quantitative easing") the resulting accumulation of debt. The good news for the US is that its total federal debt of some $10T at the outset of the crisis in 2008 was a manageable 70% of current GDP of $14T.² Suppose debt rises $3T by the end of 2011 as the Congressional Budget Office now predicts, and then rises $7T more by 2020. The result will have been a doubling of federal debt between 2008 and 2020, rising from $10T to $20T.³ While this increase is shocking, some forecasts are much worse.

Suppose, moreover, that GDP rises conservatively to $17 trillion in 2020 from today's $14T as a result of a modest 2% GDP growth recovery between 2011 and 2020. Then the federal Debt-to-GDP ratio would rise from today's 0.7 to 1.18. Interestingly, this does not represent the disaster many observers assume. To begin with, there are nations where a disturbingly high Debt-to-GDP ratio proceeded to fall way back down over time. Thus, the US Debt-to-GDP ratio was 1.25 at the end of World War II, yet it fell to 0.25 by 1980. Britain's Debt ratio upon defeating Napoleon in 1815 was over 2.7, and it fell back to 0.2 by the end of the 19^th century.

In other cases, the Debt-to-GDP ratio has stayed persistently high, neither increasing nor decreasing dramatically over time. Thus Japan has had a very high ratio of 1.5 to 1.8 for the past decade. Italy and Belgium, too, have sustained high ratios in the range of 1 to 1.25. Finally, there are the countries where the Debt ratio continues to rise after some initial shock with either hyperinflation or outright default being the end result. Such has been the fate of myriad banana republics including some large players such as Brazil, Argentina and Russia. What exactly determines which nations dig their way out, or else go under? This will be our primary focus in the pages ahead.

Rebounders versus "Banana Republics": To begin with, note that what matters is not a onetime rise in the Debt-to-GDP ratio due to a particular shock (e.g., today's US housing and credit crises), but rather the dynamic trajectory of the ratio in the years subsequent to the initial rise. It is the direction of this trajectory that is all-important. If the Debt ratio continues to rise, then it tends to accelerate due to the ever-rising cost of servicing this ever-rising "primary" deficit. Not only does the increasing debt-load itself cause ever-higher servicing costs, but the rising real rates that typically result from ever-greater debt make the spiral ever worse. The result can be economic and social collapse.

If, on the other hand, the Debt-to-GDP ratio stagnates, it tends to be associated with very low real growth, political paralysis, and a degree of social disenchantment. If the ratio falls, it is usually because of a combination of two developments: higher real growth and vigorous fiscal discipline. Rising living standards, dreams of a better future, and a sustained belief in democracy are associated with this happiest of trajectories.

Three Sets of Scenarios: Figures 3.A – 3.C illustrate the stunning range of outcomes that can result from sustained differences in the growth rates of debt versus of GDP. We have adapted the analysis here to the case of the US. We assume an initial federal debt burden of $12T for 2011, and an initial GDP value of $14T. We then grow these forward at the stipulated growth rates.

At the one extreme of very low economic growth and very high debt growth, the Debt ratio rises to an arresting 18—a half-way house to Zimbabwe. At the opposite extreme, the ratio falls to a paltry 0.4, half of today's level. These two extreme outcomes are circled in the table.

The data in the tables represent real growth rates of both debt and GDP.

E. The Case for Driving Down the Debt-to-GDP Ratio – "It's the Growth Rate, Stupid!"

We can deduce from the foregoing analysis that sustainable long run economic recovery from a debt overload requires two sets of policies: One set must be dedicated to curtailing the growth of government spending and hence, the growth of the deficit. The other set must be dedicated to maximizing real economic growth. In this way, both the numerator and the denominator of the killer Debt-to-GDP ratio will be managed so as to maximize future social welfare.

Policies aimed at augmenting real growth are arguably the more important here. This is because more rapid growth not only reduces the Debt ratio, but also causes swelling tax revenues which can help to reduce the deficit each year. That is, stronger growth drives both the numerator and the denominator in the right directions.

This reality underscores why "It's the real growth rate" must become the mantra of recoveries not only in the US, but almost everywhere else as well. Note that this "strong growth" mantra is a far cry from the Obama administration's counsel to the world at the recent G-7 conference: "Stimulate everywhere by running higher deficits!"

The True Payoffs from Strong Growth: Looking at matters from a game theoretical "Who wins?" standpoint, strong economic growth is the rising tide that lifts all ships. Within a given nation, it alone offers win-win strategies whereby most all interest groups can come out ahead. Externally across nations, strong growth generates expanding trade. Happily, the game of trade between nations is that all-important positive-sum game that encourages peace and discourages war. It creates "the ties that bind." For example, the recent globalization of the supply chain is a principal reason why the business community has been so strangely silent in demanding protectionist policies during the present crisis. When a significant portion of your own manufacturing inputs come from "abroad," do you really want trade barriers?

Finally, and perhaps most importantly, productivity-driven strong growth alone increases living standards that boost the hopes and dreams of people everywhere for a better tomorrow for their children. When citizens have realistic hopes of a better tomorrow, social unrest is minimized. Conversely, when prospects for the long run are grim, voters are easily swayed by demagogues to vote for the Hitler of their day.

Three Important Books: Are these points obvious? They should be, but they frankly are not. Moreover, they are never sufficiently emphasized, and virtually no orientation towards rapid future growth is evident in the policies and "reforms" proposed by the Obama administration, as we see in Section G below. The arguments set forth in three books support the view we are taking as regards the critical role of growth.

First, a widespread lack of understanding and appreciation of growth led Professor Ben Friedman of Harvard University to write his superb book, The Moral Consequences of Economic Growth (A. Knopf, 2005). This is the best work we know of that makes the case for growth and (more implicitly) for globalization at an appropriate economic and moral level of analysis.

Second, and at a more practical level, Alan Beattie's brand new book False Economy: A Surprising Economic History of the World (Riverhead Press, 2009) provides myriad case studies of how nations chose between success or survival or ruin by the specific policies they adopt. His case studies make very clear indeed how policies that depress the Debt-to-GDP ratio of Figure 3 correlate strongly with success, whereas policies that inflate the ratio correlate with ruin.

Third, at an even deeper and more theoretical level, there is the late Mancur Olson's magisterial The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities (Yale University Press, 1982). Olson explains from first principles how special interest groups become entrenched and, in defending their turf, usually cause nations to go bust. [Our "entitlements lobby" anybody?]

Olson's logic is game theoretical: He shows that special interest groups become the principal players in a generalized Prisoner's Dilemma game whereby individually group-rational strategies lead to the collectively irrational outcomes of declining growth, diminishing dreams, increasing social unrest, and ultimately ruin.

This book should be required reading by anyone serving in government. It is one of the best books the present author has ever read in the field of political economy.

F. Four Debt-Minimizing Strategies

Before turning to those all-important strategies for maximizing the growth in the denominator of the Debt-to-GDP ratio, consider several different strategies for minimizing the growth of the numerator.

First, counter-cyclical policies should consist of temporary increases in spending—spending that automatically expires with no Congressional vote when good times return. The Obama administration policies largely amount to permanent spending increases, and have been widely criticized as such.

Second, a new set of government accounts must be introduced that clearly distinguish government investment expenditures from non-investment expenditures. The former should not be included as part of "the deficit." Only an appropriately amortized portion should be included. Moreover, for reasons stressed below, infrastructure investments should take priority when discretionary government spending decisions are made. The current administration has not proposed the required accounting changes. This is, of course, consistent with its failure to propose serious investment spending in the first place (see below).

Third, true leadership—not to be confused with fine rhetoric—is needed to alert citizens to the true disaster we face if the growth of long-term federal debt is not curtailed. This is particularly true given the demographic realities that now lie around the corner. Nobody has made this point better than Stephen Roach in a recent commentary in Morgan Stanley's "Debating the Future of Capitalism" series, March 26, 2009:

I believe that Congress and the White House should collectively declare a formal "fiscal emergency" and empower a bi-partisan task force to develop new guidelines for federal budgetary control.

Washington did this once before in an effort to contain the runaway budget deficits of the Reagan era—deficits that now look like child's play when compared with what lies ahead. The automatic spending caps and sequestration mechanisms prescribed by the GrammRudman-Hollings Balanced Budget and Emergency Deficit Control Acts of 1985 succeeded in taking some of the optionality out of the fiscal debate.

This problem is too big—and the long-term stakes are too high—for fiscal sustainability to be entrusted to the oft-politicized whims of the year-by-year discretionary budgeting process.

Slam Dunk! Given the reality that today's deficit crisis far exceeds that of the Reagan era, it is all the more irresponsible that the President has not already proposed the "fiscal emergency task force" that Roach correctly calls for. Paul Volcker: Where are you when we need you the most? The reforms that such a task force would propose are all pretty obvious, including "sunset provisions" for all manner of government mandates, entitlement reforms, an end of ear-marking, etc.

Fourth, as noted in Section E above, policies must be adopted that maximize economic growth since faster growth is the best way to generate those higher revenues needed to reduce a given deficit. We identify specific growth policies just below.

Lingering Doubts: Even longstanding Democratic Party liberals are now expressing shock at the staggering growth of long-term government debt the US now confronts. Nonetheless, the President's cheerful rhetoric suggests little concern with the growth of the numerator. To be sure, his administration's OMB budget projections blithely assume that very high growth rates will magically return after the next three years, and nothing solves fiscal problems as well as rapid growth. Yet everyone acknowledges that these projections are smoke-and-mirrors, constituting a leadership default of the first magnitude.

Yet could all of this be deliberate? Could the administration's choice to tax and spend ad infinitum have been politically strategic in nature? After all, haven't both President Obama and his chief of staff Rahm Emanuel openly admitted that "the new budget is a means to altering the very architecture of American life, with government playing a much larger role than before"? The likelihood that their new architecture would drive the growth of numerator of the Debt-to-GDP ratio ever-higher and the growth of the denominator lower was never mentioned.

Do financial commentators even understand this risk? While the press has expressed appropriate "concern" about the sea of red ink to come, there is little sense of the true End Game at stake: Which of our Figure 3 scenarios will occur, and what will it imply?

The answer may well determine whether we face a future of peace and prosperity, or of war and privation. As a personal aside, this author has never been more concerned than he is now about the economic state of the nation.

G. Growth-Maximizing Strategies

We now identify a plethora of growth-maximizing policies. Before doing so, however, we must recall the true origins of economic growth itself. Only by understanding these origins can we identify meaningful pro-growth policies.

G. 1. The Two Principal Sources of Real Economic Growth

At the most basic level, trend growth is the sum of workforce growth plus productivity growth. Intuitively, this rate of growth equals the rate of growth of the number of workers producing the pie, plus the rate of increase of pie production per person hour. In the latter case, we distinguish between productivity increases that result solely from "working smarter" versus increases that result from increased investment per worker, or "factor stuffing" in economics jargon. The former is called pure labor productivity growth (e.g., take a weekend off and invent the differential calculus), whereas the latter is referred to as total factor productivity growth.

The very rapid growth of emerging economies is usually due to a very high rate of increase in total factor productivity growth as workers gain access to roads, computers, medicines, and other productivity-improving (but not free!) endowments for the first time. Developed economies cannot replicate this strategy, so their growth rate is much lower than the "catch-up" rates in newer economies.

Thus, policies that augment growth must operate through two channels: Increasing productivity growth (via enhanced skills and investment), and/or increasing workforce growth.

Incentive-Structure-Compatibility: In proposing pro-growth policies of both kinds, we shall keep in mind the requirement that such policies be "incentive-structure-compatible" with growth, a concept first articulated by the economist and philosopher Leonid Hurwicz in the late 1950s. Everyone acknowledges the importance of incentives in a given situation, e.g., the appropriate carrots and sticks needed to raise children, to motivate workers, etc.

What Hurwicz first articulated was the way in which the totality of incentives throughout society—its "incentive structure"—could be conducive to achieving a particular societal goal, such as maximal growth. The great importance of Hurwicz's concept is that it provides the correct analytical bridge between the micro and macro domains of social life. This was a stunning achievement, and earned him the 2007 Nobel Memorial Prize.⁴

Most "policies" and "goals" promulgated by politicians turn out not to be incentivestructure-compatible with growth, or with any other defensible objective. That is to say, most policy proposals are hot air.

Figure 3 summarizes the structure of our argument up to this point.

G.2. Productivity-Enhancing Growth Strategies

During the past three decades, a great deal of research has been done to understand the true sources of productivity growth. In particular, Paul Romer of Stanford University developed his theory of "endogenous growth" in which the rate of productivity growth is determined within the economic system, as opposed to being modeled as an external "residual" as it previously had been. In what follows, we draw on this and related research in an informal manner.

1. Infrastructure-Orientated Fiscal Stimulus: Economists increasingly believe that consumption will fall by 7% from its 72% share of US GDP in 2007 to around 65% over the next three years. Moreover, they believe it will remain at a significantly lower level. Pessimists conclude that "without a recovery of household spending to previous levels, the economy will suffer for a long time." Yet this is not the case.

Should investment spending (both in the corporate sector and in government infrastructure spending) rise by an offsetting 7% of GDP, the growth rate of GDP will not only match, but in fact exceed its old rate of growth. This is due to the role of classical macroeconomic "accelerator/multiplier" theory: A dollar invested will generate much greater future output than a dollar of transfer payments or consumption-stimulating tax cuts.

As regards today's humongous fiscal deficits, this reality implies that, the more the deficit is dedicated to infrastructure investment each year, then (i) the greater productivity will be (recall that investment raises productivity), and (ii) the greater both job growth and output will be over time via the Keynesian multiplier theory. Since virtually everyone recognizes that US infrastructure spending has been woefully inadequate for decades, and that consumption has been excessive, the current recession has, in fact, presented the government with a golden opportunity to "rebalance" the composition of GDP in a highly desirable manner.

Yet there are two additional reasons why the increased deficit should be infrastructure-investment-orientated. First, government expenditure on productivity-raising investment is not, in fact, "an expenditure" that raises the deficit and frightens bond market vigilantes. For as explained above, government investment spending of this ilk should be amortized over time. Thus, the larger the investment share of a given stimulus package, the smaller the resulting deficit. Second, to the extent that today's deficit explosion burdens the young with much more debt to be serviced, then it is our moral obligation to dedicate the extra spending to investments that raise the productivity growth and thus the size the future GDP. Doing so clearly reduces the real burden on future tax payers of servicing the debt being accumulated today.

Given this rare opportunity—and moral obligation—to tilt the economy towards long overdue investment spending, how can the Obama stimulus package have fallen so short of the mark? It is frankly embarrassing to witness Chinese policy advisors like Professor Yu Qiao of Tsinghua University scolding the US about something as basic as this:

Most of Mr. Obama's stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America's over-consumption problem and delay sustainable recovery.

Financial Times, Editorial page, April 1, 2009

Qiao's point parallels a principal point we are making in this essay. Why are we not reading this from Christina Romer or Larry Summers in Washington? Have the Best and the Brightest once again lost their moral integrity as they did during the Vietnam War era? Can they seriously believe that more transfer payments to Democratic Party special interest groups is what the nation needs in this hour of its distress? The author considers the composition of the proposed $3 trillion of discretionary stimulus over the next five years a moral travesty.

Case Study of Energy: As a case study in how poor the administration's policies are in this regard, consider its energy policies. Is anyone in the new administration reading about the disastrous 9% annual decrease in the output of "old" oil (yes, "peak oil" turned out to be true), in conjunction with a collapse of previously scheduled investments in exploration and development, and in refining capacity? Are they blind to the supply-crisis that is unfolding, one that calls not only for "renewable energy," but also for a major expansion of traditional oil and gas production?

By now, has it not become crystal clear that the increased production of traditional fuels should come from within the US, given the devolution of both the political leadership and the infrastructure of those thugocracies upon whom the US increasingly depends for 40% of its consumption? Is no thought being given to the rising probability of $500 oil prices—or perhaps outright rationing—when global energy demand recovers? [Recall how jointly price-inelastic demand and supply curves cause huge changes in price both upward and downward, as we demonstrated mathematically five years ago.]

Elementary arithmetic is all that is needed to ascertain that the administration's BTU gains from increased renewable energy production and conservation from increased "weather-stripping" will not yield even 10% of the BTU shortfall that the nation will confront. The reality, therefore, is that the country needs a vast expenditure of funds on novel and traditional sources of energy, as well as on our deteriorating energy infrastructure. Expenditures of this kind would create several million jobs of precisely the kind that are needed during the next decade. And they would leave the next generation with an improved infrastructure, in addition to lessening our extraordinary dependence on imports from rogue states.

But what do we get from the Obama team? A present value tax hike of up to $400 billion on "big oil" in one form or another, along with weather-stripping tax credits and expenditures on renewable energy alone. And who is the newly appointed spokesman for national energy policy? A highly credentialed academic who strikes virtually everyone as indecisive and ineffectual. Does even one reader of this essay know his name? [Steven Chu] Of course, his Nobel Prize supposedly substitutes for his lack of political skills. By extension, are we about to witness the "quant" financial theorist Myron Scholes appointed as Treasury Secretary after Tim Geithner steps down? After all, Scholes too, is a Nobel laureate, even if his notorious "pricing models" helped to bring down Long Term Capital Management and then the world economy a decade later. The Lord save us from "The best and the brightest!"

2. Stimulation of Innovation and Venture Capital: While increased infrastructure investment is one channel to higher productivity growth (and hence higher GDP growth), innovation is another. As someone who lived in Menlo Park, California for two decades between 1980 and 2000, the author was privileged to witness first hand the stunning comeback of the US from its "rust bowl" status of the 1970s.

The comeback was almost entirely due to a broad array of venture capital sponsored innovations, starting with the micro-processor. In a Memo he wrote for Mssrs. Clinton and Rubin in 1996, the author demonstrated that the US had an "Innovation Quotient" 17 times higher than that of our next competitor. [Finland. Think Nokia!] As a result, US productivity growth doubled from its depressed level of 1.4% in the 1970s to 3% by the late 1990s and early 2000s. No other nation came close to this achievement.

Yet now, when we need renewed innovation and enhanced productivity growth as much as we did in the 1970s, we read that the Obama Treasury Secretary Geithner has proposed to regulate the venture capital industry. Specifically, he has called for mandatory SEC registration of large firms, lest the sector become a "systemic risk" like hedge funds and proprietary trading desks. As Jack Biddle of the VC firm Novak Biddle Venture Partners has pointed out in a Wall Street Journal interview (April 9, 2009):

I cannot imagine any venture capital firm being of a size to pose 'systemic risk,' so they (the administration) either do not understand the nature of the business, or...What Washington needs to understand is that bank-style regulation could destroy the culture that created the micro-processor.

3. Education and Elitism: In contemplating the sources of productivity growth, we would all do well to recall Isaac Newton's celebrated confession that, in developing his theory of mechanics and the differential calculus, "I stood on the shoulders of giants." Politically incorrect as it is to admit, we need policies that identify and reward elite young people and entrepreneurs from a very early age, and do so regardless of where they come from. Indeed, we should be seeking young scientific talent worldwide and paying for immigrants to come to the US and study.

Instead, the stimulus package dedicates significant funds to lowest common denominator educational expenditures. In particular, virtually nothing is being proposed to end the monopoly of teachers' unions that discourages qualified teachers from attempting to teach. The consequences for productivity growth of the longstanding decline of our public schools is by now well known, and has been articulated by public figures ranging from Bill Clinton to Bill Gates and Steve Jobs.

4. Taxation that Rewards Innovation and Success: Both the president and his chief of staff Rahm Emanuel have been completely candid about their redistributionist agenda—an agenda that has even alarmed European liberals. Were they at all concerned with innovation, productivity, and growth, the administration would not publicly espouse taxation policies that punish success and reward failure. In particular, they would not have declared war on small business, since small businesses typically generate the bulk of new jobs and innovations that determine the rate of economic growth.

To be sure, disparities in the current tax code do permit Warren Buffet to incur a much lower tax rate than his receptionist, as he quipped. Such inequities must be remedied. But the fact remains that the top decile and quartile of income earners in the US pay a larger share of government tax revenues than in any other G-7 nation. If so, why does the president assume it is "fair" to hike the tax rates on top income earners, and only on this group? From an employment standpoint, the new tax rates may well send talented young Americans to live elsewhere. Starting in 2011, a New York City wage earner will pay a marginal tax rate (federal, state, and local) of over 60% on "high" incomes of $200,000. This rate is higher than comparable rates in Germany and France where taxes paid secure decent schooling and medical care, which they do not in the US. Yet even so, France has witnessed a veritable diaspora of young talent to London, the US, and Switzerland during the past two decades.

5. Incentives for Investment in the Private Sector: Productivity growth comes not only from government-sponsored infrastructure of the kind discussed above, but also from investment by private businesses of all sizes in new capital stock. It is not clear what the new tax policy will be towards investment tax credits, but such credits have not yet been identified as important. They are important, especially at a time when the search for higher productivity and hence higher economic growth must become the nation's number one priority.

6. Less Regulation, Not More: "Re-regulation" is back in vogue. But increased regulation where it's not needed chokes off innovation and growth. While the financial sector clearly needs re-regulation, it is not clear that other sectors do. Should the new administration become growth-oriented, then it must be very careful not to choke off the all-important forces of "creative destruction."

Even in the financial sector, overkill is likely. In our own view, two general forms of regulation are needed. First, incentives must be properly aligned (e.g., banks issuing securitized products must hold a certain proportion of such products in-house.) Second, leverage must be radically curtailed, a point we have stressed for three years. As for "excess pay," the limitation of leverage and proper alignment of incentives will automatically remedy most excesses of recent years. In brief, the less regulation the better.

G.3. Workforce-Enhancing Growth Strategies

1. Strong GDP Growth: The six growth-maximizing strategies above will do more to boost workforce growth than anything else. The strong correlation of workforce growth and GDP growth is well understood at both an empirical and theoretical level. Most important, perhaps, is the need to stimulate innovation so that new industries can rise and replace old industries via the unfettered forces of creative destruction. Indeed, new industries have contributed over 75% of job growth in the US during recent decades. Numerous studies have shown how policies preventing creative destruction within most of Europe depressed private sector job creation during recent decades. Most job creation occurred in the public sector. Regrettably, none of these employment realities have been discussed by the new administration.

2. Deficit Composition: Utilization of today's huge deficits for boosting investment expenditures triggers those accelerator/multiplier effects cited above that boost employment far more than transfer payments or tax cuts do. Yet the administration's stimulus package is very infrastructure-lite, as was discussed above.

3. Deregulation of the Labor Market: Labor unions have long wanted to return to the practices of card-check balloting (or majority sign-up) without secret balloting. Yet such practices are definitionally anticompetitive, and retard employment growth. The administration initially supported card-check legislation or the so-called Employee Free Choice Act, but does not have enough votes to impose it. As to the tricky issue of immigration, the Obama team is doing a good job to date supporting rights for undocumented workers who have played such an important role in the nation's economic history, and must continue to do so in the future.

4. Managing Demographic Change within the Labor Market: There will be new and important tensions within the US labor market, given the likely influx of millions of post-65 year old boomers. It is becoming clear that the retirement planning of this generation was woeful, with up to half of boomers expecting they could afford a retirement financed by the ever-rising values of stocks and houses. Such expectations have been shattered, and many boomers will have to work until age 75 to afford the lives they expect.

In many ways, this is a good development. However, it presupposes that the requisite jobs exist. Yet they will not exist unless labor markets are deregulated, not re-regulated. In particular, minimum wages and guaranteed hours of work must go by the boards. Maximum flexibility will be needed to equate supply and demand in the labor market, thereby reducing tensions between older and younger job-seekers. Such tensions have already begun to appear in today's scramble for jobs.

A welcome dividend of elderly workers joining the workforce will be the reduction of the Social Security Trust Fund deficit. If the average retirement age de facto (not de jure) rises from 64 to 70, trillions of dollars of unfunded liabilities will evaporate as people draw upon their Social Security entitlements later, and contribute longer. The present value of the resulting fiscal savings is truly huge, making it all the more important that the US labor market become as flexible and efficient as possible. The administration has never touched upon this issue.

5. Tax Policy: Any student of public finance will recall that the best kind of tax is the tax that least distorts the efficiency of the economy. The Value Added Tax (VAT) is well known to be optimal in this regard. Conversely, taxes on labor (e.g., income taxes) distort workforce growth and thus, economic efficiency the most. But the administration is wedded to higher taxes on labor, and has never proposed a VAT.

This concludes our identification of over a dozen policies that can drive the Debt-to GDP ratio down. Please note that each of the pro-growth strategies is incentive-structure-compatible with growth, as desired and as promised up front.

H. Conclusion: When Being "Smart" Is Not Enough

This essay began with a demonstration of the all-important role of the evolution of a nation's Debt-to-GDP ratio. The direction of this evolution is a good proxy for the future success or failure of the nation. We argued that a one-time shock (like today's US recession) that drives the initial Debt ratio way up does not pose the problem most people assume. Long run recovery is possible, but only if policies are adopted that drive the growth rate of the numerator down, that of the denominator up, and thus that of the ratio down.

We then identified over a dozen policies that can achieve the goal of driving down the Debt-to-GDP ratio in the longer term. The End Game that is now being played is whether policies of this kind are adopted, or whether they are not. In our view, the Obama administration has adopted both a philosophical perspective and a set of policies that will drive the ratio up. If this is indeed the price of a "new American social architecture," then it is a price that is too high.

We also proposed that these "ratio management policies" should be viewed as a refinement, and indeed an extension of classical monetary and fiscal policy. They add a new dimension to the concept of "macroeconomic policy," and to its objectives.

Why do so few administration spokesmen or economic commentators seem to share our views? Is "politics" the problem? We do not think so, at least to the extent that growth-maximizing policies are win-win policies that any good politician should be able to sell. No, the problem is rather one of the mind-set of a generation that has never before needed to confront the problems lying ahead, and that is tone deaf to philosophical issues, as opposed to "policy wonk" issues.

Today's True Challenge — Governance: In this vein, we proposed at the end of our February 2009 PROFILE that the root problems of today are not macroeconomic as much as they are political philosophical: How can democracy save itself from itself? How can people be made to realize that a reform of governance is what is now most needed—more so even than a reform of Wall Street? And even in the financial sector, it is increasingly clear that regulatory lapses in Washington were more responsible than "greed" for what has happened. Messrs. Rubin, Summers, and Greenspan actively encouraged the most pernicious of the deregulatory policies that brought down the system.

By now, it is clear that we need bold new constitutional amendments that mandate (i) sterilization of excess money creation during cyclical recoveries, (ii) fiscal surpluses during recoveries to pay down past fiscal deficits, and (iii) deficits during recessions tilted towards growth-enhancing infrastructure spending, not towards goodies for special interest groups.

In this regard, economists Martin Wolf and Stephen Roach have both correctly identified financial market "credibility" as the key to future growth, inflation, and interest rates. Can today's administration end up with any credibility when it blithely ignores the very existence of the End Game we have identified, much less those policies needed to solve it correctly? Will there be any credibility if the three proposed amendments just cited are not adopted?

In his magisterial The Rise and Decline of Nations, Mancur Olson understands that these are the topics that matter—not greed management 101. Yet barely a word is being said about these issues by the Best and the Brightest now staffing the Obama White House. Why? The explanation partly lies in a crisis of intellectual competence. Scholars trained in "macroeconomics" are as poor in discussing Olson's dilemmas of collective action as oncologists are in discussing dentistry. The fact that the macroeconomists in question are "brilliant" is irrelevant. Being smart is not enough.

The abject moral failure of the new team to identify much less to propose a solution to the End Game is extremely disturbing to the present author. Despite his initial support of President Obama, he increasingly wonders whether we have the right team in place. And he is alarmed that time to rebuild credibility is running out.

Footnotes:

¹We stressed that this hike in real rates does not occur in the case of normal-sized fiscal deficits caused by normal G-7 recessions. It only occurs when the deficits are exceptionally large, as they are turning out to be this time around. Accordingly, our analysis cannot be supported by the data of G-7 recessions during the past half century for the simple reason that we have rarely before experienced deficits of the magnitude confronting the US today. Nonetheless, our analysis can be supported by the experience of many emerging market economies that became overly indebted.

² US federal debt is often stated to be $5.5T. This is because some $4.5T of debt is held by the Social Security Administration trust funds and other entities. But what matters for the purposes of our analysis is the total debt of some $10T.

³ This forecast growth of debt excludes the growth of liabilities of the balance sheet of the Federal Reserve Bank, as well as some off-balance sheet operations by the Treasury. But much of the costs of bailing out the financial system should properly be viewed as asset exchanges, and not as increases in the fiscal deficit per se. The story is highly complicated, and mistaken interpretations are commonplace.

⁴ In one of the grandest achievements in the history of social thought, Hurwicz demonstrated mathematically that the incentive structure of "true capitalism" alone is compatible with the societal goals of efficiency, privacy, freedom, equity, and stability. In our view, this result gave a more compelling and concrete interpretation of Aristotle's concept of "The Good Life" than any theory before or since has done.

Quarterly Review and Outlook - First Quarter 2009

JohnMauldin — Mon, 20 Apr 2009 21:14:00 GMT

There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. And this week's letter does just that. I have made the comment more than once that is it unusual for two major bubbles to burst and for the conversation and our experience to be rising inflation and not a serious problem with deflation.

Van Hoisington and Dr. Lacy Hunt give us a seminar on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort.

Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter- intuitive to what we hear today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook
First Quarter 2009

Inflation/Deflation

Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that "sooner or later" inflation will inevitably return, probably with great momentum. This inflationist view of the world seems to rely on two general propositions. First, the unprecedented increases in the Fed's balance sheet are, by definition, inflationary. The Fed has to print money to restore health to the economy, but ultimately this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity. This will serve to reinforce the reflationary efforts of the Fed and lead to inflation.

These propositions are intuitively attractive. However, they are beguiling and do not stand the test of history or economic theory. As a consequence, betting on inflation as a portfolio strategy will be as bad a bet in the next decade as it has been over the disinflationary period of the past twenty years when Treasury bonds produced a higher total return than common stocks. This is a reminder that both stock and Treasury bond returns are sensitive to inflation, albeit with inverse results.

Economic Theory

If inflation and interest rates were to rise in this recession, or in the early stages of a recovery, the expansion would be cut short and the economy would either remain in, or relapse into recession. In late stages of economic downturns, substantial amounts of unutilized labor and other resources exist. Thus, both factory utilization and unemployment rates lag other economic indicators. For instance, reflecting this severe recession, unused labor and other productive resources have increased sharply. The yearly percentage decline in household employment is the largest since current data series began in 1949. In March the unemployment rate stood at 8.5%, up from a cyclical low of 4.4%. This is the highest level since the early 1980s. The labor department's broader U6 unemployment rate includes those less active in the labor markets and working part time because full time work is not available. The U6 rate of 15.6% in March was the highest in the 15 year history of the series and up from its cyclical low of 7.9%. The operating rate for all industries and manufacturing both fell to their lowest levels on record in March. Manufacturing capacity was around 15% below the sixty year average (Chart 1). Given these conditions, let's assume for the moment that inflation rises immediately. With unemployment widespread, wages would seriously lag inflation. Thus, real household income would decline and truncate any potential gain in consumer spending.

A technically superior and more complete method of capturing the concept of excess labor and capacity is the Aggregate Supply and Demand Curve (Chart 2). Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity exists. Excess capacity causes firms to cut staff, wages and other costs. Since wage and benefit costs comprise about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD. Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve thus creating higher price levels. In our opinion such a process will take well over a decade.

Record Expansion of the Fed's Balance Sheet and M2

In the past year, the Fed's balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion, and potentially larger increases are indicated for the future. The increases already posted are far above the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts. They recall Milton Friedman's famous quote that "inflation is always and everywhere a monetary phenomenon."

These gigantic increases in the monetary base (or the Fed's balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public's preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank's needs for excess reserves. These factors, beyond the Fed's control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall (Chart 3). Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments. Not surprisingly, from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline.

If this all sounds complicated you are right, it is. The bottom line, however, is that it is totally incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.

What about the M2 Surge?

M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system. The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed.

The historical record indicates that V may be likened to a symbiotic relationship of two variables. One is financial innovation and the other is the degree of leverage in the economy. Financial innovation and greater leverage go hand in hand, and during those times velocity is generally above its long-term average of 1.67 (Chart 4). Velocity was generally below this average when there was a reversal of failed financial innovation and deleveraging occurred. When innovation and increased leveraging transpired early in the 20th century, velocity was generally above the long-term average. After 1928 velocity collapsed, and remained below the average until the early 1950s as the economy deleveraged. From the early 1950s through 1980 velocity was relatively stable and never far from 1.67 since leverage was generally stable in an environment of tight financial regulation. Since 1980, velocity was well above 1.67, reflecting rapid financial innovation and substantially greater leverage. With those innovations having failed miserably, and with the burdensome side of leverage (i.e. falling asset prices and income streams, but debt remaining) so apparent, velocity is likely to fall well below 1.67 in the years to come, compared with a still high 1.77 in the fourth quarter of 2008. Thus, as the shadow banking system continues to collapse, velocity should move well below its mean, greatly impairing the efficacy of monetary policy. This means that M2 growth will not necessarily be transferred into higher GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded by 15.7%. The same pattern appears likely in Q1 of this year.

The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.

Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.

Are Massive Budget Deficits Inflationary?

Based on the calculations of the Congressional Budget Office, U.S. Government Debt will jump to almost 72% of GDP in just four fiscal years. As such, this debt ratio would advance to the highest level since 1950 (Chart 5). The conventional wisdom is that this will restore prosperity and higher inflation will return. Contrarily, the historical record indicates that massive increases in government debt will weaken the private economy, thereby hindering rather than speeding an economic recovery. This does not mean that a recovery will not occur, but time rather than government action will be the curative factor.

By weakening the private economy, government borrowing is not an inflationary threat. Much light on this matter can be shed by examining Japan from 1988 to the 2008 and the U.S. from 1929 to 1941. In the case of Japan government debt to GDP ratio surged from 50% to almost 170%. So, if large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time. Instead, their economy is in shambles. After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5% (Chart 6). As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector (Chart 7). Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.

This recent Japanese experience mirrors U.S. history from 1929 to 1941 when the ratio of U.S. government debt to GDP almost tripled from 16% to near 50%. As the U.S. debt ratio rose, long Treasury yields moved lower, indicating that the private sector was hurt, not helped, by the government's efforts. The yearly low in long Treasury yields occurred at 1.95% in 1941, the last year before full WWII mobilization. In 1941, the S&P 500, despite some massive rallies in the 1930s, was 62% lower than in 1929, and had been falling since 1936. Thus, two distinct periods separated by country and considerable time indicate that stock prices respond unfavorably to massive government deficit spending and bond yields decline.

The U.S. economy finally recovered during WWII. Some attribute this recovery to a further increase in Federal debt which peaked at almost 109% of GDP. However, the dynamics during the War were much different than from those of 1929 through 1941 and today. The U.S. ran huge trade surpluses as we supplied military and other goods to allies, which served to lift the U.S. economy through a massive multiplier effect. Additionally, 10% of our population, or 12 million persons, were moved into military services. This is equivalent to 30 million people today. Also, mandatory rationing of goods was instituted and people were essentially forced to use an unprecedented portion of their income to buy U.S. bonds or other saving instruments. This unparalleled saving permitted the U.S. economy to recover from the massive debt acquired prior to 1929.

Bonds Still an Exceptional Value

Since the 1870s, three extended deflations have occurred--two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of "extreme over indebtedness," a term originally used by Irving Fisher in his famous 1933 article, "The Debt-Deflation Theory of Great Depressions." Fisher argued that debt deflation controlled all, or nearly all, other economic variables. Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per annum more than Treasury bonds, but in deflations the risk premium was negative. In the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9% and 7% per annum, respectively, more than common stocks. In Japan's recession from 1988-2008, Treasury bond returns exceeded those on common stocks by an even greater 8.4%. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond (Table 1).

This table also speaks to the impact of massive government deficit spending on stock and bond returns. In the U.S. from 1874-94, no significant fiscal policy response occurred. The negative consequences of the extreme over indebtedness were allowed to simply burn out over time. Discretionary monetary policy did not exist then since the U.S. was on the Gold Standard. The risk premium was not nearly as negative in the late 19th century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when the government debt to GDP ratio more than tripled in both cases. In the U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S. 1928-41 and in Japan in the past twenty years, stocks posted compound annual returns of negative 2.4% and 2.3%, respectively. Therefore on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows and slow growth.

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

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Quarterly Review and Outlook - First Quarter 2009

Quarterly Review and Outlook First Quarter 2009

Inflation/Deflation

Economic Theory

Record Expansion of the Fed's Balance Sheet and M2

What about the M2 Surge?

Are Massive Budget Deficits Inflationary?

Bonds Still an Exceptional Value

Quarterly Review and Outlook
First Quarter 2009