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Archive for February 2014

Archive for February, 2014

Outside the Box: World Money Analyst Update on Europe

 

For the last two weeks on Thursdays we have brought you special editions of Outside the Box featuring World Money Analyst Managing Editor Kevin Brekke’s interviews with WMA contributing editors. We heard from Ankur Shah on emerging markets and Alexei Medved on Russia, and this week we wrap up the series with a frank, hard-hitting interview with Dirk Steinhoff, who covers the European and Scandinavian markets for WMA.

Kevin and Dirk are both based in Switzerland, and so they lead off with a discussion of the recent Swiss referendum on immigration. Dirk’s interpretation of the vote, which imposes quotas on the number of foreigners allowed to enter the country, is that it has implications for the entire European Union:

[T]he Swiss people basically decided that they want to control immigration themselves and do not want to give up this control to the centralized administration in Brussels. I think that this is a clear signal to the Swiss government that the Swiss people don’t want to give up more sovereignty and that they would like to see more decentralization in the future.

Which leads Kevin and Dirk to take up the broader issues of the unresolved Eurozone debt crisis, unemployment mess, and the fate of the euro. With EU parliamentary elections coming up in May, there is change in the air! OK, let’s turn it over to Kevin and Dirk for the details.

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

 

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World Money Analyst Update on Europe

World Money Analyst: With me today is Dirk Steinhoff. Dirk is a contributing editor at World Money Analyst and covers the European and Scandinavian markets. Great to have you with us.

Dirk Steinhoff: Thank you very much for having me.

WMA: Seeing that you’re in Zurich and I’m in Fribourg, let’s start with a look at developments in our own backyard. The Swiss are known for their system of direct democracy via use of the referendum. The recent success of a referendum that will restrict immigration into Switzerland made global headlines. What’s your position on the immigration issue and the consequences of this vote?

Dirk: First of all, I should mention that I was born and raised in Berlin and moved with my family to Switzerland in 2007. One of the main reasons why I decided to leave Germany and come to Switzerland, next to the great Swiss landscape, was the strongly centralized development of the European Union, which reminds me painfully of the political system in the former DDR [communist East Germany].

European politicians live a life that is completely detached from those that don’t belong to this elitist political class. Their decisions are based on distorted experience and lobbyist influence and not on real life experience and independent judgment. The strong, centralized power of Brussels, in combination with the desire to regulate everything in life, increasingly limits personal freedom, limits the development of entrepreneurship (and therefore the creation of non-government-related workplaces), and eliminates local, regional, and national characteristics.

The state is much less dominant in Switzerland, mainly due to its federalist and decentralized political system, which limits the power of the federal government. Due to my own background and my own moral conviction, I personally believe that every human being should be able to live and work wherever he or she wants, as long as they are self-reliant, willing to integrate, and do not become a burden to the community they recently entered.

My interpretation of the referendum is that the Swiss people basically decided that they want to control immigration themselves and do not want to give up this control to the centralized administration in Brussels. I think that this is a clear signal to the Swiss government that the Swiss people don’t want to give up more sovereignty and that they would like to see more decentralization in the future.

It also interesting to note that most of the media in Europe (even Swiss media) were shocked by the outcome of the vote. In sharp contrast, other polls in various European countries actually show that most citizens would have voted similarly to the Swiss, and some by an even higher margin than the outcome of the Swiss vote. I think that in the long run more and more of the European people will ask for the Swiss model of democracy to be implemented in their home countries.

Although the rhetoric used by politicians in Europe might change to the negative in the short term, I do not think that the referendum will have a long-term negative effect on the relations between Switzerland and Brussels. I believe that Brussels has to come to terms with our form of democracy and has to respect our sovereignty, even if they might disagree with some of our decisions.

WMA: The immigration debate is not unique to Switzerland, of course, and is a divisive issue across Europe. This seems to be part of a trend where we’ve seen a rise in popularity of nationalist and anti-euro parties? What’s your view?

Dirk: You are right. The severe criticism of Switzerland because of the outcome of the referendum has eclipsed the fact that many European countries face the same issue. People are not only unhappy with the immigration politics within the EU, they are becoming more EU skeptical in general.

The political parties critical of the European Union – like the UK independence party in Great Britain, the Finns Party (formerly the True Finns) in Finland, the Lega Nord in Italy, the FPÖ in Austria, the AfD in Germany, the French Front Nationale, the Golden Dawn in Greece, and the Party of Freedom in the Netherlands – are gaining popularity. Of course, the reasons for and the scope of their EU criticism vary a lot. 

I think this trend can be summed up as follows: the people want to have a voice and be able to decide their own fate! Pretty much everybody in the EU is unhappy about one issue or another. The Southern European countries are unable to cope with the austerity measures, and on the other hand you have a large part of the German population that is simply unwilling to continue financing the complete EU.  I believe this trend will gain momentum, and it will bring some surprises in the elections to the European Parliament in May 2014.

Europe has so many different cultures that centralization just doesn’t work, because there isn’t a one-size-fits-all answer to most issues. The euro is a perfect example of this!

WMA: That’s an important point on the euro. With the continued rise of anti-euro sentiment, what is your outlook for the currency? Will the euro survive?

Dirk: I don’t know. There are different scenarios that I can imagine for the euro: strong countries leaving the Eurozone, unwilling to pay for a bottomless pit of EU debt; weak countries leaving the Eurozone in order to be able to devalue their currencies and regain competiveness; or a split into a strong northern euro and a weaker southern euro. Or some combination of these. As you can see, there are many possibilities, and what we will see depends on economic and political developments in European countries over the next several years. In my view, something will happen and we won’t have the same euro in five years time that we have today.

WMA: The adoption of the common currency has limited how individual countries can respond to fiscal stresses. News about the euro debt crisis has been very quiet lately. What is the situation?

Dirk: As you say, there has hardly been any news recently regarding the troubles in the EU, which does not mean that the problems are solved. They are still bubbling under the surface. With the current papering-over and continuation of indebtedness, the need to address the problems, with their inherent negative consequences for most people, has been postponed. Because of that, most of the harsh protest has faded and turned away from the streets and is canalized into the euro-skeptic political parties. And when there have been noteworthy protests, such as last November in French Brittany, media coverage was excluded.

What has changed in the last year? Absolutely nothing fundamentally! So the euro crisis will at some point reappear with all its inevitable consequences.

WMA: You mention France, so let’s continue down that path. The small and mid-sized Eurozone countries – Spain, Portugal, Italy, and Greece – are essentially bankrupt as measured by GDP and in receivership by Brussels. Today, there is growing speculation that France, too, is headed for trouble soon. What do you think?

Dirk: I totally agree! They have too much debt, a radical socialist government, and absurd, business-unfriendly regulation. I have several friends who are business owners in France, and they are all contemplating leaving the country and moving their businesses abroad.  The quantity of regulation they have to comply with simply cannot be handled by a normal business, and the labor laws are so strict that no business owner in their right mind wants to take on the risk of employing someone.

Taking into consideration the unhealthy debt levels they have, the unsustainable social programs they offer, and the complete lack of any growth impulses, I have to believe that the French are indeed headed for trouble soon. And, as the second largest economy in the EU, France matters. If France stumbles, the EU is at risk.

WMA: Drawing on your comments about strict labor laws, the unemployment numbers in many EU countries are mind-boggling. You discussed this situation in your recent article for World Money Analyst. Can you talk about this for a minute?

Dirk: As we have seen since 2008, the trillions in newly created fiat money have mainly fueled asset bubbles. However, the real economy has not profited from it, because this money has not been lent to private industry. We are still facing 30% lower money velocity than before 2008 and that means that more than 30% of credit in circulation has disappeared. This is also why the real economy is still going down the drain.

Most jobs have been created within the government or government-related entities; and as we all know, these jobs are paid for by the taxpayers and are not a source of production. Therefore, I personally believe the situation in the labor market will further deteriorate, especially among the young generation, below 25; they are going to suffer the most. The current youth unemployment rates in Spain and Italy are just shocking: 58% and 42%, respectively. We are losing a whole generation, and we cannot predict how drastically the damage we are doing to them will play out in the future.

WMA: High and sustained rates of joblessness can lead to frustration and anger by the unemployed that turns to civil unrest and protests. We’ve seen riots in several EU countries, including France, Greece, and Bosnia. Is that also a real danger for the stronger European countries?

Dirk: Yes, this is a real danger. As soon as the deterioration of people’s personal economic situations reaches a certain level they will be on the streets, and that includes the streets of the stronger countries. At the moment, most people still believe that all the debt and all the rescue programs come for free.

WMA: What does this all mean for the outlook for European stocks and bonds?

Dirk: That you have to watch closely what the European Central Bank and governments do. It’s a tricky situation – you don’t want to miss any upside rallies in equities and bonds induced by loose monetary policies. Yet, on the other hand you know the party could end at any time. Risk management is essential.  The day of reckoning can be postponed by governments and central banks much further – as we know from the US and Japan – than common sense would allow for.

WMA: In your opinion, what European countries have the best economic outlook?

Dirk: The countries that have been strong in the past, with competitive industries and with sound current-account and budget balances. Countries like Germany, Austria, Denmark, Sweden, and Norway. And Switzerland. 

WMA: As you mentioned above, in May 2014 there will be the EU Parliament election. Will that change anything?

Dirk: The potential increase of parliamentarians that are critical of Europe I mentioned before could intensify tensions within the EU and complicate the functioning of the EU system. But I don’t expect a quick change.

WMA: We must talk about the un-loved Swiss franc. Since Switzerland began intervention in the currency markets to halt the rise of the franc against the euro, the mainstream consensus has it that the franc is doomed. But the performance of the franc against other currencies, in particular the US dollar, has been very strong. What’s your take on the Swiss franc going forward?

Dirk: It’s hard to say. In a euro crisis I would expect the Swiss National Bank [the central bank] to remove the floor to the euro. In such a situation the power of the SNB to keep the floor would be simply too small, I think. There are also attempts in Switzerland to once again constitutionally back the Swiss franc by gold. We’ll have to see. The Swiss franc, to me, still belongs to the upper class of paper currencies.

WMA: Do you have any last thoughts for our readers?

Dirk: Globally, we have entered a time when substantial corrections of past misadventures are likely to occur. It’s not the end of the world, but it’s worth being prepared.

WMA: I really appreciate your insights on the European markets. Thank you for taking the time to speak with us today.

Dirk: The pleasure was mine.

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Outside the Box: Buffett’s annual letter: What you can learn from my real estate investments

 

It does not hurt to be reminded once in a while about what it means to be a “true investor,” and who better to remind us than Warren Buffett? Today’s Outside the Box comes to us from the pages of Fortune magazine (hat tip to my good friend Tom Romero of Capital Research Partners, who is a pretty fair investor in his own right).

Fortune seems to have had the inside scoop on Mr. Buffett’s pronouncements over the years. I still keep some old Fortune magazines with interviews of Mr. Buffett to remind myself about the basics. For whatever reason I was up at 5 o’clock this morning and began reading this piece, and it functioned just as well as coffee as a wake-up call.

Warren starts off by telling us the stories of two relatively minor real estate investments he made, one in the ’80s and the other in the ’90s, but where he’s going is straight to the heart of some fundamental investing principles.

Most of us get all wrapped up, from time to time, in the daily or weekly movements of our investments; but Warren wants us to remember that “Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Easier said than done; but he’s right, of course. Now, it’s certainly OK dwell at length on the macroeconomic big picture, right? I mean, that’s half my fun most days! No, says Warren,

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)

So Warren wants our feet planted squarely on the field of play; he doesn’t want us up in the stands or, heaven forbid, watching the game on TV. And forget reading some commentator’s analysis of yesterday’s game or his take on the rest of the season!

Well, OK. So if this is the last Outside the Box or Thoughts from the Frontline you ever read, at least I got you this far, right?

But read on, and be sure not to miss Warren’s very pithy (and timely!) quotation from the late Barton Biggs.

And let me point out that when Warren suggests a future portfolio of 90% S&P index funds, he is talking about very, very long-term portfolio design and not something that retirees who need income or have a shorter-term focus (less than multiple decades) should be thinking about.

And to be fair, Buffet’s process of choosing which investments to put into his portfolio would not allow him to end up with very many components of the S&P 500. So I don’t share his bias against active management, though I have to agree that most of what passes for active management is problematic. But there is a lot we need to remember and ponder in Buffett’s Benjamin Graham old-style value investing.

I have never met the man, but I would like to. I think we might have more in common than some readers would imagine. Including hamburgers.

Today I’m flying to Los Angeles, where I will speak tonight and tomorrow for my partners at Altegris Investments. I am particularly looking forward to spending time with Jack Rivkin. I always learn a lot. Then I get on a plane to fly all the way across the country to Miami. I will be speaking for my close friend Darrell Cain at his annual conference as well as spending time with Pat Cox, who is going to come over from the West Coast of Florida. I hope to get a good part of this weekend’s letter done on the flight.

Then it’s on to Washington DC for a series of meetings. George Gilder is flying down from Boston and has offered to introduce me to a few of his friends, and I will do the same for him. We will hopefully be sitting down for a video in which we’ll discuss some mutually interesting ideas, as well as share a dinner or two where we’ll talk about a variety of policies with a few people who are perhaps in positions to do something about them.

Packing for a week in a variety of different climates is always an interesting process. And keeping up with my reading and writing and gym time and, most importantly, friend time will make for a very busy next seven days. You make sure you enjoy yourself. Now let’s see what Warren has to tell us about investing.

Your thinking a lot about portfolio strategy lately analyst,

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

 

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Buffett’s annual letter: What you can learn from my real estate investments

This story is from the March 17, 2014 issue of Fortune.

February 24, 2014: 5:00 AM ET

In an exclusive excerpt from his upcoming shareholder letter, Warren Buffett looks back at a pair of real estate purchases and the lessons they offer for equity investors.

By Warren Buffett

“Investment is most intelligent when it is most businesslike.”
–Benjamin Graham, The Intelligent Investor

It is fitting to have a Ben Graham quote open this essay because I owe so much of what I know about investing to him. I will talk more about Ben a bit later, and I will even sooner talk about common stocks. But let me first tell you about two small non-stock investments that I made long ago. Though neither changed my net worth by much, they are instructive.

This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath as in our recent Great Recession.

In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.

I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.

In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. Again, a bubble had popped – this one involving commercial real estate – and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.

Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.

I joined a small group – including Larry and my friend Fred Rose – in purchasing the building. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.

Income from both the farm and the NYU real estate will probably increase in decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.

I tell these tales to illustrate certain fundamentals of investing:

•You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”

•Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.

•If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.

•With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

•Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)

My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in determining the success of those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings, whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there – do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.

During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?

When Charlie Munger and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decision.

It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

I have good news for these nonprofessionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial. The goal of the nonprofessional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

That’s the “what” of investing for the nonprofessional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’s observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

If “investors” frenetically bought and sold farmland to one another, neither the yields nor the prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire Hathaway (BRKA) shares will be fully distributed to certain philanthropic organizations over the 10 years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s. (VFINX)) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.

And now back to Ben Graham. I learned most of the thoughts in this investment discussion from Ben’s book The Intelligent Investor, which I bought in 1949. My financial life changed with that purchase.

Before reading Ben’s book, I had wandered around the investing landscape, devouring everything written on the subject. Much of what I read fascinated me: I tried my hand at charting and at using market indicia to predict stock movements. I sat in brokerage offices watching the tape roll by, and I listened to commentators. All of this was fun, but I couldn’t shake the feeling that I wasn’t getting anywhere.

In contrast, Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. These points guide my investing decisions today.

A couple of interesting sidelights about the book: Later editions included a postscript describing an unnamed investment that was a bonanza for Ben. Ben made the purchase in 1948 when he was writing the first edition and – brace yourself – the mystery company was Geico. If Ben had not recognized the special qualities of Geico when it was still in its infancy, my future and Berkshire’s would have been far different.

The 1949 edition of the book also recommended a railroad stock that was then selling for $17 and earning about $10 per share. (One of the reasons I admired Ben was that he had the guts to use current examples, leaving himself open to sneers if he stumbled.) In part, that low valuation resulted from an accounting rule of the time that required the railroad to exclude from its reported earnings the substantial retained earnings of affiliates.

The recommended stock was Northern Pacific, and its most important affiliate was Chicago, Burlington & Quincy. These railroads are now important parts of BNSF (Burlington Northern Santa Fe), which is today fully owned by Berkshire. When I read the book, Northern Pacific had a market value of about $40 million. Now its successor (having added a great many properties, to be sure) earns that amount every four days.

I can’t remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would underscore the truth of Ben’s adage: Price is what you pay; value is what you get. Of all the investments I ever made, buying Ben’s book was the best (except for my purchase of two marriage licenses).

Warren Buffett is the CEO of Berkshire Hathaway. This essay is an edited excerpt from his annual letter to shareholders.

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Things That Make You Go Hmmm: Appetite for Distraction

 

… It was during the siege of Fort Sumter that the story I want to share with you takes place….

This story came to me from the pen of Jared Dillian, the very talented writer of an excellent publication called The Daily Dirtnap; and the moment I read it I knew I had to share it with my readers, because it illustrates perfectly something I have been talking to people about for years.

Readers can, and definitely should check out Jared’s fantastic work HERE; and to give you a taste of Jared’s enviable narrative prowess, I am going to let him tell you the story as he told it to me:

The Calhoun Mansion

Let me tell you again why I like gold and silver.

I was in Charleston two weekends ago for my mom’s birthday. We did a horse and carriage ride, a historical tour, around the city. I always thought those things were cheesy, but as it turns out, the horse and carriage tours are very highly regulated, the tour guides have to pass a series of knowledge exams and then take continuing education. I kid you not! Ours had been doing it for six years, and was good.

So as we went by the Calhoun Mansion on Meeting Street, the tour guide fella starts telling us about the house. It was built by a guy named George Walton Williams, who was the richest guy in town. This was back during the Civil War. It’s a 24,000 square foot mansion with 14 foot ceilings. It’s just monstrous. It cost $200,000 to build — back in the 1860s! So how did Mr. George Walton Williams make his money?

Well, as you probably know, Charleston is a port city, and during the War, the Union Navy blockaded the port and then bombarded the city for weeks and months, but during this time, there were these guys who were “blockade runners” who would sneak by the navy ships, bringing necessary supplies to the city, which was under siege. Blockade runners made a lot of money — five grand a trip sometimes — but you know who made even more money? George Walton Williams did.

He financed the blockade runners.

Williams was not the only one doing this, but he was the most successful, why? Because he insisted on being paid only in gold and silver. If you know your Civil War history you also know that there was a Confederate currency, and I don’t know if Mr. Williams had a particular view on the Confederate dollar, but at the conclusion of the war, the Confederate dollar collapsed, and everyone was left holding the bag — except for George Walton Williams.

Williams became like a J.P. Morgan character in the city — Charleston was the center of Southern finance, and Williams singlehandedly bailed out the Broad Street banks. He also built a pretty cool house.

Sorry to interrupt; I know you were enjoying Jared’s prose, but we’re just about to get to the point of this story, so I want to make sure everybody is paying close attention.

This next paragraph contains the fundamental principle of investing in gold and silver, which so few people genuinely understand — despite the multitudes of commentators expending countless thousands of words.

Hit ‘em between the eyes, Jared:

So these anti-gold idiots are just that, idiots, or else they have the memory of a goldfish, because currencies come and currencies go, as sure as night follows day. It is the natural order of things. And as you can see, it’s not about trading gold to get rich or getting long gold or buying one by two call spreads or getting fancy, it literally is about protecting yourself in the end. It’s not like Williams got rich. He just stayed rich. Everyone else got poor.

It’s not like Williams got rich. He just stayed rich. Everyone else got poor.

That’s it. Right there.

Thanks, Jared, I’ll take it from here.

Click here 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.

Thoughts from the Frontline: The Worst Ten-Letter Word

 

“Inequality has emerged as a major issue in the US and beyond. A generation ago it could reasonably have been asserted that the overall growth rate of the economy was the main influence on the growth in middle-class incomes and progress in reducing poverty. This is no longer a plausible claim.

“The share of income going to the top 1 per cent of earners has increased sharply. A rising share of output is going to profits. Real wages are stagnant. Family incomes have not risen as fast as productivity. The cumulative effect of all these developments is that the US may well be on the way to becoming a Downton Abbey economy. It is very likely that these issues will be with us long after the cyclical conditions have normalized and budget deficits have at last been addressed.”

– Lawrence Summers (in the Financial Times)

“Cyberpunk is a postmodern science fiction genre noted for its focus on ‘high tech and low life.’ It features advanced science, such as information technology and cybernetics, coupled with a degree of breakdown or radical change in the social order. ‘Classic cyberpunk characters were marginalized, alienated loners who lived on the edge of society in generally dystopic futures where daily life was impacted by rapid technological change, an ubiquitous datasphere of computerized information, and invasive modification of the human body.’”

– Lawrence Person (Wikipedia)

A new word is achieving ubiquity. The word has always been with us and at times has been a beacon to attract the friends of liberty and opportunity. But now I’m afraid it is beginning to be used as a justification for social and economic policies that will limit the expansion of both liberty and opportunity. The word? Inequality. More specifically, the word has become problematic when used in close proximity to the word income. There are those who believe that income inequality is the proximate cause of the Great Recession, if not the imminent demise of Western Civilization, pushing us into a dystopian world that will come to resemble the one depicted in the movie Blade Runner.

(Note: Blade Runner exemplifies a genre of science fiction called cyberpunk, defined above.)

This week we begin what will probably be a multi-week series on the subject of income inequality. Over the years, I’ve written many times about the lack of income growth for the middle class in the developed world. We have also looked at the growing spread between the top 1% or 5% or 10% and those further down the income scale. The widening spread is an undeniable fact. But what should be done about it? Do we take money from the more well-off, or do we increase opportunities for all? How do we increase opportunity without social expenditures for education and healthcare, and where will the money come from? What trade-offs do we get for the lost productivity and reduced savings that result from increased taxes? What institutional and policy barriers are there? These are all fundamentally important questions.

What spurred me to start this series was a recent paper from two economists (one from the St. Louis Federal Reserve) who are utterly remarkable in their ability to combine more bad economic ideas and research techniques into one paper than anyone in recent memory. Their even more remarkable conclusion is that income inequality was the cause of the Great Recession and subsequent lackluster growth. “Redistributive tax policy” is suggested approvingly. If direct redistribution is not politically possible, then other methods should be tried, the authors say.

So what is this notorious document? It’s “Inequality, the Great Recession, and Slow Recovery,” by Barry Z. Cynamon and Steven M. Fazzari. One could ask whether this is not just another bad economic paper among many. If so, why should we waste our time on it? And this week we’re actually not going to lay the paper out on the slab and dissect it; we’re just going to prepare for the post-mortem by getting up to speed on the issues it tries to address.

The problem is that the subject of income inequality has now permeated the national dialogue not just in the United States but throughout the entire developed world. It will shape the coming political contests in the United States. How we describe income inequality and determine its proximate causes will define the boundaries of future economic and social policy. In discussing the multiple problems with the paper, we have the opportunity to think about how we should actually address income inequality. And hopefully we’ll steer away from simplistic answers that conveniently mesh with our political biases.

I am pretty certain that by the end of the series I will have been able to offend nearly every reader, and some of you multiply. That’s OK – it means we’re thinking outside our boxes. I will admit to having been forced, of late, to change some of my more reflexively conservative positions with regard to the structural causes of income distribution trends and, even more importantly, the distribution of opportunity. It is the latter concept that should command our particular attention, and a fair distribution of opportunity should appeal to both libertarians (I more or less think of myself as one) and progressives.

The unfair distribution of opportunity is not an injustice that can be redressed simply by composing erudite paeans to free markets or social justice, even though politicians will try. The problem is far more complex than that. Are we in fact, as Larry Summers suggests, on the road to a Downton Abbey economy – or, even worse, a Blade Runner-like dystopia?

I should note that Professor Summers’ op-ed is a not entirely uneven discussion of the problem. “Given the widespread frustration with stagnant incomes, and an increasing body of evidence suggesting that the worst-off have few opportunities to improve their lot, demands for action are hardly unreasonable. The challenge is knowing what to do.” We will address Summers’ conclusions later in this series, but for now let’s think about how to approach the challenge of income inequality.

A quick search for the word inequality in Google Trends reveals that the general public is starting to take a lot more interest in the concept. Monthly searches for the word inequality have more than doubled in the past year or so. (Odd trivia fact: Indiana is the state with the highest search interest in inequality, ahead of college liberal Massachusetts.)

Of the underlying or related searches, income inequality is the most frequently searched term. It spiked to all-time highs after President Obama’s State of the Union address in January.

We have to take this data with a grain of salt, but it clearly shows that inequality is becoming a more popular search term. And if it is becoming a more popular search, that is clearly because people are thinking and talking about it a lot more. And if people are thinking and talking about the subject of income inequality a lot more, then my readers, who are by and large thought leaders in their respective worlds, have a serious responsbility to inform that discussion.

The fact that incomes of various segments of our society are diverging is not really disputable. There are many ways to sort for the reasons for income differentials, but one of the ways is by education level, where the income differences have become rather stark over the last 40 years. Note in the chart below that incomes for all segments of the population generally rose in tandem up until the beginning of the Information Age in the early ’70s, and then the disparity began to grow. Those with more education saw their incomes increase while those with less education saw their incomes fall.

As Summers noted, a rising share of GDP is going to profits as opposed to wages. This is a trend that started at the beginning of the last decade.

One other odd bit of information that I came across while researching this topic is that between 1979 and 2002 the frequency of long work hours (more than 50 hours a week) increased by 14.4 percent among the top quintile of wage earners but fell by 6.7 percent for the lowest quintile. And those extra hours translate into extra income. (You can see the NBER study here.) I don’t know about you, but my hours have significantly increased since 2002. Not sure that is relevant, but just saying.

Robber Barons

Let’s take a somewhat philosophical and less databased approach to income inequality. Mainstream economists and policy makers are still thinking of inequality through the lens of 19th and early 20th century experience, when robber barons like Carnegie, Rockefeller, and Vanderbilt supposedly lined their pockets by withholding reasonable wages from the working poor.

This is precisely what Larry Summers was getting at in this week’s Financial Times op-ed:

The share of income going to the top 1 percent of earners has increased sharply. A rising share of output is going to profits. Real wages are stagnant. Family incomes have not risen as fast as productivity. The cumulative effect of all these developments is that the US may well be on the way to becoming a Downton Abbey economy.

That thinking assumes that if income inequality is rising, the top 1% is getting richer at the expense of the working class, because it assumes production still heavily exploits the relatively unskilled labor that most Americans can provide through hard work. It does not discriminate between value-added labor and value-added information and innovation.

As I argued three weeks ago, the gains from the Information Age have been unevenly distributed throughout the economy. This is a structural problem in the sense that the productivity gains from the first two Industrial Revolutions are essentially thoroughly distributed through the economy. All workers saw their incomes increase along with increasing productivity for the 200 years of the Industrial Revolutions. Yes, entrepreneurs, innovators, and knowledge workers saw their incomes rise faster, but a rising tide of productivity lifted all boats.

The same phenomenon is playing out now in developing markets, where much of the basic infrastructure of industrial revolution is still being built. I would expect that the same income inequality issues would develop in those markets in conjunction with the full rollout of industrial revolution and the shift to a knowledge-based economy.

Another observation that I did not make three weeks ago but have subsequently come to embrace is that knowledge workers have indeed seen their incomes increase because of their ability to put their knowledge to work more productively. Goods-producing workers have by and large not seen much rising productivity in the last 30 years due solely to their work and thus have not seen an increase in their incomes. To the extent that workers have skills, their incomes rise.

(Please. I get that it is more complicated than this. Increased foreign competition for lower-skilled jobs and the bursting of two major bubbles have also put a dent in US incomes.)

That being said, the top 1% is getting richer either by (1) allocating capital to the right places (which all right-thinking people want to see happen), or (2) by employing skills that most of the American work force does not have – because production increasingly depends on the hard work of creative workers with hard-earned skills gained through education and experience.

Today, a much smaller percentage of our labor force is responsible for a much greater percentage of economic output. Their wages are rising because their productivity is rising.

The trouble with conventional wisdom about income inequality is that it is so fails to factor in productivity and the sources of productivity.

While populist politicians, mainstream economists, and envious market watchers would like to brand billionaire inventors like Tesla CEO and PayPal Founder Elon Musk, Facebook CEO Mark Zuckerberg, or eBay cofounder Pierre Omidyar as modern-day robber barons, they haven’t really robbed anyone. The emerging class of billionaires is creating value that did not exist before they arrived, and they’re doing it with relatively small teams of highly skilled knowledge workers. And they deserve every penny they earn.

On the flip side, a growing majority of our labor force is responsible for a much smaller percentage of economic output. Their wages are stagnant because more people are competing for a shrinking number of jobs.

The World’s First Trillionaire

I have brought to your attention before a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. It’s not directly about investing, although he touches on that subject. Rather, it’s about chaos theory, complexity theory, and critical states. It is written in a manner any thoughtful layman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies.

Buchanan talks about power laws and critical states. He wraps up his opening chapter like this:

There are many subtleties and twists in the story … but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I’ve mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before.

Now, let’s think about this for a moment. I’ve written about the sand pile game where researchers created a computer simulation of the sand piles that we built as kids at the beach. In their simulation of the sand pile, they found that as the number of grains of sand involved in an avalanche doubled, the likelihood of an avalanche was reduced by 2.14 times. We find something similar with earthquakes. In terms of energy, the data indicate that earthquakes become four times less likely each time the energy they release is doubled. Mathematicians refer to this as a “power law,” a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

As I noted a few weeks ago in Outside the Box, we are indisputably living through the greatest era in human history. Humanity is immeasurably richer than it was 100 or 50 or even 20 years ago. And along with everyone getting richer, we’ve seen a rising number of super-rich. But as the Huffington Post noted a few weeks ago, even the super-rich are getting left behind by the uber-rich.

Eighty-five people have as much money as do the poorest 3.5 billion. The top 1% have almost half the liquid wealth that has been accumulated in the world. There are 1,426 known billionaires, and gods know how many additional kleptocrats and people who have managed to maintain some semblance of privacy.

I’ll bet you a great dinner at your favorite restaurant that the distribution of the world’s wealth very clearly follows a power law similar to the one that describes the distribution of earthquakes and other phenomena. (There is an economics paper in there somewhere. Send it to me when you’ve written it!)

Thought experiment: if world GDP grows at 3% compounded for the next 100 years, world gross domestic product will be 16 times greater than it is today. That’s simple math. But if the future is anything like the past, the distribution of that enormous increase will not be even throughout the population. Not everybody will be 16 times richer, and some people will be fabulously richer. Unbelievably richer. Off-the-charts and mind-bendingly richer.

Someday, and with the real possibility of its happening in our lifetimes, we will see the world’s first trillionaire. This week we awakened to the fascinating story of WhatsApp cofounder Jan Koum selling his company to yet another of the elitist uber-rich, Mark Zuckerberg, founder of Facebook. Theoretically, the 37-year-old Koum walks away with about $6.9 billion – after starting out as a refugee from Kiev some 20 years ago, living on food stamps. He created this fabulous wealth with a partner and less than 70 employees in just a few years on the strength of an idea, a lot of chutzpah, and venture capital from the very firm that Zuckerberg spurned less than 10 years ago (Sequoia Capital – and that in itself is a great side story you can learn about on Google).

Of course that is not yet $1 trillion, but that is not how we get to the world’s first trillionaire. Many of the young men and women who are billionaires today are going to be living to the end of this century. What if a few of them are able to compound their wealth at 6%, 8%, or even 10% a year? Below is a chart of what Jan Koum might see his wealth become if he were inclined to continue the chase.

Zoum has almost as much net worth today as Elon Musk, founder of PayPal and Tesla Motors ($10 billion). As noted above, there may be as many as 2,000 billionaires in the world, with more being created every day. I can think of half a dozen ideas that could generate more than $10 billion for their creators. A cure for cancer could easily be worth $100 billion. A new, clean, localized energy source could create multiples of that. There are already five family groups with over $50 billion each. At 6% compound returns they could top $1 trillion within 50 years, although several are giving away most of their wealth.

The point? It is not a matter of whether someone will be worth $1 trillion or whether they even deserve it. It is simply going to happen at some point. Quite frankly, I don’t care. I hope they take their capital and put it to productive uses that make the world richer and a better place to live while they themselves are getting fabulously rich. As long as they do it on an even playing field, “good on them.”

Income inequality is not going away. Visually, and given the realities of the unfolding Age of Transformation, we may even see greater disparities.

I do agree with Summers on one point: “It is very likely that these issues will be with us long after the cyclical conditions have normalized and budget deficits have at last been addressed.”

What else can we expect as long as we continue to rely on a 20th century education system to equip 21st century workers? When we allow crony capitalism to create an unequal playing field with special benefits for some? When businesses successfully lobby to create barriers to entry for future competition so that they can maintain their profits without having to compete? When we give tax benefits that help a relative few so that we are forced to tax those who are productive at ever higher rates?

Instead of obsessing over the rising income inequality that has always accompanied great periods of innovation (it took decades for the first and second Industrial Revolutions to be reflected in productivity numbers as well as overall wages), Larry Summers, Paul Krugman, and other “big league” mainstream economists should be advising President Obama, the House, the Senate, and every voter who will listen about the importance of aggressive reforms in education, entitlements, and tax/regulatory policy.

They should be asking why knowledge workers are moving ahead, while more of the labor force is left behind. And they should be formulating policies that can empower and encourage more unskilled workers (or workers with outdated skills) to become highly skilled knowledge workers in the coming decades. But such questions don’t suit their political agendas. These are not questions with easy answers. They demand hard work not only on the part of politicians, but also from the people wanting the benefits. The Age of Transformation will require constant education and updating of skills.

There is no way for a government to protect its citizens from increasingly accelerating change without ultimately destroying the benefits delivered by that change. The focus has to become on how to help people adapt and prosper in an environment of unremitting change. What sort of government and what economic policies will foster an environment that increases productivity and income for everyone?

Next week we will in fact get to the actual economic paper which kick-started me into this line of thinking, and we’ll also look at a remarkable study which shows that income mobility in the United States is still roughly where it was 40 years ago. As I will point out, that’s not good enough. Many countries (such as Denmark) do much better, and perhaps we should learn why and how. We will learn that trying to stimulate demand may not be the best monetary policy, and in fact it may be producing the actual environment in which income inequality is increasing. Ideas have consequences, and bad ideas typically have bad consequences. But all that’s for next week.

Houston, Los Angeles, Miami, Washington DC, Argentina, South Africa, San Diego, Brussels, and Geneva

I’m enjoying my longer than usual respite from travel, but tomorrow I will see my schedule pick up aggressively. I will be in Houston tomorrow night, then back home for a day before I go to Los Angeles, then fly cross-country to Miami for a speech for my friend and partner Darrell Cain. Then we’ll enjoy a fabulous Saturday evening soirée on the beach, when Patrick Cox, editor of Transformational Technology Alert, will come over from the West Coast of Florida for the evening to join us.

From Miami I will head to Washington DC for a few days of meetings. Then it’s back home for almost two weeks before I head to Argentina for a few weeks. (Those of you interested in learning more about what’s going on in Argentina and at La Estancia de Cafayate, where I’ll be spending close to two weeks in the second half of March, might enjoy an article David Galland recently penned (he is such a beautiful writer), entitled “Argentine Diary: A Day in the Life on the Front Lines of a Crisis.”

From Argentina I’ll fly more or less directly to South Africa for a week. I’ll spend the first few days at a game resort and then jump into a speaking tour that will take me to Cape Town, Durban, and Johannesburg at the behest of Glacier by Sanlam, a very-full-service financial firm. I am looking forward to that trip.

After that, I am home for a little over two weeks before I head out to Brussels and Geneva (and perhaps another European city or two) and then head back home to prepare for my Strategic Investment Conference in San Diego, May 13-16. This is a fabulous conference, and you really should make plans to attend.

One of the people I will be meeting in DC is my old friend George Gilder. I was talking to him yesterday about schedules, and he noted that he came really close to not being able to … stay on schedule. It seems he was involved the day before in a head-on collision that totally destroyed both cars, but everyone in the cars walked away due to air bags and the marvelous collapsing design of recent-vintage cars. I am grateful for that new technology, because we need minds like George Gilder around for a lot longer to help us think about how to deal with the age of accelerating change. Not to mention that I would miss him personally. DC is shaping up to be an interesting few days, and I will report back to you.

It is time to hit the send button. I really do have to get a better handle on the timing of my trips. I will be leaving Dallas when the weather is perfect but have nothing scheduled for August when 100° days are typical. But then that is why God invented air conditioning. Have a great week!

Your wondering how his kids will adapt analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

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Outside the Box: World Money Analyst Update on Russia

 

In last week’s special Thursday edition of Outside the Box, World Money Analyst Managing Editor Kevin Brekke interviewed WMA contributor Ankur Shah on emerging markets, but they didn’t touch on one very important emerging market: Russia. So this week I have brought Kevin back to sound out the views of Alexei Medved, WMA’s Russia and CIS contributing editor.

And right off the top, Alexei tells us two significant and surprising things about the Russian market:

One should look at investing in Russia from at least two time perspectives: long term, meaning 10-plus years, and a medium time horizon of 1-3 years.

Long term, Russia is still the best-performing major stock market in the world for the period 2000–2013, when measured in US dollars against the major market indexes. It is well ahead of not only all developed markets, but also the markets in China, Brazil, and several other emerging markets that were and are much more a centre of attention by Western media and investors. This long-term outperformance was achieved despite the fact that 2013 was not a good year for Russian equities, with the RTS Index down 5% in 2013.

Medium term, the Russian market remains the most undervalued. The average P/E is about 4.5, significantly below other emerging markets and way below the multiple on shares in the developed markets.

Needless to say, there are challenges with investing in Russia, too; and Alexei and Kevin cover them thoroughly. If you have wondered about Russia – or for that matter the markets of emerging and developed countries anywhere else in the world – you really should tune in to World Money Analyst.

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

 

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World Money Analyst Update on Russia

World Money Analyst: I am very pleased to speak with Alexei Medved. Alexei is the Russia and CIS contributing editor at World Money Analyst, and I caught him at his office in London. Thank you for joining us today.

Alexei Medved: My pleasure, thank you for inviting me.

WMA: As you and I have discussed before, Russia remains a little-understood market for many Western investors. Can you talk a little about the investment backdrop for Russia?

Alexei: One should look at investing in Russia from at least two time perspectives: long term, meaning 10-plus years, and a medium time horizon of 1-3 years.

Long term, Russia is still the best-performing major stock market in the world for the period 2000–2013, when measured in US dollars against the major market indexes. It is well ahead of not only all developed markets, but also the markets in China, Brazil, and several other emerging markets that were and are much more a centre of attention by Western media and investors. This long-term outperformance was achieved despite the fact that 2013 was not a good year for Russian equities, with the RTS Index down 5% in 2013.

Medium term, the Russian market remains the most undervalued. The average P/E is about 4.5, significantly below other emerging markets and way below the multiple on shares in the developed markets.

WMA: How has the Russian market held up so far this year, with emerging markets under pressure?

Alexei: Since the start of this year, the Russian market has underperformed other markets, down 8% in US dollar terms. This, to a large extent, could be explained by a noticeable decline of the ruble against the US dollar (-5.5%).

As you know, so far this year many emerging markets and emerging market currencies have been punished significantly, as Western institutional investors became worried about macroeconomic pressures in some of the emerging economies, like Turkey and Argentina. These countries have problems that are real and serious: too much external debt, a trade deficit, a budget deficit, declining foreign currency reserves, etc. So, it is understandable why foreign investors withdrew a lot of money from these markets recently.

What is hard to understand is why they also withdrew significant amounts of money from the Russian market. In my view, it is primarily because most investors continue to view emerging markets as a single class of investments. So, when they withdraw money they do it across the board, in all emerging markets. This is generally not the best approach. In contrast, investors do not approach developed markets as a single class, but differentiate between the countries.

WMA: Using your examples of Turkey and Argentina, how does Russia compare in terms of the macro picture?

Alexei: The macroeconomic position of Russia is vastly different from that of Argentina or Turkey. For starters, Russia has a positive trade balance and a balanced budget, unlike these and many other emerging and developed countries. Russia also has a very low debt load, with the ratio of external government debt-to-GDP around 10%, much lower then the roughly 95% in the US and even higher in some European countries. Further, the unemployment rate in Russia is around 5.5%, meaning the country is essentially running at full employment.

The unrefined “sell everything that’s emerging” approach apparently in play by Western institutional investors has led to the Russian market being unjustifiably punished. The good news is that the punishment has created even better investment opportunities for investors who can avoid “heard mentality.” There are solid, profitable Russian companies that are trading today at very low valuations.

WMA: One of your areas of expertise is the use of short-dated, US-dollar-denominated Eurobonds to capture higher yield and manage risk. Can you explain this strategy a little for our readers?

Alexei: Of course. I think Russia and the CIS also present a good opportunity for fixed income investors. Given my serious worries about a possibility of rising inflation and yields in developed markets, we recommend investing only in relatively short-term bonds (under 4 years). Our [Alexei's independent business] weighted portfolio maturity is now under 2 years. One can either invest in Russian sovereign debt or the safest corporate bonds and receive somewhat higher yields than in comparable developed-economy bonds. Investing in bonds that do not have an investment grade rating from one of the major rating agencies is another option.

Based on our local knowledge, we particularly like some high-yield bonds where we have a decent understanding of the company and believe that the bonds will be repaid, despite fairly low ratings from the credit agencies. This way, we invest in bonds that offer 10%-12% yields.

WMA: Switching to issues of politics and governance, many observers are concerned about issues of corruption in Russia, making it difficult for an investor to navigate the market. Has the current government embraced reforms on this?

Alexei: Obviously, one has to be very careful when considering investing in Russian equities or bonds. For investors that lack knowledge about the country, I do not recommend they attempt a do-it-yourself approach to selecting Russian shares. A better approach is to either invest through an index fund or to seek share selection advice from people who specialize in the Russian market on a day-to-day basis. This is in spite of the fact that over the last decade, Russia to some extent became much more investable.

Back to your question, corporate governance has generally improved, although perhaps not as much as some investors would like. The government is taking steps in this direction, yet a lot remains to be done. As Russia recently became a full member of the World Trade Organization (WTO), and its market is opening up to external competition, Russian companies will have to become more efficient to compete, and thus more profitable for investors.

Many investors have yet to wake up to the reality that Russia is a serious global player that’s here to stay. This opens up even more opportunities for investors.

WMA: The January issue of World Money Analyst highlighted the importance of taking a longer view on markets and investments, something that you and I agree on. You’ve made some great recommendations at WMA, and recently advised to take profits on two stocks that were held for a year or longer. Can you briefly go over these trades?

Alexei: Yes, as I said earlier, one has to look at these opportunities on a medium- to long-term investment timeline and not attempt to trade these markets, as one’s investments can get unjustifiably punished, as is happening now. We have been active in the Russian market for over 20 years and certainly maintain such an approach when we look at investments to recommend to our clients. Once the investment is made, we monitor it on a constant basis, as one cannot just “salt it away.” Once the shares reach our target price, we sell them and move on to the next opportunity.

In the January 2014 issue of WMA, I recommended taking profits on two positions. The first was the shares of Russian airline Aeroflot, recommended in the January 2013 issue. By January 2014, its shares had moved up nicely on the back of stellar company operating results. We advised to sell the shares and realized an 84% gain, including the dividend, in 12 months.

The second was the shares of AFK Sistema, a large-cap (US$18 billion) company that restructured itself from a conglomerate into essentially a private equity fund. I recommended its GDRs in the July 2012 issue. By January 2014 the shares had moved up significantly, and I advised to sell in that month’s issue of WMA. We pocketed a total return of 63% in 18 months.

These returns are particularly remarkable against a negative 5.6% return of the

Russian RTS Index in 2013. While we still like both of these shares, their significant appreciation had reached our price targets, so it was time to cash in some chips. And seeing that these shares are now trading lower, we got out at the right time and preserved the investors’ profits.

WMA: We can’t talk about Russia and not mention the ruble. Investing in certain currencies – like the Canadian dollar and Norwegian krone – has been in vogue for several years on the premise that these are “resource currencies” supported by the natural resource wealth of the issuing country. With Russia’s vast mineral and commodity wealth, should we consider the ruble a commodity currency?

Alexei: Given that Russia is a large producer of oil, gas, and some other commodities, to some extent the ruble should be seen as a commodity currency, perhaps even a petrocurrency. So, if one believes that the oil price is likely to decline significantly and stay low for years to come, one should not buy Russia. However, if one believes that the oil price trend is flat to up in the medium and long term, Russia will do well macroeconomically. 

WMA: Next to the emerging markets, another big issue is developments in Ukraine. You have covered Ukraine for World Money Analyst subscribers. The country seems to be caught in a conflict about alliances: to enter into a closer economic alignment with Moscow, or shift to stronger ties with the EU. What are your thoughts on this and the investment implications for Ukraine?

Alexei: It is very sad that the situation in Ukraine has deteriorated as far as it has. Some lives have been lost. Ukraine is torn between the current government that is leaning towards the Customs Union with Russia, and a large proportion of the population, perhaps a majority, which would support a closer cooperation with the EU.

Ukrainians are also fed up with perceived government corruption and diminishing civil liberties in the country. In December, Russia provided a US$15 billion rescue package to Ukraine and immediately disbursed US$3 billion. It remains to be seen which way the current situation will be resolved.

However, there are some corporate bonds in Ukraine that should be relatively immune to this political turmoil. One of the companies we like in Ukraine is MHP, the largest chicken meat producer in Europe. The company is fairly insulated against possible further depreciation of the local currency, as it sells 37% of its products abroad. After the recent sell-off in Ukrainian bonds, one can buy the Eurobond of MHP priced in US$ with a maturity in April 2015 and a yield-to-maturity of 10.6%. Such a high yield on short-dated paper is very hard to find elsewhere.

WMA: Any final thoughts for investors about the opportunities in Russia?

Alexei: The latest sell-off of Russian shares represents an opportunity to buy quality companies at discount prices. Today, we can see compelling value in world-class companies with assets not just in Russia but globally (including the USA), good corporate governance, and nice dividends. In short, I agree with Warren Buffet: “Buy when others are fearful.”

WMA: Alexei, thank you for sharing your valuable insights into the dynamic Russian market.

Alexei: You are welcome. My pleasure.

Learn more about World Money Analyst here.

Outside the Box: Notes to the FOMC

 

Janet Yellen, the new Fed chair, has her admirers and her detractors. One unabashed admirer is my good friend David Zervos, Jefferies’ chief market strategist, who during the past several months has taken to hollering “Dammit Janet, I love you!” He was at it again yesterday:

Last week was certainly a week for the lovers. Q’s broke to new cyclical highs, spoos moved to within just a few points of all time record highs, and Friday was St. Valentine’s day! It was all about LOVE, LOVE and LOVE! But for those folks still hiding out in the HATER camp – those who probably spent Friday evening watching Blue Valentine, War of the Roses or Scenes from Marriage – last week must have felt more like a St Valentine’s day massacre. These folks, and their econometrically deceitful overlay charts of 1927-1929 vs 2012-2014, were shredded by our new goddess of pleasure, beauty, love and of course easy money – Janet “Aphrodite” Yellen. She gave the haters a taste of the Hippolyos treatment!! And once again it was a triumph of love over hate!!

Janet delivered the perfect message for markets. Her focus on underemployment was unquestionable. Her commitment to eradicate joblessness via the power of monetary policy was also unwavering. And for anyone who thought she would be hawkish, or even middle of the road, this speech was a wake up call. The reality is that we are dealing with a die-hard Keynesian dove! It’s really not that complicated.

That said some folks seem to think the rally was mostly a function of the data. Weak ISM, payrolls, retail sales and IP were apparently the drivers of a 5 percent rally off the lows. Pullease!! That is preposterous. The reality is the market was jittery (and downright freaky) into the Fed chairmanship transition. Risk was pared back by folks who began to incorrectly price in a surprise from Janet! And leverage induced illiquidity created an overshoot to the downside. Weak hands sold, and all the usual haters came out of their bunkers to once again warn of impending doom. But as per the norm, their day in the sun was short-lived. The dust has settled and the haters lost again! Love is in the air my friends, and we owe a great deal of thanks to our new goddess of easy money. Dammit Janet, I love you! Good luck trading.

Take note of this phrase: “the new Goddess of Easy Money.” It is now in the lexicon. I wonder how many virgins will be sacrificed to this new deity. (Just kidding, Janet!)

Now, David is not above having a bit of fun in his always-entertaining commentaries, but for a somewhat more substantial take on the opening of the Yellen era, I suggest we turn to John Hussman. I wouldn’t call John a Yellen detractor, exactly, but he is certainly inclined to take the Fed down a notch or three. Check out these zingers:

While we all would like to see greater job creation and economic growth, there is little demonstrated cause-and-effect relationship between the Fed’s actions and the outcomes it seeks, other than provoking speculation in risk-assets by depriving investors of safe yield….

[T]he “dual mandate” of the Federal Reserve is much like charging the National Weather Service to balance the frequency of sunshine versus rainfall….

The FOMC should be slow to conclude that monetary policy is what ended the credit crisis…. The philosophy seems to be “If an unprecedented amount of ineffective intervention is not sufficient, one must always do more.”

At present, U.S. equity valuations are about double their norms, based on historically reliable measures.

The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield.

I think John would agree with me that the current economic theory driving our monetary policy is both inadequate and outdated. Is it any wonder that he concludes that monetary policy as it is practiced today is simply part of the problem? It is as if we are trying to fly a 747 using the knowledge and skills we learned while driving a car, and all the while looking in the rearview mirror. (Do those things have rearview mirrors?)

You can find John’s “Weekly Market Comment” and other valuable analysis at the Hussman Funds website.

This weekend I will be writing about some of the recent analysis concerning income inequality. I’ve actually been thinking a lot about it in conjunction with the rise of the Age of Transformation. I think about it a lot, most personally in terms of my own seven kids. I’m not so concerned about income inequality as I am about income opportunity. It seems to me that we have an education system that was designed to meet the needs of the US and the Second Industrial Revolution that was grown atop the industrial British Empire.

We are simply not preparing most of our children for the challenges that lie ahead. Many of course are going to do quite well, but that will be in spite of the educational process, not because of it. The complete higher-academic and bureaucratic capture of the educational process is as much at the root of income inequality as the other usual suspects are. There is more than one cause, and another root is the manipulation of capitalism and free markets by vested interests.

But that’s all too serious, because now it’s time to hit the send button and think hard about an Italian dinner and the Miami Heat being in town. Even if Lebron James is on the other team, he is simply a pleasure to watch. Lebron, you should’ve come to Dallas to play with Dirk!

Your getting ready to sit courtside analyst,

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

 

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Notes to the FOMC

John P. Hussman, Ph.D.

The following are a few observations regarding Dr. Yellen’s testimony to Congress. The objective is to broaden the discourse with alternative views and evidence, not to disparage FOMC members. We should all hope that Dr. Yellen does well in what can be expected to be a challenging position in the coming years.

  1. While we all would like to see greater job creation and economic growth, there is little demonstrated cause-and-effect relationship between the Fed’s actions and the outcomes it seeks, other than provoking speculation in risk-assets by depriving investors of safe yield. That’s essentially the same M.O. that got us into the housing crisis: yield-starved investors plowing money into mortgage-backed securities, and Wall Street scrambling to create “product” by lending to anyone with a pulse. To suggest that fresh economic weakness might justify further efforts at quantitative easing is to assume a cause-and-effect link that is unreliable, if evident at all, and to overlook the already elevated risks.
  1. In this context, the “dual mandate” of the Federal Reserve is much like charging the National Weather Service to balance the frequency of sunshine versus rainfall. If Congress was to require the Federal Reserve to change itself into a butterfly, it would not be the fault of the Federal Reserve to miss that objective. Moreover, what is absent from nearly every reference to the dual mandate is the phrase “long run” that is repeatedly included in that mandate. It seems probable that the cyclical response to economic weakness following the 2000-2001 recession – suppressing safe yields in a way that encouraged yield-seeking and housing speculation – was largely responsible for present, much longer-term difficulties.
  1. The FOMC should be slow to conclude that monetary policy is what ended the credit crisis. The main concern during that period was the risk of widespread bank insolvency, resulting from asset losses that were wiping out the razor-thin capital levels at banks. In the first weeks of March 2009, in response to Congressional pressure, the Financial Accounting Standards Board changed accounting standards (FAS 157) to allow “significant judgment” in the valuation of assets, instead of valuing them at market prices. That change coincided precisely with the low in the financial markets and the turn in leading economic measures. By overestimating the impact of its actions, the FOMC may underestimate the risks. The philosophy seems to be “If an unprecedented amount of ineffective intervention is not sufficient, one must always do more.”
  1. At present, excess reserves in the U.S. banking system amount to $2.4 trillion – more than double the total amount of demand deposits in the U.S. banking system, far more than all commercial and industrial loans combined, and 25% of total deposits in U.S. banks. Short term interest rates have averaged less than 10 basis points since late-2009, when the Fed’s balance sheet $2 trillion smaller. Based on the tight relationship between monetary base / nominal GDP and short-term interest rates, it is evident that even an immediate and persistent reduction in the Federal Reserve’s balance sheet of $20-25 billion per month would be unlikely to result in even 1% Treasury bill rates until 2020, absent much higher interest on reserves. The FOMC has done what it can – probably too much. A focus on the potential risks of equity leverage (where NYSE margin debt has surged to a record and the highest ratio of GDP in history aside from the March 2000 market peak), covenant lite lending, and other speculative outcomes should be high on the priorities of the FOMC.
  1. Dr. Yellen suggests that equity valuations are not “in bubble territory, or outside of normal historical ranges.” The historical record begs to differ on this. The first chart below reviews a variety of reliable valuation measures relative to their historical norms. The second shows the relationship of these measures with actual subsequent 10-year equity returns. With regard to alternate measures of valuation such as price/unadjusted forward operating earnings, or various “equity risk premium” models, it would be appropriate for the FOMC to estimate the relationship between those measures and actual subsequent market returns. Having done this, the spoiler alert is that these methods do not perform very well. In contrast, the correlation between the measures below and actual subsequent 7-10 year equity returns approaches 90%. At present, U.S. equity valuations are about double their norms, based on historically reliable measures.

The chart below shows how these measures are related with actual subsequent 10-year total returns in the S&P 500. The specific calculations are detailed in a variety of prior weekly comments (the price / revenue and Tobin’s Q models are straightforward variants of the others).

  1. Finally, when confronted with the difficulties that quantitative easing has posed for individuals on fixed incomes, Dr. Yellen asserted that interest rates are low not only because of Fed policy, but because of generally lackluster economic conditions. This argument is difficult to support, because there is an extraordinarily close relationship between the level of short-term interest rates and quantity of monetary base per dollar of nominal GDP (see the chart below). With regard to long-term interest rates, it’s notable that the 10-year Treasury yield is actually higher than when QE2 was initiated in 2010, and is also higher than the weighted average yield at which the Federal Reserve has accumulated its holdings. In order to restore even 1% Treasury bill yields without paying enormous interest on reserves, the Fed would not only have to taper its purchases, but actively contract its balance sheet by more than $1.5 trillion.

 

The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield. Importantly, one should not equate elevated stock prices with aggregate “wealth” (as higher current prices are associated with lower future returns, but little change in long-term cash flows or final purchasing power). Rather, the effect of QE is to give investors the illusion that they are wealthier than they really are. It is certainly possible for any individual investor to realize wealth from an overvalued security by selling it, but this requires another investor to buy that overvalued security. The wealth of the seller is obtained by redistributing that wealth from the buyer. The constant hope is to encourage a trickle-down effect on spending that, in any event, is unsupported by a century of economic evidence.

The risks of continuing the recent policy course have accelerated far beyond the potential for benefit. The Fed is right to wind it down, and as it does so, the FOMC should focus on addressing the potential fallout from speculative losses that to a large degree are now unavoidable. Ultimately, the U.S. economy will be best served by a return to capital markets that allocate scarce savings toward productive investment rather than speculative activity. The transition to that environment will pose cyclical challenges, but is well worth achieving if the U.S. economy is to escape the grip of what is now more than 15 years of Fed-enabled capital misallocation.

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© 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
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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.

The article Outside the Box: Notes to the FOMC was originally published at mauldineconomics.com.

Thoughts from the Frontline: The Economic Singularity

 

I fully intended to write today about a recently released academic paper that illustrates nearly every bad idea currently being bandied about in the field of economics. The insidious part is that the paper is considered mainstream and noncontroversial. Simply reading it required me to up my blood pressure medicine dosage. It is going to take me a little longer to finish that letter, and I realized that it needs a certain setup – one that coauthor Jonathan Tepper and I conveniently wrote a few months ago and included in the book Code Red.

So next week we’ll take a deep dive into the most dangerous economics paper written in a long time (that is perhaps only minor hyperbole on my part); but today, by way of setup, let’s think about central banks and liquidity traps and see if we agree that central bankers are driving the car from the back seat based upon a fundamentally flawed theory of how the world works. That theory helped produce the wreck that was the Great Recession and will have its fingerprints all over the next one. So this week we’ll have a preliminary round before putting on the sparring gloves next week.

Here is a part of chapter 7 from Code Red. By the way, the book has done very well and is getting great reviews, with 49 readers giving us five stars. And three people who apparently didn’t read the book gave it one star anyway. Check out the reviews on Amazon.

The 2014 Strategic Investment Conference: Investing in a Transformational World

But before we turn to the chapter, I want to note that this year for the first time we are not requiring Strategic Investment Conference attendees to be accredited investors. A change of venue that gives us a little more room and a shuffling of the speaking schedule allow us to open the event to everyone. If you are from outside the United States, you will not have as much trouble getting accepted into the conference as you may have encountered in the past. I am really excited about this change and hope that we have a significant contingent of non-US citizens at the conference. The speaker lineup is certainly international in breadth.

We sent out a note earlier this week encouraging you to register for the Strategic Investment Conference, which is coming up in mid-May. This is our 11th conference (cosponsored by Altegris Investments), and it will be our biggest and most comprehensive yet. Our attendees regularly say it is the best investment conference they attend anywhere. Click on this link to learn more. Rather than simply listing the names as we normally do, I have provided a little color about who the speakers are and what we can expect to hear. Register now to get the early-bird discount, which lasts for only a few more days.

Stuck in a Liquidity Trap

From Code Red, by John Mauldin and Jonathan Tepper

Like a car, an economy has lots of moving parts; everyone thinks they know how to drive it when they’re in the back seat; and it crashes too often. But on a more serious note, the analogy of a car works especially well when you think of where large parts of the global economy are.

Today central banks can make money cheap and plentiful, but the money that is created isn’t moving around the economy or stimulating demand. They can step on the accelerator and flood the engine with gas, but the transmission is broken, and the wheels don’t turn. Without a transmission mechanism, monetary policy has no effect.

This has not always been the case, but it is today. After some credit crises, central banks can cut the nominal interest rate all the way to zero and still be unable to stimulate their economies sufficiently. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning). The Great Financial Crisis plunged us into a liquidity trap, a situation in which many people figure they might just as well sit on cash. Many parts of the world found themselves in a liquidity trap during the Great Depression, and Japan has been stuck in a liquidity trap for most of the time since their bubble burst in 1989.

Economists who have studied liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy. In fact, if you look recessions that have happened after debt crises, growth was almost always very slow. For example, a study by Oscar Jorda, Moritz Schularick, and Alan Taylor found that recessions that occurred after years of rapid credit growth were almost always worse than garden-variety recessions.

One of the key findings from their study is that it is very difficult to restore growth after a debt bubble. Central banks want to create modest inflation and thereby reduce the real value of debt, but they’re having trouble doing it. Creating inflation isn’t quite as simple as printing money or keeping interest rates very low. Most Western central banks have built up a very large store of credibility over the past few decades. The high inflation of the 1970s is a very distant memory to most investors nowadays.

And almost no one seriously believes in hyperinflation. The United Kingdom has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the United States – when the Continental Congress printed money to pay for the Revolutionary War and so started a period of extremely high inflation. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall … coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts….”)

Japan and Germany have not had hyperinflation for over sixty years. Today’s central bankers want inflation only in the short run, not in the long run. As Janet Yellen recognized, central banks with established reputations have a credibility problem when it comes to committing to future inflation. If people believe deep down that central banks will try to kill inflation if it ever gets out of hand, then it becomes very hard for those central banks to generate inflation today. And the answer from many economists is that central bankers should be even bolder and crazier, sort of like everyone’s mad uncle or, more politely, to be “responsibly irresponsible,” as Paul McCulley has quipped.

In a liquidity trap the rules of economics change. Things that worked in the past don’t work in the present. The models of economies that we mentioned above become even less reliable. In fact they sometimes suggest actions that are in fact actually quite destructive. So why aren’t the models working?

Sometimes the best way to understand a complex subject is to draw an analogy. So with an apology to all the true mathematicians among our readers, today we will look at what we can call the Economic Singularity.

The Economic Singularity

Singularity was originally a mathematical term for a point at which an equation has no solution. In physics, it was proven that a large enough collapsing star would eventually become a black hole, so dense that its own gravity would cause a singularity in the fabric of spacetime, a point where many standard physics equations suddenly have no solution.

Beyond the “event horizon” of the black hole, the models no longer work. In general relativity, an event horizon is the boundary in spacetime beyond which events cannot affect an outside observer. In a black hole it is “the point of no return,” i.e., the point at which the gravitational pull becomes so great that nothing can escape.

This theme is an old friend to readers of science fiction. Everyone knows that you can’t get too close to a black hole or you will get sucked in; but if you can get just close enough, you can use the powerful and deadly gravity to slingshot you across the vast reaches of spacetime.

One way that a black hole can (theoretically) be created is for a star to collapse in upon itself. The larger the mass of the star, the greater the gravity of the black hole and the more surrounding space-stuff that will get sucked down its gravity well. The center of our galaxy is thought to be a black hole with a mass of 4.3 million suns.

We can draw a rough parallel between a black hole and our current global economic situation. (For physicists this will be a very rough parallel indeed, but work with us, please.) An economic bubble of any type, but especially a debt bubble, can be thought of as an incipient black hole. When the bubble collapses in upon itself, it creates its own black hole with an event horizon beyond which all traditional economic modeling breaks down. Any economic theory that does not attempt to transcend the event horizon associated with excessive debt will be incapable of offering a viable solution to an economic crisis. Even worse, it is likely that any proposed solution will make the crisis more severe.

The Minsky Moment

Debt (leverage) can be a very good thing when used properly. For instance, if debt is used to purchase an income-producing asset, whether a new machine tool for a factory or a bridge to increase commerce, then debt can be net-productive. Hyman Minsky, one of the greatest economists of the last century, saw debt in three forms: hedge, speculative, and Ponzi.

Roughly speaking, to Minsky, hedge financing was when the profits from purchased assets were used to pay back the loan; speculative finance occurred when profits from the asset simply maintained the debt service and the loan had to be rolled over; and Ponzi finance required the selling of the asset at an ever higher price in order to make a profit. Minsky maintained that if hedge financing dominated, then the economy might well be an equilibrium-seeking, well-contained system. On the other hand, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy would be what he called a deviation-amplifying system. Thus, Minsky’s Financial Instability Hypothesis suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by (stable) hedge finance to a structure that increasingly emphasizes (unstable) speculative and Ponzi finance.

Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles that are seemingly part of financial markets. He claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops; and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As the climax of such a speculative borrowing bubble nears, banks and other lenders tighten credit availability, even to companies that can afford loans, and the economy then contracts.

“A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”

In our previous book, Endgame, we explore the idea of a Debt Supercycle, the culmination of decades of borrowing that finally ends in a dramatic bust. Unfortunately, much of the developed world is at the end of a 60-year-long Debt Supercycle. It creates our economic singularity. A business-cycle recession is a fundamentally different thing than the end of a Debt Supercycle, such as much of Europe is tangling with, Japan will soon face, and the United States can only avoid with concerted action in the next few years.

A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past, or in a manner that the models would predict.

There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Raising taxes or cutting spending to reduce debt will have an almost immediate impact on economic growth. But there is a limit to how much money a government can borrow. That limit clearly can vary significantly from country to country, but to suggest there is no limit puts you clearly in the camp of the delusional.

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.

Thoughts from the Frontline: The Economic Singularity

 

I fully intended to write today about a recently released academic paper that illustrates nearly every bad idea currently being bandied about in the field of economics. The insidious part is that the paper is considered mainstream and noncontroversial. Simply reading it required me to up my blood pressure medicine dosage. It is going to take me a little longer to finish that letter, and I realized that it needs a certain setup – one that coauthor Jonathan Tepper and I conveniently wrote a few months ago and included in the book Code Red.

So next week we’ll take a deep dive into the most dangerous economics paper written in a long time (that is perhaps only minor hyperbole on my part); but today, by way of setup, let’s think about central banks and liquidity traps and see if we agree that central bankers are driving the car from the back seat based upon a fundamentally flawed theory of how the world works. That theory helped produce the wreck that was the Great Recession and will have its fingerprints all over the next one. So this week we’ll have a preliminary round before putting on the sparring gloves next week.

Here is a part of chapter 7 from Code Red. By the way, the book has done very well and is getting great reviews, with 49 readers giving us five stars. And three people who apparently didn’t read the book gave it one star anyway. Check out the reviews on Amazon.

The 2014 Strategic Investment Conference: Investing in a Transformational World

But before we turn to the chapter, I want to note that this year for the first time we are not requiring Strategic Investment Conference attendees to be accredited investors. A change of venue that gives us a little more room and a shuffling of the speaking schedule allow us to open the event to everyone. If you are from outside the United States, you will not have as much trouble getting accepted into the conference as you may have encountered in the past. I am really excited about this change and hope that we have a significant contingent of non-US citizens at the conference. The speaker lineup is certainly international in breadth.

We sent out a note earlier this week encouraging you to register for the Strategic Investment Conference, which is coming up in mid-May. This is our 11th conference (cosponsored by Altegris Investments), and it will be our biggest and most comprehensive yet. Our attendees regularly say it is the best investment conference they attend anywhere. Click on this link to learn more. Rather than simply listing the names as we normally do, I have provided a little color about who the speakers are and what we can expect to hear. Register now to get the early-bird discount, which lasts for only a few more days.

Stuck in a Liquidity Trap

From Code Red, by John Mauldin and Jonathan Tepper

Like a car, an economy has lots of moving parts; everyone thinks they know how to drive it when they’re in the back seat; and it crashes too often. But on a more serious note, the analogy of a car works especially well when you think of where large parts of the global economy are.

Today central banks can make money cheap and plentiful, but the money that is created isn’t moving around the economy or stimulating demand. They can step on the accelerator and flood the engine with gas, but the transmission is broken, and the wheels don’t turn. Without a transmission mechanism, monetary policy has no effect.

This has not always been the case, but it is today. After some credit crises, central banks can cut the nominal interest rate all the way to zero and still be unable to stimulate their economies sufficiently. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning). The Great Financial Crisis plunged us into a liquidity trap, a situation in which many people figure they might just as well sit on cash. Many parts of the world found themselves in a liquidity trap during the Great Depression, and Japan has been stuck in a liquidity trap for most of the time since their bubble burst in 1989.

Economists who have studied liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy. In fact, if you look recessions that have happened after debt crises, growth was almost always very slow. For example, a study by Oscar Jorda, Moritz Schularick, and Alan Taylor found that recessions that occurred after years of rapid credit growth were almost always worse than garden-variety recessions.

One of the key findings from their study is that it is very difficult to restore growth after a debt bubble. Central banks want to create modest inflation and thereby reduce the real value of debt, but they’re having trouble doing it. Creating inflation isn’t quite as simple as printing money or keeping interest rates very low. Most Western central banks have built up a very large store of credibility over the past few decades. The high inflation of the 1970s is a very distant memory to most investors nowadays.

And almost no one seriously believes in hyperinflation. The United Kingdom has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the United States – when the Continental Congress printed money to pay for the Revolutionary War and so started a period of extremely high inflation. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall … coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts….”)

Japan and Germany have not had hyperinflation for over sixty years. Today’s central bankers want inflation only in the short run, not in the long run. As Janet Yellen recognized, central banks with established reputations have a credibility problem when it comes to committing to future inflation. If people believe deep down that central banks will try to kill inflation if it ever gets out of hand, then it becomes very hard for those central banks to generate inflation today. And the answer from many economists is that central bankers should be even bolder and crazier, sort of like everyone’s mad uncle or, more politely, to be “responsibly irresponsible,” as Paul McCulley has quipped.

In a liquidity trap the rules of economics change. Things that worked in the past don’t work in the present. The models of economies that we mentioned above become even less reliable. In fact they sometimes suggest actions that are in fact actually quite destructive. So why aren’t the models working?

Sometimes the best way to understand a complex subject is to draw an analogy. So with an apology to all the true mathematicians among our readers, today we will look at what we can call the Economic Singularity.

The Economic Singularity

Singularity was originally a mathematical term for a point at which an equation has no solution. In physics, it was proven that a large enough collapsing star would eventually become a black hole, so dense that its own gravity would cause a singularity in the fabric of spacetime, a point where many standard physics equations suddenly have no solution.

Beyond the “event horizon” of the black hole, the models no longer work. In general relativity, an event horizon is the boundary in spacetime beyond which events cannot affect an outside observer. In a black hole it is “the point of no return,” i.e., the point at which the gravitational pull becomes so great that nothing can escape.

This theme is an old friend to readers of science fiction. Everyone knows that you can’t get too close to a black hole or you will get sucked in; but if you can get just close enough, you can use the powerful and deadly gravity to slingshot you across the vast reaches of spacetime.

One way that a black hole can (theoretically) be created is for a star to collapse in upon itself. The larger the mass of the star, the greater the gravity of the black hole and the more surrounding space-stuff that will get sucked down its gravity well. The center of our galaxy is thought to be a black hole with a mass of 4.3 million suns.

We can draw a rough parallel between a black hole and our current global economic situation. (For physicists this will be a very rough parallel indeed, but work with us, please.) An economic bubble of any type, but especially a debt bubble, can be thought of as an incipient black hole. When the bubble collapses in upon itself, it creates its own black hole with an event horizon beyond which all traditional economic modeling breaks down. Any economic theory that does not attempt to transcend the event horizon associated with excessive debt will be incapable of offering a viable solution to an economic crisis. Even worse, it is likely that any proposed solution will make the crisis more severe.

The Minsky Moment

Debt (leverage) can be a very good thing when used properly. For instance, if debt is used to purchase an income-producing asset, whether a new machine tool for a factory or a bridge to increase commerce, then debt can be net-productive. Hyman Minsky, one of the greatest economists of the last century, saw debt in three forms: hedge, speculative, and Ponzi.

Roughly speaking, to Minsky, hedge financing was when the profits from purchased assets were used to pay back the loan; speculative finance occurred when profits from the asset simply maintained the debt service and the loan had to be rolled over; and Ponzi finance required the selling of the asset at an ever higher price in order to make a profit. Minsky maintained that if hedge financing dominated, then the economy might well be an equilibrium-seeking, well-contained system. On the other hand, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy would be what he called a deviation-amplifying system. Thus, Minsky’s Financial Instability Hypothesis suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by (stable) hedge finance to a structure that increasingly emphasizes (unstable) speculative and Ponzi finance.

Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles that are seemingly part of financial markets. He claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops; and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As the climax of such a speculative borrowing bubble nears, banks and other lenders tighten credit availability, even to companies that can afford loans, and the economy then contracts.

“A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”

In our previous book, Endgame, we explore the idea of a Debt Supercycle, the culmination of decades of borrowing that finally ends in a dramatic bust. Unfortunately, much of the developed world is at the end of a 60-year-long Debt Supercycle. It creates our economic singularity. A business-cycle recession is a fundamentally different thing than the end of a Debt Supercycle, such as much of Europe is tangling with, Japan will soon face, and the United States can only avoid with concerted action in the next few years.

A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past, or in a manner that the models would predict.

There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Raising taxes or cutting spending to reduce debt will have an almost immediate impact on economic growth. But there is a limit to how much money a government can borrow. That limit clearly can vary significantly from country to country, but to suggest there is no limit puts you clearly in the camp of the delusional.

The Event Horizon

In our analogy, the event horizon is relatively easy to pinpoint. It is what Rogoff and Reinhart call the Bang! moment, when a country loses the confidence of the bond market. For Russia it came at 57% of debt-to-GDP in 1998. Japan is at 240% of debt-to-GDP and rising, even as its population falls – the Bang! moment approaches. Obviously, Greece had its moment several years ago. Spain lost effective access to the bond market last year, minus European Central Bank intervention. As did Italy, with other countries to follow.

As an aside, it makes no difference how the debt was accumulated. The black holes of debt in Greece and in Argentina had completely different origins from those of Spain or Sweden or Canada (the latter two in the early ’90s). The Spanish problem did not originate because of too much government spending; it developed because of a housing bubble of epic proportions. 17% of the working population was employed in the housing industry when it collapsed. Is it any wonder that unemployment is now 25%? If unemployment is 25%, that both raises the cost of government services and reduces revenues by proportionate amounts.

The policy problem is, how do you counteract the negative pull of a black hole of debt, before it’s too late? How do you muster the “escape velocity” to get back to a growing economy and a falling deficit – or, dare we say, even a surplus to pay down the old debt? How do you reconcile the competing forces of insufficient growth and too much debt?

The problem is not merely one of insufficient spending; the key problem is insufficient income. By definition, income has to come before spending. You can take money from one source and give it to another, but that is not organic growth.

We typically think of organic growth as only having to do with individual companies, but we think the concept also applies to countries. The organic growth of a country can come from natural circumstances like energy resources or an equable climate or land conducive to agricultural production, or it can come from developing an educated populace. There are many sources of potential organic growth: energy, tourism, technology, manufacturing, agriculture, trade, banking, etc.

While deficit spending can help bridge a national economy through a recession, normal business growth must eventually take over if the country is to prosper. Keynesian theory prescribed deficit spending during times of business recessions and the accumulation of surpluses during good times, in order to be able to pay down debts that would inevitably accrue down the road. The problem is that the model developed by Keynesian theory begins to break down as we near the event horizon of a black hole of debt.

Deficit spending is a wonderful prescription for Spain, but it begs the question of who will pay off the deficit once Spain has lost the confidence of the bond market. Is it the responsibility of the rest of Europe to pay for Spain or Greece? Or Italy or France, or whatever country chooses not to deal with its own internal issues?

Deficit spending can be a useful tool in countries with a central bank, such as the US. But at what point does borrowing from the future (and our children) come to be seen as a failure to deal with our own lack of political will in regards to our spending and taxation policies? There is a difference, as I think Hyman Minsky would point out, between borrowing money for infrastructure spending that will benefit our children and borrowing money to spend on ourselves today, with no future benefit.

The deficit has to be controlled, of course. To continue on the current path will only feed our Black Hole of Debt even more “mass,” making it that much harder to escape from. But to try and power away (cutting the deficit radically) all at once will blow the engines of the economy. Suddenly reducing the deficit by 8% of GDP, either by cutting spending or raising taxes, is a prescription for an almost immediate depression. It’s just basic math.

As we outline in Endgame (shameless plug), each country has to find its own path. But it’s clear that Spain, like Greece, is simply going to have to default on part of its debt. So will Ireland and Portugal. Japan will resort to printing money in amounts that will boggle the imagination and terrify the world, as they finally come to grips with the fact that they must deal with their deficit spending.

The Glide Path

Indulge us for a moment as we think about our own country. The United States still has the chance to pursue what we call the “glide path” option. We can reduce the deficit slowly, by say 1% a year, while aggressively pursuing organic growth policies such as unleashing the energy and biotechnology sectors, providing certainty to small businesses about government healthcare policies, reducing the regulatory burden on small businesses and encouraging new business startups, creating a competitive corporate tax environment (a much lower corporate tax with no deductions for anything, including oil-depletion allowances), implementing a pro-growth tax policy, etc. We can balance the budget within 5-7 years. If the bond market perceived that the United States was clearly committed to a balanced budget, rates would remain low, the dollar would be stronger (especially as we become energy independent), and we would steam away from the black hole. If something like Simpson-Bowles could be accomplished, with an even more radically restructured tax policy, it would be enormously bullish for the United States in particular and for the world in general. Healthcare is clearly the challenge, but a compromise can be crafted, as has been demonstrated by the several bipartisan proposals that have been sponsored by conservative Republicans and liberal Democrats. The key word is compromise.

The crucial outcome is whether we can achieve the compromise that will be needed to get us on a glide path to a balanced budget. If a compromise is not crafted in the next few years, it will be even more difficult in 2016, which is an election year. That may be too late, as the bond market may be watching Europe and Japan imploding and wonder why the United States is any different. Remember, the event horizon is determined by the confidence of the bond market in the willingness and ability of a country to pay its debts with a currency that has a value that can be maintained. Trillion-dollar deficits will call into question the value of the dollar. That will mean higher interest rates, which will mean a much bigger, more deadly black hole.

We should note that something similar to the glide path was tried during the Clinton administration. Spending growth was controlled and the economy was allowed to grow its way out of debt. While the U.S. economy is fundamentally weaker today than it was then, it should still be possible for the U.S. free-market economy to once again become an engine of growth.

We think the analogy of an Economic Singularity is a good one. The Black Hole of Debt simply overwhelms the ability of current economic theories to craft solutions based on past performance. Each country will have to find its own unique way to achieve escape velocity from its own particular black hole. That can be through a combination of reducing the debt (the size of the black hole) and growth. Even countries that do not have such a problem will have to deal with the black holes in their vicinity. As an example, Finland is part of the eurozone and finds itself gravitationally affected by the black holes of debt created by its fellow eurozone members. And China has recently seen its exports to Europe drop by almost 12%. I would imagine that has been more or less the experience of most countries that export to Europe.

In science fiction novels, a spaceship’s straying too close to a black hole typically results in no spaceship. There are also hundreds of examples of what happens to nations that drift too close to the Black Hole of Debt. None of the instances are pretty; they all end in tears. For countries that have been trapped in the gravity well of debt, there is only the pain that comes with restructuring. It is all too sad.

The usual response by central banks when confronted with a debt crisis is to provide liquidity and create more money. But as we’ll discover in the next section, not all money is created equal; and central banks don’t really control the broad money supply at all.

Los Angeles, Miami, Washington DC, Argentina, and South Africa

A quick housekeeping note. I was autographing about 300 Code Red’s late last Sunday night, and – let’s just blame it on having taken a sleeping pill earlier – in the process of signing books and looking at emails I somehow managed to fat-finger the delete key on my entire inbox. I was some 200 emails behind, and now they are dispersed among the 50,000 or so deleted emails of the past year. I leave emails in my inbox because I intentionally do not want them to go out of sight, since I intend to act on them in some way. While I remember a few messages that were in there, there are many more that are simply gone from memory. If I owe you something, you might want to shoot it back at me.

It is rather odd to be in Dallas where it is a beautiful 60° day and to see the massive snowstorm on the East Coast. Who knew that we should be holding the Winter Olympics in Raleigh, North Carolina? I’m enjoying my longer than usual respite from travel, but by the end of the month I will see my schedule pick up aggressively. I will be in Houston for a night, back home for a few days before I go to Los Angeles, and then fly cross-country to Miami. From Miami I will go to Washington DC for a few days of meetings. Then it’s back home for almost two weeks before I head to Argentina and then South Africa for a month. Thanks for the recommendations on South African game lodges last week. Based on your suggestions we have booked what looks to be a very nice four days of relaxation prior to a hectic speaking trip around South Africa.

It will be interesting to be in two of the more stressed emerging markets and to see firsthand what is happening. I will report back. It also looks like a trip to Europe is shaping up in early May, prior to my Strategic Investment Conference. And Italy in early June for a little working vacation.

It’s time to hit the send button and then head to the gym. It seems that every so often somebody turns the dial down on my metabolism, and it becomes harder and harder to maintain my weight. Since I can’t find out who is turning the dial down, my only response is to ramp up my gym time and turn down that second piece of bread. Have a great week, and I hope the weather turns better for those on the coasts.

You’re trying to figure out how it all fits together analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

© 2013 Mauldin Economics. All Rights Reserved.

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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.

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140209-01

Thoughts from the Frontline: A Most Dangerous Era

 

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an essay by Frédéric Bastiat in 1850, “That Which Is Seen and That Which Is Unseen”

The devil is in the details, we are told, and the details are often buried in an appendix or footnote. This week we were confronted with a rather troubling appendix in the Congressional Budget Office (CBO) analysis of the Affordable Care Act, which suggests that the act will have a rather profound impact on employment patterns. You could tell a person’s political leaning by how they responded. Republicans jumped all over this. The conservative Washington Times, for instance, featured this headline: “Obamacare will push 2 million workers out of labor market: CBO.” Which is not what the analysis says at all. Liberals immediately downplayed the import by suggesting that all it really said was that people will have more choice about how they work, giving them more free time to play with their kids and pets and pursue other activities. Who could be against spending more time with your children?

Paul Krugman noted that the data means that potential GDP will be reduced by as much as 0.5% per year, which he dismissed as a small number. And he states that people voluntarily reducing their work hours does not have the same economic effect as people being laid off or fired. Which is true, but not the point nor the import of that pesky little appendix.

Where Will the Jobs Come From?

To me the economic and employment effects of Obamacare are another piece of the larger puzzle called Where Will the Jobs Come From? This may be the most important economic question of the next 30 years. Because this topic has been the focus of my thinking for the past few years, I could be reading more into the CBO’s report than I should, but indulge me as I make a few points and then see if I can tie them together in the end.

First let’s look at what the report actually said. The CBO stated that the implementation of the Affordable Care Act will result in a “substantially larger” and “considerably higher” reduction in the labor force than the “mere” 800,000 the budget office estimated in 2010. The overall level of labor will fall by 1.5% to 2% over the decade, the CBO figures. The revision was evidently driven by economic work done by a professor at the University of Chicago by the name of Casey Mulligan. (When you do a little research on Professor Mulligan and look past the multitude of honors and awards, you find people calling him the antithesis of Paul Krugman. I must therefore state for the record that I already like him.) For you economics wonks, there is a very interesting interview with Professor Mulligan in the weekend Wall Street Journal. For those who don’t go there, I will summarize and quote a few salient points.

Let’s be clear. This report and Mulligan’s research do not say Obamacare destroys jobs. What they suggest is that Obamacare raises the marginal tax rates on income, and to such an extent that it reduces the rewards for working more hours for marginally higher pay at certain income levels. The chart below does not pertain to upper-income individuals but rather to those at the median income level.

What Mulligan’s work does demonstrate is that the loss of government benefits has the same effect on an individual as a tax increase. If you lose a government subsidy because you work more hours, then for all intents and purposes it is the same as if you were taxed at a higher rate. Quoting now from the WSJ piece:

Instead, liberals have turned to claiming that ObamaCare’s missing workers will be a gift to society. Since employers aren’t cutting jobs per se through layoffs or hourly take-backs, people are merely choosing rationally to supply less labor. Thanks to ObamaCare, we’re told, Americans can finally quit the salt mines and blacking factories and retire early, or spend more time with the children, or become artists.

Mr. Mulligan reserves particular scorn for the economists making this “eliminated from the drudgery of labor market” argument, which he views as a form of trahison des clercs [loosely translated, "the betrayal of academic economists" – JM]. “I don’t know what their intentions are,” he says, choosing his words carefully, “but it looks like they’re trying to leverage the lack of economic education in their audience by making these sorts of points.”

A job, Mr. Mulligan explains, “is a transaction between buyers and sellers. When a transaction doesn’t happen, it doesn’t happen. We know that it doesn’t matter on which side of the market you put the disincentives, the results are the same…. In this case you’re putting an implicit tax on work for households, and employers aren’t willing to compensate the households enough so they’ll still work.” Jobs can be destroyed by sellers (workers) as much as buyers (businesses).

He adds: “I can understand something like cigarettes and people believe that there’s too much smoking, so we put a tax on cigarettes, so people smoke less, and we say that’s a good thing. OK. But are we saying we were working too much before? Is that the new argument? I mean make up your mind. We’ve been complaining for six years now that there’s not enough work being done…. Even before the recession there was too little work in the economy. Now all of a sudden we wake up and say we’re glad that people are working less? We’re pursuing our dreams?” The larger betrayal, Mr. Mulligan argues, is that the same economists now praising the great shrinking workforce used to claim that ObamaCare would expand the labor market.

Paul Krugman interprets the CBO estimates to mean a loss of the number of hours that would be equivalent to the loss of 2 million jobs. The Wall Street Journal sees that same number as equivalent to 2.5 million jobs. Professor Mulligan’s research suggests that they are still off by a factor of two and that it could be closer to 5 million job equivalents.

That means a drop in potential GDP growth of somewhere between 0.5% and 1% per year. A small price to pay for universal healthcare, suggests Krugman. I would personally see it as a large price to pay for structuring healthcare reform the wrong way. That we need healthcare reform and that we as a country want it to be universal is clear. But the CBO report makes it evident that there is a hidden economic cost to the country in the way healthcare reform is currently structured. Dismissing potential GDP growth loss of 0.5% per year as “not all that much” is simply not intellectually sufficient.

(And that is taking Krugman’s estimate of 0.5% to be the actual negative effect. There are other economists who can produce credible estimates that are much higher, but for the purposes of this letter Krugman’s lower estimate will do.)

Doug Henwood over at The Liscio Report produced some fascinating research this week on what it has meant for our economy to be growing at a lower rate since 2007. In another report, the CBO offered its own estimate of future growth, which the normally sanguine Henwood thinks has the potential to make us complacent. Let’s jump right to his impact paragraphs (emphasis mine):

Another way to measure where GDP is relative to where it “should” be is by comparing the actual level to its long-term trend. [That's what's graphed below.] This technique shows the economy in a much deeper hole than the CBO does.

By this method, actual GDP at the end of 2013 was 86.7% of its trend value. That’s actually 3 points below where it was when the recession ended. Consumption was 87.4% of its trend value; investment, 75.1%; and government, 84.5%. (Note that government, despite perceptions to the contrary, has been falling, not rising, relative to its trend.)

These are huge gaps. In nominal dollar terms, per capita GDP is $8,278 below its 1970–2007 trend. Using the CBO’s less dramatic gap estimate works out to an actual per capita GDP $2,141 below its potential. Either way, that’s a lot of money. One way of reconciling the $6,137 disparity between the figures derived from CBO’s method and the trend method is by pointing to the long-term economic damage done by the financial crisis and recession.

The hit to investment, productivity, and labor force participation is enormous and long-lived. To put that $6,137 number in perspective, it’s very close to the per capita GDP of China. That is not small, and if the CBO is even half right, it’s not going away any time soon.

By the way, Casey Mulligan argues in his 2012 book, The Redistribution Recession, that the expansion of the welfare state through the surge in food stamps, unemployment benefits, disability, Medicaid, and other safety-net programs was responsible for about half the drop in work hours since 2007, and possibly more.

The CBO is de facto admitting that the increase in the entitlement spending due to Obamacare is going to reduce GDP. If Mulligan’s larger projection is right, we could lose roughly 10% of GDP potential over the next decade. That means the pie in the future will be smaller by 10%. That is a huge difference, not an inconsequential one. It means tax revenues needed to pay for government benefits will be 10% smaller. I am not arguing for or against whether such benefits are a proper expenditure of money; I’m simply saying that we cannot ignore the economic consequences simply because they may be politically inconvenient.

Think about this for a moment. We have lost the equivalent of Chinese per-person GDP in the space of seven years as a result of policy choices made by both Republican and Democratic administrations and due to the financial repression visited upon us by the Federal Reserve – which, by the way, has created multiple bubbles. The way we structure our policy decisions has consequences beyond the obvious.

More Unintended Consequences

Rather than immediately jumping to some kind of conclusion on employment that simply offers a number and doesn’t offer insight, I want us to look at the larger picture of work and what we get paid for it. We are rightly concerned in the developed world about the concentration of income and wealth in the top fraction of the population. When 85 people own 46% of the world’s wealth, as we’ve repeatedly heard the past few weeks, what does this portend for the future?

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.

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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.

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Thoughts from the Frontline: A Most Dangerous Era

 

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an essay by Frédéric Bastiat in 1850, “That Which Is Seen and That Which Is Unseen”

The devil is in the details, we are told, and the details are often buried in an appendix or footnote. This week we were confronted with a rather troubling appendix in the Congressional Budget Office (CBO) analysis of the Affordable Care Act, which suggests that the act will have a rather profound impact on employment patterns. You could tell a person’s political leaning by how they responded. Republicans jumped all over this. The conservative Washington Times, for instance, featured this headline: “Obamacare will push 2 million workers out of labor market: CBO.” Which is not what the analysis says at all. Liberals immediately downplayed the import by suggesting that all it really said was that people will have more choice about how they work, giving them more free time to play with their kids and pets and pursue other activities. Who could be against spending more time with your children?

Paul Krugman noted that the data means that potential GDP will be reduced by as much as 0.5% per year, which he dismissed as a small number. And he states that people voluntarily reducing their work hours does not have the same economic effect as people being laid off or fired. Which is true, but not the point nor the import of that pesky little appendix.

Where Will the Jobs Come From?

To me the economic and employment effects of Obamacare are another piece of the larger puzzle called Where Will the Jobs Come From? This may be the most important economic question of the next 30 years. Because this topic has been the focus of my thinking for the past few years, I could be reading more into the CBO’s report than I should, but indulge me as I make a few points and then see if I can tie them together in the end.

First let’s look at what the report actually said. The CBO stated that the implementation of the Affordable Care Act will result in a “substantially larger” and “considerably higher” reduction in the labor force than the “mere” 800,000 the budget office estimated in 2010. The overall level of labor will fall by 1.5% to 2% over the decade, the CBO figures. The revision was evidently driven by economic work done by a professor at the University of Chicago by the name of Casey Mulligan. (When you do a little research on Professor Mulligan and look past the multitude of honors and awards, you find people calling him the antithesis of Paul Krugman. I must therefore state for the record that I already like him.) For you economics wonks, there is a very interesting interview with Professor Mulligan in the weekend Wall Street Journal. For those who don’t go there, I will summarize and quote a few salient points.

Let’s be clear. This report and Mulligan’s research do not say Obamacare destroys jobs. What they suggest is that Obamacare raises the marginal tax rates on income, and to such an extent that it reduces the rewards for working more hours for marginally higher pay at certain income levels. The chart below does not pertain to upper-income individuals but rather to those at the median income level.

What Mulligan’s work does demonstrate is that the loss of government benefits has the same effect on an individual as a tax increase. If you lose a government subsidy because you work more hours, then for all intents and purposes it is the same as if you were taxed at a higher rate. Quoting now from the WSJ piece:

Instead, liberals have turned to claiming that ObamaCare’s missing workers will be a gift to society. Since employers aren’t cutting jobs per se through layoffs or hourly take-backs, people are merely choosing rationally to supply less labor. Thanks to ObamaCare, we’re told, Americans can finally quit the salt mines and blacking factories and retire early, or spend more time with the children, or become artists.

Mr. Mulligan reserves particular scorn for the economists making this “eliminated from the drudgery of labor market” argument, which he views as a form of trahison des clercs [loosely translated, "the betrayal of academic economists" – JM]. “I don’t know what their intentions are,” he says, choosing his words carefully, “but it looks like they’re trying to leverage the lack of economic education in their audience by making these sorts of points.”

A job, Mr. Mulligan explains, “is a transaction between buyers and sellers. When a transaction doesn’t happen, it doesn’t happen. We know that it doesn’t matter on which side of the market you put the disincentives, the results are the same…. In this case you’re putting an implicit tax on work for households, and employers aren’t willing to compensate the households enough so they’ll still work.” Jobs can be destroyed by sellers (workers) as much as buyers (businesses).

He adds: “I can understand something like cigarettes and people believe that there’s too much smoking, so we put a tax on cigarettes, so people smoke less, and we say that’s a good thing. OK. But are we saying we were working too much before? Is that the new argument? I mean make up your mind. We’ve been complaining for six years now that there’s not enough work being done…. Even before the recession there was too little work in the economy. Now all of a sudden we wake up and say we’re glad that people are working less? We’re pursuing our dreams?” The larger betrayal, Mr. Mulligan argues, is that the same economists now praising the great shrinking workforce used to claim that ObamaCare would expand the labor market.

Paul Krugman interprets the CBO estimates to mean a loss of the number of hours that would be equivalent to the loss of 2 million jobs. The Wall Street Journal sees that same number as equivalent to 2.5 million jobs. Professor Mulligan’s research suggests that they are still off by a factor of two and that it could be closer to 5 million job equivalents.

That means a drop in potential GDP growth of somewhere between 0.5% and 1% per year. A small price to pay for universal healthcare, suggests Krugman. I would personally see it as a large price to pay for structuring healthcare reform the wrong way. That we need healthcare reform and that we as a country want it to be universal is clear. But the CBO report makes it evident that there is a hidden economic cost to the country in the way healthcare reform is currently structured. Dismissing potential GDP growth loss of 0.5% per year as “not all that much” is simply not intellectually sufficient.

(And that is taking Krugman’s estimate of 0.5% to be the actual negative effect. There are other economists who can produce credible estimates that are much higher, but for the purposes of this letter Krugman’s lower estimate will do.)

Doug Henwood over at The Liscio Report produced some fascinating research this week on what it has meant for our economy to be growing at a lower rate since 2007. In another report, the CBO offered its own estimate of future growth, which the normally sanguine Henwood thinks has the potential to make us complacent. Let’s jump right to his impact paragraphs (emphasis mine):

Another way to measure where GDP is relative to where it “should” be is by comparing the actual level to its long-term trend. [That's what's graphed below.] This technique shows the economy in a much deeper hole than the CBO does.

By this method, actual GDP at the end of 2013 was 86.7% of its trend value. That’s actually 3 points below where it was when the recession ended. Consumption was 87.4% of its trend value; investment, 75.1%; and government, 84.5%. (Note that government, despite perceptions to the contrary, has been falling, not rising, relative to its trend.)

These are huge gaps. In nominal dollar terms, per capita GDP is $8,278 below its 1970–2007 trend. Using the CBO’s less dramatic gap estimate works out to an actual per capita GDP $2,141 below its potential. Either way, that’s a lot of money. One way of reconciling the $6,137 disparity between the figures derived from CBO’s method and the trend method is by pointing to the long-term economic damage done by the financial crisis and recession.

The hit to investment, productivity, and labor force participation is enormous and long-lived. To put that $6,137 number in perspective, it’s very close to the per capita GDP of China. That is not small, and if the CBO is even half right, it’s not going away any time soon.

By the way, Casey Mulligan argues in his 2012 book, The Redistribution Recession, that the expansion of the welfare state through the surge in food stamps, unemployment benefits, disability, Medicaid, and other safety-net programs was responsible for about half the drop in work hours since 2007, and possibly more.

The CBO is de facto admitting that the increase in the entitlement spending due to Obamacare is going to reduce GDP. If Mulligan’s larger projection is right, we could lose roughly 10% of GDP potential over the next decade. That means the pie in the future will be smaller by 10%. That is a huge difference, not an inconsequential one. It means tax revenues needed to pay for government benefits will be 10% smaller. I am not arguing for or against whether such benefits are a proper expenditure of money; I’m simply saying that we cannot ignore the economic consequences simply because they may be politically inconvenient.

Think about this for a moment. We have lost the equivalent of Chinese per-person GDP in the space of seven years as a result of policy choices made by both Republican and Democratic administrations and due to the financial repression visited upon us by the Federal Reserve – which, by the way, has created multiple bubbles. The way we structure our policy decisions has consequences beyond the obvious.

More Unintended Consequences

Rather than immediately jumping to some kind of conclusion on employment that simply offers a number and doesn’t offer insight, I want us to look at the larger picture of work and what we get paid for it. We are rightly concerned in the developed world about the concentration of income and wealth in the top fraction of the population. When 85 people own 46% of the world’s wealth, as we’ve repeatedly heard the past few weeks, what does this portend for the future?

Understand that wealth distribution is all relative:

You need an annual income of $34,000 a year to be in the richest 1% of the world, according to World Bank economist Branko Milanovic’s 2010 book The Haves and the Have-Nots. To be in the top half of the global population, you need to earn just $1,225 a year. For the top 20%, it’s $5,000 per year. You enter the top 10% with $12,000 a year. To be included in the top 0.1% requires an annual income of $70,000.” (From a brilliant piece by Morgan Housel titled “50 Reasons We’re Living Through the Greatest Period in World History,” in The Motley Fool.)

(Most of the readers of this letter are in the top 1% and many are in the top 0.1%. Feel better about yourself now?)

Now stay with me here. I am going to work toward making a connection between the following section and the Affordable Care Act. In last week’s Thoughts from the Frontline we explored the long-term obstacles to growth in emerging markets, as a powerful wave of new technologies shrinks developed-world trade demand for energy and manufactured goods.

I believe this disruption in long-standing trade relationships signals a gradual realignment in the global economy as the developed world moves toward a Third Industrial Revolution and threatens to leave a lot of global workers behind. This week, let’s shift our focus to the long-term impact of tech transformation on productivity and wages in developed markets – particularly in the USA, where the majority of the innovation is happening.

The gist is simple and unavoidable: Since the majority of jobs are vulnerable in some way to automation, almost all of us – your humble analyst included – will have to make a real effort to continually learn and hone new skills in order to participate in the new economy. There has never been a better time for talented workers who possess the right mix of skills and creativity to capitalize on new technology, and there has never been a worse time for workers who lack the skills or creativity to tap into the abundance that awaits. (I invite readers to cogently disagree with that last sentence. I hope I am wrong. Seriously, I think about this a lot and am open to learning.)

The Great Divergence: Productivity & Wages

Over the very long term, the real drivers of lasting economic growth around the world have been the great spurts of innovation enabled by the First and Second Industrial Revolutions – two transformative periods between 1750 and the mid-1970s during which the invention of world-changing “general-purpose technologies” like the steam engine, electricity, and indoor plumbing enabled generations of follow-on innovation and drove massive gains in productivity and real GDP per capita.

The miracle of industrialization was that real wages grew roughly in line with productivity – meaning that the returns to labor and the returns to capital were fairly evenly distributed. As workers produced more output in less time and with less effort, they also received higher pay. This relationship held until the mid-1970s, when real wages suddenly flat-lined in the face of rising productivity.

It seems that the positive effects on wages produced by the First and Second Industrial Revolutions petered out in the late ’70s, just as the Information Revolution was producing what could be called the Information Economy.

Thus far, the gains of the Information Economy have been unevenly distributed, and the past 40 years have not been kind to the American worker. US multinationals began to outsource more and more manufacturing jobs to lower-wage emerging markets just as computers started to enable the use of increasingly capable but also increasingly complex technologies. Average workers could not easily join the Information Economy without the skills or educational foundation to adapt from labor-intensive manufacturing work to knowledge-intensive information work; and so they have not participated in the real wage gains available to higher-skilled workers.

As you can see in the chart below, workers with college and graduate-level educations have enjoyed higher wages while workers with less education have struggled to make ends meet.

Still, earning a college degree does not guarantee gainful employment, something that many of us told our children would happen as we encouraged them simply to “go to college.” Ultimately, scoring a good job comes down to skills. The vast majority of jobs are vulnerable to some kind of disruption or displacement from computer-enabled innovation. Meaning that – at some point in their careers – most workers will have to learn new skills and evolve as technology evolves. As you can see in the following chart from a study by Oxford University professors Carl Benedikt Frey and Michael Osbourne, nearly 50% of all jobs in the United States run a very high risk of displacement or disruption by computerized automation in the coming years. (Warning: reading the study requires the information skills and especially math that they suggest may be lacking.)

All this suggests that the current trend, wherein the average wage earner has not seen his wages increase along with GDP and corporate earnings growth, is likely to continue, not due to some malignant greed on the part of heartless corporate entities but because of the very nature of the Information Economy and the emerging Third Industrial Revolution. Those with skills and adaptability are going to continue to outperform, at least with regard to income, those who have not been able to develop the necessary skills for the coming economic transformation.

The next chart illustrates just how long this trend has continued and how significantly different the directions are between corporate profits and wages as a percentage of GDP. Given the uneven nature of the future employment market, it may be quite some time before we see these lines cross again. The last time it took the deepest recession in our lifetimes, but the bounce down was only temporary.

A Most Dangerous Era

Now, what does the shifting of jobs in a knowledge-based economy have to do with work incentives in the Affordable Care Act? If we structure a society in which people are incentivized not to work, we are going to create a society that not only produces less but that displays a growing disparity in the distribution of wealth. If we offer people economic reasons not to work, we should not be surprised when they take us up on the offer. We can disguise that offer as all sorts of necessary social reforms, but at the end of the day a smaller labor force will affect the size of the pie that we all want to see grow and to partake of. I refer you back to Bastiat, whom I quoted at the beginning of this letter: it is the unseen things in well-intentioned public policies that will have small, incremental, but finally significant effects upon the whole economic body.

I have struggled with allergies off and on over the years. What I have learned is that allergies are incremental. I can be around many things to which I only have a mild allergic reaction, and I have no symptoms. But when I’m around many of them all at once I have to start looking for my allergy medicine. One can argue, perhaps correctly, that the economic effects of a particular policy like the Affordable Care Act are only a minor problem. But it is the cumulative effect of numerous social policies, regulations, monetary policies, incentive structures, lack of educational reform (and the list goes on and on) that takes a toll on our economic body.

If government is small relative to the economy, then incremental changes in its policies have a lesser effect than when the government is large and its policies pervasive.

The coming Third Industrial Revolution requires a profound realignment and restructuring of the incentive systems built into our society. We are talking about a technological revolution that in its compound effects will accelerate change to such an extent that we will see as much change in the next 10 to 20 years as we saw all of last century. Suggesting that one employment- or growth-reducing policy or another only makes a small difference and is worth the price we’ll pay is a flippant dismissal of the dynamics of the situation we face. These things have consequences.

Jeremy Grantham in his recent quarterly letter looks at the incremental effect of a lower growth rate. He tells us that the remarkably steady 3.3% US growth rate from 1880 to 1980 multiplied income 26 times over that century, that the 2.8% average growth from 1980 to 2000 would compound income 16 times over a period of a century, but that the 1.4% rate experienced over the past 13 years would multiply income by just 4 times over a century.

How Do You Spell Assume?

In the same report mentioned at the beginning of this letter, the CBO gave us its economic and budget outlook for 2014 to 2024. They projected GDP growth of 3.1% this year and 3.4% in 2015 and 2016.

But growth, according to the CBO, will fall to 2.7% in 2017 and continue to slow “to a pace that is well below the average seen over the past several decades,” largely because of slower growth in the labor force due to the aging population and mild inflation (under 2.0%) for the next several years.

How significant is this slowing? The CBO estimates if the economy grows just one-tenth of a percentage point slower each year for 10 years, the cumulative deficit will be $311 billion greater than the $7.9 trillion it is now projecting. That 0.5% less GDP growth per year that Krugman expects would therefore translate into another $1.5 trillion added to the deficit that would have to be dealt with either through reduced spending or increased taxes. That amount is just slightly less than 10% of our current GDP. I think that is significant. But that’s just me, the deficit worrywart.

I agree with the conclusion of Ezra Klein (if not his general thesis), writing in Bloomberg on February 6:

Policies don’t exist in vacuums. By untying the link between employment and health care, the Affordable Care Act reduces the incentive to work. But there are ways to increase incentives to work without making people dependent on their jobs for health insurance. We can help people without taking away their health care.

It’s all connected: healthcare, financial regulation, technological transformation, energy policy, foreign policy, trade policy, immigration, tax reform (and the list goes on and on and on). Everything contributes to the environment for business and economic activity; and when the environment is good, that translates into jobs. It is becoming ever more vitally important to focus on how our policies across the board connect and to see them as parts of a whole rather than in a simplistic one-off manner. Does a policy not only allow us as a society to behave in a more responsible manner but also allow us to grow our economy and create jobs? If it doesn’t do both, then it’s back to the drawing board.

I’ll finish with one final chart (courtesy of my friend Philippa Dunne at The Liscio Report). This is a chart of new businesses being created. New businesses are the true engine of economic growth and job creation. Policy makers need to think about this chart with every decision they make. They need to determine why the trend is clearly down and how to reverse it.

Los Angeles, Miami, Argentina, and South Africa

I will be speaking next week at the George W. Bush Presidential Library auditorium with local celebrity investment advisor Erin Botsford, who wrote The Big Retirement Risk: Running Out of Money Before You Run Out of Time. The event is sponsored by my partners at Altegris Investments. (It sold out before I even had a chance to mention it. Sorry.)

And speaking of Altegris, let me suggest for further reading that you look at the work of my old friend Jack Rivkin, who has become (to my great delight) the new Chief Investment Officer there. A respected thought leader, Jack has had CIO roles in the investment industry with Neuberger Berman, Citigroup Investments, and Paine Webber and has overseen tens of billions of dollars. His work has also been featured in one of Harvard Business School’s most-read case studies. You can find his full biography here if you’re interested. If it seems that he’s done a lot (and he has!) it’s because he’s been at it for a while. Jack and I share an avid interest in how the future of technology will shape our society, and I treasure the time I get to spend with him talking about that.

Since joining Altegris in December, Jack has begun offering commentary about global economic and political events, trends, investing, and alternative investments. People in the know in the investment community pay attention to what Jack says. I highly encourage you to visit his “CIO Perspectives” at Altegris.com to read his latest articles. Jack consistently makes very good points in his commentaries, and I think you will find he has real insights on the topics we’ve been discussing of late.

In mid-March I will fly to Cafayate, Argentina, where I get to relax and spend time with friends Bill Bonner and Doug Casey and Mauldin Economics business partners David Galland and Olivier Garret. The plan is to round up a serious four-wheel-drive vehicle and trek to Bonner’s hacienda at 9,000 feet in the Andes. We made the trip last year but had to be towed several times as your humble analyst got us stuck in sand and again as we crossed the river. There is literally no road for the last hour, just (hopefully) dry riverbed and cow paths over very rocky terrain. Quite the adventure and fabulous fun with a great deal of fantastic conversation awaiting us at Bill’s. Last year I even ventured out horseback riding, although I might ask for a less frisky animal this year. I may be a Texan, but I was not born in the saddle.

Then in one of those “you can’t get there from here” trips, I’ll fly back to Texas, only to get on another plane later that same evening to fly to South Africa (don’t even ask). I hope to spend four days at some fabulous game reserve in South Africa but have yet to choose which one. I am open to suggestions. My only requirement is wifi.

It is time to hit the send button. This weekend should prove a great deal of fun. I intend to see The Monuments Men with that long list of (ahem) older stars, and then the next night Paul Simon and Sting are in concert just a few blocks away. When I tell people I’m going, nearly all of them (especially the ladies) tell me their favorite Sting song, but I have to admit that I’m going for Paul Simon. He has been one of my favorites for almost 50 years. His songs dominate my playlist. His music simply feeds my soul. “Bridge Over Troubled Water,” “The Sound of Silence,” “Graceland,” “Diamonds on the Soles of Her Shoes,” and the inimitable “Slip Sliding Away.” I met him once at a Yankees World Series game, but that’s another story. Have a great week and spend some time with your favorite musician. It will make the future world a little less scary.

Your still crazy after all these years analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

© 2013 Mauldin Economics. All Rights Reserved.

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