Strict Standards: Declaration of mystique_CategoryWalker::start_lvl() should be compatible with Walker::start_lvl(&$output, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 71

Strict Standards: Declaration of mystique_CategoryWalker::end_lvl() should be compatible with Walker::end_lvl(&$output, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 71

Strict Standards: Declaration of mystique_CategoryWalker::start_el() should be compatible with Walker::start_el(&$output, $object, $depth = 0, $args = Array, $current_object_id = 0) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 71

Strict Standards: Declaration of mystique_CategoryWalker::end_el() should be compatible with Walker::end_el(&$output, $object, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 71

Strict Standards: Declaration of mystique_PageWalker::start_lvl() should be compatible with Walker::start_lvl(&$output, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 127

Strict Standards: Declaration of mystique_PageWalker::end_lvl() should be compatible with Walker::end_lvl(&$output, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 127

Strict Standards: Declaration of mystique_PageWalker::start_el() should be compatible with Walker::start_el(&$output, $object, $depth = 0, $args = Array, $current_object_id = 0) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 127

Strict Standards: Declaration of mystique_PageWalker::end_el() should be compatible with Walker::end_el(&$output, $object, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 127
Archive for September 2013

Archive for September, 2013

130928-01

Thoughts from the Frontline: Renminbi: Soon to Be a Reserve Currency?

 

I get the question all the time: when will the Chinese renminbi (RMB) replace the US dollar as the major world reserve currency? The assumption behind such questions is almost always that the coming crisis in US entitlement programs will force the Fed to monetize even more debt, thereby killing the dollar. Or some derivative line of that thought. Contrary to the thinking of fretful dollar skeptics, my firm belief is that the US dollar is going to become even stronger and will at some point actually deserve to be the reserve currency of choice rather than merely the prettiest girl in the ugly contest – the last currency standing, so to speak.

But whether the Chinese RMB will become a reserve currency is an entirely different question. Of course it will, over time, but the question has always been when. There are some preconditions required for reserve currency status. Quietly, apart from anything that might happen to the US dollar, China is working to meet those conditions. Rather than wallowing in concerns about China’s actions, we might opt for a more thoughtful and constructive response: to welcome the RMB to the reserve currency club and hope that it gets here soon. The world will be a better place when that happens. And off the radar screen, it may be happening right now. Today we look at global trade flows and international balances and try to imagine a world in which much “common wisdom” gets stood on its head. It should make for an interesting thought experiment, to say the least. (This letter will print a little longer than usual, as there are numerous charts and graphs.)

One of the prerequisites for a true reserve currency is that there must be a steady and ready supply of the currency to facilitate global trade. The United States has done its part in providing an ample supply of US dollars by running massive trade deficits with the rest of the world, primarily with oil-producing nations and with Asia (most notably China and Japan), for all manner of manufactured products. The US consumer has been the buyer of last resort for several decades (I say, somewhat tongue in cheek). Those dollars typically end up in the reserve balances of various producing nations and find their way back to the US, primarily invested in US government bonds. In an odd sense, the rest of the world has been providing vendor financing to the US, the richest nation in the world.

The US Trade Deficit Turns Positive

The US trade deficit (a key component of the current account deficit – see chart on next page) fell to an unprecedented percentage of GDP during the last decade, a development that normally heralds a significant drop in a currency. Fortunately, the “exorbitant privilege” of controlling the world’s dominant currency in reserve holdings, international trade, and financial transactions has helped shield the US dollar from a hard correction; but that status quo is in danger. After flooding the world with US dollars for more than twenty years, the US has reduced its current account deficit by 58% since the 2007-2008 financial crisis began. Looking ahead, I and many other observers believe this measure can continue to improve, due two surprisingly positive factors:

  1. The US energy boom in shale oil and gas. The US has caught an incredibly well-timed “lucky break” made possible by the combination of new exploration, production, and processing technologies (such as horizontal drilling and fracking) and by the serendipitous discovery of massive supplies of oil and gas, often in areas that already have significant infrastructure and/or are accessible at reasonable costs. This energy renaissance is part of the reality that has made Houston, Texas, the number one port in the United States, with even more growth coming in the near future when the Panama Canal expansion is completed in 2014. US manufacturers are turning less-expensive oil and gas into value-added fossil fuel products and exporting them to the world. This trend will become ever more important. Indeed, when the first LNG export terminal is opened in a few years, the additional exports will approach $80 billion a year, I am told. From one terminal! There are four in the process of being approved and more on the planning boards. The math is there for anyone to do. Spot prices in the US natural gas-producing areas are under $4. The Japanese are paying more than $14. Even I can do that arbitrage. Just for fun, the next graph, from the Energy Information Administration, shows the rise in spot gas prices over the last six months, from a level that had been far too low. It also shows the arbitrage potential that exists right here in the US.

  1. The consequent renaissance in US manufacturing. With cheaper energy and new technologies like advanced robotics and 3D printing, the US is producing more than we ever have – we’re just doing it with fewer people.

These two trends are bullish for the US in general. But that’s another story for another letter. The point today is that the US current account deficit is collapsing. A positive trade balance is not an unthinkable prospect today. It is quite possible that the US will be more or less energy self-sufficient by the end of the decade and could have a positive trade balance not long after that. I should note that exporting value-added chemicals made from less expensive energy will contribute even more to the positive balance than simply selling the raw natural gas.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

130924_OTB_sm

Outside the Box: Uttin’ on the Itz

 

Last Thursday, prior to the FOMC announcement, I was having an early lunch with Kyle Bass so he could get back to the office in time for the announcement. As we were finishing up, I was invited to come sit with another group of friends and traders who also happened to be in the same restaurant. Everyone was sure there would be some type of tapering. That message had been clearly communicated to the markets. When the announcement came, the telephones went off and everyone erupted with various forms of surprise. I fully admit to being speechless. I kept waiting for some kind of explanation, and none came. The more we talked about it and the more I thought about it later, the more convinced I became that this was one of the more ham-handed policy announcements from the Fed in a very long time. Why would you go to the trouble of getting the market all ready for the onset of tapering, build expectations, and then jerk out the rug? What in the wide, wide world of sports is going on?

I’ve been with Louis Gave and David Rosenberg this weekend here in Toronto. Everyone is searching for an answer on the FOMC’s move. Louis came up with what I’m affectionately calling his conspiracy theory. He thinks Obama is quite upset that he can’t have Summers as Fed chair and that his staff is crossways with Yellen. Reports suggest she has not even been interviewed yet. Really? If that’s the case then perhaps Obama would rather stick with Bernanke for another two years and then make another try for Summers or maybe even a rested Geithner. Steve Cucchiaro (of $18.5 billion-under-management Windhaven fame) asked if Summers had maybe communicated through back channels to Bernanke that he wanted to end the tapering, and Bernanke was helping him out; but then when he was no longer in the running for Fed chair, Janet Yellen came and said, “Ben, I’m not ready to end tapering yet,” so Bernanke took one for the team.

I heard directly from another friend that he was in the offices of one of the world’s largest bond managers, and they had actually been at the Fed the previous week and were confident there would be a small tapering. Did you see the way bonds got ripped after the announcement? These bond managers were pissed (that’s a technical economics term). Can we trust the Fed now? Years of work building transparency and a confidence in the narrative, and then they blow it on a meaningless non-taper?

This week’s Outside the Box is from Ben Hunt. It echoes some of my own concerns about the Fed and raises others. Quoting:

Two things happened this week with the FOMC announcement and subsequent press conferences by Bernanke, Bullard, etc. – one procedural and one structural. The procedural event was the intentional injection of ambiguity into Fed communications. As I’ll describe below, this is an even greater policy mistake than the initial “Puttin’ on the Ritz” show Bernanke produced at the June FOMC meeting when “tapering” first entered our collective vocabulary. The structural event … which is far more important, far more long-lasting, and just plain sad … is the culmination of the bureaucratic capture of the Federal Reserve, not by the banking industry which it regulates, but by academic economists and acolytes of government paternalism. These are true-believers in too-clever-by-half academic theories such as management of forward expectations and in the soft authoritarianism of Mandarin rule. They are certain that they have both a duty and an ability to regulate the global economy in the best interests of the rest of us poor benighted souls.

This is one of the more incendiary OTBs in a while, and I think you should set aside some time to think on the implications Ben is writing about.

One of the important things the Federal Reserve provides when there is a crisis is that sense that “daddy’s home.”. Whether or not you personally believe the Fed has any significant power to actually do anything, the general market does believe it, and that’s the important thing. Now the Fed is at significant risk of damaging its reputation for decisiveness and clarity. We can only hope there is not another crisis coming out of Asia or Europe in the next few months that would require Federal Reserve action. What could they do now that would actually be credible? And while I don’t see a crisis developing in a short timeframe, it is the things that we don’t see, the Lions in the Grass, that create so many problems. Just saying…

I am at the airport in Toronto as I write this note. Tonight I get to have dinner with my friends Art Cashin, Barry Ritholtz, Barry Habib, Rich Yamarone, Christian Menegatti, and David Rosenberg; and Jack Rivkin may show up a little later. Ian Bremmer is supposed to drop by for early drinks before he heads off for dinner with Prime Minister Abe of Japan. It looks like it will be a spirited evening, with lots to talk about. I am not sure what I will write about this weekend, but I bet I’ll get a few ideas this evening.

And speaking of the venerable Art Cashin, I will not be the only one at the table tonight who is mystified by the Fed’s action. And apparently some members of the FOMC agree with Art and me. Art wrote this morning:

 Candor With A Capital C – Yet Again – One of the Fed speakers yesterday was the President of the Dallas Fed, Mr. Richard Fisher.  Mr. Fisher is a favorite of floor traders since, when he speaks, the message is clear, not couched in monetary argot.  He didn’t deviate from that habit at all yesterday.

His speech was on current banking trends and a post-Lehman review.  He said that too big to fail banks were “a dagger pointed at the heart of the economy.”  At the end of his speech he said:

A Deliberate Deflection

As I said at the beginning of my remarks, I am going to try to avoid answering questions you might have about last week’s FOMC meeting and what some in the press have now labeled “the taper caper.” Nearly every Federal Reserve Bank president and his or her sister will be speaking to this topic this week, so you will be getting an earful of cacophonous comments on this subject.

Today, I will simply say that I disagreed with the decision of the committee and argued against it. Here is a direct quote from the summation of my intervention at the table during the policy “go round” when Chairman [Ben] Bernanke called on me to speak on whether or not to taper: “Doing nothing at this meeting would increase uncertainty about the future conduct of policy and call the credibility of our communications into question.” I believe that is exactly what has occurred, though I take no pleasure in saying so.

While he may have deflected further questioning on the “taper caper,” he did not deflect all questions.  Again his candor brought headlines.  Here’s a bit from Bloomberg on the Fed Chair succession:

“The White House has mishandled this terribly,” Fisher said today in response to a question from the audience after giving a speech in San Antonio, Texas. “This should not be a public debate,” he said, adding that the Fed “must never be a political instrument.”

On another question, Mr. Fisher apparently said that although Janet Yellen was dead wrong in her policy direction, she would make a great Chair.

We doubt that Mr. Fisher ever hears the question, “What exactly do you mean by that?”  We could use more such candor elsewhere. 

You have yourself a good week, and I’ll report back. And now sit down while we hear from Ben Hunt.

Your wishing he knew what was going on in Bernanke’s head analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

Uttin’ On the Itz

By Ben Hunt, Ph.D.

High hats and arrowed collars, white spats and lots of dollars
Spending every dime, for a wonderful time
If you’re blue and you don’t know where to go to
Why don’t you go where fashion sits,
Puttin’ on the Ritz.
– Irving Berlin

Hegel remarks somewhere that all great, world-historical facts and personages occur, as it were, twice. He has forgotten to add: the first time as tragedy, the second as farce.
– Karl Marx

I never could bear the idea of anyone expecting something from me. It always made me want to do just the opposite.
– Jean-Paul Sartre, “No Exit”

Every time I hear a political speech or I read those of our leaders, I am horrified at having, for years, heard nothing which sounded human.
– Albert Camus

The structure of a play is always the story of how the birds came home to roost.
– Arthur Miller

In Young Frankenstein, Mel Brooks and Gene Wilder brilliantly reformulate Mary Shelley’s Frankenstein; or, The Modern Prometheus, a tragedy in the classic sense, as farce. The narrative crux of the Brooks/Wilder movie is Dr. Frankenstein’s demonstration of his creation to an audience of scientists – not with some clinical presentation, but by both Doctor and Monster donning top hats and tuxedos to perform “Puttin’ on the Ritz” in true vaudevillian style. The audience is dazzled at first, but the cheers turn to boos when the Monster is unable to stay in tune, bellowing out “UTTIN ON THE IIIITZ!” and dancing frantically. Pelted with rotten tomatoes, the Monster flees the stage and embarks on a doomed rampage.

Wilder’s Frankenstein accomplishes an amazing feat – he creates life! – but then he uses that fantastic gift to put on a show. So, too, with QE. These policies saved the world in early 2009. Now they are a farce, a show put on by well-meaning scientists who have never worked a day outside government or academia, who have zero intuition for, knowledge of, or experience with the consequences of their experiments.

Two things happened this week with the FOMC announcement and subsequent press conferences by Bernanke, Bullard, etc. – one procedural and one structural. The procedural event was the intentional injection of ambiguity into Fed communications. As I’ll describe below, this is an even greater policy mistake that the initial “Puttin’ on the Ritz” show Bernanke produced at the June FOMC meeting when “tapering” first entered our collective vocabulary. The structural event … which is far more important, far more long-lasting, and just plain sad … is the culmination of the bureaucratic capture of the Federal Reserve, not by the banking industry which it regulates, but by academic economists and acolytes of government paternalism. These are true-believers in too-clever-by-half academic theories such as management of forward expectations and in the soft authoritarianism of Mandarin rule. They are certain that they have both a duty and an ability to regulate the global economy in the best interests of the rest of us poor benighted souls. Anyone else remember “The Committee to Save the World” (Feb. 1999)? The hubris levels of current Fed and Treasury leaders make Rubin, Greenspan, and Summers seem almost humble in comparison, as hard as that may be to believe. The difference is that the guys on the left operated in the real world, where usually you were right but sometimes you were wrong in a clearly demonstrable fashion. A professional academic like Bernanke or Yellen has never been wrong. Published papers and books are not held accountable because nothing is riding on them, and this internal assumption of intellectual infallibility follows wherever they go. As a former cleric in this Church, I know wherefore I speak.

There’s frequent hand-wringing among the chattering class about whether or not the Fed has been “politicized.” Please. That horse left the barn decades ago. In fact, with the possible exception of Paul Volcker (and even he is an accomplished political animal) I am hard pressed to identify any Fed Chairman who has not incorporated into monetary policy the political preferences of whatever Administration happened to be in power at the time.

Bureaucratic capture is not politicization. It is the subversion of a regulatory body, a transformation in motives and objectives from within. In this case it includes an element of politicization, to be sure, but the structural change goes much deeper than that. Politicization is a skin-deep phenomenon; with every change in Administration there is some commensurate change, usually incremental, in policy application. Bureaucratic capture, on the other hand, marks a more or less permanent shift in the existential purpose of an institution. The WHY of the Fed – its meaning – changed this week. Or rather, it’s been changing for a long time and now has been officially presented via a song-and-dance routine.

What Bernanke signaled this week is that QE is no longer an emergency government measure, but is now a permanent government program. In exactly the same way that retirement and poverty insurance became permanent government programs in the aftermath of the Great Depression, so now is deflation and growth insurance well on its way to becoming a permanent government program in the aftermath of the Great Recession. The rate of asset purchases may wax and wane in the years to come, and might even be negative for short periods of time, but the program itself will never be unwound.

There is very little difference from a policy efficacy perspective between announcing a small taper of, say, a $10 billion reduction in monthly bond purchases and announcing no taper at all. But there is a HUGE difference from a policy signaling perspective between the two. Doing nothing, particularly when everyone expects you to do something, is a signal, pure and simple. It is an intentional insertion of uncertainty into forward expectations, a clear communication that the self-imposed standards for winding down QE as established in June are no longer operative, that the market should assume nothing in terms of winding down QE.

Think of it this way … why didn’t the Fed satisfy market expectations, their prior communications, and their own stated desire to wait cautiously for more economic data by imposing a minuscule $5 billion taper? Almost every market participant would have been happy with this outcome, from those hoping for more accommodation for longer to those hoping that finally, at last, we were on a path to unwind QE. Everyone could find something to like here. But no, the FOMC went out of its way to signal something else. And that something else is that we are NOT on automatic pilot to unwind QE. A concern with self- sustaining growth and a professed desire to be “data dependent” are satisfied equally with either a small taper or doing nothing. Choosing nothing over a small taper is only useful insofar as it signals that the Fed prefers to maintain a QE program regardless of the economic data. And that’s a position that almost every market participant can find a reason to dislike, as we’ve seen over the past few days. I mean … when even Fed apologist extraordinaire Jon Hilsenrath starts to complain about Fed communications (although his latest article title remains “Market Misreads Signals”), you know that you have a Fed whose preference functions are not identical to the market’s.

Moreover, Bernanke and his team are taking steps to prevent future FOMC’s or Fed Chairs from reversing this transformation of QE from emergency policy to government program. In addition to the implicit signal given by choosing no taper over a small taper, there was an explicit signal in both Bernanke’s comments on Wednesday and in Bullard’s interviews on Friday – the Fed is adding an inflation floor to its QE linkages, alongside the existing unemployment linkage. Previously we were told that QE would persist so long as unemployment is high. Now we are told that QE will also persist so long as inflation is low. Importantly, these are being presented as individually sufficient reasons for QE persistence. If unemployment is high OR inflation is low, QE rolls on. Precedent matters a lot to any clubby, self- consciously deliberative Washington body, from the Supreme Court to the Senate to the FOMC, and by setting multiple explicit macroeconomic linkages to QE – all of which are one-way thresholds designed to continue asset purchases – this Fed is making it much harder for any future Fed to reverse course.

But wait, there’s more …

Given the manner in which inflation statistics are constructed today – and just read Janet Yellen’s book (The Fabulous Decade: Macroeconomic Lessons from the 1990’s, co-authored with Alan Blinder) if you think that the Fed is unaware of the policy impact that statistical construction can achieve … changing inflation measurement methodology is one of the key factors she identifies to explain how the Fed was able to engineer the growth “miracle” of the 1990’s – inflation is now more of a proxy for generic economic activity than it is for how prices are experienced. In a very real way (no pun intended), the meaning and construction of concepts such as real economic growth and real rates of return are shifting beneath our feet, but that’s a story for another day. What’s relevant today is that when the Fed promises continued QE so long as inflation is below target, they are really promising continued QE so long as economic growth is anemic. QE has become just another tool to manage the business cycle and garden- variety recession risks. And because those risks are always present, QE will always be with us.

In Pulp Fiction the John Travolta character plunges a syringe of adrenaline into Uma Thurman’s heart to save her life. This was QE in March, 2009 … an emergency, once in a lifetime effort to revive an economy in cardiac arrest. Now, four and a half years later, QE is adrenaline delivered via IV drip … a therapeutic, constant effort to maintain a certain quality of economic life. This may or may not be a positive development for Wall Street, depending on where you sit. I would argue that it’s a negative development for most individual and institutional investors. But it is music to the ears of every institutional political interest in Washington, regardless of party, and that’s what ultimately grants QE bureaucratic immortality.

It is impossible to overestimate the political inertia that exists within and around these massive Federal insurance programs, just as it is impossible to overestimate the electoral popularity (or market popularity, in the case of QE) of these programs. In the absence of a self-imposed wind-down plan – and that’s exactly what Bernanke laid out in June and exactly what he took back on Wednesday – there is no chance of any other governmental entity unwinding QE, even if they wanted to. Which they don’t. Regardless of what political party may sit in the White House or control Congress in the years to come, it will be as practically impossible and politically unthinkable to eliminate QE as it is to eliminate Social Security or food stamps. QE is now a creature of Washington, forever and ever, amen.

The long-term consequences of this structural change in the Fed are immense and deserve many future Epsilon Theory notes. But in the short to medium-term it’s the procedural shifts that have been signaled this week that will impact markets. What does it mean for market behavior that Bernanke intentionally delivered an informational shock by forcing uncertainty into market expectations?

First, it’s important to note that this is not really an issue of credibility. The problem is not that people don’t believe that Bernanke means what he said on Wednesday, or that they won’t believe him if he says something different in October. The problem is that the Fed is entirely believable, but that the message is not one of “constructive ambiguity” as the academic papers written by Fed advisors intend, but one of vacillation and weakness of will.

From a game theoretic perspective, ambiguity can be a very effective strategy in pretty much whatever game you are playing. Alan Greenspan was a master of this approach, famous for the lack of clarity in his public statements. Other well-known practitioners of intentionally opaque statements include Mao Zedong (hilariously lampooned in Doonesbury when Uncle Duke had a short-lived stint as the US Ambassador to China) as well as most Kremlin communications in the Soviet era. Clarity and transparency can also be a very effective strategy in pretty much any game, particularly if you’re playing a strong hand or you want to make sure that your partner follows your lead. For example, throughout the Cold War both the Americans and the Russians would place certain strategic assets in plain sight of the other country’s surveillance apparatus so that there would be no mistaking the strength and intent of the signal.

The key to the success of both strategies – intentional ambiguity and intentional clarity – is consistency and, very rarely, the “gotcha” moment of a strategy switch. To use a poker analogy, the tight player who has a reputation for never bluffing can take down a big pot with a bluff much more easily than a player who is impossible to read and has a reputation as a frequent bluffer. Of course, this bluff can only be used once in a blue moon or the reputation for being a tight player will be lost, as will future bluffing effectiveness. Also, the reputation as a tight player must be established effectively prior to the first bluff.

To stick with the poker analogy, here’s my take on what the Fed has done. For the past four months, they’ve tried to create a reputation as a tight player, meaning that they have laid out fairly clear standards for how they will interpret labor data (the equivalent of cards dealt face up) to set the extent and timing of QE tapering. The market responded as it always does, setting its expectations on the basis of the Fed’s statements, and moving up or down as each new labor data card was revealed. But then on Wednesday, the Fed revealed a bluff to win … nothing … and announced that they would now be playing in an unpredictable fashion. It was almost as if Bernanke had read a beginner’s poker instruction book when he was at Jackson Hole in late August that said you have to be a hard-to-read player who bluffs a lot to succeed at poker, and decided as a result to change his entire strategy. I don’t know what you would think about a player like that in your poker game, but words like “weak”, “fish”, and “donkey” come to my mind.

In fact, I think that the poker instruction book metaphor is just barely a metaphor, because we know that several papers at Jackson Hole took Bernanke to task for his communication policy to date. For example, Jean-Pierre Landau, a former Deputy Governor of the Bank of France and currently in residence at Princeton’s Woodrow Wilson School, presented a paper focused on the systemic risks of the massive liquidity sloshing around courtesy of the world’s central banks. For the most part it’s a typical academic paper in the European mold, finding a solution to systemic risks in even greater supra-national government controls over capital flows, leverage, and risk taking. But here’s the interesting point:

“Zero interest rates make risk taking cheap; forward guidance makes it free, by eliminating all roll-over risk on short term funding positions. … Forward guidance brings the cost of leverage to zero, and creates strong incentives to increase and overextend exposures. This makes financial intermediaries very sensitive to “news”, whatever they are.”

Landau is saying that the very act of forward guidance, while well-intentioned, is counter-productive if your goal is long-term systemic stability. There is an inevitable shock when that forward guidance shifts, and that shock is magnified because you’ve trained the market to rely so heavily on forward guidance, both in its risk-taking behavior (more leverage) and its reaction behavior (more sensitivity to “news”). This argument was picked up by the WSJ (“Did Fed’s Forward Guidance Backfire?”), and it continued to get a lot of play in early September, both within the financial press and from FOMC members such as Narayana Kocherlakota.

I think that Bernanke took these papers and comments to heart … after all, they come from fellow trusted members of the academic club … and decided to change course with communication policy. No more clearly stated forward guidance, but rather the oh-so-carefully crafted ambiguity of an Alan Greenspan. Here would be a Monster that can sing and dance, one that can be trotted on stage in a tux and tails and is sure to delight the audience with a little number by Irving Berlin. What could possibly go wrong? Well, the same thing as the first performance back in June – a complete misunderstanding of the real-world environment into which these signals are injected.

At least in June the Fed still projected an aura of resolve. Today even that seems missing, and that’s a very troubling development. Creating a stable Narrative is a function of inserting the right public statement signals into the Common Knowledge game. As described above, it really doesn’t matter what the Party line is, so long as it is delivered with confidence, consistency, and from on high. But once the audience starts questioning the magician’s sleight-of-hand mechanics, once the Great and Terrible Wizard of Oz is forced to say “pay no attention to that man behind the curtain”, the magician has an audience perception problem. Fair or not, there is now      a question of competence around Fed policy and its decision-making process. Sure the Monster can sing, but can it sing well?

Unfortunately, I think that this perception of an irresolute, somewhat confused Fed is poised to accelerate in the forthcoming nomination proceedings for a new Chair, not dissipate. If strength of will and resolve of purpose is the quality you need to project, then the Fed needs a Strongman on a Horse:

not a Wise Oracle Baking Cookies.

Sorry, but it’s true.

I mean, does anyone doubt that Janet Yellen is a consensus builder who would feel more at home at a faculty tea with Elizabeth Warren than a come-to-Jesus talk with Zhou Xiaochuan? Does anyone doubt that Larry Summers is the polar opposite, a bureaucratic Napoleon who would absolutely revel in lowering the boom on Zhou or Tombini … or Bullard or Yellen, for that matter? But it looks like Yellen is the shoo- in candidate, so whatever perceptions of Fed wishy-washiness and indecision that are currently incubating are likely to grow, no matter how unfair those perceptions might be.

What does all this mean for how to invest in the short to medium-term? Frankly, I don’t think that “investment” is possible over the next few months, at least not as the term is usually understood, and at least not in public markets. When you listen to institutional investors and the bulge-bracket sell-side firms that serve them, everything today is couched in terms of “positioning”, not “investment”, and as a result that’s the Common Knowledge environment we all must suffer through. This is the fundamental behavioral shift in markets created by a Fed-centric universe – the best one can hope for is a modicum of protection from the caprice of the Mad God, and efforts to find some investable theme are dashed more often than they are rewarded. The Narrative of Central Bank Omnipotence – that all market outcomes are determined by monetary policy, especially Fed policy – is stronger than ever today, so if you’re looking to take an exposure based on the idiosyncratic attributes or fundamentals of a publicly traded company … well, I hope you have a long time horizon and very little sensitivity to the price path in the meantime. I will say, though, that the counter-narrative of the Fed as Incompetent Magician, which is clearly growing in strength right alongside the Omnipotence Narrative, makes gold a much more attractive option than this time a year ago.

As for where all this game-playing and stage-strutting ultimately ends up, I want to close with two quotes by academics who are very far removed from the self-consciously (and self-parodying) “scientific” world view of modern economists. Weaver and Midgley are from opposite ends of the political spectrum, but they come to very similar conclusions. I’ll be examining the paths in which the “birds come home to roost”, to use Arthur Miller’s phrase, in future notes. I hope you will join me in that examination, and if you’d like to be on the direct distribution list for these free weekly notes please sign up at Follow Epsilon Theory.

The scientists have given [modern man] the impression that there is nothing he cannot know, and false propagandists have told him that there is nothing he cannot have.
– Richard M. Weaver, “Ideas Have Consequences”

Hubris calls for nemesis, and in one form or another it’s going to get it, not as a punishment from outside but as the completion of a pattern already started.
– Mary Midgley, “The Myths We Live By”

Like Outside the Box?
Sign up today and get each new issue delivered free to your inbox.
It’s your opportunity to get the news John Mauldin thinks matters most to your finances.

© 2013 Mauldin Economics. All Rights Reserved.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
To subscribe to John Mauldin’s e-letter, please click here: http://www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

130921_TFTF_sm

Thoughts from the Frontline: Rich City, Poor City

 

“The future is already here,” intoned William Gibson, one of my favorite cyberpunk science fiction authors, “it’s just not very evenly distributed.” Paraphrasing Gibson, the pension crisis is already here; it’s just not very evenly distributed. For the past two weeks we’ve been exploring the problems of state pension funds. This week we will conclude our look at pension plans for the nonce with a 30,000-foot overview of the states and then take a deeper dive into one city: mine. This will give you at least one version of how to do your own homework about your own hometown. But fair warning, depending on your locale, you may need medical help or significant quantities of an adult beverage after you finish your research. Then again you may be pleasantly surprised and congratulate yourself on choosing a particularly adept hometown. And be on notice that, no matter what your personal conclusion and how well-grounded your analysis is, there will be people who live in your neighborhood who think you are utterly full of, well, let’s just say “nonsensical matter” and leave it at that. This is a family letter.

Into the Transformational Future

First, a quick announcement. I am constantly asked where the future jobs will be, and I think hard about the answer to that very personal question (it’s crucial to those of us who have young kids). Will we see Gibson’s dystopian world or Ian Banks’ world of abundance? The answer is, of course, that secular growth in employment will come from the new, transformational technologies that are already being created all around us, truly new industries that will change everything and create opportunities for work that we can’t even imagine yet, in the same way the automobile or telecommunications or the McCormick reaper both took some jobs away and created even greater opportunities. The transition is the thing, though. It will be filled with opportunities for some and forced change for others, while we wait for the future to become more evenly distributed. In the next few weeks, you are going to get a letter from me that will tell you about the newest addition to Mauldin Economics, the Transformational Technologies Alert, written by my longtime friend Pat Cox, who is no stranger to readers of this letter. Pat and I have long wanted to work together, exploring the future and especially biotech. He is the best, and you will want to join us from the very beginning. We invite you to charge ahead into the future with us, exploring opportunities that will begin to change your own life right now. And now back to pensions…

Through the courtesy of one of your fellow readers I’ve been given a treasure trove of data on 702 city pension plans. I won’t say that I got lost in the data, but the search and rescue teams sent to find me had to go back for extra supplies. There were some very dark alleys that it took a while to find my way back out of. Not to mention some twists and turns that were totally surprising.

So first I need to say a big thank you to Gregg L. Bienstock and Justin Coombs of Lumesis for giving me access to their data. Gregg is a cofounder of Lumesis, and their signature software is called (appropriately enough, given the oceans of data they plumb) DIVER. They’ve compiled data on 54,000 issuers of municipal and state bonds from over 100 sources. They sent me an Excel file on the major pension plans of every state and the pension plans of cities with populations over 100,000. And Justin was kind enough to create multiple spreadsheets and graphs upon request and patiently explain their data. The bulk of the data in this letter is from http://www.lumesis.com. The opinions are my own and should not be attributed to Lumesis. From time to time we will also look at another fascinating study from the Pew Charitable Trusts on pensions and retiree healthcare in 61 cities.

As we have seen the last two weeks (here and here), the assumptions that states make about their future investment returns are fairly unrealistic and generally nothing like what they’ve achieved for the last 10 years. This makes their balance sheets look far better than they really are, and for some states the discrepancy is pretty stark. Witness Illinois, where unfunded pension liabilities run north of $280 billion, give or take. That is more than $20,000 for every man, woman, and child in the state. And the bill keeps rising every month as the state plows ever deeper in debt to its own future.

Keeping in mind the caveat that the percentages may actually be worse than reported, let’s look at a few graphs on a state-by-state basis. This first graph shows the funded ratio of state pension plans through 2012. (Note: on all the graphs the large “island” below Louisiana is a representation of Puerto Rico. To its left is Alaska, and both are obviously not to scale.)

The next graph shows actuarial required contributions (ARC). The ARC is simply the amount of money required to fund the pension plan given the return assumptions of the plan. The important thing to note here is the amount of blue in the graph. If you ask your local politicians how their pension plan is doing, they can probably tell you with a straight face (and because they don’t know any better) that their state’s pension is fully funded. I note with some alarm that “conservative” Texas doesn’t fare very well. While Texas claims funding above 80%, a more reasonable assumption on returns suggests it is no better than 43%. Can Rick Perry run for president as a conservative on that number? Then again, can New Jersey Republican governor uber-star Chris Christie run on his state’s funding level of 33%? Just asking.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Outside the Box: The Need for a New Economics

 

In today’s Outside the Box, my good friend George Gilder, the well-known techno-utopian, attempts with some success to turn economics on its ear. “The economy is not chiefly an incentive system,” he asserts, “it is an information system.” And information, truly understood, is about the introduction of novelty, or “surprise,” into a system. In the case of the economy, it’s about invention and entrepreneurship. The new information that is injected gets converted into knowledge; and thus, says George, it is accumulated knowledge, rather than money or material, that constitutes true wealth.

And thus the economy is driven not so much by powerful people and institutions wielding the levers of the economic machine as it is by the ever-increasing power of information and knowledge. Economists and the governments they work for often appear to prefer a deterministic, no-surprises (and too-big-to-fail) economy, but that way lies economic stagnation. If determinism worked, socialism would have thrived.

Knowledge is centrifugal: it’s dispersed in people’s heads, and that has never been more true than in the Age of the Internet. And it is this universal distribution of knowledge which feeds back to the economy through the creative insights and entrepreneurial efforts of people worldwide that constitutes our chief hope for economic growth in the era opening up before us, where the limits of monetary manipulation and material extraction are becoming painfully apparent.

Here is a telling sentence from George:

Whether fueled by debt or seized by taxation, government spending in economic “stimulus” packages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.

The writing is on the wall: either we reinvent ourselves and our global economy, or the noise that is obviously building in the system will overwhelm the creation and transmission of knowledge, and the great human quest for the democratization of wealth will fail. But, as George says, “[C]apitalism is not a system of equilibrium; it is an engine of disruption and invention…. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.” So we do have plenty of grounds for hope.

For the young among my readers, George Gilder wrote the seminal work Wealth and Poverty (which has been recently updated) back in the early ’80s, selling over 1 million copies and influencing a generation. He was Ronald Reagan’s most-quoted living author. He has written many books since then, but his latest book, Knowledge and Power, is in my opinion even more important.

When you combine Gilder’s work with Nassim Taleb’s Antifragility, along with the ideas that appeared in the recent Outside the Box piece by Charles Gave on the natural rate of interest, you can begin to get a real sense of why the design of the current monetary system is so flawed. Gilder’s work is foundational to that understanding. We have given our central banks a mandate far outside their actual capabilities: we’ve made them responsible for employment. With their limited tools, they have set about to improve employment but are disseminating corruption in their communications to the markets, in ways they neither intend nor understand. The framework that dominates the thinking of current central bankers simply does not encompass the new paradigm being advanced by Gilder, Taleb, Gave, and others.

Once you grasp the futility of the current structure, you can begin to make sense of the direction of the economy and understand how to position portfolios for continuing periods of exceptional volatility. In one of the great human ironies, the drive to reduce the fragility of the system in fact creates an even more fragile system, until we have a Minsky Moment on steroids. But that’s a topic for yet another book. I have talked George into writing a summary of Knowledge and Power for today OTB, but it does no more than skim the surface. His books should be included in your fall reading.

George and I have spent many hours talking about new technologies and their implications. Longtime readers know I have a deep fascination with technology and creativity. I have recently been able to get my great friend Pat Cox (who knows more about such things than I have forgotten) to agree to come and write for Mauldin Economics. We will shortly be launching a newsletter focused on technologies that have the potential to transform our society — and ways to invest in them. Pat Cox should be a familiar name to readers of Outside the Box, and I can’t tell you how thrilled I am to be able to work together with him, exploring the fascinating new world that is being created all around us.

I am still thinking through the implications of what I saw on my recent trip to North Dakota. There was just so much positive energy and potential everywhere that it makes you want to come up with ways to transfer that process in every area of the economy. Ironically, if it was up to the federal government as currently comprised, the Bakken oil play wouldn’t exist. It is messy and chaotic and not at all capable of being directed by a central planner. In short, it is massively successful, without one dollar of government money funding the individual businesses. There are no Solyndras in North Dakota. I’m sure there are lots of small failures here and there, but they haven’t cost taxpayers any equity money.

It is a busy week for me here in Dallas, with lots of meetings and research and writing piling on top of one another, plus family, gym, and other personal commitments. Tomorrow I get to have lunch with my friend Kyle Bass and go from there to spend a few hours with Dr. Woody Brock, who is in town for a speech. However much time I have with Kyle or Woody is not enough, as there are just too many ideas to capture in a few hours. But we all talk fast and try to get in as much as possible. I live for these times.

I think I’ll hit the send button and turn back to my reading. I just had a huge database of over 500 city pension plans pop into my inbox, and that is going to capture my attention for the next few hours. You gotta love having readers who can access just about anything and get it to you. When I come up for air I’ll write about what I learned this week. And speaking of weeks, you have a good one.

Your finding out that yoga hurts analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

The Need for a New Economics

By George Gilder

Why is it that so many Americans seem to believe that government spending, fueled by debt or taxes, can drive economic growth and wealth creation? Why do they believe that low interest rates, enforced by the Federal Reserve, can somehow spur business and investment? Why do they imagine that money and consumer demand impel the economy forward?

The reasons, I believe, are rooted in an economic confusion between knowledge and power. Many economists believe that growth is impelled by the exercise of power, represented by money creation and by government spending and guarantees. By manipulating the so-called “levers of the economic machine,” government power can enlarge demand, inducing businesses to invest and consumers to spend. This process is seen to generate the demand that fuels economic growth.

These images of the economy of power are part of the very creation story of economics in an era of new machines and sources of energy. The first economic models were explicitly based on the dynamics of the steam engine then impelling the industrial revolution. Isaac Newton’s physical “system of the world” became Adam Smith’s “great machine” of the economy, an equilibrium engine transforming coal and steam into economic growth and progress.

Exploring technology investments over recent decades, however, I found myself preoccupied less with sources of power than with webs of knowledge in a field of study called Information Theory. On one level this theory was merely a science of networks and computers. Its implications, however, would change our deepest concepts of the nature of wealth. It would show that wealth is not money or power or demand. It is essentially the accumulation of knowledge.

Information theory effectively began with Kurt Godel’s demonstration in 1930 that all logical systems, including mathematics, are intrinsically incomplete and depend on axioms that they cannot prove. This epochal finding is often obscured by elaborate explanations of the intricate mathematics he used to prove it. But as John Von Neumann in his audience was first to recognize, Godel’s proof put an end to the idea of the universe, or the economy, as a mechanism. Godel’s proof, as he himself understood, implied the existence of autonomous creation.

Godel’s proof led directly to the invention by Alan Turing of a universal generic computer, a so-called Turing machine. By this abstract conception, which became the foundation for all computer science, Turing showed that no mechanistic computer system could be complete and consistent.  Turing concluded that all logical systems were intrinsically oracular.

Computers could not be Smithian “great machines” or Newtonian “systems of the world.” They inexorably relied upon human programmers or oracles and could not transcend their creators. As Turing wrote, he could not specify what these oracles would do. All he could say was that “they could not be machines.” In a computer, they are programmers. In an economy, they are entrepreneurs.

In 1948 a rambunctiously creative engineer, Claude Shannon, from Bell Labs and MIT, translated Godel’s and Turing’s findings into a set of technical concepts for gauging the capacity of communications channels to bear information.

Shannon resolved that all information is most essentially surprise. Unless messages are unexpected they do not convey new information. An orderly and predictable mechanism, such as a Newtonian system of the world or Smithian great machine, embodies or generates no new information.

Studying information theory for decades in my exploration of technology, I finally found the resolution to the enigmas that currently afflict most economic thought. A capitalist economy is chiefly an information system, not a mechanistic incentive system. Wealth is the accumulation of knowledge. As Thomas Sowell declared in 1971: All economic transactions are exchanges of differential knowledge, which is dispersed in human minds around the globe. Knowledge is processed information, which is gauged by its news or surprise.

Surprise is also a measure of freedom and criterion of creativity. It is gauged by the freedom of choice of the sender of a message, which Shannon termed “entropy.” The more numerous the possible messages that can be sent, the more uncertainty at the other end about what message was sent and thus the more information there is in the actual message when it is received.

In Knowledge and Power, I sum up information theory as the treatment of human communications or creations as transmissions down a channel, whether a wire or the world, in the presence of the power of noise, with the outcome measured by its “news” or surprise, defined as entropy and consummated as knowledge.

Since these communications or creations can be business plans or experiments, information theory supplies the foundation for an economics driven not by equilibrium and order but by surprises of enterprise that yield knowledge and wealth.

Information theory requires that such a process be experimental and its results be falsifiable. The businesses conducting entrepreneurial experiments must be allowed to fail or go bankrupt. Otherwise there is no yield of knowledge and thus no production of wealth. Wealth does not consist in material capital that can be appropriated by the greedy or the government but in learning processes and knowledge creations that can only thrive in freedom.

After all, the Neanderthal in his cave had all the material resources and physical appetites that we have today. The difference between our own wealth and Stone Age poverty is not an efflorescence of self-interest but the progress of learning, accomplished by entrepreneurs conducting falsifiable experiments of enterprise.

The enabling theory of telecommunications and the internet, information theory offered me a path to a new economics that could place the surprising creations of entrepreneurs and innovators at the very center of the system rather than patching them in from the outside as “exogenous” inputs. It also showed that knowledge is not merely a source of wealth; it is wealth.

Summing up the new economics of information are ten key insights:

1) The economy is not chiefly an incentive system. It is an information system.
2) Information is the opposite of order or equilibrium. Capitalist economies are not equilibrium systems but dynamic domains of entrepreneurial experiment yielding practical and falsifiable knowledge.
3) Material is conserved, as physics declares. Only knowledge accumulates. All economic wealth and progress is based on the expansion of knowledge.
4) Knowledge is centrifugal, dispersed in people’s heads. Economic advance depends on a similar dispersal of the power of capital, overcoming the centripetal forces of government.
5) Creativity, the source of new knowledge, always comes as a surprise to us. If it didn’t, socialism would work. Mimicking physics, economists seek determinism and thus erroneously banish surprise.
6) Interference between the conduit and the contents of a communications system is called noise. Noise makes it impossible to differentiate the signal from the channel and thus reduces the transmission of information and the growth of knowledge.
7) To bear high entropy (surprising) creations takes a low entropy carrier (no surprises) whether the electromagnetic spectrum, guaranteed by the speed of light, or property rights and the rule of law enforced by constitutional government.
8) Money should be a low entropy carrier for creative ventures. A volatile market of gyrating currencies and grasping governments shrinks the horizons of the economy and reduces it to high frequency trading and arbitrage in a hypertrophy of finance.
9) Wall Street wants volatility for rapid trading, with the downsides protected by government. Main Street and Silicon Valley want monetary stability so they can make long term commitments with the upsides protected by law.
10) GDP growth is fraudulent when it is mostly government spending valued retrospectively at cost and thus shielded from the knowledgeable judgments of consumers oriented toward the future. Whether fueled by debt or seized by taxation, government spending in economic “stimulus” packages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.
11) Analogous to average temperature in thermodynamics, the real interest rate represents the average returns expected across an economy. Analogous to entropy, profit or loss represent the surprising or unexpected outcomes. Manipulated interest rates obfuscate the signals of real entrepreneurial opportunity and drive the economy toward meaningless trading and arbitrage.
12) Knowledge is the aim of enterprise and the source of wealth. It transcends the motivations of its own pursuit. Separate the knowledge from the power to apply it and the economy fails.  

The information theory of capitalism answers many questions that afflict established economics. No business guaranteed by the government is capitalist. Guarantees destroy knowledge and wealth by eliminating the precondition of falsifiability. Unless entrepreneurial ideas can fail or businesses go bankrupt, they cannot succeed in creating new knowledge and wealth. Epitomized by heavily subsidized and guaranteed leviathans, such as Goldman Sachs, Archer Daniels Midland, Harvard and Fanny Mae, the crisis of economics today is crony statism.

The message of a knowledge economy is optimistic. As Jude Wanniski wrote, “Growth comes not from dollars in people’s pockets but from ideas in their heads.” Capitalism is a noosphere, a domain of mind. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.

As experience after World War II when US government spending dropped 61 percent in two years, in Chile in the 1970s when the number of state companies dropped from over 500 to under 25, in Israel and New Zealand in the 1980s when their economies were massively privatized almost over-night, and in Eastern Europe and China in the 1990s, and even in Sweden and Canada in recent years, economic conditions can change overnight when power is dispersed and the surprises of human creativity are released.

Perhaps the most powerful demonstration that wealth is essentially knowledge came in the rapid post world war II revival of the German and Japanese economies. Nearly devoid of material resources, these countries had undergone the nearly complete destruction of their physical plant and equipment. As revealed by decades of experience with unsuccessful ministrations of foreign aid, the mere transfer of financial and political power is impotent to create wealth without the knowledge and creativity of entrepreneurs.

Information Theory is a foundation for revitalizing all the arts and sciences, from physics and biology to mathematics and philosophy. All are transformed by a recognition that information is not order but disorder. The universe is not a great machine that is inexorably grinding down all human pretenses of uniqueness and free will. It is a domain of creativity in the image of a creator.

In the same way, capitalism is not a system of equilibrium; it is an engine of disruption and invention. All economic growth and human civilization stem from the surprises of creativity and the growth of knowledge in a domain of constitutional order.

The great mathematician Gregory Chaitin, inventor of algorithmic information theory, explains that to capture the surprising information in any social, economic, or biological science requires a new mathematics of creativity imported from the world of computers. He writes: “Life is plastic, creative! How can we build this out of static, eternal, perfect mathematics? We shall use post-modern math, the mathematics that comes after Godel, 1931, and Turing, 1936, open not closed math, the math of creativity…”

Entropy is a measure of surprise, disorder, randomness, noise, disequilibrium, and complexity. It is a measure of freedom of choice. Its economic fruits are creativity and profit. Its opposites are predictability, order, low complexity, determinism, equilibrium, and tyranny.

Predictability and order are not spontaneous and cannot be left to an invisible hand. It takes a low-entropy carrier (no surprises) to bear high-entropy information (full of surprisal). In capitalism, the predictable carriers are the rule of law, the maintenance of order, the defense of property rights, the reliability and restraint of regulation, the transparency of accounts, the stability of money, the discipline and futurity of family life, and a level of taxation commensurate with a modest and predictable role of government. These low entropy carriers bear all our bounties of surprising wealth and progress.

Like Outside the Box?
Sign up today and get each new issue delivered free to your inbox.
It’s your opportunity to get the news John Mauldin thinks matters most to your finances.

© 2013 Mauldin Economics. All Rights Reserved.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
To subscribe to John Mauldin’s e-letter, please click here: http://www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

130914_TFTF_sm

Thoughts from the Frontline: Nothing But Bad Choices

 

It is hard to imagine a more stupid or more dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong.
– Thomas Sowell

With a few exceptions here and there, crises in government funding don’t simply arrive on the doorstep unannounced. Their progress toward the eventual Bang! moment is there for all the world to see. What final misdeed triggers the ultimate phase of the crisis is less predictable, but the root cause is almost always the same: debt. And whether that debt is actually borrowed or is merely promised to the populace, when the market becomes worried that the ability of the government to fund its promises is suspect, then the end is near. Last week we began a series on what I think is an impending crisis in the unfunded pension liabilities of state and local governments in the United States.

To talk about the situation using the word crisis can seem a little hyperbolic. The problems are distributed throughout the country, yet not every city or state has significant unfunded pension liabilities. And even those that do can muddle through for very long time before a smoldering problem explodes into an actual crisis. Think Detroit. You could see the crisis building for years and years in the media before it finally reached the breaking point. And Detroit was not the first city to go bankrupt, though it has been the largest. But unless significant action is taken to alleviate the problem of debt, we are going to see even larger cities and then whole states enter a crisis period. And as we will see from the data, we are not talking insignificant states. This week we continue our series on the unfunded liabilities of states and cities. Note: this letter will print a little longer than most, as there are lots of charts and graphs.

As we discussed in last week’s letter on state pensions, official estimates of accrued liabilities understate funding shortfalls by conveniently assuming unrealistic investment returns into perpetuity. While official estimates report state-level unfunded liabilities across all 50 states at only $1 trillion today, the unfunded liability burden jumps to over $4 trillion if we discount those liabilities at more reasonable expected rates of return.

In case you were wondering, the $4.1 trillion funding shortfall includes only state-run pensions, meaning that funding gaps at local levels of government are not included. We went to great lengths this past week to calculate the total pension gap at both state and local levels across all fifty states, but we were told the data does not exist – at least not in one place.

Many cities and counties invest their funds with state pension plans rather than managing them separately, but the best estimate I could get was that if you included all the separately managed city and county pensions, it might increase the total amount by anywhere from 10 to 20%.

Even without another $500 billion to $1 trillion in unfunded pension liabilities, the implications of this gaping hole in the available pension research are truly mind-blowing, considering that, in extreme cases such as we are seeing in Detroit, local unfunded liabilities may become obligations of the states for purely political reasons. So we are stuck looking at the problem from a state-run-pension perspective, knowing that the actual shortfall could be even larger. If anyone knows of better sources for this data, I would really appreciate hearing about them.

The Aggregate or the Particular?

It may be tempting to look at aggregate pension shortfalls at the national level, but these shortfalls really amount to a state-by-state issue that will ultimately force troubled states to (1) increase taxes, (2) cut public services, and/or (3) reduce retirement benefits for current and already retired public employees. Cities and counties like Detroit (or Chicago?) that manage their own pensions and are underfunded will confront the same set of choices.

Making matters even more complicated, not all states can legally cut public employee retirement benefits. Illinois, Alaska, Louisiana, Hawaii, Michigan, Arizona, and New York (shown in red below) all have clauses in their state constitutions that protect public employee defined-benefit pension plans. While most states can reduce pensions to address their budget deficits, these seven must first amend their state constitutions. As you can see, several of these states are at the bottom of the pack in terms of funding ratios, but Illinois is the most vulnerable. (Funding ratios use the more conservative model suggested by Moody’s and GASB, as we talked about last week.)

At only 24% funded, according to Moody’s new methodology, Illinois is the single-most underfunded state in the union – the worst of an entire basket of bad apples. This week will focus primarily on Illinois, but we will cast our eye around the country in coming weeks.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

130914-01

Thoughts from the Frontline: Nothing But Bad Choices

 

It is hard to imagine a more stupid or more dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong.
– Thomas Sowell

With a few exceptions here and there, crises in government funding don’t simply arrive on the doorstep unannounced. Their progress toward the eventual Bang! moment is there for all the world to see. What final misdeed triggers the ultimate phase of the crisis is less predictable, but the root cause is almost always the same: debt. And whether that debt is actually borrowed or is merely promised to the populace, when the market becomes worried that the ability of the government to fund its promises is suspect, then the end is near. Last week we began a series on what I think is an impending crisis in the unfunded pension liabilities of state and local governments in the United States.

To talk about the situation using the word crisis can seem a little hyperbolic. The problems are distributed throughout the country, yet not every city or state has significant unfunded pension liabilities. And even those that do can muddle through for very long time before a smoldering problem explodes into an actual crisis. Think Detroit. You could see the crisis building for years and years in the media before it finally reached the breaking point. And Detroit was not the first city to go bankrupt, though it has been the largest. But unless significant action is taken to alleviate the problem of debt, we are going to see even larger cities and then whole states enter a crisis period. And as we will see from the data, we are not talking insignificant states. This week we continue our series on the unfunded liabilities of states and cities. Note: this letter will print a little longer than most, as there are lots of charts and graphs.

As we discussed in last week’s letter on state pensions, official estimates of accrued liabilities understate funding shortfalls by conveniently assuming unrealistic investment returns into perpetuity. While official estimates report state-level unfunded liabilities across all 50 states at only $1 trillion today, the unfunded liability burden jumps to over $4 trillion if we discount those liabilities at more reasonable expected rates of return.

In case you were wondering, the $4.1 trillion funding shortfall includes only state-run pensions, meaning that funding gaps at local levels of government are not included. We went to great lengths this past week to calculate the total pension gap at both state and local levels across all fifty states, but we were told the data does not exist – at least not in one place.

Many cities and counties invest their funds with state pension plans rather than managing them separately, but the best estimate I could get was that if you included all the separately managed city and county pensions, it might increase the total amount by anywhere from 10 to 20%.

Even without another $500 billion to $1 trillion in unfunded pension liabilities, the implications of this gaping hole in the available pension research are truly mind-blowing, considering that, in extreme cases such as we are seeing in Detroit, local unfunded liabilities may become obligations of the states for purely political reasons. So we are stuck looking at the problem from a state-run-pension perspective, knowing that the actual shortfall could be even larger. If anyone knows of better sources for this data, I would really appreciate hearing about them.

The Aggregate or the Particular?

It may be tempting to look at aggregate pension shortfalls at the national level, but these shortfalls really amount to a state-by-state issue that will ultimately force troubled states to (1) increase taxes, (2) cut public services, and/or (3) reduce retirement benefits for current and already retired public employees. Cities and counties like Detroit (or Chicago?) that manage their own pensions and are underfunded will confront the same set of choices.

Making matters even more complicated, not all states can legally cut public employee retirement benefits. Illinois, Alaska, Louisiana, Hawaii, Michigan, Arizona, and New York (shown in red below) all have clauses in their state constitutions that protect public employee defined-benefit pension plans. While most states can reduce pensions to address their budget deficits, these seven must first amend their state constitutions. As you can see, several of these states are at the bottom of the pack in terms of funding ratios, but Illinois is the most vulnerable. (Funding ratios use the more conservative model suggested by Moody’s and GASB, as we talked about last week.)

At only 24% funded, according to Moody’s new methodology, Illinois is the single-most underfunded state in the union – the worst of an entire basket of bad apples. This week will focus primarily on Illinois, but we will cast our eye around the country in coming weeks.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Outside the Box: Advantage America

 

Today’s Outside the Box, which comes to us from good friend Gary Shilling, is unusual because that old confirmed bear is waxing positively bullish about the future prospects of the US. In doing so he mirrors my own views. It is just a matter of time before I go from being bearish on the US because of the dysfunctional US government to being an irrational perma-bull, at least for the next few decades. There is just too much upside potential with this country of ours — if we can muster the political will to handle our serious fiscal issues.

Gary builds the positive case beyond the fiscal concerns, and a compelling case it is. In six crucial areas, he says — demographics, entrepreneurial activity, labor relations, domestic vs. foreign debt financing, currency strength, and energy independence — the US is better positioned than any of its major competitors.

Gary pays particular attention to the importance of a strong US dollar. The dollar is not even close to being unseated as the world’s primary reserve and trading currency; but that is not to say there won’t be currency challenges ahead, with the biggest global currency war since the 1930s just getting fired up. Already competitive devaluations and protectionist measures are rampant around the globe. Can the US take the high road? If we want to maintain the privileged position of our currency, we must.

OTB readers can subscribe to Gary Shilling’s Insight for one year for $335  via e-mail. Along with 12 months of Insight you’ll also receive a free copy of his full report detailing why he believes it will be “advantage America” in the coming years and a free copy of Gary’s latest book, Letting Off More Steam. To subscribe, call 1-888-346-7444 or 973-467-0070 between 10 am and 4 pm Eastern time or email insight@agaryshilling.com. Be sure to mention “Outside the Box” to get the special report and free book in addition to your 12 months of Insight (available only to new subscribers).

I’m in Chicago this afternoon doing interviews and catching up on my reading before giving a speech this evening. Tomorrow morning I’m off to the Dakotas, where I will spend the day with oil entrepreneur Loren Kopseng talking about shale oil and gas. Coincidentally, I just got a question for Loren from the research team at Mauldin Economics. Can I ask him about the new, potentially $20-trillion shale oil find in Australia and what he thinks of it? I’m sure it won’t dampen his enthusiasm for all things Bakken, but it does go to illustrate that shale oil is not just a US phenomenon. Oil has always been there. It just takes technology and the willingness and ability to use it to get it out of the ground. Plus high enough energy prices, of course.

I have been reading about new shale oil discoveries all over the world. Enthusiasm about oil and gas discoveries in the eastern Mediterranean was palpable in Cyprus. I should note that it was a Texas company that was crazy enough to go after that oil, which will soon make Israel energy independent and supply a great deal of energy to Europe. And we note that Russia is very concerned about its potential port in Syria. Just a coincidence, I’m sure.

The first thought that leapt to mind upon reading the query about Australian oil was, “Ho-hum, yet another oil discovery.” But then the thought that followed very closely was that this is a country whose people more closely resemble crazy Texans than anyplace else I have been (and for whatever reason, I find that a good thing). There is plenty of capital Down Under, and it would not surprise me if they figured out how to exploit these shale oil reserves. I’ll have to do a little homework before I head out to Saudi Arabia in January. There will be interesting questions to ask my hosts. The world just keeps getting more interesting every day. (I just watched a lengthy presentation on robotics and continue to be amazed at the progress that is being made. Interesting times indeed!)

I’m not sure where I will be when I write this week’s letter, but it will show up again this weekend. And have a great week. ($20 trillion? Really? Really!?! And I thought Texas oil guys were irrationally exuberant.)

You’re fascinated by human ingenuity analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

Advantage America

(excerpted from the July 2013 edition of A. Gary Shilling’s Insight)

Beyond what I believe are bright prospects for a return to rapid U.S. economic growth and the resulting decline in federal debt-to-GDP, Americans in future years will enjoy six major advantages over developed and developing country competitors in the globalized world.

1. Demographics

Demographics are one. The current immigration debate in Washington isn’t over throwing illegals out but over how to give them legal status and a path to citizenship while attracting highly educated and skilled newcomers. Only a few other countries such as Canada and Australia are at least as open as America.

Immigrants tend to be younger than current residents and have higher birth rates, especially Hispanics. So the U.S. fertility rate of 2.06 is close to the 2.1 births per child-bearing woman needed to sustain the population in the long run (Chart 1).

In contrast, the fertility rates in all European countries and even Canada and Australia are below the reproduction level. Japan’s, the lowest at 1.39, is compounded by the total lack of any immigration. China’s fertility rate is just 1.55 because of the one-child-per-couple policy, which the government is reconsidering.

Most immigrants have jobs, either those requiring high skills and education or low level work that natives shun. They’re not old enough to draw Social Security and Medicare benefits in large numbers but their payroll taxes help provide benefits for retiring postwar babies.

Because of aging populations in all major countries, immigrants are needed to keep the 15-64 working-age population from falling faster as a percentage of the total. By 2040, the U.S. ratio, 60.3%, is projected to be the highest of any developed country. China’s ratio falls rapidly from 72.4% in 2010 to 63.1% in 2040 due to its one-child policy, and already, new labor force entrants age 15-24 are declining in number.

Even if the 2 million people who left the labor force in the last two decades for non-demographic reasons never re-enter because their skills are rusty or they prefer disability benefits and food stamps, it won’t impede robust real GDP annual growth of about 3.5% after the Age of Deleveraging is completed. With 2.5% growth in productivity per year, employment would need to rise 1% annually. That’s about 1.44 million more workers per year.

The working-age population in future years is projected by the Bureau of Labor Statistics to rise about 2.2 million per annum. With the current participation rate of 64% (Chart 2), that would produce 1.4 million new job-seekers, about the same as new labor demand, assuming these new entrants’ skills match those that are needed. And a declining unemployment rate would add more to the employed.

2. Entrepreneurial Spirit

Another big advantage for the U.S. is the American entrepreneurial spirit, observed by de Tocqueville in the 1830s and still going strong today. Despite perceptions of an erosion of U.S. economic vigor, America still seems way ahead of whoever is in second place. It starts with the education system, which has many faults but does encourage free inquiry and the challenging of accepted doctrine.

Foreigners attending U.S. colleges and universities are often shocked when they are encouraged to question professors. Japan discourages individuality. “The nail that sticks up must be hammered down,” is their expression. Chinese education involves rote learning with no emphasis on student inquiry, begging the question: How is China going to grow after she gets her labor force fully employed and catches up to Western technology?

Furthermore, China’s economy remains heavily tied to bureaucratic, inefficient state-owned enterprises that produce about half of GDP and employ around a quarter of the labor force. Over half of companies listed on the Shanghai Stock Exchange are SOEs, the direct result of the government’s preference for them as IPO issuers while private businesses are starved for capital. SOEs are so inefficient that they require loans at sub-market rates from the government banks, subsidized by low deposit rates.

Government direct subsidies to about 90% of the companies listed on China’s stock exchanges, most of them SOEs, were up 23% last year to $13.8 billion. These subsidies were equal to 4% of total profits, which rose less than 1% and were in the form of cheap land, tax rebates, support for loan repayments and simple cash. Without subsidies, many Chinese companies would fail due to excess capacity and weak export demand.

With the renaissance of U.S. oil and gas production and resurgence of robotic and capital-intensive manufacturing, the U.S. bested China for the first time since 2001 as the more favorable place for foreign direct investment, according to a recent survey (Chart 3).

Leaping American oil and gas production has created a global energy supply cushion that allows the U.S. to deal with Iran and other trouble spots without debilitating spikes in oil prices.

3. Labor Flexibility

An added long-term advantage for the U.S. in international competition is her flexible labor markets. Labor unions are becoming a thing of the past, especially in the private sector and now increasingly among state and local employees (Chart 4). Partly as a result, U.S. wages are flexible on the down side. Surveys show that of the people out of work for six months (Chart 5) who do find new jobs, a third work for less money than previously.

Working for less is almost unheard of in Europe and lifetime employment is the rule in Japan. China is increasing minimum wages about 25% per year to provide more consumer spending power as she strives to shift from an export-led to a domestically-driven economy. But higher wages erode the global competitiveness of China and production is shifting to cheaper locales like Vietnam, Bangladesh and Pakistan.

The auto industry is a case in point. After the Great Recession drove GM and Chrysler into bankruptcy, U.S. automakers introduced $14 per hour wages for new employees, half the level of veterans. So in 2011, the average pay of U.S. autoworkers including benefits was $38 per hour compared to $66 in Germany and $37 in Japan. U.S. pay has increased $3 per hour since 2007, but $12 in Japan and $14 in Germany. As a result, vehicles from U.S. auto plants are beginning to be shipped abroad in numbers.

4. Declining Need For Foreign Financing

An additional major advantage for the U.S. in future years is the likely decline in dependence on foreign financing. The current account deficit measures the extent that U.S. investment exceeds the combined saving of consumers, business and government. With consumer saving low and large federal deficits, the current account deficit has been sizable, about $400 billion at annual rates. This deficit is financed by increases in foreigners’ holdings of stocks, Treasurys, real estate, etc., as they recycle dollars back to dollar-denominated investments.

I don’t share the fears of some that the Chinese or others will dump their huge holdings of Treasurys and other dollar-denominated securities (Chart 6). They’re not suicidal, and if they started selling, the value of their remaining Treasurys would collapse and a global recession would no doubt follow as interest rates skyrocketed. China and other export-led economies would be the big losers in the resulting buyers’ market.

But accidents can and do happen, so America’s global status will improve if the trade and current account deficits shrink. That’s likely if my forecast of a rise in the household saving rate back to double digits unfolds (Chart 7).

As I’ve discussed in my recent book, The Age of Deleveraging, and in many past Insight reports, Americans have little choice but to save more. They no longer trust their stock portfolios as they did in the 1980s and 1990s to substitute for saving out of current income to educate their kids and finance early retirement. The nosedive in house prices after heavy cash-out refinancing of mortgages and home equity loans has removed much of the home equity they earlier used to finance oversized spending. The postwar babies have been notoriously poor savers and desperately need to keep working and save much more for their old age.

As the saving rate rises, spending will grow more slowly, the reverse of what occurred when the saving rate slid from 12% in the early 1980s to 1%. That drove consumer spending growth about a half-percentage point per year faster than after-tax income and fueled the domestic economy. It also propelled the many Asian and other lands whose economies are driven by exports, largely to U.S. consumers. For every 1% rise in American consumer spending, U.S. imports—the rest of the world’s exports—rise 2.8% on average.

A rising consumer saving rate will retard the growth in spending on everything, including imports. This will curtail the exports of export-led economies like China, whose leaders are aware of this likelihood and are working to shift that economy to domestic emphasis. In any event, the resulting shrinking of the U.S. trade and current account deficits will put fewer dollars in foreign hands that will be recycled into U.S. investments.

But fewer will be needed since money is fungible, and the high consumer saving will provide more money to replace foreign funds in financing the federal deficits and other needs. At a 10% household saving rate, $1.2 trillion would be available to finance federal deficits, now less than $1 trillion, as well as business net borrowing.

On balance, the U.S. will meet more of its financing needs internally, but probably not all. If the American trade and current account deficits disappeared completely, the many Asian, Latin American and other import-led economies would be in severe trouble until they converted to domestically-driven states. Also, without U.S. current account deficits, the dollars that almost every foreign country depend on as their primary reserve currency would be difficult to accumulate.

Needless to say, as long as the economies and other developing countries remain export-led, they will be coupled to the economic health of the buyers of their exports, principally the U.S. and Europe. In the fall of 2007, on the eve of the Great Recession, many thought that China and India would lead global growth and indeed support the U.S. economy as the American housing and consumer sectors faltered.

Nevertheless, we wrote in “The Chinese Middle Class: 110 Million Is Not Enough” (Nov. 2007 Insight), that China’s middle class, those with discretionary spending power, was growing but not yet big enough to carry the economy. Ditto for India. We predicted that “the looming U.S. recession will spread globally,” including to China.

Well, as they say, the rest is history. China’s growth collapsed to recession levels (Chart 8) and was only revived by massive government stimuli. China’s middle class is growing rapidly, but domestic spending is not yet big enough and China’s exports are still important enough to keep her coupled to the West. This dependency is magnified by her immense excess capacity problem and ongoing financial crisis. It will probably take about a decade before China’s domestic economy can carry the economic ball.

5. Strong Dollar

A rising dollar is another long-run advantage for the U.S. in the global arena, reflecting the economic, political and financial strength of America as well as the buck’s continuing status as the world’s primary reserve and trading currency.

A review of history since ancient times reveals six characteristics of a dominant global currency. The buck will likely remain the winner in at least five of the six for many years.

1. Rapid growth in the economy and GDP per capita, promoted by robust productivity growth. This is probably the most necessary condition for a dominant international trade and reserve currency. It was key to British sterling’s success in the 19th century and the dollar’s superior position since then. It’s also necessary to support globally-dominant military structures in modern democracies while still satisfying voters with acceptable standards of living.

In the last decade, the U.S. has excelled in productivity gains among developed areas. Her emphasis on entrepreneurial activity and American superiority in new technologies suggest this lead will persist.

2. A large economy, probably the world’s biggest. That was true of ancient Rome, which had an unusually effective administration and centralized control for the times. With the breakdown of communications in the Middle Ages, size was less important and allowed relatively small Italian city-states and their currencies to achieve international primacy. In modern times, Singapore and Switzerland meet our other qualifications but are just not big enough to have primary currencies.

With rapid productivity growth and relatively open immigration, America will probably continue in this role. Population is falling in Japan and will soon follow in other developed lands as well as China with her one child-per-family policy.

3. Deep and broad financial markets. Internationally, money—especially today when it can be transferred anywhere in a split second—wants to be where the action is. That requires not only a powerful and large economy but also deep and broad markets in which to invest. Today, the U.S. Treasury market trumps all others in size and, in the eyes of investors (Chart 9), in safety as witnessed by the mad rush into Treasury bonds in times of recent global trouble.

Similar American stock market capitalization is four times that of China, Japan or the U.K. and is over three times the eurozone’s (Chart 10). Almost 50% of Treasurys are held by foreigners but only 9.1% of Japan’s government net debt is owned by non-Japanese. According to the IMF, 62% of the world’s currency reserves are in dollars. The 24% in euros is down from 29% four years ago. Foreigners so love investing in the U.S. that at the end of 2012, it exceeded U.S. investment abroad by $4.4 trillion, up from $4 trillion a year earlier.

4. Free and open financial markets and economy. Foreign investors are willing to hold a country’s currency if they are convinced they can invest it in financial or tangible assets in that country with few restrictions. The U.S. is essentially open, which is necessary if the Chinese and Japanese are to continue to recycle their current account surpluses with the U.S. into Treasuries and other American investments.

Free and open markets persist in the U.S. but less so in Europe with the eurozone crisis. China will probably continue to control tightly her financial markets and currency, anathema for an international trading and reserve currency. Nevertheless, China is relaxing control of her currency slowly and the yuan has surpassed the Russian ruble and the Danish krone to become the world’s 13th most used currency for international payments.

5. Lack of substitutes. A primary global currency, by definition, has no close competitors. The risk is that the top dog gets fat and lazy while upstarts surpass it in productivity growth, and ultimately, in GDP-per-capita or GDP-per-employee. That’s how the Dutch lost out to the British in the late 1700s, and in turn, the U.K. was overrun by the U.S. a little more than a century later.

Today, the rigidly controlled Chinese economy and financial markets eliminate the yuan as a rival to the dollar for the foreseeable future. Export-dependent and inward-looking Japan does not want the yen to be a primary global currency. And the ongoing eurozone financial crisis and recession eliminate the euro for at least a number of years.

6. Credibility in the value of the currency. Internationally, money is fleet-footed, congenitally cautious and runs from uncertainty over risk of confiscation, debasement, etc., as discussed in our earlier review of history. The Roman aureus, the Byzantine solidus and the Arabian dinar all went out of international style when those empires waned, but the related debasement of those currencies speeded the exit. On the flip side, in World War I, Britain went off the gold standard only to return in 1925 with the prewar price of gold in sterling. With immense wartime inflation in the interim, that action vastly overpriced sterling, causing uncertainty and leading to a mass exodus of U.K. money to New York and elsewhere.

Credibility in the dollar has been strained by its overall decline since 1985 (Chart 11), but still is substantial. The troubling current account deficit will probably continue to shrink as retrenching consumers moderate imports, as discussed earlier, as U.S. production becomes increasingly competitive, and as net U.S. energy imports move toward exports. Also, in effect, competitive devaluations will ultimately be against the U.S. dollar. This will only add to the greenback’s luster as the only safe haven currency of any size in a persistently uncertain world.

6. Energy Independence

America is on her way to self-sufficiency in energy. To the dismay of Peak Oil devotees, horizontal drilling and fracking technology have unlocked from shale oceans of natural gas and petroleum. Combined with the oil sands in Canada and other nonconventional sources of energy as well as higher auto fuel-efficiency and other conservation measures, there are predictions that the U.S. could be relatively free from foreign oil dependence by 2020. Cheap natural gas is a competitive advantage for U.S. producers, especially of petrochemicals and nitrogen fertilizers.

Leaping American oil and gas production has created a global energy supply cushion that allows the U.S. to deal with Iran and other trouble spots without debilitating spikes in oil prices.

Like Outside the Box?
Sign up today and get each new issue delivered free to your inbox.
It’s your opportunity to get the news John Mauldin thinks matters most to your finances.

© 2013 Mauldin Economics. All Rights Reserved.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
To subscribe to John Mauldin’s e-letter, please click here: http://www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

Thoughts from the Frontline: Unrealistic Expectations

 

“In the short run, the market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine, assessing the substance [intrinsic value] of a company.”
– Benjamin Graham

Way back in the Paleozoic era (as far as markets are concerned), circa 2003, I wrote in this letter and in Bull’s Eye Investing that the pension liabilities of state and municipal plans would soon top $2 trillion. This was of course far above the stated actuarial claims at the time, and I was seen as such a pessimist. Everyone knew that the market would compound at 9%, so any problems were just a rounding error.

Now it turns out I may have been a tad optimistic. Two well-respected analysts of pension funds have produced reports this summer suggesting that pensions are now underfunded by more than $4 trillion and possibly more than $5 trillion. I would like to tell you that the underfunding is all the bad news, but when you probe deeper into the problems facing pension funds, it just gets worse. The two reports conclude that pension plan sponsors seem determined to keep digging themselves an ever-deeper hole. But to hear the plan sponsors tell it, the situation is readily manageable and the risks are minimal. Except that pesky old reality keeps confounding their expectations.

And that is the crux of the problem. Whether you believe there really is a problem boils down to the assumptions you make about future returns. If you believe the projections trotted out by pension fund management and the bulk of the pension consulting groups, the underfunding is a mere $1 trillion — a large amount to be sure but manageable for most states.

The emphasis here is on most. Some states and municipalities are in far worse shape than others, and to be honest with you, I don’t see how some of them can meet their commitments. Others are trying to be responsible and fulfill their pension fund obligations based on the assumptions their “experts” come up with, but the problem is that those assumptions may be overly optimistic. The seemingly small difference of just 1% of GDP growth can make a huge difference in pension liabilities (and thus taxpayer obligations).This week we begin a series focusing on the problems facing US state and local pension funds. This issue has relevance to you not only as a taxpayer but also as an investor, because it goes to the very core of the question, what is the level of reasonable returns we can expect to see from our investments in the future? This is not a problem that is restricted to the US — it’s global. Sadly, we don’t live in a Lake Wobegon world where all pension funds and investment portfolios are above average. Not everyone can be David Swenson, the famous chief investment officer of Yale University. Truth be told, David Swenson will have a difficult time being David Swenson in the next 20 years.

Unrealistic Expectations

The past 10 years have seen a growing number of economists and financial analysts questioning the propriety of the methods used to forecast pension fund liabilities. This is more than an academic exercise, as the numbers you choose to base your models upon make massive differences in the projected outcomes. As we will see, those differences can run into the trillions of dollars and can mean the difference between solvency and bankruptcy of municipalities and states. The implicit assumption in many actuarial forecasts is that states and cities have no constraints on their ability to raise money. If liabilities increase, then you simply raise taxes to meet the liability. However, fiscal reality has begun to rear its head in a few cities around the country and arrived with a vengeance in Detroit this summer. It seems there actually is a limit to how much cities and states can raise.

“Aah,” cities assure themselves, “we are not Detroit.” And it must be admitted that Detroit truly is a basket case. But it may behoove us to remember that Spain and Italy and Portugal and Ireland and Cyprus all said “We are not Greece” prior to arriving at the point where they would lose access to the bond market without central bank assistance.

In response to growing concerns over public pension debt, the Governmental Accounting Standards Board (GASB) and Moody’s have both proposed revisions to government reporting rules to make state and local governments acknowledge the real scope of their pension problems. (While it is possible to ignore Moody’s, based on the fact that it is just one of three private rating agencies, it is impossible to ignore GASB, which is the official source of generally accepted accounting principles (GAAP) used by state and local governments in the United States.

Under the new GASB rules, governments will be required to use more appropriate investment targets than most public pension plans have been using, bringing them more in line with accounting rules for private-sector plans. Pension plans can continue to use current investment targets for the amounts the plans have successfully funded; but for the unfunded amounts, pension plans must use more reasonable investment forecasts, such as the yield on high-grade municipal bonds, currently running between 3 and 4 percent. From my perspective, not requiring reasonable investment forecasts on already funded accounts is still unrealistic, but the new GASB rules are a major step in the right direction, and I applaud GASB for taking a very politically difficult stance.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

To subscribe to John Mauldin’s e-letter, please click here: www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Outside the Box: How Fed Policy Has Devastated Three Generations of Retirees

 

Retirement can be an unpleasant prospect if you’re not ready for it. This week’s Outside the Box is in in-depth report on Americans’ retirement prospects, which comes to us from Dennis Miller, a columnist for CBS Market Watch, and editor of Miller’s Money Forever. It’s not just the Boomers who are trying (often in vain) to retire this decade; it’s also Gen-Xers, who are the most indebted generation (and the one that saw their assets depreciate the most in the Great Recession). The Millennials haven’t been spared, either; in fact, over time they may be the hardest-hit, since near-zero interest rates are keeping them from compounding their savings in the early years of their careers, when the power of compounding is greatest. In addition, the difficult post-college job market and sky-high levels of student loans have kept most Millennials out of the stock market, and they are far less likely than previous generations to open a retirement savings account.

This is not a problem the government is going to be able to fix. One way and another, Social Security will do less for people in coming years, not more. We are all going to be more dependent upon our own resources if we want to have anything that resembles what we have come to think of as a secure and comfortable retirement.

Miller, along with my partner David Galland, former US Comptroller General David Walker, Jeff White of American Financial, and John Stossel of Fox Business, will be discussing retirement strategies for individual investors during a broadcast set for Thursday, September 5.  You can learn more here.

Let me correct a mistake from last week. The time for the world premiere of Money for Nothing in Dallas is 7 PM this Friday, September 6. It will be at the AMC theater in Northpark, and you can order tickets online at the AMC website. This is going to be a fun event, and the film is one that you will want to see when it comes to a theater near you. I wish everyone in the US could watch this. It’s that important.

My weekend at the world science fiction convention (WorldCon) was even better than I imagined. I must confess that I did not attend many of the events, as I spent my weekend vacation time relaxing and talking with some of my favorite authors, often long into the night. Many of the truly great science fiction books over the years have contained significant economic thought, and I enjoyed discussing some of the more philosophical repercussions of these imaginary worlds the gentlemen who created them. Many of them have written multiple books arguing several sides of the same topic. Their work is sometimes utopian, sometimes end-of-the-world-as-we-know-it, but my favorite authors are always thought-provoking as well as entertaining. Many are true polymaths with formidable knowledge of an amazing range of topics that they weave into their work. My only real complaint is that the best do not write enough.

Have a great week and to my friends of the Jewish persuasion let me wish you Shanah Tova.

You’re not even thinking about retiring analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com


 

How Fed Policy Has Devastated Three Generations of Retirees

By Dennis Miller

One aspect of the American Dream has always been the prospect of enjoying one’s golden years in retired bliss. And while everyone knows that the rules of the game have been subject to change over the years, the recent, unprecedented changes in fiscal policy have proved to be a virtual wrecking ball to Americans’ retirement dreams.

Over the past few years, the Federal Reserve has moved from simple interest rate manipulation to wholesale market interference with the goal of maintaining bank solvency and equity prices. This steamroller-style interference in the markets has had massive consequences. And not just for the Baby Boomers who are now hitting retirement age, but also for their children and children’s children—three American generations whose retirement hopes have been left to swing in the wind on a string of broken promises.

Baby Boomers Get Their Risk On

The Baby Boomer generation (born 1946 – 1964) is quite used to adjusting to ever-changing conditions when it comes to retirement.

For decades, receiving a pension was what one looked forward to for their old age. But as you can see in the chart below, at least in the private sector that idea has become as extinct as a T-rex.

Its replacement became the 401(k) and the IRA—tax-deferred vehicles that let savers take control of their own retirement, for better or worse.

Granted, Americans have built up a sizable nest egg in these defined-contribution retirement accounts—more than $5.4 trillion in IRAs alone—but the cumulative savings fail to tell the larger story. The dire truth is that Baby Boomers are caught in a trap, simultaneously trying to preserve capital and generate yield through wild market swings like 2000′s massive crash, 2008′s 30% correction, and 2010′s flash crash.

The market’s frequent large “corrections” have had a sobering effect on Boomers’ investment behavior. In an attempt to avoid the swings while still making money to live off, Boomers have flooded the bond market with money and significantly reduced their stock market exposure.

As you can see in the right-most bars on the graph above, Boomers who are in their sixties today have significantly reduced the weighting of equities in their portfolios over the last decade—much more so than their peers of just 10 years earlier.

It’s true that since the bursting of the housing bubble in 2007, major indexes have recovered to a point where anyone who stayed put after the crash should have been made whole again. Yet the actual market participation by the Boomers has been considerably lower—thrice bitten, twice shy—meaning many missed out on the equity market’s recovery.

Instead, hundreds of billions of dollars flowed into the bond markets over the past five years, as evidenced by the $50 billion upswing in bond ETF assets in 2012, and the $125 billion in bond-based mutual fund net inflows over the same period.

Following a protective instinct, conservative investors shifted their money from stocks to bonds… at exactly the time interest rates were rapidly falling for most classes of income investments.

Boomers have suffered more losses and settled for lower income than ever before. The double whammy took a serious toll on the retirement dreams of many. But that was OK, because there was always Social Security as a backstop.

It’s become increasingly obvious, though, that Social Security is not keeping up with the times.

By tying its payouts to the Consumer Price Index (CPI)—a measure as flawed at predicting actual consumer prices as a groundhog at predicting the weather (a consumer price that doesn’t include fuel or food?)—as a net effect, the real value of Social Security payouts has shrunk dramatically.

Here’s a chart of official consumer inflation vs. the real numbers calculated by economist John Williams of ShadowStats (he uses the US government’s unadulterated accounting methods of the 1980s). While the official number is 2%, real inflation is in the 9% range.

Washington has been cutting Social Security payments for years, just in a way that wasn’t obvious to most newscasters and taxpayers—at least not until it was time to collect, as increasing numbers of Boomers now are.

Between the downfall of the pension, Boomers’ eschewing of the stock market, and the government’s zero interest rate policy, for many Americans retiring in their sixties has become little more than wishful thinking—and a financially comfortable retirement now requires taking significantly more risk than most are willing or able to handle.

Generation X Strikes Out

Traditionally, the 45-55 age group has been the most fervent retirement savers, but that has changed drastically in the last 25 years. As you can see in this chart, the most rapid declines in participation rate for the black line (age 45-54) coincide with major dips in the market, such as in 2001 and 2007.

To make matters worse, Gen-Xers (born 1965 – 1980) are also the most debt-ridden generation of the past century.

According to the Pew Research Center, Gen-Xers and Baby Boomers alike have much lower asset-to-debt ratios than older groups. Whereas War and Depression babies got rid of debt over the past 20 years, Boomers and Gen-Xers were adding to their load:

  • War babies: 27x more assets than debt
  • Late Boomers: 4x more assets than debt
  • Gen-Xers: 2x more assets than debt

That situation deteriorated further in the last six years; while all groups lost money in the Great Recession, the Gen-Xers were the hardest-hit.

As Early and Late Boomers struggled with asset depreciation of 28% and 25%, respectively, Gen-Xers lost almost half (45%) of their already smaller wealth. They also lost 27% of home equity during the crisis, the largest percentage loss of the groups studied by Pew.

Millennials: Down a Well and Refusing the Rope

The effects of a prolonged period of low interest rates on current and near-term retirees are obvious. But the long-term effects on those now in their early years of working and saving may be much greater.

We’ve all been taught about the power of compound interest. Put away $10,000 today, compounding at 7%, and in 20 years you have about $40,000 and in 30 years nearly $80,000.

As powerful a tool as long-term compounding is, though, nothing can cut the legs out from under it more than saving less early on or earning less in the first few years. Any small change to the input has a drastic effect on what comes out the far end.

The Millennials—those born between 1981 and 2000—are suffering from both right now. It’s no secret that interest rates are low, and there is little that their generation, whose oldest members are now in their early thirties, can do about it.

Shrinking interest rates are wreaking real havoc on the Boomers’ children, extending the time to retirement for that generation by nearly a decade.

Why would any politician pass legislation to change Social Security eligibility, a measure that usually doesn’t bode well for reelection, if they can simply rely on fiscal policy to accomplish the same net effect?

To make matters worse, the years of financial turmoil, a tough post-college job market, high levels of student loans, and numerous other factors have kept most Millennials out of the stock markets.

Millennials are far less likely to open a retirement savings account than previous generations.  According to a recent Wells Fargo survey, “In companies that do not automatically enroll eligible employees, just 13.4% of Millennials participate in the plan.”

This is worse even than the number EBRI collected in the graph presented earlier, which still pegged retirement plan participation rates at all-time lows for the 20-something set. Only a small percentage of Millennials are taking even the most basic step toward taking charge of their own retirement.

With their parents and grandparents showing them the failure of the pension system and Social Security first-hand, one would think the opposite might be true. But the numbers clearly show that Millennials are less interested in saving for their future retirement than their parents were.

Having seen it happen to their own grandparents, maybe they are just resigned to the idea that they’ll have to work well into their golden years anyway. And who could blame their generation for not trusting the stock markets with their capital after seeing what happened to their parents’ nest eggs so many times during their own childhoods?

The youngest working generation is eschewing investment, at what might be a great cost down the road.

Adapt to Survive

Multiple years of shrinking interest rates, thanks to heavy bond buying by the Federal Reserve in its Quantitative Easing program, have taken an immense toll on generations of savers. The increased risk that current and future retirees have to take on to meet their income needs has left many shaken and financially insecure.

As a result, many are now looking to new strategies to make up for the shortfall the Fed’s zero interest rate policy has created—shifting their focus from bonds to dividend-paying stocks and adapting as they go along.

Dennis Miller is a noted financial author and “retirement mentor,” a columnist for CBS Market Watch, and editor of Miller’s Money Forever (www.millersmoney.com), an independent guide for investors of all ages on the ins and outs of retirement finance—from building an income portfolio to evaluating financial advisors, annuities, insurance options, and more.  He also recently participated alongside John Stossel and David Walker in America’s Broken Promise, an online video event that premieres Thursday, September 5th.

Like Outside the Box?
Sign up today and get each new issue delivered free to your inbox.
It’s your opportunity to get the news John Mauldin thinks matters most to your finances.

© 2013 Mauldin Economics. All Rights Reserved.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
To subscribe to John Mauldin’s e-letter, please click here: http://www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

Soft%20Focus_fmt

Things That Make You Go Hmmm…A Barrel of Monkeys

 

“What’s more fun than a Barrel of Monkeys? Nothing!”

Not my words, but those of the Milton Bradley Co., which still produces under license a game first created by a gentleman named Leonard Marks, who sold the rights to his simple but addictive game to Lakeside Toys in 1965.

It would be difficult to imagine a simpler premise for a game than that of Barrel of Monkeys. The rules of the game, printed on the bottom of the plastic barrel in which the monkeys are contained, are simplicity itself:

Dump monkeys onto table. Pick up one monkey by an arm. Hook other arm through a second monkey’s arm. Continue making a chain. Your turn is over when a monkey is dropped.

Easy!

Each barrel contains 12 monkeys but can accommodate, at a push, 24, which makes the game so much more enjoyable. What could be better than assembling a long chain of tangled monkeys, each reliant on those either side of it for purchase, with just the one person holding onto a single monkey’s arm at the top end of the chain, responsible for all those monkeys dangling from his fingers.

Of course, with great power comes great responsibility; and that lone hand at the top of the chain of monkeys has to be careful — any slight mistake and the monkeys will tumble, and that, I am afraid, is the end of your turn. You don’t get to go again because you screwed it up and the monkeys came crashing down.

On May 22nd of this year, Ben Bernanke’s game of Barrel of Monkeys was in full swing. It had been his turn for several years, and he looked as though he’d be picking up monkeys for a long time to come. The chain of monkeys hanging from his hand was so long that he had no real idea where it ended.

That day, in prepared testimony before the Joint Economic Committee of Congress in Washington, DC, Bernanke stated that the Fed could increase or decrease its asset purchases depending on the weakness or strength of data:

The program relates the flow of asset purchases to the economic outlook. As the economic outlook — and particularly the outlook for the labor market — improves in a real and sustainable way, the committee will gradually reduce the flow of purchases.

To assuage any lingering doubt, he continued:

I want to be very clear that a step to reduce the flow of purchases would not be an automatic, mechanistic process of ending the program. Rather, any change in the flow of purchases would depend on the incoming data and our assessment of how the labor market and inflation are evolving.

Markets fluttered a little as they tend to do around these carefully stage-managed performances, but remained largely sanguine. However, in the Q&A session that followed his prepared remarks, Bernanke, in response to a fairly innocuous question, went a little off-piste, straying into some improv, making a suggestion that, within minutes, had given rise to a phenomenon which by the end of the day had earned its very own soubriquet: the “Taper Tantrum”:

If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases. If we do that it would not mean that we are automatically aiming towards a complete wind down. Rather we would be looking beyond that to see how the economy evolves and we could either raise or lower our pace of purchases going forward.

The statement contained the usual bit about the Fed being open to both decreasing OR increasing bond purchases; but it added one, as it turned out vital, piece of information:

“… we could in the next few meetings … take a step down in our pace of purchases.”

Boom! That’s all it took. The monkeys began to shiver, shake, and screech.

Now, I have been saying for the longest time that these days nothing matters to anybody until it matters to everybody, and that is largely down to the Fed themselves (and their peers across the various oceans and borders who are complicit in this era of free money). The proof of my statement is seen in the fact that as soon as Bernanke mentioned that the “taper” — which, let’s face it, EVERYBODY knows has to happen sooner or later — would possibly begin before the end of 2013, markets began to crumble.

The S&P 500 dropped a quick 6% on the outlandish idea that free money by the trillion wasn’t going to continue forever, and this came as something of a shock to investors who had watched the index levitate relentlessly as the stimulus being applied by the Fed to the tune of $85bn a month did its job — and by “did its job” I wish I were talking about lowering unemployment and stimulating growth; but, alas, I’m talking about bolstering bank balance sheets and driving equity prices to unsustainable and unfairly valued levels.

As you can see from the chart below, the market turned around and recovered its losses pretty quickly as a seemingly endless procession of Fed governors and “friendly” journalists were rolled out to explain — in increasingly panicked tones — that everything was OK and that the esteemed Chairman didn’t actually say they would definitely be cutting off the easy money.

Source: Bloomberg

In his own prepared remarks the following morning, Fed mouthpiece and Wall Street Journal reporter Jon Hilsenrath was quick to soothe:

(WSJ): The next step by the Fed could be especially tricky. One worry at the central bank is that a single small step to shrink the size of the program could be interpreted by investors as the first in a larger move to end it altogether. [Yesterday] Mr. Bernanke sought to dispel that view, part of a broader effort by Fed officials to manage market expectations.

If the Fed takes one step to reduce the bond buying, it won’t mean the Fed is “automatically aiming towards a complete wind-down,” Mr. Bernanke said. “Rather we would be looking beyond that to seeing how the economy evolves and we could either raise or lower our pace of purchases going forward. Again that is dependent on the data,” he said.

It’s OK, folks. Ben’s got this. Calm down.

After the scrambling was over and the 6% air pocket was safely navigated, the S&P 500 first regained and then surpassed its previous high. At this point, the Punditocracy (as my buddy Scott calls it) declared that any “taper” had now been priced in.

And there the story should have ended. Nothing to see here folks, get back to your couches.

But of course it didn’t end.

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.