Friday, May 13, 2011
PIMCO's Largest Position Is Gold
Amazing!
from International Business Times:
Anne Gudefin, PIMCO’s global equities portfolio manager, likes gold.
“The largest position in [our] fund is gold, which we think is a very good form of protection against what can go wrong,” said Gudefin in an interview with Fortune published on May 12.
“We were encouraged by the fact that a lot of the central banks, especially in Asia, are big buyers. We think that's an underlying trend that's very favorable for gold,” she said.
The latest IMF data show that the central banks that have added to their gold positions include Thailand, Mexico, and Russia.
These central banks, like PIMCO, are likely attracted by gold’s historic reputation as a store of value, especially at a time of heightened uncertainties.
On the economics side, uncertainties include the European debt crisis, the US housing market, the US budget deficit, the possible negative effects of QE2, the Chinese properties market, and Chinese inflation.
Treasury Shorts Shaken
Indecisive Market
Yesterday, stocks rallied on a failed US Treasury auction. After a failed attempt to rally again today, stocks have collapsed. Dow is currently down about 100 points, but still maintaining a level above yesterday's lows. I think that with QE2 coming to a close in less than 7 weeks, the markets are anticipating the potential for malaise that had prevailed over the past three years each time the Fed has stopped monetizing the debt!
Yesterday, I read interesting analysis by Chris Martenson that suggested that about 2/3 of the volume of the stock market during QE2 was due to money creation by the Fed. That's doesn't make me feel warm and fuzzy going forward.
Prediction From One of Wall Street's More Accurate Prognosticators
from Bloomberg interview of John Taylor:
Higher-risk assets, such as equities, the euro and emerging market currencies, have either peaked or will do so by end of July, according to Taylor, who manages about $8.5 billion and uses statistical models to help predict future movements in assets. Global investors have tempered their optimism about the U.S. and world economies and plan to put more of their money in cash and less in commodities over the next six months, a Bloomberg survey released today found.
FX Concepts, whose returns last year were the company’s best since 2006, reaped gains in the first half of 2010 betting on a slide in the euro against the dollar and then profited by its rise the rest of the year. At present, the fund is short the common currency, which means it will profit if it declines.
Taylor, who predicted several times since 2010 that the euro will eventually fall to parity versus the dollar, boosted returns by wagering on short term swings higher in the shared European currency. FX Concepts, in a Jan. 27 note, said the euro would move higher in a medium-term trend and in April predicted the currency was poised to reach a technical target of $1.4925.
“There is absolutely statistically no way that Greece can survive,” said Taylor, who just returned from France. “There is a one in 10,000 chance; if the Germans give Greece their money to pay back their debt then they’ll be fine. But there is no way Germany will do that.”
Greek government bonds fell today, pushing the two-year note yield to a record high of 26.77 percent. The bonds have lost investors 11 percent this year.
“As the spread of Greek two-year debt goes absolutely crazy over German, it means that at some point we are going to have to have a crisis,” said Taylor, whose Global Currency fund gained 3.33 percent last month. “And I think it’s very soon.”
Inflation Surges
CPI was up this morning, sending stocks lower.
Wednesday, May 11, 2011
And Plunge Still More
Gas, Crude Futures Drop on Bearish EIA Surprise
NEW YORK (AP) - Gasoline futures tumbled 6 percent Wednesday after the government reported that the U.S. unexpectedly increased supplies last week.
Analysts expected gasoline supplies to shrink for the 12th week in a row as a rash of operating problems during the past few months idled numerous refineries around the country. Energy Information Administration data showed that supplies increased last week by 1.3 million barrels, growing as gasoline demand dropped for the seventh week in a row to 9 million barrels per day.
Gasoline for June delivery dropped after the report, losing 22 cents at $3.1588 per gallon on the New York Mercantile Exchange. Gas supplies typically decline in the spring as refineries purge their stocks of winter fuels. This year supplies fell more than expected as fires, power outages and other random problems temporarily knocked refineries out of commission during the past few months. Mississippi River flooding also may affect some refineries, analysts said.
Corn Limit Down on USDA Report
Grains hit hard at open, but bargain hunters emerging; prices well off their lows; corn dn 22, beans dn 9, wht dn 16 to dn
Stocks Looking Weak Today
Tuesday, May 10, 2011
True Finn Party Rejects More EU Bailouts
Editorial in WSJ by True Finn Party leader Timo Soini:
When I had the honor of leading the True Finn Party to electoral victory in April, we made a solemn promise to oppose the so-called bailouts of euro-zone member states. These bailouts are patently bad for Europe, bad for Finland and bad for the countries that have been forced to accept them. Europe is suffering from the economic gangrene of insolvency—both public and private. And unless we amputate that which cannot be saved, we risk poisoning the whole body.
At the risk of being accused of populism, we'll begin with the obvious: It is not the little guy that benefits. He is being milked and lied to in order to keep the insolvent system running. He is paid less and taxed more to provide the money needed to keep this Ponzi scheme going. Meanwhile, a kind of deadly symbiosis has developed between politicians and banks: Our political leaders borrow ever more money to pay off the banks, which return the favor by lending ever-more money back to our governments, keeping the scheme afloat.
In a true market economy, bad choices get penalized. Not here. When the inevitable failure of overindebted euro-zone countries came to light, a secret pact was made.
Instead of accepting losses on unsound investments—which would have led to the probable collapse and national bailout of some banks—it was decided to transfer the losses to taxpayers via loans, guarantees and opaque constructs such as the European Financial Stability Fund, Ireland's NAMA and a lineup of special-purpose vehicles that make Enron look simple. Some politicians understood this; others just panicked and did as they were told.
The money did not go to help indebted economies. It flowed through the European Central Bank and recipient states to the coffers of big banks and investment funds.
Further contrary to the official wisdom, the recipient states did not want such "help," not this way. The natural option for them was to admit insolvency and let failed private lenders, wherever they were based, eat their losses.
That was not to be. As former Finance Minister Brian Lenihan recently revealed, Ireland was forced to take the money. The same happened to Portuguese Prime Minister José Sócrates, although he may be less forthcoming than Mr. Lenihan about admitting it.
Two Alternative and More Meaningful Measurements of GDP
by Rob Arnott of Agora Financial:
Gross Domestic Product is used to measure a country’s economic growth and standard of living. It measures neither. Unfortunately, the finance community and global centers of power are wedded to a measure that bears little relation to reality, because it confuses prosperity with debt-fueled spending.
Washington is paralyzed by fears that any withdrawal of stimulus, whether fiscal or monetary, whether by the Administration, the Fed, or the Congress, may clobber our GDP. And they’re right. But, GDP is the wrong measure.
Without an alternative, we will continue to make bad policy choices based on bad data. Eventually, our current choices may wreak havoc with our future prosperity, the future purchasing power of the dollar, and the real value of U.S. stocks and bonds.
What is GDP?
GDP is consumer spending, plus government outlays, plus gross investments, plus exports minus imports. With the exception of exports, GDP measures spending. The problem is GDP makes no distinction between debt-financed spending and spending that we can cover out of current income.Consumption is not prosperity. The credit-addicted family measures its success by how much it is able to spend, applauding any new source of credit, regardless of the family income or ability to repay. The credit-addicted family enjoys a rising “family GDP”—consumption—as long as they can find new lenders, and suffers a family “recession” when they prudently cut up their credit cards.
In much the same way, the current definition of GDP causes us to ignore the fact that we are mortgaging our future to feed current consumption. Worse, like the credit-addicted family, we can consciously game our GDP and GDP growth rates—our consumption and consumption growth—at any levels our creditors will permit!
Consider a simple thought experiment. Let’s suppose the government wants to dazzle us with 5% growth next quarter (equivalent to 20% annualized growth!). If they borrow an additional 5% of GDP in new additional debt and spend it immediately, this magnificent GDP growth is achieved! We would all see it as phony growth, sabotaging our national balance sheet—right? Maybe not. We are already borrowing and spending 2% to 3% each quarter, equivalent to 10% to 12% of GDP, and yet few observers have decried this as artificial GDP growth because we’re not accustomed to looking at the underlying GDP before deficit spending!
From this perspective, real GDP seems unreal, at best. GDP that stems from new debt—mainly deficit spending—is phony: it is debt-financed consumption, not prosperity. Isn’t GDP, after excluding net new debt obligations, a more relevant measure? Deficit spending is supposed to trigger growth in the remainder of the economy, net of deficit-financed spending, which we can call our “Structural GDP.” If Structural GDP fails to grow as a consequence of our deficits, then deficit spending has failed in its sole and singular purpose.1
Of course, even Structural GDP offers a misleading picture. Our Structural GDP has grown nearly 100-fold in the last 70 years. Most of that growth is due to inflation and population growth; a truer measure of the prosperity of the average citizen must adjust for these effects. Accordingly, let’s compare real per capita GDP with real per capita Structural GDP.
A New Measure of Prosperity
Real per capita GDP has recovered to within 2.5% of the 2007 peak of $48,000 (in 2010 dollars). So, why do we feel so bad? For one thing, after two recessions, we’re up barely 6% in a decade. Furthermore, this scant growth is entirely debt-financed consumption. The real per capita Structural GDP, after subtracting the growth in public debt, remains 10% below the 2007 peak, and is down 5% in the past decade. Net of deficit spending, our prosperity is nearly unchanged from 1998, 13 years ago.As a diagnostic for why this has happened, let’s go one step further. Few would argue that a healthy economy can grow without the private sector leading the way. The real per capita “Private Sector GDP” is another powerful measure that is easy to calculate. It nets out government spending—federal, state, and local. Very like our Structural GDP, Private Sector GDP is bottom-bouncing, 11% below the 2007 peak, 6% below the 2000–2003 plateau, and has reverted to roughly match 1998 levels.
Figure 1 illustrates the situation. Absent debt-financed consumption, we have gone nowhere since the late 1990s.
Figure 1. Real GDP, Structural GDP, and Private Sector GDP, Per Capita, 1944-2011
Source: Research Affiliates
As the private sector has crumbled, and Structural GDP has lost 13 years of growth, tax receipts have collapsed. Real per capita federal tax receipts have tumbled to levels first achieved in 1994, and are fully 25% below the peak levels of 2000.2 The 2000 peak in tax receipts was, of course, bolstered by unprecedented capital gains tax receipts following the wonder years of the 1990s. But this surge in tax receipts fueled a perception—even in a Republican-dominated government!—that there was money to burn, as if the capital gains from the biggest bull market in U.S. stock market history would continue indefinitely!
What does this mean for the citizens and investors in the world’s largest economy? If we continue to focus on GDP, while ignoring (and even facilitating) the decay of our Structural GDP and our Private Sector GDP, we’ll continue to borrow and spend, mortgaging our nation’s future. The worst case result could include the collapse of the purchasing power of the dollar, the demise of the dollar as the world’s reserve currency, the dismantling of the middle class, and a flight of global capital away from dollar-based stocks and bonds.
None of these consequences is likely imminent. But, few would claim today that they are impossible. Most or all of these consequences can likely still be avoided. But, not if we hew to the current path, dominated by sheer terror at the thought of a drop in top-line GDP.
After World War II, the U.S. Government “downsized” from 43.6% of GDP to 11.6% in 1948 (under a Democrat!). Did this trigger a recession? Measured by GDP, you bet! From 1945 to 1950, the nation convulsed in two short sharp recessions as the private sector figured out what to do with all the talent released from government employment, and real per capita GDP flat-lined. But, underneath the pain of two recessions, a spectacular energizing of the private sector was underway. From the peak of government expenditure in 1944 until 1952, the per capita real Structural GDP, the GDP that was not merely debt-financed consumption, soared by 87%; the Private Sector GDP, in per capita real terms, jumped by more than 90%.
Was the recent 0.5% drop in GDP in the United Kingdom a sign of weakness, or was this drop merely the elimination of 0.5% of debt-financed GDP that never truly existed? Spending dropped by over 1% of GDP; Structural GDP was finally improving!
We must pay attention to the health—or lack of same—for our Structural GDP and our Private Sector GDP before they lose further ground.
Conclusion
Government outlays were not reined in by either political party for most of the past decade. Real per capita government outlays now stand some 50% above the levels of just 10 years ago, even with Structural GDP and Private Sector GDP down over the same span. Federal spending is more than 40% of the Private Sector GDP for the first time since World War II.Even our calculation of the national debt burden (debt/GDP) needs rethinking. Is the family that overextends correct in measuring their debt burden relative to their income plus any new debt that they have accumulated in the past year? Isn’t it more meaningful to compute debt relative to Structural GDP, net of new borrowing?! Our National Debt, poised to cross 100% of GDP this fall, is set to reach 112% of Structural GDP at that same time, even without considering off-balance-sheet debt.3 Will Rogers put it best: “When you find yourself in a hole, stop digging.”
While many cite John Maynard Keynes as favoring government spending during a recession, he never intended to create structural deficits. He recommended that government should serve as a shock absorber for economic ups and downs. He prescribed surpluses in the best of times, with the proceeds serving to fund deficits in the bad times, supplemented by temporary borrowings if necessary. And he loathed inflation and currency debasement, which he correctly viewed as the scourge of the middle class.
GDP provides a misleading picture and a false sense of security. Instead of revealing an economy that we all viscerally know is weaker than a decade ago, it suggests an economy that is within hailing distance of a new peak in prosperity for the average American. Top-line GDP has recovered handily from its lows, on the back of record debt-financed consumption. But, our Structural GDP and Private Sector GDP are both floundering. Focusing on top-line GDP tempts us all to rely on ever more debt-financed consumption, until our lenders say “no más.”
The cardiac patient on the gurney has had his shot of adrenaline and is feeling better, but he is still gravely ill—more so than before his latest heart attack—as these two simple GDP measures amply demonstrate.
Endnotes
1. A “correct” measure would subtract all new debt that is backed only by future income, lacking collateral. Very little private debt lacks collateral, and very little public debt is backed by anything other than future income. So, for simplicity’s sake in this article, we subtract only net new government debt.2. Despite no change in tax rates since 2003, this situation is often blamed on the perfidy of the affluent, not the evaporation of capital gains, hence capital gains taxes. We should recognize that the enemy is not success, it is poverty. But, when we rue the latter, we too often blame the former.
3. See the November 2009 issue of Fundamentals, entitled “The ‘3-D’ Hurricane Force Headwind,” for more details on the daunting levels of off-balance-sheet debt. Our debt/GDP ratio may be poised to cross 100% of GDP this fall, but our GAAP accounting debt burden is already well past 400% of GDP and well past 500% of Structural GDP.
Monday, May 9, 2011
Government Itself Is the Bigger Market Manipulator
by Chris Powell at Journal Inquirer:
As gasoline prices passed $4 per gallon in Connecticut, Sen. Richard Blumenthal and Rep. Joseph D. Courtney joined President Obama in denouncing "speculators" and urging investigation of manipulation in the oil market. There are a few problems with this.
First is that such investigations have been undertaken before, including investigations by Blumenthal himself during his 20 years as Connecticut's attorney general, and they never found anything more than the OPEC oil producer cartel's public but uneven efforts to support the oil price. Anti-competitive as its activity is, OPEC's formation a half century ago was only a defensive response to the rigging of the currency markets by Western central banks and particularly by the U.S. Treasury Department and Federal Reserve, which were manipulating the value of the world reserve currency, the dollar, the international means of payment for oil, long before OPEC began to try to manipulate the oil price.
The second problem is that there are always speculators in all major markets. There were speculators in the oil market when gasoline last went to $4, in the summer of 2008, again when it crashed to $1.65 at the end of that year, and ever since then as it has risen back to $4. Big players in commodity markets can get away with a lot of manipulation because regulation by the U.S. Commodity Futures Trading Commission is so weak, but as the biggest players are investment banks allied with the government, which wants lower commodity prices, much of that manipulation is actually downward.
Third, and most important, the value of the U.S. dollar as measured in other currencies has fallen about 13 percent over the last year, hitting its lowest point since the dollar's last link to gold was broken in 1971. The dollar's fall reflects the U.S. government's long mismanagement of its finances and the nation's economy.
Any review of market manipulation should start with the biggest manipulator -- the U.S. government itself. With nearly complete secrecy, the Federal Reserve lately has been funneling hundreds of billions of dollars to private financial institutions, purportedly to stabilize markets. Congress and the public have little idea of what actually has been done with this money, nor any idea at all of the private understandings the Fed and Treasury Department have with investment houses like J.P. Morgan Chase that often act as government agents in the markets.
Further, federal law long has established an office in the Treasury Department whose very purpose is market manipulation: the Exchange Stabilization Fund. While it originally was intended to stabilize the dollar against foreign currencies, the fund is authorized to intervene in any market at the discretion of the treasury secretary and president. The law says the fund's decisions "are final and may not be reviewed by another officer or employee of the government."
The Fed and the Treasury Department routinely refuse to answer questions about their secret market interventions. Now that the government bond market is admittedly and almost entirely a Fed operation, even reputable market observers suspect that the government's market intervention has become comprehensive as the government's financial mismanagement has worsened -- that not just the bond market but the dollar and equity markets as well are being held up only because of secret government intervention.
So congressional investigation of market manipulation should start with the government itself -- if members of Congress aren't too scared of what they might find.
Fed Fingers at Work
My thoughts exactly:
“I also suspect that this selloff was not an accident, that it was possibly orchestrated by the Fed acting behind the scenes. The surge in commodities was becoming an enormous problem for them. Bernanke said at his press conference that there was nothing the Fed could do about it. That was a preposterous statement and it should have rung bells. While the Fed did not overtly ‘do anything about it,’ there’s no way that this is just the invisible hand of the market at work, in my view.
“The question now is whether the Fed will be able to control or mitigate the process on the downside. I have my doubts. Markets can be manipulated up to a point. When they become unstable, the reactions can become self-feeding and uncontrollable. The powers that be may find that there are unintended consequences. This is where I would hope that technical analysis will come in handy." Lee Adler, Wall Street Examiner
Sunday, May 8, 2011
Stockman: "Major Conflagration" Coming
"I think it's going to take a major dislocation in the bond market, a real conflagration on the part of the people who have to buy this debt, before the country wakes up."-- David Stockman, Budget Director, Reagan White House
Mauldin: Headwinds to Economic Growth Over the Next Five Years
Enemy of Spain
Second, Endgame continues to do well, so thanks to those who have purchased it, and if you haven’t already got your copy you should go to www.amazon.comThe Endgame, Part 2
There is an argument that the US should pursue a strong growth and jobs policy as its #1 goal and that growth, along with spending cuts and/or tax increases (depending on your views), will bring us out of the current doldrums and help us solve the budget deficit. I set the table in both the book and last week’s letter that the US is going to be growth challenged for years to come. Let me review a few items in brief and add a few more, then we will get to my predictions of what the next five years will look like. Don’t jump ahead. Without understanding the elements that are lining up to retard growth, the forecast will not make much sense.First, job #1 MUST be to reduce the deficit below the nominal growth rate of GDP. Period. The level of debt threatens to overwhelm everything else, and at some point can produce a crisis like those evolving in Europe and Japan. I have outlined the reasons for this in depth, so here I merely make the assertion.
As I explained at length, if you increase government spending it will increase GDP IN THE SHORT TERM. The economic literature suggests this effect lasts about 4-5 quarters. Further, tax cuts will produce a growth in GDP of roughly 1 to 3 times the total amount of the cut over the next few years (depending on whose research you read, but the consensus is clearly that tax cuts make a difference). It sadly follows that increasing taxes will have a negative effect of roughly the same amount.
Now, basic economic accounting shows that if you reduce government spending you are going to reduce GDP over the short term by a rough equivalent (GDP = Consumption (C) + Investments (I) + Government Spending (G) + (Net exports)).
Therefore, the first headwind to economic growth over the next five years is the reduction of the deficit. While there is a longer-term difference between tax cuts and tax increases, in the short term (4-5 quarters) there is a simple drag effect. And we are going to need to cut government spending by about 1.5% of GDP per year every year for five years (allowing for some growth) to get the deficit to a manageable level.
Below is a chart I used last week that is from my friend Rob Arnott at Research Affiliates (and to whose annual conference I am flying to as I write this letter), but it bears looking at again. The chart needs a little set-up. It shows the contribution of the private sector and the public sector to GDP. Remember, the C in the equation is private and business consumption. The G is government. And G makes up a rather large portion of overall GDP.
The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has come from government spending. Private-sector spending is where it was almost 13 years ago, accompanied by no growth in median real income and no growth since 2000 in the actual number of jobs, even as population grew by 30 million.
As we bring government spending down, unless it is accompanied by private-sector growth, we will see overall real GDP shrink. That is just the how it works. Now, in the fullness of time (or a few years), the smaller government expenditures and deficit will mean more money for private-sector investment and productivity growth, but the process of simply getting the deficit under control is going to mean slower growth. Wrap your head around that. While Republicans (including me) want to control Congress and the presidency in 2012, the policy choices made in 2013 will not be met with a robust return to 4% growth and immediate jumps in employment levels. It is going to take a lot of education to convince voters that there is no magic in spending cuts (or even tax increases) and that we will need to stay the course, even while there is a general malaise in the economy. My advice to my fellow Republicans? Do not sell the concept that voting Republican will provide a quick fix. It will get you slaughtered in 2014. More on why below, in the conclusions.
Let’s quickly list other headwinds.
· The next headwind we will face, in 2012, is a tax increase of about 2% for almost everyone, as we lose the reduction in Social Security taxes that was passed to 2011 as part of the Bush tax cut extension. This means less money in the pockets of everyone making below about $100,000, which is significant in terms of the drag on GDP.
· The stimulus package of 2009 is fading from view. There is little reason to think any of it will come back. Look at that graph again and see how much worse GDP would have been without it. But for all that, we are watching growth soften of late, with the economy now down to 1.8%. We didn’t get the organic growth in the economy that the Keynesians promised. Where is that multiplier effect? It actually seemed to be a negative multiplier, which Austrian economics suggested it would be. Score one for von Mises and Hayek.
· QE2 is stopping in June. The hope at the Fed is that the economy can take over from there. But the last time QE was stopped, in 2010, the results were not impressive; and now we can look across the pond to England to see what is happening as they are about 6 months further along in their ending of QE. It is hard to get encouraged from the data, as it looks like growth in England has slowed. And the real effects of their new austerity pursuits have not really been felt. Can the Fed start up again? Or more apropos might be the question, “Will the Fed start another round of QE?” My answer is that, when they see the economy slip into recession, they will use the only real tool they have left, and that is to inject liquidity into the economy.
· A McKinsey study on the aftereffects of debt crises (in numerous countries) that require deleveraging in one form or another, is that for the first two years there is a significant slowing of GDP, and the slower growth does not dissipate for 4-6 years. We have not started deleveraging as a nation. The real work now looks like it will be done in 2013; and thus the real pain, the study suggests, is in our future.
· Unemployment is back at 9%, rising this morning another 0.2%. The real level is easily above 10% if you count people who were in the work force as recently as 2008. Five percent of the nation’s workers are not paying income, Social Security or Medicare taxes. Many of them are on food stamps and unemployment, which are driving deficits at the federal and state levels higher. It is hard to imagine a robust economy that does not somehow figure out how to drive the unemployment level down, yet economic growth of 3% or more is required. We are simply not there.
· I noted above that private-sector jobs have gone nowhere for 11 years. But transfer payments as a percentage of private-sector income and wages have risen inexorably for the past 50 years. Below is a chart from Madeline Schnapp, the chief economist of Trimtabs. Let me quote from the email she sent me along with the chart:
“Here is the graph which generated a HUGE amount of controversy when published awhile back. For lack of a better term, I called the ratio the "TrimTabs Dependency Ratio." What it is, using BEA data, is a ratio of ‘BEA's government social benefits to persons’ divided by ‘BEA's wages and salaries.’
“While wages and salaries are about 50% of total personal income (other sources of personal income are benefits, interest, dividends, etc.), it is the largest bucket of income that produces revenue for the government via our tax structure. Therefore wages and salaries are currently the engine of support for the government’s social programs.
“FYI, the BEA's definition of government ‘Social Benefits to Persons’ includes Social Security, Medicare, Medicaid (the biggies), unemployment insurance, supplemental nutrition (SNAP, formerly food stamps), veteran's benefits, etc.
“For the ratio to go back to something sustainable, e.g. 20%, either wages and salaries need to rise, benefits need to be trimmed, or taxes need to go up.
“Be careful not to confuse ratio with proportion. In this chart, I am comparing the size of one thing to the size of another (backpacker analogy); it is not a proportion, e.g. one thing as a part of another.
“Another useful analogy is:
“There is the engine (wages and salaries) pulling rail cars up a hill. In those cars are the Defense Department, the EPA, government social benefits to persons, etc. Since 1960, the size of the social benefits rail car has grown from 10% the size of the engine, to now 35%. The ‘Little Engine that Could’ is rapidly becoming the ‘Little Engine that Couldn't.’”
· I showed two charts and research last week that clearly demonstrates that at some point the size of government becomes a drag on the economy. That may seem contradictory to my first point in this letter (reducing government spending will reduce GDP), but it is not. The first point was a short-term effect, and the size of government is a longer-term effect. We now have a government that is too large, and it acts as a headwind to growth.
· The research of Rogoff and Reinhart clearly shows that, as the debt-to-GDP level of a country approaches 90%, there seems to be a slowing of potential GDP growth by about 1%. This is an observation of the data, not a theory. And this graph from David Walker suggests we are getting there. Notice it does not include state and local debt, which it should. We are very close to this level, if not there already.
Muddle Through, or Crisis?
Betting against the power of the free-market economy in the US is generally a bad idea. Yet when I suggested back in 2003 that we would see a slow-growth Muddle Through Economy for the remainder of the decade, it turns out I was right. We only grew at 1.9% last decade, which was the worst performance since the Depression. Ugh.So where are we for the next five years?
I think we have two choices as a country. We can elect to deal with the deficit proactively, or wait until there is a crisis and react. And make no mistake, there is a an approaching Endgame, with regard to how much debt the market will let us have. We don’t know that point now, but if it happens it will be quite a “surprise!”
What happens if we make the choice to get the deficit under control? What that really means is that we have to decide how much health care we want and how we want to pay for it. Let’s forget for the moment how that happens. Let’s just be optimistic and say we do make those decisions.
For me, that is the best-case scenario. But it means a slow-growth, Muddle Through Economy for quite some time, perhaps as long as 5-6 years, though getting better as time goes on. It also means it is highly likely we will have at least one recession during that period, as growth will be close to “stall speed” and any exogenous shock could tip us into recession. Recessions mean higher unemployment, lower tax revenues, and an even deeper hole that will require more fiscal discipline and work. It will make maintaining corporate earnings growth at today’s expected levels more difficult, which puts a headwind to the US-based equity markets. Of course, a recession will mean (on average) a 40% retrenchment of US equities. It will also mean another deflation scare and a likely QE3. Bernanke can bring back and polish his “helicopter” speech, but this time he will be able to tell us what happened.
Then there is the crisis scenario. Let’s assume we do not deal with the deficit in any meaningful way. Eventually the debt will rise to epic, Greek proportions. The bond vigilantes arise from the dead and start to push up interest rates. Interest as a percentage of government spending rises, crowding out other government expenses or increasing the debt still further.
Then we have a crisis. We are FORCED by the bond market to get the deficits under control, but now we are doing so in a crisis. Health care will have to be slashed by far more than it would in a more controlled scenario. Tax increases will be brutal. You think Social Security is untouchable? Not in this crisis world. Means testing and spending freezes will be the rule of the day. Military cuts will seem draconian. Our allies who depend on us for a defense shield will not be happy. Education? On the chopping block. The economy will not be Muddle Through, but Depression 2.0. Unemployment will go north of 15%.
What’s my basis for this? History. This movie has played over and over again in various countries in modern history. While we may be the world’s superpower, we are not immune from the laws of economic reality.
In such a scenario, I expect QE 3-4-5-6. Could the Fed literally monetize the debt and then “poof” it? When our backa are against the wall, don’t assume that what has been seen as normal will be the reigning paradigm.
Let me jump out on a real limb. I was having dinner last Monday with Christian Menegatti, the #2 economist at friend Nouriel Roubini’s economic analysis shop. We were comparing notes (imagine that), and he said their opinion is that the US has until 2015 before the bond market really calls the deficit hand. Knowing that Nouriel is seen as the ultimate bear, it makes me nervous to put out my own even more bearish analysis.
I think the crucial point will be reached in late 2013. If the bond market sees a serious move to control the deficit, I think they let us “skate.” Then we Muddle Through. But if not, I think we begin to see some real push-back on rates then.
Why so early? Because bond investors are going to be watching the slow-motion train wreck that is happening in Europe and especially Japan. It is one thing for Greece to default (which they will in one form or another, with lots of rumors flying this morning), yet another for Japan to do so. Japan is big and makes a difference. Japan could start to go as early as the middle of 2013. As I have said, Japan is a bug in search of a windshield. Whenever this happens, 2013 or a year or so later, it is going to spook the bond market. The normal indulgence that a superpower and reserve-currency country would be accorded will become much more strained. It will seemingly happen overnight. Think Lehman Brothers on steroids.
I think the chances we will deal with this potential crisis are about 75%. Not doing so is such a horrific outcome that I think politicians will do the right thing. See, I am an optimist. (What was it Winston Churchill said? “You can always depend on the Americans to do the right thing, after they have exhausted all the other possibilities.”)
And let me note that I have had some rather at-length, high-level (but very off-the-record) discussions with politicians on the right in recent weeks. More and more of them are really getting it. But as one said to me, “John, I can’t run on that platform.” And that is the reason that I give it a 25% chance that we’ll wait until a crisis hits us. If the “good guys” (my view, not yours, gentle reader – I know many of you are of the more liberal persuasion) need a real push to act correctly, we are not in good shape.
I totally recognize it will not be easy to fix it. It will probably mean tax increases, which will not be good for the economy. And spending cuts that will be painful. I get all the consequences. I have written about them. But the goal is to get rid of the cancer of the deficit. It could truly destroy our economic body. Sometimes, if you have cancer, you take very ugly chemicals into your body, which have very serious side effects. The prospect does not make me happy at all, but we have made bad choices as a country for decades, and now we have to pay the price.
Just a few more thoughts. Republicans should demand a total restructuring of the tax code in return for any tax increase. I would opt for lower corporate rates to help make us competitive (say 10-15%) and include all foreign corporate income, and get rid of the mass of exemptions. Lower personal rates and a consumption tax would suit me just fine, as both an economist and a businessman; but I know that’s not some people’s cup of tea. Just saying. I like David’s Walker’s thoughts about $3 of spending cuts for every $1 of tax increases. And can we get rid of some of the “tax expenditures,” like mortgage interest deductions? We all pay 4% in income tax so that a minority can have interest-rate deductions. (I have written about efforts we need to undertake that would more than offset any hit to real estate.) At least reduce it for mortgages over $1 million. If you can afford a mortgage that big, you don’t need the deduction.
Every one of those tax expenditures is someone’s else tax break that is vital to the future of the Republic, but if we got rid of all tax expenditures in one massive move (or over time) we could simplify the tax code and come within a few hundred billion of balancing the budget. Walker says the breaks total $1.2 billion. Basically, these are goodies that Congress hands out to get votes. Get rid of them all, I say. It will be politically difficult, but we need drastic action.
And I might suggest that Democrats should come to the table this year rather than waiting until 2013. If unemployment is north of 8% next election, as I think likely, you will lose more seats and (probably) the White House, given today’s polls. Why not negotiate now when you have the Senate and can get what you can? Maybe “my guys” are being obstinate, but the sooner we do this the sooner we get through it.
And that is my point. We do get through it, either as adults or forced to do so by the bond market. One way or another, by the latter part of this decade, in the fullness of time, this too shall pass.
The eternal optimist in me wants to quickly point out that neither scenario is the end of the world. Yes, we may have to tighten our belts, some more than others, but life goes on. We all figure out our own paths. While investing has been more difficult the last five years, we are all still alive, celebrating birthdays and grandchildren. New businesses that will dramatically change our lives are being formed every day. There are lots of opportunities for business and investment, perhaps just not the traditional ones we are used to. Maybe gold goes to $5,000, but I hope it goes to $500. Either way I will still buy some physical gold every month as insurance, with the dream that I’ll give it to my great-great grandchildren as a novelty from the days when we thought gold had value. But I will still buy, just in case. I simply don’t completely or naively trust the &*%@^&’s who are running the place.
Seriously, I expect that, beginning later this decade we will see the secular bear crawl back into hibernation and a roaring secular bull market cycle come charging out. We will all get to once again be geniuses.
The book I am starting to write this month (finally!) will be called The Millennium Wave, in which we’ll look at what our world may be in 2032. The journey there will be bumpy, but what a world it will be! So, over the next few months and quarters, we will keep our eye on the politicians and see what happens. I will be looking for good hedges and places to invest that don’t depend on Washington DC or the other capitals of the world. And I will keep on writing to you, gentle reader, every week.
Last thought: I encourage you to get involved in the process in whatever way you deem correct. This is going to be the most important national conversation we have had in a long time, and you should be a part of it. Make your voice and vote count!
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