from Zero Hedge:
Some less than pleasant observations from the billionaire founder
of Elliott Management, Paul Singer, extracted from his periodic letter
to clients.
AMERICA’S LIABILITIES
The budget deficit for the latest fiscal year (which ended on
September 30) was reported to be around $700 billion. However, this
figure would be many times higher if the government’s unfunded
entitlement programs were included. Even before taking into account
liabilities stemming from the Affordable Care Act (ACA), which cannot
even be calculated yet because so many of its assumptions are either
erroneous or outright fabrications, and because many of its provisions
keep getting delayed by the Administration for purposes of political
advantage, the present value of the future obligations of the federal
government is currently around $92 trillion. These obligations have been
growing by over 10% per year since 2000, during which time nominal GDP
has risen just 3.8% per year. At this rate, the federal government will
owe an estimated $200 trillion on the entitlement programs by 2021
(again, excluding the effects of ACA) and $300 trillion by 2025.
These numbers are not fantasies. At present, there is no
acknowledgement by a large portion of the American political
establishment that this insolvency even exists. Nor have the leaders of
this establishment made any concrete progress toward restoring solvency
by taking up serious proposals to rein in unpayable promises. Quite the
contrary: Politicians and policymakers continually tell people that such
entitlement obligations will be met – a claim they must know cannot
possibly be true.
Recently, we had a conversation with a mainstream economist who told
us that the government is not actually insolvent because the long-term
entitlements are not really liabilities that need to be counted, any
more than the military budget for the year 2030 needs to be counted.
This assertion is incorrect. Military spending, like any other form of
discretionary spending, can be cut quickly and arbitrarily, as
Washington recently made clear. And such spending is in exchange for
goods and services delivered at the time the money is spent. In 2030,
the government can buy many more tanks, or many fewer, than it is buying
today. It has not promised to buy any amount. In fact, aside from
military entitlements such as veterans’ health care, there is no
obligation to spend any money at all on the military in 2030. By
contrast, entitlements represent concrete governmental promises that are
being made today about future spending – promises on which people are
being (falsely) told that they can rely. And at the time the money is
scheduled to be delivered, the recipient is delivering no goods or
services. Only someone who has never run a business could say
with a straight face that such obligations are not really liabilities
and need not be included in the accounting.
High inflation (or hyperinflation) is one way that devious or
clueless policymakers attempt to deal with unpayable promises. It is
devious, because without formally imposing a tax, it takes money from
savers and investors and pays it to borrowers and voters. It is
clueless, because the cycle of government handouts and demands for more
benefits is like a game of “chase the tail” – because it dissipates the
real value of promised benefits, it brings the ultimate prize no closer
while destroying the value of money and dissolving societal cohesion in
the process.
The U.S. is in a “warm-up” phase on this score at present. The
promises made by U.S. politicians are huge. Absent reform, they will
lead to societal ruin. But so far, there has been no collapse of the
dollar – possibly because there is no alternative fiat currency against
which it can collapse. Gold is trading at $1,300 per ounce, not $5,000
per ounce. The $100 million co-op apartment in New York and the £100
million flat in London are thought of as oddities, not “coming
attractions” for the evaporation of the value of paper money. Wage
inflation is small (even though labor markets for desirable skills are
tighter than most people think), and the arithmetic of government statistics (jobs, growth and inflation) is distorted and dishonest almost beyond measure.
There is something missing in investors’ reasoning that leads to their current complacency, and that is an understanding of the circularity of confidence in a fragile system. Since
the system is fundamentally unsound, all it would take is a loss of
confidence to set off a collapse in the purchasing power of money, a
major currency or the global stock and/or bond markets. “Risk off” today
still means buying U.S. Treasuries, but this may not be the case at
some unpredictable but abrupt future turning point in market psychology.
Markets are fast and self-reinforcing today, creating facts rather than
reflecting them. We believe investor confidence today is unjustified. The
leaders of the Developed World have chipped away at the solidity that
would ordinarily justify confidence in their leadership, markets and
currencies, such that confidence can be lost at any moment. If confidence in a sound system is unfairly lost, then countertrend forces can act to stem the panic and restore stability. But
a justified loss of confidence in an unsound system would generate much
more damage and be, for a period of time and price, unstoppable.
That result is what governments have risked by their poor policies,
their lack of attention to the risks posed by the inventions of the
modern financial system, and their neglect of the fiscal balance sheet. Since
this combination is relatively new, particularly the enormity of
Developed World debt and obligations, as well as the complexity and
extraordinarily high leverage of the financial system (especially given
the size of derivatives books), there is no way to tell exactly how it all will end. Badly, we guess.
* * *
KE=1/2*M*V2
For those who did not recognize the above formula, you are in good
company. It is the equation showing that kinetic energy is a function of
mass and velocity, but that the relationship is not linear: A doubling
of velocity causes a quadrupling of kinetic energy.
What is the relevance to financial markets and trading? We believe
some of the same elements are present when financial leverage rises
beyond certain levels. Any complex portfolio contains expectations about
maximum expected price movements and possible losses, together with
assumptions about the dispersion of returns and correlation. Obviously
when markets turn adverse, if those assumptions turn out to be overly
optimistic, then losses ensue. Capital represents a cushion against
losses, a cushion that is very important to the investor, but even more
important to the system as a whole. When leverage goes up, it takes
smaller and smaller perturbations in prices, correlations and volatility
to generate serious losses requiring palliative action. But as leverage
increases among key market players, the possibility of large losses and
involuntary liquidation behavior creates contagion from one player to
another, a kind of chain-reaction effect as losses occur too quickly for
reflection and sellers become price-insensitive, causing larger losses –
and even failure – to spread from one firm to another. Extreme leverage
removes the cushion and the robustness of structure, and it is the
proximate cause of disequilibrium. As with kinetic energy, excessive
leverage is nonlinear, subject to tipping points, and can cause (and did
cause in 2008) massive and abrupt systemic failure.
This nonlinearity of leverage is a function of similar positioning
and contagion. We do not believe that the system today is any safer than
it was when it failed in 2007 and 2008. Global leverage is up,
not down, contrary to the popular misconception. Private debt is
unchanged from 2007 levels, but public debt has risen globally from $70
trillion to $100 trillion. It appears that a
number of major American financial institutions have de-risked
themselves somewhat, although this is impossible to discern from
publicly available filings (which is why rumor and conjecture will
govern the way markets perceive large financial institutions in the next
market crisis). European financial institutions still maintain more
leverage and bigger derivatives books than their American counterparts,
as well as large holdings of sovereign debt that they were coerced into
buying as part of the “save-the-euro” panic.
In fact, the global financial system is arguably less safe than it was in 2008. The
unquestioned creditworthiness of the Developed World governments ended
the most intense phase of the 2008 crisis, as the financial system was
ultimately all but guaranteed by governments. A catalyzing force for the next crisis might be a failure of confidence in one or more of those major governments or in China. Such
a failure alone could cause major stress in markets, as either
currencies or bond markets could experience sudden collapses. Also
potentially impactful is one of the major lessons of 2008: It is wise to
move assets and sell claims and securities immediately if a debtor or
counterparty is perceived to be in trouble. This maxim could make the
next market crisis play out on a hair-trigger, with a stressful lead-in
and then a simultaneous rush to the exits.
Those who think the scenario above is an exaggeration should ask
themselves the following question: After decades of advancements in
human knowledge and purported innovations in the global financial
system, why did 2008 turn into the worst financial crisis since
the Great Depression? The answer is that the system was unsound, largely
due to excessive leverage and the complexity of financial instruments. In
the 80-plus years since the 1929 crash and the subsequent Depression,
there clearly have been a large number of geopolitical and financial
events, yet none of them caused financial collapse until 2008. Of
course, we understand that a combination of public and private errors
and misconceptions led to the financial crisis, but it was the
unfettered use of leverage that made the episode pass over the line into
systemic collapse.
We do not think policymakers have learned anything much from the
financial crisis, but that fact can truly be demonstrated only as time
passes. In our view, monetary policy extremism has papered over (no pun
intended) the lack of fundamental reforms that would enable the
Developed World to grow faster and more sustainably with financial
institutions that are solid and robust enough to withstand the next
periods of economic and financial stress. We believe the world’s
financial institutions are still essentially dependent on governments, but the Developed World governments themselves are hopelessly insolvent. The
insolvency may not be manifested in a market reaction tomorrow or even
next year, but the numbers are obvious and compelling, not conjectural
or fanciful. Markets focus on something when they want to, not when
“visionaries” think they should.
It is important to note that mass human behavior cannot be modeled or
predicted with any degree of precision. When forces are brought to bear
that suggest a possible shift in direction of mass human behavior
(examples include oppression, tyranny, economic underperformance,
inflation, incentives and disincentives), there is no way of telling if,
how or when such forces will actually result in a change of vector.
