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Archive for July 2014

Archive for July, 2014

Outside the Box: Big Banks Shift to Lower Gear

 

For today’s Outside the Box, good friend Gary Shilling has sent along a very interesting analysis of the big banks. Gary knows a lot about what went down with the big banks during and after the Great Recession, and he tells the story well.

After the bailout of banks during the financial crisis, many wanted too-big-to-fail institutions to be broken up. Big banks resisted and pointed to their rebuilt capital, but regulators are responding with restraints that strip them of proprietary trading and other lucrative activities and push them towards spread lending and other traditional commercial banking businesses. The fiasco at Citigroup, JP Morgan’s London Whale, and BNP Paribas’s sanctions violations have spurred regulators as well.

Regulators are pressured to impose big fines and get guilty pleas for infractions. Meanwhile, big bank deleveraging proceeds. In this new climate, big banks are still profitable but at reduced levels and are moving toward utility and away from growth-stock status. The end of mortgage refinancing and weak security trading are also drags.

Banks are reacting by taking more risks, but regulators are concerned as long as depositors’ money is at risk. Still, regulators want to keep big banks financially sound and profitable enough to serve financial needs.

Gary’s analysis is extensive and thorough, but it’s only one part of his monthly Insight report. If you subscribe to Insight for $335 via email, you’ll receive a free copy of Gary Shilling’s full report on large banks, excerpted here, plus 13 monthly issues of Insight (for the price of 12), starting with their August 2014 report.

To subscribe, call them at 1-888-346-7444 or 973-467-0070 between 10 AM and 4 PM Eastern time or email insight@agaryshilling.com. Be sure to mention Outside the Box to get your free report on the big banks. (This offer is for new subscribers only.)

I am back from Whistler, British Columbia, where I spent the weekend at Louis Gave’s 40th birthday party. I went to Louis’s new home on the mountain, where you can ski down and take the gondola back up when you want to go home. Sunday afternoon Louis and I sat and talked for a few hours about the state of the world, interrupted now and again by the excitement of the children when a mother bear and cub walked through the yard. Later we saw another mother with two cubs.

The conversation drifted to the state of the investment industry in which we both work. It echoed similar conversations I have had over the world with other market participants. There is a growing feeling (admit it, you probably feel it too) that significant changes in the investment business are coming at us rather swiftly. Everywhere I go people are trying to figure out what those changes will entail. I’m not talking about just another bear market. In the same way, much of the music industry was sitting fat and happy in 2000 – they had little idea that Napster was just around the corner. And while Napster came and went, the way that people consume music today is significantly different than it was 10 or 15 years ago.

I have the feeling that the investment industry is getting ready to be hit by its equivalent of Napster. I’m not quite sure what that ultimately means, other than in 10 years (or maybe less) clients will be consuming their investment research and advice in a different manner. Old dogs are going to have to learn new tricks or be retired to the porch. And I am not ready to retire, so I will need to master a few new tricks, I guess. Of course, I would like to avoid Napster and go straight to Spotify. Then again, wouldn’t we all?

As Louis drove us back to the hotel – past more bears – he remarked that one does have to be careful around them. “Not really,” I said. “I have run with more than a few bears in my life and been OK.” He looked at me rather strangely, and I added. “Yeah, like Marc Faber, Gary Shilling, Rosie in his former life. Those were REAL bears. These are just cute animals.” He smiled and kept driving.

I will write my next note from Maine, where my son Trey and I will be going to fish for the 8th year in a row at what has become known as Camp Kotok. And though they tell me they are all around us there, the only bears I have seen are some of my fellow campers.

Your ready to lose the fishing contest again,

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

 

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Big Banks Shift to Lower Gear

(Excerpted from the July 2014 edition of A. Gary Shilling’s INSIGHT)

In February 2007, the subprime mortgage bubble broke (Chart 1). Big British bank HSBC was forced to take a $1.8 billion writedown on its U.S. Household subprime lending unit’s bad loans, at the time an unprecedented amount, and subprime mortgage lender New Century reported disappointing fourth quarter results.

Quick Spreading

At the time, many housing bulls tried to convince us that the problem was limited to subprime loans that were made to people they, luckily, would never have to meet. But it spread to Wall Street. Bear Stearns was laden with subprime-related securities and when market lenders refused to finance the firm, the New York Fed provided $30 billion in short-term financing. On March 16, 2008, the firm merged with JP Morgan Chase bank in a stock swap worth $2 per share, only 7% of its value two days earlier and 1% of the $172 a share price for Bear Stearns in January 2007. Morgan bank paid $1 billion and the New York Fed was stuck with $29 billion.

Lehman Brothers was next. But this time, the Fed and the Bush Administration refused to bail out that firm and it filed for bankruptcy on September 15, 2008 when outside financing of its hugely leveraged portfolio disappeared and its net worth was a negative $129 billion.

With a meltdown of major Wall Street firms in prospect that probably would have spread worldwide, the Fed and the Administration twisted Congress’ arms into passing the Troubled Asset Relief Program. TARP originally authorized $700 billion to finance troubled assets but it soon morphed into a bailout fund for banks and other troubled financial institutions and took equity positions in 707 banks. The objective was to stabilize their balance sheets and encourage them to lend.

Some $475 billion of TARP money was disbursed and all but $40 billion has been repaid. That $40 billion went to automakers GM and Chrysler as well as insurer AIG – two of them non-banks. But that didn’t stop Washington from placing most of the blame for the financial crisis on the big banks and their CEOs. After all, when a lot of people lose a lot of money, there is a cosmic need for scapegoats, and the big banks have served themselves up for this role.

Too Big To Fail

Much of Wall Street is financed by very short-term loans, often only overnight. So if one firm gets in trouble, funding woes can spread quickly to other firms in the same business, regardless of their individual size, as lending dries up. This is the systemic risk problem. Nevertheless, Congress addressed the situation with such measures as “living wills,” plans prepared by banks to liquidate themselves quickly in the event of future troubles. But if a specific bank were in deep difficulty, would others remain untouched? Can you “keep your head when all about are losing theirs and blaming it on you?”

Then there is the Volcker Rule, proposed by former Fed Chairman Paul Volcker and part of the 2010 Dodd-Frank financial reform law. It strips banks of proprietary trading for their own accounts even though proprietary trading was not a problem for any troubled firms during the financial crisis.

Most significant is the Too-Big-To-Fail concept, the belief that big banks need to be broken up so they can fail individually without endangering the entire financial system. Proponents apparently dismiss the systemic risk reality and forget that bank runs took down many small banks in the early 1930s as well as large ones. We recall a story of people queued up to withdraw their money from a bank in a line that stretched past another bank. So they made a run on that second bank while waiting!

The too-big-to-fail concept originated
in the 1980s when Continental Illinois
had to be rescued. That bank wasn’t
involved in exotic financial activities but rather straightforward commercial banking, taking deposits and making loans. Unfortunately, it made too many bad loans, as have failed predecessors over the centuries.

Bank Concentration

The too-big-to-fail concept is also fueled by the increasing concentration of bank assets. Sure, the number of banks continues to fall (Chart 2), largely due to mergers. The FDIC now insures 6,730 institutions, down from an earlier peak of 18,000 in 1985. But most of the decline of 10,000 banks in the 1984-2011 years was among small banks with less than $100 million in assets due to mergers, consolidations and failures, with 17% of banks collapsing. Increasing costs of regulations since 2008 has also speeded the demise of small banks. At the same time, the number of banks with $100 million to $1 billion in assets has risen since 1985. More regulation in response to earlier collapse in the residential mortgage market, and economies of scale, are encouraging mergers of medium-sized banks into larger units.

Many observers believe banks with less than $1 billion in assets are too small to cope with increased regulation. Last year, in 204 bank mergers, the target bank had assets under that level, about the same as the 206 in 2012 but up hugely from 102 in 2009 before the pressure to merge was fully felt. Not only Dodd-Frank regulations, but also the new “qualified mortgage” rules by the Consumer Finance Protection Bureau that insures borrowers can afford mortgages, are very costly for small banks.

Also, the number of bank branches continues to drop, in part due to mobile and electronic banking. Last year, 2,563 branches disappeared and reduced the total to 96,339 in mid-2013 (Chart 3). This is a far cry from the situation in the early 1960s when I was working on my Ph.D at Stanford and a girlfriend from the Chicago area was visiting me in the summer. She had a letter of introduction from Continental Illinois so she could cash checks at Bank of America, then entirely located in California. While filling out the Bank of America forms in San Francisco, she was stymied by the blank that called for the branch of her bank. Illinois at the time had only unit banking, one location per bank. The Bank of America officer in turn couldn’t understand her problem because of that bank’s statewide branch network.

Big Banks Balloon

Nevertheless, the largest banks’ share of assets continues to leap. It was propelled in the 1990s by the progressive relaxation and final elimination in 1999 of the Depression- era Glass-Steagall law that kept commercial banks out of investment banking. Then with the 2008 financial crisis, stronger big banks bought weaker competitors – with government encouragement, we might add. JP Morgan Chase took over failed Washington Mutual as well as Bear Stearns, Bank of America acquired mortgage lender Countrywide and Merrill Lynch, and Wells Fargo purchased Wachovia. At the end of 2013, the five largest institutions controlled 44.2% of total bank assets, up from 38.4% in 2007. As of March 31, 2014, those 107 institutions with over $10 billion in assets were only 1.7% of the total number but held 80.8% of all bank assets (Chart 4).

In addition, critics of big banks note that buyers of bank debt are more lax in their due diligence of a bank that’s too big to fail because they anticipate a government bailout if needed. This allows the leaders of these banks to borrow cheaply and take bigger risks in a self-feeding cycle of more leverage and more risks.

A recent New York Fed study found that big banks pay 0.31 percentage points less than smaller banks when issuing high-quality bonds, and an even bigger advantage in comparison with nonfinancial corporations where the spread is 0.5 percentage points. Similarly, the IMF reports a borrowing advantage of 0.6 percentage points for too-big-to-fail banks in Japan and the U.K. and 0.9 in the eurozone.

Furthermore, bank CEO pay is much more linked to size than performance. A recent study revealed that the eight U.S. “Systemically Important Banks” – Wells Fargo, JP Morgan Chase, Goldman Sachs, State Street, Bank of New York Mellon, Morgan Stanley, Citigroup and Bank of America – had a median stockholder total return (stock appreciation plus dividends) of 38% since 2009 while the return for smaller banks like US Bancorp, PNC and Sun Trust exceeded 100%. But the median total pay, including cash and stock awards of the large banks between 2010 and 2013, was $57 million compared with $35 million for the second tier. Sure, larger firms are more complex and harder to manage but they can make bigger mistakes, as shown by JP Morgan’s $6.2 billion loss with the London Whale, as we’ll discuss later. No wonder big bank CEOs resist dismemberment and want to grow even bigger!

Break-Up Proponents

Among those now advocating the breaking up of big banks is Sanford Weill, who, ironically, earlier led the charge to end Glass-Steagall so he could merge insurer Travellers, which he headed, with Citigroup. In fact, the Gramm-Leach-Bliley Act that killed Glass-Steagall was dubbed the “Citigroup Authorization Act.” In announcing his reversal in opinion in July 2013, Weill said, “I think the earlier model was right for that time. I think the world changed with the collapse of the real estate market and the housing bubble and what that did because ofleverage ofcertain institutions. So I don’t think it’s right anymore.” He also said, “I am suggesting that they be broken up so that the taxpayer will never be at risk, the depositors won’t be at risk.” And he admitted, “Mistakes were made.”

Others advocating the break-up of big banks include Philip Purcell, the former CEO of Morgan Stanley, Sheila Bair, the former head of the FDIC, John Reed, who ran Citigroup before it was merged with Travellers, Thomas Hoenig, former Kansas City Fed President and Dallas Fed President Richard Fisher. A number in Congress are also on board including Sen. Ron Johnson from Wisconsin.

Like unscrambling an egg, it’s hard to envision how big banks with many, many activities could be split up. But, of course, one of the arguments for doing so is they’re too big and too complicated for one CEO to manage. Still, there is the example of the U.K., which plans to separate deposit-taking business from riskier investment banking activities – in effect, recreating Glass-Steagall.

In any event, among others, Phil Purcell believes that “from a shareholder point ofview, it’s crystal clear these enterprises are worth more broken up than they are together.” This argument is supported by the reality that Citigroup, Bank of America and Morgan Stanley stocks are all selling below their book value (Chart 5). In contrast, most regional banks sell well above book value.

Push Back

Not surprising, current leaders of major banks have pushed back against proposals to break them up. They maintain that at smaller sizes, they would not be able to provide needed financial services. Also, they state, that would put them at a competitive disadvantage to foreign banks that would move onto their turf.

The basic reality, however, is that the CEOs of big banks don’t want to manage commercial spread lenders that take deposits and make loans and also engage in other traditional banking activities like asset management. They want to run growth companies that use leverage as their route to success. Hence, their zeal for off-balance sheet vehicles, proprietary trading, derivative origination and trading, etc. That’s where the big 20% to 30% returns lie – compared to 10% to 15% for spread lending – but so too do the big risks.

Capital Restoration

The strategy of big bank CEOs seems to be to fight break- up proposals tooth and nail in the hope that as memories of the 2008-2009 bailouts fade, so too will interest in reducing their size. Furthermore, the vast majority of banks, big and small, have restored their capital. Most banks are comfortably above impending capital requirements. At the end of the first quarter, 98.2% of all FDIC-insured institutions representing 99.8% of industry assets (and therefore all the big banks) met or exceeded the requirements of the higher regulatory capital category.

Nevertheless, the FDIC and Federal Reserve are planning a new “leverage ratio” schedule that would require the eight largest “Systemically Important Banks” to maintain loss-absorbing capital equal to at least 5% of their assets and their FDIC-insured bank subdivisions would have to keep a minimum leverage ratio of 6%. This compares with 3% under the international Basel III schedule. Six of these eight largest banks would need to tie up more capital. Also, regulators may impose additional capital requirements for these “Systemically Important Banks” and more for banks involved in volatile markets for short-term borrowing and lending. The Fed also wants the stricter capital requirements to be met by 2017, two years earlier than the international agreement deadline.

The number of institutions on the FDIC’s “Problem List” fell to 411 and the assets of those banks dropped to $126.1 billion in the first quarter. Bank failure numbers have yet to return to pre-crisis levels, but have dropped considerably since the 157 peak in 2010 (Chart 6). Similarly, the percentage of institutions with quarterly losses continues to fall
while the percentage with quarterly earnings increases exceeds the pre-crisis
level (Chart 7).

More Regulation

Despite the improving financial status
of banks, especially larger institutions,
their push back against being dismembered has been met with more regulation. The unvoiced strategy in Washington seems to be, if the big banks
don’t agree to be broken up, they’ll be regulated to the point that they wish they
were, or at least to the degree that individual failures are much less likely
and far less damaging if they do occur.
Slowly but surely, they’re being busted back toward spread lending and other traditional commercial banking businesses and bereaved of many risky but highly-profitable activities – highly-profitable until adjusted for risks. Consider the higher Basel III capital requirements, the pressures to orient executive compensation toward long- run risk-adjusted profitability and away from short-run speculation, the divestiture of non-core bank assets, the Volcker Rule, the selling ofbranches and subsidiary banks, etc.

Late last year, the FDIC prepared a plan to unwind large banks on the edge of collapse without taxpayer bailouts. The FDIC would keep parts of the bank open, prioritize payments to creditors and recapitalize the firm. “Unsecured creditors and shareholders must bear the losses of the financial company without imposing a cost on U.S. taxpayers,” said FDIC Chairman Martin Greenberg.

All of these new regulation proposals strike us as fighting the last war. With all the Dodd-Frank and other regulations now in place and the losses, chastisements and embarrassments of bankers, mortgage lenders, homeowners, etc., it’s unlikely that a repeat of the 2008 financial crisis and the speculation that spawned it will occur any time soon. That doesn’t mean that financial bubbles are extinct, but that the next one will occur in a different area that is outside the scope of the regulatory reaction to the last crisis. Besides, all those super bright, million-dollar per year guys and gals on Wall Street can figure out how to beat most $100,000 regulators any day!

Fed Proposals

Meanwhile, the Fed and the Office of the Controller of the Currency, another bank regulator, in March 2013 told banks to avoid funding takeover deals that would leave companies with high debts. But since then, “judging from aggressive market data, it appears that many banks have not fully implemented standards set forth” in March 2013, said a senior Fed official recently. In March of this year, the OCC said there would be “no exceptions” to the guidance for newly-issued loans. These junk “leveraged” loans have seen a rapid reduction in investor-protecting covenants that moves them back to previous day’s levels that proved disastrous when the 2008 financial meltdown hit.

In a similar vein, the Fed’s point man on regulations, Gov. Daniel Tarullo, said recently that after reading accounts of the role that money market and other short-term markets played in the financial crisis, a “broadly applicable” minimum margin requirement makes sense. Fed Chairwoman Janet Yellen also backs new rules for short-term funding to mitigate risks to the financial system.

The final version of the Volcker Rule has been delayed by haggling over the difference between genuine hedging of customer assets and proprietary trading with bank assets. The Volcker Rule isn’t expected to be implemented until 2015 and promises to be very specific as to what is and what isn’t a hedge. Meanwhile, Wall Street houses such as Goldman Sachs have exited their in-house trading.

More Examiners

Regulators are adjusting their staffs to better understand and control financial institutions’ activities. The New York Fed roughly doubled its supervision staff since the crisis and has between 15 and 40 overseeing each of the largest bank holding companies. The OCC, which regulates banks with national branch networks like JP Morgan and Wells Fargo, has upped its staff examining large banks by 20% since 2007, with up to 60 at the largest institutions. These examiners have access to computer systems and can attend internal strategy meetings and readily meet with bank executives and board members.

At the same time, the heat is on banks to beef up their compliance. Regulators are concerned that banks don’t comprehend their own operations, including measuring risks and planning for future crises. The OCC recently said that only two of 19 banks have met the standards it laid out after the crisis. Among other things, it wants two independent directors on boards of national banks and independent officers to track and monitor all business lines.

Large banks are hyping their compliance staffs. JP Morgan plans to add over 13,000 people and the industrywide hiring effort is creating a war for talent with escalating pay levels. Similarly, bank risk officers are multiplying like fruit flies as the OCC warns that “credit risk is now building after a period of improving credit quality and problem loan cleanup.” At major banks, their numbers are rising over 15% annually.

Wells Fargo now has 2,300 in its risk management department, up from 1,700 two years ago and the department’s budget has doubled to $500 million. In contrast, the bank’s total workforce has remained flat. Goldman Sachs put its chief risk officer on the 34-person management committee for the first time in the firm’s 145-year history. Senior risk officer pay is up as much as 40% from a few years ago and equal to the compensation of chief financial officers and general counsels. Earlier, they were paid a third less.

Large banks are being pushed by regulators to specify in writing which risks and how much they’re willing to take to meet financial goals. Risk officers are being urged to examine big losses or big profits for signs of undue risks.

The efforts of regulators and risk officers may be having significant effects. At the end of 2013, the five largest banks had $793 billion in equity capital to protect against losses, up 19% from $667 billion in 2009. At the same time, their value at risk, in effect their exposure to losses on any given trading day, fell 64% from $1.05 billion to $381 million

Who’s The Toughest?

Then there is the war among regulators to be the toughest. They’re chastised in and out of Washington for leveling billion-dollar fines that are still just a cost of doing business for major banks, for letting them off with mere “we neither admit nor deny” statements and for not sending individual bankers to jail. The relatively new SEC Chairwoman Mary Jo White promises to be a lot tougher, but the results are yet to be seen. The OCC recently detailed risk management standards for banks with over $50 billion in assets, which puts the monkeys on the bank board members’ backs and requires banks to have independent audit and risk management offices that can take their concerns directly to the board.

Then there’s the game of one
regulator trying to deflect
pressure by saying that other
regulators are lax. The SEC
has criticized the Financial
Industry Regulatory Authority, which it oversees, for being
too lenient in its sanctions. In
the five years since the financial
crisis, FINRA did not
discipline any Wall Street
executives and imposed fines
of $1 million or more 55 times
compared with 259 times for
the SEC. FINRA regulated
4,100 brokerage firms and over 600,000 brokers and collected just $74.5 million in fines last year compared to $3.9 billion for the SEC. Note, however, that the SEC, not FINRA, takes the most serious fraud cases while FINRA concentrates on lesser infractions such as operations breakdowns where penalties are smaller.

Derivatives

Dodd-Frank has bereaved banks of much of their origination in trading in futures, options and other derivatives. Derivative trading is largely being transferred to exchanges that guarantee fulfillment of the contracts as opposed to the highly-profitable over-the-counter derivatives that banks trade but with which investors or speculators have to look to counterparties to be good for losses. This is the “counterparty risk” problem. Still, the seven largest banks still accounted for 98% of the $215 trillion notional value of derivative contracts as of March 31 (Chart 8), 85% of which were interest rate contracts (Chart 9).

Still, regulators are concerned with derivatives. Those from 10 European and North American countries recently released a report that said many large banks and their regulators are still not ready to deal with difficulties in the huge derivatives market. They lack the information to consistently and accurately know who their counterparties are. Officials estimate that banks are up to three years away from having the necessary systems in place.

Dark Pools And High-Speed Trading

Another area of concern to regulators is dark pools, private trading venues that don’t disclose their activities publicly and account for 14% of all stock trading. Another 23% occurs in other off-exchange locales. The purpose of dark pools is to facilitate large institutional trading without exposure to high-frequency traders. Barclays bank runs Barclays LX, the country’s second largest dark pool, which is marketed with the motto, “Protecting clients in the dark.” But the New York Attorney General has charged that Barclays offered access to Barclays LX to high-speed traders. The bank is also accused of using other trading venues that benefit Barclays rather than its customers.

Under pressure from their institutional investor clients, many large brokers are routing trades away from Barclays LX and other dark pools. The SEC is investigating dark pools to determine whether they accurately disclose how they operate and whether they treat all investors fairly. Chairwoman White said in June that the size of off-exchange trading “risks seriously undermining” the quality of the U.S. stock market. Goldman Sachs recently agreed to pay an $800,000 fine for mispricing 400,000 trades in dark pool Sigma X in 2011. The firm already reimbursed clients with $1.67 million.

Citigroup Charades

One big bank that remains squarely in regulators’ gun sights is Citigroup, and for good reason. The present firm resulted from the merger of Citicorp and Travellers in 1998. Vikram Pandit left Morgan Stanley in 2005 after being passed over for CEO and, with two colleagues, started a hedge fund, Old Line. It was sold to Citigroup in 2007, right at the top of the financial bubble, for $800 million. Even though that hedge fund was not very successful and eventually closed, Pandit rose to be CEO of the firm in December 2007.

On his watch, the company’s stock continued its collapse from what would have been $564 per
share in December 2006, except for the
10-to-1 reverse split in May 2011 to avoid the embarrassment of its selling at penny stock prices (Chart 10). The swoon to the trough in March 2009 was 98.2%.

Pandit’s relations with regulators were poor and he didn’t help matters by letting the bank consider completing the purchase of a private jet after receiving $45 billion in TARP bailout money. Despite his announcement to the Citigroup directors that all was well with regulators, the bank failed the Fed’s stress test in 2012. So it was not allowed to increase its quarterly dividend from one-cent per share to five cents and it requested but could not buy back up to $6.4 billion in stock. Shareholders were not amused and Pandit was shown the door in October.

Pandit told Congress in February 2009 that “my salary should be $1 per year with no bonus until we return to profitability.” After some improvement in the bank’s finances, he was awarded a $23.2 million retention package in 2011, close to the top of CEO compensation. Nevertheless, in April 2012, 55% of shareholders voted against increasing his pay to $15 million, the first nonbinding rejection of a compensation plan by a major bank.

History Repeats

In a repeat of history, last March the Fed again said Citigroup flunked its stress test, only the second bank along with Ally Financial to fail twice. So it can’t raise its quarterly dividend from one-cent to five cents per share.

It wasn’t the quantitative part of the test that tripped up Citigroup. Its Tier 1 capital ratio would only fall to 7% under very adverse conditions, still well above the fed’s 5% minimum. That adverse scenario, specified by the Fed, includes a deep recession with leaping unemployment, a steep decline in house prices and a 50% plummet in equity prices. Also, in the third annual stress test, the Fed made its own projection of the bank’s balance sheet, assuming the assets rise during tough times rather than fall as banks had assumed, so more bank capital would be necessary. In addition, the Fed forced eight big banks to assume the default of their largest counterparty.

The Fed this year flunked Citigroup on the quantitative side of the stress test. It cited deficiencies in Citi’s capital-planning process and risk assessments. The Fed had earlier warned the bank about these problems, but received an inadequate response. In effect, the Fed is questioning whether Citigroup is too big and too complex to manage without posing systemic risk.

The London Whale

In failing Citigroup in its stress test, the Fed has yet to bring up the bank’s risks controls in Mexico and the Banamex loss. But the Fed and other regulators have been clear over JP Morgan Chase’s lack of controls that led to the London Whale disaster in 2012.

Banks normally invest funds they’re not using for loans in Treasurys, but with low interest rates, JP Morgan became aggressive. As an example, at the end of 2006, it held $600 million in riskier corporate debt, or about 1% of total investments, but jumped those holdings to $10 billion, or 5% of all security holdings, two years later, and $62 billion, or 17% of the total, at the end of 2008 after the Fed initiated its zero interest rate policy. Similarly, non-U.S. residential mortgage security holdings jumped from $2 billion at the end of 2008 to $75 billion in early 2012. At the time, CEO Jamie Dimon disputed the idea that the bank was taking on more risk. “I wouldn’t call it more aggressive. I would call it better,” he said.

Meanwhile, the bank’s culture of risk-taking – and we believe the tone in any organization is set at the top – was rampant in London. A JP Morgan bank trader, Bruno Iksil, was making huge bets totaling $82 billion, with insurance-like derivatives called credit default swaps so big that he became known as the London Whale. That attracted hedge funds to take the other side of his trades, figuring he’d have to unwind them sooner or later. Meanwhile, his boss was urging him to put even higher values on his positions. When asked about this trading on April 13, 2012, Dimon said concerns were “a complete tempest in a teapot.”

Then came revelations of losses of at least $2 billion and Dimon began to realize the extent of the problem. “There’s blood in the water – hedge funds are going to come after us and make it worse,” he was told by a colleague. And they did, with the loss leaping to $6.2 billion by July. Dimon tried to get ahead of the bad public relations by stating that the trades were “flawed, poorly executed, poorly reviewed and badly monitored.”

The Chief Investment Office in which these trades took place was supposed to manage and hedge the firm’s fixed- income assets. But it has become clear that the CIO was taking directional bets and speculating in contradiction of the impending Volcker Rule. In 2011, risk-control caps that had required traders to exit positions when their losses exceeded $20 million were dropped. Subsequently, Dimon admitted as much, saying, “What this hedge morphed into violates our own principles.” Also, he was slow to fire Ina Drew, who was responsible for the CIO, and he dithered about clawing back the $14.7 million in stock awards she received.

Bones And Joints

Furthermore, Dimon, the bank and Wall Street faced huge fallout from this mess. He has led the charge against the Volcker Rule and other new bank regulations and had considerable credibility in Washington and on Wall Street because his bank largely avoided the near-financial meltdown.

Dimon was known as the smart, hands-on operator who says he knows all the “bones and the joints” of the bank. Is his being shocked! shocked! to discover the $6.2 billion loss proving what many regulators and legislators believe: that big banks are too complicated to manage and should be broken up? If they’re too big to fail, it’s ironic that when asked, in hindsight, what he should have paid more attention to, Dimon quipped, “Newspapers,” no doubt referring to the April 6, 2012 front page Wall Street Journal story about the London Whale.

Furthermore, the London Whale fiasco has not hindered Dimon’s compensation, although he suffered a pay cut at the time. In January 2014, the JP Morgan board raised his pay 74% to $20 million for 2013, a year in which the bank agreed to more than $20 billion in fines and other legal payouts and suffered its first quarterly loss in nine years. In making that award, which included $18.5 million in stock, the board cited “the regulatory issues the company has faced and the steps the company has taken to resolve those issues.”

Well, in contrast to Citigroup, JP Morgan’s stock fell “only” 70% during the financial crisis. Since then, it has rallied 260% to now exceed the May 2007 peak by 8%. And investors didn’t have lasting concerns over the 2012 London Whale losses and lack of controls. Regulators, however, may have the last word.

Fines

That lack of investor worry comes despite the huge fines and other penalties being paid by JP Morgan and other big banks over bad mortgages, manipulation of currency, interest rate and commodity markets, and illegally helping Americans to avoid taxes.

The CFTC and JP Morgan settled for $100 million in the London Whale case after the regulator charged the bank with reckless use of manipulative devices. The bank also acknowledged wrongdoing as part of the $970 million settlement with the SEC, OCC, the Fed and U.K. regulators in September 2013 in the same case.

The SEC got $200 million of that total and admissions by JP Morgan that it misstated its first quarter 2012 financial results, failed to properly oversee its traders and didn’t keep its board of directors informed about the trading problems. This is only the second time, after the settlement with hedge fund company SAC, that the SEC obtained admission of wrongdoing and it is in line with Chairwoman White’s promise to get tough and get more admissions. Earlier, U.S. District Court Judge Jed S. Rakoff rejected a $285 million settlement the SEC negotiated with Citigroup, in part because Citi did not admit liability.

BNP

Big foreign banks with U.S. operations are not beyond the reach of American regulators. France’s largest bank, BNP Paribas, has finally agreed to pay $9 billion in penalties and plead guilty to criminal charges over concealing about $30 billion in oil and other transactions with countries that are sanctioned by the U.S. including Iran, Cuba and Sudan. Also, as demanded by New York State regulators, 30 people will leave the bank. Starting in January, the bank will lose its permission to clear certain dollar transactions for a year. The alternative to accepting these harsh sanctions was being banned from done business in lucrative U.S. financial markets.

Since French banks dominate trade financing and these transactions between the Americas and Asia are carried out in U.S. dollars, this last penalty is especially meaningful for BNP, although the bank has six months to arrange a transition to other firms that will handle this business during BNP’s absence. French President Francois Hollande called the demands by U.S. regulators “unfair and disproportionate,” but with classic French face-saving, Finance Minister Michel Sapin took credit for the limited scope of the dollar ban. “In line with the demands of the French authorities, this agreement sanctions the activities of the past and protects the future,” he said.

Prosecutors in the Justice Department and Manhattan District Attorney’s office were especially irked by BNP’s slow and incomplete response to their requests for documents and interviews in 2009 concerning transactions that took place between 2002 and 2009. U.S. authorities believe that BNP employees took deliberate steps over several years to hide their dollar transactions with U.S.-sanctioned countries. Transactions were run through intermediate banks to avoid detection, in schemes that resemble money-laundering. BNP apparently did not expect this big of a fine since it reserved only about $1.1 billion. It plans to maintain its dividend and its stock rose 3.6% on the news, although it had dropped 18% since February when the bank announced the provision for possible U.S. fines….

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Important Disclosures

Things That Make You Go Hmmm: Ann Elk’s Theory On Brontosauruses

 

Though they reunited this past month for a series of concerts at London’s O2 Arena, the cast of Monty Python last assembled onstage together at London’s Drury Lane Theatre a staggering 40 years ago.

As they took to the stage at the O2 in early July, the surviving members of perhaps the most famous comedy troupe in history (sadly, Graham Chapman died in 1989) boasted a combined age of 357.

As expected, neither of these facts deterred people from flocking to see the Pythons; nor, it has to be said, did the occasional “senior moment” on stage prevent rapturous critics from garlanding them with rave reviews.

The centrepiece of the show was, of course, the famous “Parrot Sketch” in which John Cleese returns a dead Norwegian Blue parrot to “the very boutique” from whence it came “not ’alf an hour ago.”

The sketch, written by Cleese and Chapman in 1969, took aim at the British fondness for euphemism (particularly as pertains to death) and (somewhat ironically, given the subject) became one of the most mimicked pieces of comedy ever conceived.

The YouTube video I linked to above (just in case there is still anybody out there who HASN’T seen the “Parrot Sketch”) has 4.5 million views alone.

However, buried in the Python’s canon of work lies another sketch which proved far less popular amongst the viewing public but which found favour amongst (of all groups) the scientific community.

The sketch, “Anne Elk’s Theory on Brontosauruses,” appeared in the 31st episode of Monty Python’s Flying Circus, which was entitled “The All-England Summarize Proust Competition”; and it featured Chapman as a television interviewer and Cleese (in drag) as Miss Anne Elk, a paleontologist, who was in the studio to discuss her new, ground-breaking theory on the afore-mentioned dinosaurs.

What followed when Elk was questioned about her theory is classic Python:

Presenter: You have a new theory about the brontosaurus.

Anne Elk: Can I just say here, Chris, for one moment, that I have a new theory about the brontosaurus?

Presenter: Uh… Exactly…

Very long pause

(prompting) What is it?

Anne Elk: Where?

Presenter: Your new theory

Anne Elk: Oh! What is my theory?

Presenter: Yes!

Anne Elk: What is my theory that it is? Well, Chris, you may well ask me what is my theory.

Presenter: I am asking.

Anne Elk: Good for you. My word yes. Well Chris, what is it, that it is, this theory of mine. Well, this is what it is. My theory, that I have, that is to say, which is mine… is mine.

Presenter: Yes, I know it’s yours! What is it?

Anne Elk: … Where? … Oh! This is it.

Starts prolonged throat clearing

Anne Elk: (clears throat) This theory, which belongs to me, is as follows… (more throat clearing) This is how it goes… (clears throat) The next thing that I am going to say is my theory. (clears throat) Ready?

Inevitably, after such a prolonged build-up, the payoff is predictable in that Elk is clearly stalling in order to avoid explaining her theory for as long as possible; but, eventually, she is forced into laying it out for the whole world to see:

Anne Elk: My Theory, by A. Elk (Miss). This theory goes as follows and begins now:

All brontosauruses are thin at one end; much, much thicker in the middle; and then thin again at the far end. That is my theory that is mine and belongs to me and I own it and what it is, too.

… and in that instant, she is exposed for what she is: a fraud.

The scientific community adopted Anne Elk’s theory on brontosauruses to describe any scientific observation which is not actually a theory but rather a minimal account; and that sobriquet — it seems to me — merits far broader application and acceptance.

Lately I seem to be constantly reminded of Anne Elk everywhere I turn, as the world descends into chaos and those charged with running it (at least officially) stumble from pillar to post, relying on the public’s buying into whatever they spin in order to press their agenda.

We see it in the rush to demonize Vladimir Putin for the MH17 tragedy, along with everything else that remotely touches Russia; we see it in the one-sided reporting of events in the Middle East; and we see it in the broad-brush strokes painted across the China canvas when assumptions are made about what is happening inside the political hierarchy that runs the Middle Kingdom.

However, the one place it is glaringly obvious (and has been for a number of years) is in the talk emitting from the mouths of the world’s central bank governors.

Now, I am no great fan of Putin; nor do I feel able to confidently choose sides between various factions in the Middle East — mainly because I find it impossible to take what I read in the mainstream media at face value and therefore come to what I would consider a well-informed opinion — but the beauty of central bankers is that they hold press conferences and release detailed minutes of their meetings which, if anything, throw perhaps too much light onto their deliberations, operations, and machinations for anybody’s good — least of all their own.

July 26th, 2012: Anne Elk’s Mario Draghi’s Theory on Preserving the Euro:

 

This theory, which belongs to me, is as follows… (more throat clearing) This is how it goes… (clears throat) The next thing that I am going to say is my theory. (clears throat) Ready?

We think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made, to make it irreversible.

But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Now, unlike Anne Elk’s (brackets, “Miss,” close brackets), Draghi’s theory — though in effect every bit as toothless should his bluff ever have been called — was taken at face value by a gullible public; and disaster was averted (though, along with the gullibility, there was also an implicit explicit bribe put carefully in place — buy bonds of bankrupt countries, and we’ll make sure you don’t lose money).

Many of you will probably not remember what the edge of the abyss looked like, so here are a couple of reminders — just for old times’ sake:

 

The chart above shows the yields on 10-year government bonds for Greece’s $242 billion economy; Spain’s $1.35 trillion economy; and the behemoth, Italy’s $2.17 trillion economy through 2011, going into the unveiling of Draghi’s Elk Theory plan and beyond.

Due to scaling issues, the plot for Greece is on a separate scale on the right-hand side of the chart; but, if you look carefully, you’ll see that yields on its 10-year bonds peaked at 37% in early 2012 and, despite some serious jawboning on the part of EU politicians, were still at 28% in July when Draghi cleared his throat.

Remember those days? Europe was teetering on the edge of oblivion, and each day saw the chances of a disorderly unwind of the euro increase to the point where even some of the more staunch pro-Europe voices began to waver in their certainty about its future.

Writing somewhat presciently a few short weeks before Draghi unveiled his Elk Theory, plan, The Economistlaid out the bind perfectly:

(Economist): Even the single currency’s die-hard backers now acknowledge that it was put together badly and run worse.

Greece should never have been let in. France and Germany rode a coach and horses through the rules designed to prevent government borrowing getting out of hand. The high priests of euro-orthodoxy failed to grasp that, though Ireland and Spain kept to the euro’s fiscal rules, they were vulnerable to a property bust or that Portugal and Italy were trapped by slow growth and declining competitiveness.

A break-up, many argue, would allow individual countries to restore control over monetary policy. A cheaper currency would help match wages with workers’ productivity, for a while at least. Advocates of a break-up imagine an amicable split. Each government would decree that all domestic contracts—deposits and loans, prices and pay—should switch into a new currency. To prevent runs, banks, especially in weak economies, would shut over a weekend or limit withdrawals. To stop capital flight, governments would impose controls.

All good, except that the people who believe that countries would be better off without the euro gloss over the huge cost of getting there. Even if this break-up were somehow executed flawlessly, banks and firms across the continent would topple because their domestic and foreign assets and liabilities would no longer match. A cascade of defaults and lawsuits would follow. Governments that run deficits would be forced to cut spending brutally or print cash.

Has anything changed in Greece since July 26th, 2012? Well, let’s see:

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

Things That Make You Go Hmmm: Anne Elk’s Theory On Brontosauruses

 

Though they reunited this past month for a series of concerts at London’s O2 Arena, the cast of Monty Python last assembled onstage together at London’s Drury Lane Theatre a staggering 40 years ago.

As they took to the stage at the O2 in early July, the surviving members of perhaps the most famous comedy troupe in history (sadly, Graham Chapman died in 1989) boasted a combined age of 357.

As expected, neither of these facts deterred people from flocking to see the Pythons; nor, it has to be said, did the occasional “senior moment” on stage prevent rapturous critics from garlanding them with rave reviews.

The centrepiece of the show was, of course, the famous “Parrot Sketch” in which John Cleese returns a dead Norwegian Blue parrot to “the very boutique” from whence it came “not ’alf an hour ago.”

The sketch, written by Cleese and Chapman in 1969, took aim at the British fondness for euphemism (particularly as pertains to death) and (somewhat ironically, given the subject) became one of the most mimicked pieces of comedy ever conceived.

The YouTube video I linked to above (just in case there is still anybody out there who HASN’T seen the “Parrot Sketch”) has 4.5 million views alone.

However, buried in the Python’s canon of work lies another sketch which proved far less popular amongst the viewing public but which found favour amongst (of all groups) the scientific community.

The sketch, “Anne Elk’s Theory on Brontosauruses,” appeared in the 31st episode of Monty Python’s Flying Circus, which was entitled “The All-England Summarize Proust Competition”; and it featured Chapman as a television interviewer and Cleese (in drag) as Miss Anne Elk, a paleontologist, who was in the studio to discuss her new, ground-breaking theory on the afore-mentioned dinosaurs.

What followed when Elk was questioned about her theory is classic Python:

Presenter: You have a new theory about the brontosaurus.

Anne Elk: Can I just say here, Chris, for one moment, that I have a new theory about the brontosaurus?

Presenter: Uh… Exactly…

Very long pause

(prompting) What is it?

Anne Elk: Where?

Presenter: Your new theory

Anne Elk: Oh! What is my theory?

Presenter: Yes!

Anne Elk: What is my theory that it is? Well, Chris, you may well ask me what is my theory.

Presenter: I am asking.

Anne Elk: Good for you. My word yes. Well Chris, what is it, that it is, this theory of mine. Well, this is what it is. My theory, that I have, that is to say, which is mine… is mine.

Presenter: Yes, I know it’s yours! What is it?

Anne Elk: … Where? … Oh! This is it.

Starts prolonged throat clearing

Anne Elk: (clears throat) This theory, which belongs to me, is as follows… (more throat clearing) This is how it goes… (clears throat) The next thing that I am going to say is my theory. (clears throat) Ready?

Inevitably, after such a prolonged build-up, the payoff is predictable in that Elk is clearly stalling in order to avoid explaining her theory for as long as possible; but, eventually, she is forced into laying it out for the whole world to see:

Anne Elk: My Theory, by A. Elk (Miss). This theory goes as follows and begins now:

All brontosauruses are thin at one end; much, much thicker in the middle; and then thin again at the far end. That is my theory that is mine and belongs to me and I own it and what it is, too.

… and in that instant, she is exposed for what she is: a fraud.

The scientific community adopted Anne Elk’s theory on brontosauruses to describe any scientific observation which is not actually a theory but rather a minimal account; and that sobriquet — it seems to me — merits far broader application and acceptance.

Lately I seem to be constantly reminded of Anne Elk everywhere I turn, as the world descends into chaos and those charged with running it (at least officially) stumble from pillar to post, relying on the public’s buying into whatever they spin in order to press their agenda.

We see it in the rush to demonize Vladimir Putin for the MH17 tragedy, along with everything else that remotely touches Russia; we see it in the one-sided reporting of events in the Middle East; and we see it in the broad-brush strokes painted across the China canvas when assumptions are made about what is happening inside the political hierarchy that runs the Middle Kingdom.

However, the one place it is glaringly obvious (and has been for a number of years) is in the talk emitting from the mouths of the world’s central bank governors.

Now, I am no great fan of Putin; nor do I feel able to confidently choose sides between various factions in the Middle East — mainly because I find it impossible to take what I read in the mainstream media at face value and therefore come to what I would consider a well-informed opinion — but the beauty of central bankers is that they hold press conferences and release detailed minutes of their meetings which, if anything, throw perhaps too much light onto their deliberations, operations, and machinations for anybody’s good — least of all their own.

July 26th, 2012: Anne Elk’s Mario Draghi’s Theory on Preserving the Euro:

 

This theory, which belongs to me, is as follows… (more throat clearing) This is how it goes… (clears throat) The next thing that I am going to say is my theory. (clears throat) Ready?

We think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made, to make it irreversible.

But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Now, unlike Anne Elk’s (brackets, “Miss,” close brackets), Draghi’s theory — though in effect every bit as toothless should his bluff ever have been called — was taken at face value by a gullible public; and disaster was averted (though, along with the gullibility, there was also an implicit explicit bribe put carefully in place — buy bonds of bankrupt countries, and we’ll make sure you don’t lose money).

Many of you will probably not remember what the edge of the abyss looked like, so here are a couple of reminders — just for old times’ sake:

 

The chart above shows the yields on 10-year government bonds for Greece’s $242 billion economy; Spain’s $1.35 trillion economy; and the behemoth, Italy’s $2.17 trillion economy through 2011, going into the unveiling of Draghi’s Elk Theory plan and beyond.

Due to scaling issues, the plot for Greece is on a separate scale on the right-hand side of the chart; but, if you look carefully, you’ll see that yields on its 10-year bonds peaked at 37% in early 2012 and, despite some serious jawboning on the part of EU politicians, were still at 28% in July when Draghi cleared his throat.

Remember those days? Europe was teetering on the edge of oblivion, and each day saw the chances of a disorderly unwind of the euro increase to the point where even some of the more staunch pro-Europe voices began to waver in their certainty about its future.

Writing somewhat presciently a few short weeks before Draghi unveiled his Elk Theory, plan, The Economistlaid out the bind perfectly:

(Economist): Even the single currency’s die-hard backers now acknowledge that it was put together badly and run worse.

Greece should never have been let in. France and Germany rode a coach and horses through the rules designed to prevent government borrowing getting out of hand. The high priests of euro-orthodoxy failed to grasp that, though Ireland and Spain kept to the euro’s fiscal rules, they were vulnerable to a property bust or that Portugal and Italy were trapped by slow growth and declining competitiveness.

A break-up, many argue, would allow individual countries to restore control over monetary policy. A cheaper currency would help match wages with workers’ productivity, for a while at least. Advocates of a break-up imagine an amicable split. Each government would decree that all domestic contracts—deposits and loans, prices and pay—should switch into a new currency. To prevent runs, banks, especially in weak economies, would shut over a weekend or limit withdrawals. To stop capital flight, governments would impose controls.

All good, except that the people who believe that countries would be better off without the euro gloss over the huge cost of getting there. Even if this break-up were somehow executed flawlessly, banks and firms across the continent would topple because their domestic and foreign assets and liabilities would no longer match. A cascade of defaults and lawsuits would follow. Governments that run deficits would be forced to cut spending brutally or print cash.

Has anything changed in Greece since July 26th, 2012? Well, let’s see:

Click here to continue reading this article from Things That Make You Go Hmmm… – a free 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: Time to Put a New Economic Tool in the Box

 

[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.

– Friedrich Hayek, from the introduction to his Nobel Prize acceptance speech in 1974

Last week we took a deep dive into how the concept of GDP (gross domestic product) came about. We looked at some of the controversies surrounding GDP statistics that we use to measure the growth of the economy, and we noted that the GDP tool seems designed to reflect and serve an economic theory (Keynesianism) that prefers to focus on the demand side of economic activity. If your measurement of the growth of the economy is entirely defined by final consumption (that is, consumer spending) and government spending, then if you want to try to improve growth you are left with just two policy dials to adjust:

  1. How do we increase consumption?
  2. How much government spending should there be to stimulate growth when the economy is in a recession?

But what if there are other ways to measure the economy? Might those other measurement tools suggest a different set of policies and methods to help the economy grow? Indeed, I noted last week that the one thing – besides science fiction – that Paul Krugman and I agree on is that we need more growth. (There are actually some economists out there who don’t agree with that assessment. Go figure.)

As it happens, Mr. Krugman stumbled upon my post and wrote the following under the heading “The Horror, the Horror”:

I happened to click on this John Mauldin post, in which he informs us that GDP is a Keynesian plot, and that without it Hayek would of course have won the macroeconomic debate. Oh, kay – but that’s not the horror. It’s this:

“We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. … This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world.”

Oh, boy.

Well, we did feature two of Paul K’s least favorite people at the conference. (His debates with Niall are classic.) I don’t know why, but I started reading the comments to Paul’s piece from readers, some of which were quite thoughtful and showed that commenters had actually read my letter. To those who found me from that link, let me point out that we also had at the conference my good friend, über-Keynesian Paul McCulley, who, along with two or three of the other speakers, was more than capable of defending the Keynesian position. Paul has been a featured speaker at our conference for over 10 years, but I am quite sure there are many people who wonder why we would include him. As I have always maintained in this letter and in my Outside the Box letter, I think it is important to consider and try to appreciate all positions. In fact, I even featured Mr. Krugman himself in Outside the Box, back in 2009.

(At the end of this letter I offer a link to let you see our conference speeches and judge the various positions for yourself.)

All that being said, Mr. Krugman, I don’t think GDP as it is measured today is a Keynesian plot. GDP is a valuable measurement tool, if you understand what is being measured and all those asterisks with caveats that attend any such measure. But as we will see in this week’s letter, there are other ways to measure GDP that would suggest additional policy dials for spurring economic growth.

Say’s Law Makes a Comeback

Actually, the debate on what constitutes an economy goes back much further than Keynes and Hayek. The debate was well recounted in an essay by economist Steve Hanke, a professor of applied economics at Johns Hopkins University. Let’s quote a few paragraphs:

The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.

The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon – courtesy of John Maynard Keynes – this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.

Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.

All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand – namely, a fiscal stimulus [read: lower taxes and/or higher government spending].”

The BEA Introduces Gross Output

So what other tool than GDP might we use? Conveniently, on this very day, July 25, 2014, the Bureau of Economic Analysis begins to publish a quarterly statistic called “gross output.” A good part of the reasoning behind this new statistic and the impetus to produce it comes from a book published in 1990 by my friend of 30 years Dr. Mark Skousen. The book was titled The Structure of Production, and in it Skousen forcefully argued that production rather than demand should be the basis for analyzing the strength of an economy. No less an authority on productivity than Peter F. Drucker commented in a review at the time, “The next economics will have to be centered on supply and the factors of production rather than being functions of demand. I’ve read Mark Skousen’s book twice, and it comes the closest to achieving this goal.”

Gross output (GO) measures the total output of an economy, including investments made by businesses in order to produce their goods, such as capital outlays on new equipment, raw materials, or other business-to-business transactions. In Structure, Skousen makes the case that modern economists downplay the importance of the business sector in the economy and overstate the importance of consumer spending. He believes that the GDP should not be used as the sole measure of economic activity.

Let’s go to the lead editorial by Mark that was published in the Wall Street Journal just a few months ago:

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.

Important Disclosures

Thoughts from the Frontline: Time to Put a New Economic Tool in the Box

 

[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.

– Friedrich Hayek, from the introduction to his Nobel Prize acceptance speech in 1974

Last week we took a deep dive into how the concept of GDP (gross domestic product) came about. We looked at some of the controversies surrounding GDP statistics that we use to measure the growth of the economy, and we noted that the GDP tool seems designed to reflect and serve an economic theory (Keynesianism) that prefers to focus on the demand side of economic activity. If your measurement of the growth of the economy is entirely defined by final consumption (that is, consumer spending) and government spending, then if you want to try to improve growth you are left with just two policy dials to adjust:

  1. How do we increase consumption?
  2. How much government spending should there be to stimulate growth when the economy is in a recession?

But what if there are other ways to measure the economy? Might those other measurement tools suggest a different set of policies and methods to help the economy grow? Indeed, I noted last week that the one thing – besides science fiction – that Paul Krugman and I agree on is that we need more growth. (There are actually some economists out there who don’t agree with that assessment. Go figure.)

As it happens, Mr. Krugman stumbled upon my post and wrote the following under the heading “The Horror, the Horror”:

I happened to click on this John Mauldin post, in which he informs us that GDP is a Keynesian plot, and that without it Hayek would of course have won the macroeconomic debate. Oh, kay – but that’s not the horror. It’s this:

“We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. … This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world.”

Oh, boy.

Well, we did feature two of Paul K’s least favorite people at the conference. (His debates with Niall are classic.) I don’t know why, but I started reading the comments to Paul’s piece from readers, some of which were quite thoughtful and showed that commenters had actually read my letter. To those who found me from that link, let me point out that we also had at the conference my good friend, über-Keynesian Paul McCulley, who, along with two or three of the other speakers, was more than capable of defending the Keynesian position. Paul has been a featured speaker at our conference for over 10 years, but I am quite sure there are many people who wonder why we would include him. As I have always maintained in this letter and in my Outside the Box letter, I think it is important to consider and try to appreciate all positions. In fact, I even featured Mr. Krugman himself in Outside the Box, back in 2009.

(At the end of this letter I offer a link to let you see our conference speeches and judge the various positions for yourself.)

All that being said, Mr. Krugman, I don’t think GDP as it is measured today is a Keynesian plot. GDP is a valuable measurement tool, if you understand what is being measured and all those asterisks with caveats that attend any such measure. But as we will see in this week’s letter, there are other ways to measure GDP that would suggest additional policy dials for spurring economic growth.

Say’s Law Makes a Comeback

Actually, the debate on what constitutes an economy goes back much further than Keynes and Hayek. The debate was well recounted in an essay by economist Steve Hanke, a professor of applied economics at Johns Hopkins University. Let’s quote a few paragraphs:

The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.

The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon – courtesy of John Maynard Keynes – this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.

Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.

All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand – namely, a fiscal stimulus [read: lower taxes and/or higher government spending].”

The BEA Introduces Gross Output

So what other tool than GDP might we use? Conveniently, on this very day, July 25, 2014, the Bureau of Economic Analysis begins to publish a quarterly statistic called “gross output.” A good part of the reasoning behind this new statistic and the impetus to produce it comes from a book published in 1990 by my friend of 30 years Dr. Mark Skousen. The book was titled The Structure of Production, and in it Skousen forcefully argued that production rather than demand should be the basis for analyzing the strength of an economy. No less an authority on productivity than Peter F. Drucker commented in a review at the time, “The next economics will have to be centered on supply and the factors of production rather than being functions of demand. I’ve read Mark Skousen’s book twice, and it comes the closest to achieving this goal.”

Gross output (GO) measures the total output of an economy, including investments made by businesses in order to produce their goods, such as capital outlays on new equipment, raw materials, or other business-to-business transactions. In Structure, Skousen makes the case that modern economists downplay the importance of the business sector in the economy and overstate the importance of consumer spending. He believes that the GDP should not be used as the sole measure of economic activity.

Let’s go to the lead editorial by Mark that was published in the Wall Street Journal just a few months ago:

Why pay attention to gross output? For starters, research I published in 1990 shows it does a better job of measuring total economic activity. GDP is a useful measure of a country’s standard of living and economic growth. But its focus on final output omits intermediate production and as a result creates much mischief in our understanding of how the economy works.

In particular, it has led to the misguided Keynesian notion that consumer and government spending drive the economy rather than saving, business investment, technology and entrepreneurship. GDP data at the end of 2013 put consumer spending first in importance (68% of GDP), followed by government expenditures (18%), and business investment third (16%). Net exports (-2%) makes up the difference.

Thus journalists and many economic analysts report that “consumer spending drives the economy.” And they focus on retail spending or consumer confidence as the critical factors in driving the economy and stock market. There is an underlying anti-saving mentality in this analysis, as evidenced by statements frequently made during debates on tax cuts or tax rebates that if consumers save their tax refund instead of spending it, it will do no good for the economy. Presidents including George W. Bush and Barack Obama have echoed this sentiment when they encouraged consumers to spend rather than save and invest their tax refunds.

Although consumer spending accounts for about 70% of GDP, if you use gross output as a broader measure of total sales or spending, it represents less than 40% of the economy. The reality is that business outlays – adding capital investment and all business spending in intermediate stages of the supply chain – are substantially larger than consumer spending in the economy. They make up more than 50% of economic activity.

Going back to my more visual “dials” metaphor, when you look at gross output you see that it gives us an additional and much larger dial for stimulating growth than simply trying to increase consumer spending. The real driver of the economy, as measured by gross output, is not consumer spending but private production and business spending. And indeed, we find that that is where the jobs are, and they are far higher-paying jobs than in the retail sector, which is where final consumption resides.

Let’s look at a few graphs my associate Worth Wray created for me today using the new data provided by the Bureau of Economic Analysis. You can see the actual data here. We will come back to the BEA’s tables in a little bit, as there are some fascinating insights to be gleaned about the US economy.

This first graph compares seasonally adjusted GDP and GO. Notice how much more sensitive gross output was to the 2009 Great Recession. Also note that measuring by gross output we find that the US economy is about $30 trillion in total production and transactions, roughly twice the amount measured by GDP.

We might as well address one of the objections to gross output here. It seemingly “double counts” transactions to produce a final number. And there is no question that it does. But that is not the point. To ignore all of the business activity that it takes to create a product that goes into retail consumption misses the primary driver of employment and wealth creation. All along the production chain, each business adds value to what eventually becomes the final product. 

I would not argue that gross output should be the primary tool in the economic measuring box. But neither should GDP. Just like a screwdriver and a hammer, they both have their uses.

Next, let’s compare growth rates of GDP and GO for the last eight years. Notice that these numbers are not adjusted for inflation, so you see the massive falloff in production during the 2009 Great Recession. We use nominal GDP here so that we can have an apples-to-apples comparison. One other thing to note is that GO did not fall in the first quarter of 2014, although GDP did. This goes a long way toward explaining why we saw positive improvement in the employment numbers even when the economy had seemingly fallen into the doldrums if not a quarterly recession.

GO also acted as a leading indicator, at least this one time, of the Great Recession. GO might also suggest that we are not in a recession today. (Please note that this instance doesn’t prove anything, as there are only two data points, and we would need many more to actually establish a semi-predictive relationship. But it has piqued my interest.)

Just for the record, here is what US GO growth versus real GDP growth looks like. You can see the negative real GDP trend clearly in 2011, but again on that occasion a recession was not confirmed by gross output.

Finally, I was curious to see the relationship between the unemployment rate, GDP, and GO. We can clearly see unemployment rising dramatically during the recession (note the inverted scale on the right-hand axis) and then gradually falling along with the solid growth shown in the gross output statistic, in spite of very weak post-recession GDP numbers (in what should have been a recovery).

We also see that GO is significantly more sensitive than GDP is to the business cycle.  During the 2008-09 recession, nominal GDP fell only 2% (due largely to countercyclical increases in government spending), but GO collapsed by over 7%, and intermediate inputs fell by 10%.  Since 2009, nominal GDP has increased 3-4% a year, but GO has climbed more than 5% a year.

Steve Hanke’s essay on Keynes and Say (excerpted above) concludes with an enthusiastic endorsement of the new BEA gross output statistic and what it will mean for economic analysis. I personally think it will take a good long while for the statistic to work its way into the mainstream, but this is a start, and it’s a good one. Let’s rewind the tape to Steve:

But, when it comes to the public and the debate about public policies, there is nothing quite like official data. So, until now, demand-side GDP data produced by the government has dominated the discourse. With GO, GDP’s monopoly will be broken as the U.S. government will provide official data on the supply side of the economy and its structure. GO data will complement, not replace, traditional GDP data. That said, GO data will improve our understanding of the business cycle and also improve the quality of the economic policy discourse.

So, what makes up the conventional measure of GDP and the new GO measure? And what makes up the gross domestic expenditures (GDE) measure, a more comprehensive, close cousin of GO? The accompanying two tables answer those questions. And for readers who are more visually inclined, bar charts for the two new metrics – GO and GDE – are presented.

[I apologize for the fuzziness of the next two charts – they were this way in the original. –JM]

These changes are big – not only conceptually but also numerically. Indeed, in 2013 GO was 76.4% larger than GDP, and GDE was 120.4% larger. Why? Because GDP measures only the value of all final goods and services in the economy. GDP ignores all the intermediate steps required to produce GDP. GO corrects for most of those omissions. GDE goes even further, and is more comprehensive than GO.

Even though the always-clever Keynes temporarily buried J.-B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away (see the accompanying bar charts). And, yes, the alleged importance of fiscal policy withers away, too.

Contrary to what the standard textbooks have taught us and what the pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures.

Time to Put a New Economic Tool in the Box

That last paragraph is worth reading twice. And let’s think through what it means. That’s something I think most of us intuitively understand: that private business is the driver of the economy and jobs. If you are trying both to increase the size of the economy (growth) and to raise overall employment, the biggest policy dial, if you look at these alternative measures of the economy, becomes business activity and productivity.

Of course, it is one thing to say that we want to increase business activity and another thing to do it. Elsewhere I have shown evidence that we are now losing more companies than we are creating, for the first time in decades. We are making it so hard in the United States to create new businesses that we are losing the principal driver of economic growth and new jobs. The dual burdens of complex regulations and ever-higher taxes reduce the amount of money available to actually produce products and services for customers.

First, Let’s Kill All the Regulations

How’s this for a catchy new policy for the upcoming presidential election cycle? I would like to see someone promise (and actually follow through with) a mandatory reduction of 20% of all federal regulations in the US. Each cabinet-level department would be required to reduce their regulation count by 5% a year for four years. They would get to choose which rules are unnecessary, duplicative, or just plain dumb. I would count as a double bonus different departments getting rid of rules that conflict with each other’s. (That happens so much that it drives businesses crazy. Such regulations mean that, no matter what you do, you’re violating somebody’s rule.)

And if we really think private production is important, then why not create policies to reward savers and investors rather than punish them? Of course that would mean appointing people to the Federal Reserve who would not suppress interest rates to the benefit of bankers and borrowers and the detriment of savers.

The counterargument will be that lower interest rates spur business growth. And those who support that position will point to charts which show that lower rates have been accompanied by business growth since World War II. I think that is a correlation without causation.

The real cause of post-recession recoveries was not low rates but rather businesses restructuring their operations to become more productive and more responsive to consumer demand. Sure, lower-cost capital is useful, but in the real world of small and medium-sized businesses the driver is productivity and investments which, coupled with proper cost-savings management, create turnarounds.

I’ve lived through a few recessions in the past almost 65 years. The one resounding theme you hear when you talk to business people during a recession is that there is not a lack of low-cost money but rather a lack of customers. So yes, final consumption (consumer spending) is clearly an important part of the growth equation. But these additional measurement tools show that consumption is not the only part, or even the most important part: we need to be just as focused on productivity as we are on consumer demand. It is not either/or. It is both/and.

I find it highly ironic that the very Keynesian economists who deride supply-side economics as trickle-down voodoo support monetary policies that are even more demonstrably trickle-down and which almost all of the research on the wealth effect says do not work. And meanwhile, trickle-down fiscal policies (increased government spending) are somehow supposed to stimulate private production on a long-term basis. All such policies truly do is distort the market and increase the national debt.

Borrowing money today for consumption (as opposed to borrowing to buy productive assets) is simply bringing forward future consumption. That money will have to be paid back in the future, at which time it will not be available for consumption. Debt is future consumption moved forward, and it simply creates current demand at the expense of future demand. Unless of course you live in an academic world where you can increase debt ad nauseum, with no restraints on spending or deficits, whether personal or public.

Where Did the Jobs Come From?

GDP growth in the first quarter was a disquieting -2.9%. Yet unemployment fell? How did that happen? If we go to the gross output statistics in today’s BEA release, which the BEA has broken down by industry, the answer becomes quite clear. Overall, gross output was up marginally for the quarter. But there are sectors within the economy that were humming along on all eight cylinders. Mining, which includes energy production, was up almost 15% over the last year. In fact mining was responsible for all of the growth in gross output for private industries in the first quarter. And we know that energy is where a large percentage of the new jobs are. I should note that the other driver of growth in GO was utilities.

The two main culprits responsible for the negative GDP number last quarter were healthcare and exports. Sure enough, we look in the individual BEA data and see that healthcare and social assistance spending were down.

As a business practice, you generally want to do more of what is working and less of what is not. And if energy production is producing new jobs, shouldn’t we be doing more to encourage energy production? Which will have the added bonus of lowering energy costs? That seems like a twofer to me.

Summing up, I think the BEA is to be commended for giving us another tool in our economic measurement box. GO helps make the point that productivity and private investment are essential to a growing economy. To focus only on consumer spending and government deficits as policy tools is insufficient to produce the desired results and might even sow the seeds of the next crisis, as did the Fed in the last decade.

It is hubris on the part of economists today to think we can turn a few dials and control the business cycle and the economy. There is a role for central banks and monetary policy, just as there is a place for government and deficit spending, but neither of these policy dials should be primary. The main producer of economic growth will always be private industry and individual effort. When government helps to create an environment where entrepreneurship can thrive, we will see economic growth that provides jobs and income. Hayek did not believe it was possible to spend your way out of an economic crash. He believed that genuine recovery from a post-boom crash called not just for adequate spending but also for a return to sustainable production – production purged of boom-era distortions caused by easy money.

I think it is appropriate, since we began this letter with a quote from Friedrich Hayek’s acceptance speech for the 1974 Nobel Prize in economics, to end with an excerpt from his closing thoughts in that speech (which you can read in its entirety, and I would suggest you do so, here):

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

There is danger in the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, “dizzy with success”, to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

More Videos from the Conference

As I noted at the beginning of the letter, we are making available a number of the videos from the Strategic Investment Conference last May. So let me take one more opportunity to call your attention to this great Mauldin Circle Member Exclusive. As I mentioned last week, we have made select videos of our highest-rated speakers available to Mauldin Circle members. There is just an incredible amount of valuable insight in these presentations from such giants as Newt Gingrich, Niall Ferguson, Kyle Bass, Paul McCulley, Ian Bremmer, and David Rosenberg. I encourage you to take the time to watch at least a few.

You can access the videos, absolutely free, just by becoming a Mauldin Circle member. In addition to these select videos, you’ll get access to summaries and presentations of many more speakers from the conference. In order to join, you must be an accredited investor. Register here to be qualified by my partners at Altegris and added to the subscriber roster. Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from selected speakers at our 2014 conference.

If you are already a Mauldin Circle member, simply log in to the “members only” area of the Altegris website at http://www.altegris.com. Click on the “SIC 2014” link in the upper left corner to view the videos and more. If you have forgotten your login information, simply click “Forgot Login?” and your information will be sent to you.

Whistler, Maine, Montana, and San Antonio

One of my kids reminded me just before I left town yet again that I had told them I was going to be home most of the summer.  That was the original plan, but things just seem to come up. I am finishing this letter in Whistler, British Columbia, looking out over the mountains and getting ready to attend Louis Gave’s 40th birthday party (which he is celebrating over the next three days). Tomorrow, with any luck, I will be able to explore the area and maybe get in a little hiking. It seems appropriate that we talked today about the French economist Say, since I will be spending the evening with my current favorite French economist, Charles Gave, father of Louis. (By the way, Charles just put out a call suggesting it is time to short French bonds outright.)

We get home Monday afternoon, and Wednesday I leave for a stopover in New York on my way to Grand Lake Stream in Maine (via Bangor) with my youngest son, Trey. And I’m sure there will be plenty of fuel for the fires of debate to be found in my recent letters, as a couple noted Keynesian types will be there, along with the usual assortment of Federal Reserve economists and Austrian economic recidivists like me.

Later in the month I intend to go to Flathead Lake in Montana to spend some time with my friend Darrell Cain and other business partners, where we will think about the future. In the middle of September I will be at the Casey Research Summit. And while that is all that is on my schedule today, past performance is indicative that a few more outings will show up on the schedule.

In 1986, I was allowed to accompany Dr. Gary North and Dr. Mark Skousen to a small Austrian village up in the mountains near Innsbruck. There we sat down with 86-year-old Friedrich Hayek. We had traveled up there on the spur of the moment, hoping to meet him. His quite-protective wife agreed to let us talk with him for a few minutes, although she was worried about our tiring him too much. We sat down in a small room and turned on a tape recorder. Gary and Mark were not really interested in talking economics at this meeting; they wanted to talk about the “inner circle” that had gathered in Vienna around the economist Ludwig von Mises.

What ensued was interesting. When we walked into the room, we could tell that Hayek was a little weary from having met with yet another group of people wanting to discuss the economic ideas he had written about for decades. But as he realized that what Gary and Mark wanted to talk about was history that had not yet been written about – an invitation to walk back through his own memories – he visibly grew brighter and stronger. What was a promised 30 minutes stretched into three hours. I should have been taking notes, as I now remember so little of it. It’s one of the truly great opportunities in my life that I wasted. I had no idea then how special the moment was. However, getting to spend time with the man who some call the greatest economist of the last century, and to see him come alive for a few hours, was an experience that is indelibly imprinted in my mind. And to be fair to myself, there are very few conversations whose particulars I can recall 30 years on. But I do remember the moment and still feel its impact on me.

I sometimes wonder whether Mark or Gary have that recording or their notes. I keep meaning to ask.

The sun has come out, and it is a marvelous summer day in the mountains of British Columbia. I think I should hit the send button and go explore little bit before the party tonight, where we may create a few more memories. You have a great week. I’ll be ready next week from Maine, when my young associate Worth Wray and I will once again be thinking about China.

Your just enjoying the journey analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Outside the Box: Geopolitics and Markets

 

Growing geopolitical risk is on everyone’s mind right now, but in today’s Outside the Box, Michael Cembalest of J.P. Morgan Asset Management leads off with a helpful reminder: the only time since WWII that a violent conflict has had a medium-term negative effect on markets was in 1973, when the Israeli-Arab war led to a Saudi oil embargo against the US and a quadrupling of oil prices. And he backs up that assertion with an interesting table of facts labeled “War zone countries as a percentage of total world… [population, oil production, GDP, etc.].”

Having gotten that worry out of the way, he takes on the dire warnings that have recently been issued by the BIS, the IMF, and even the Fed, about a disconnect between market enthusiasm and the undertow of global economic developments. (He gives this section the cute title “Prophet warnings.”) Let’s look, he says, at actual measures of profits and how markets are valuing them; and then he goes on to give us a “glass half-full” take on prospects for the US economy for the remainder of the year. He throws in some caveats and cautions, but Cembalest thinks we could finally see another 3% growth quarter this year, which could create room for further profit increases.

There are good sections here on Europe and emerging markets here, too. Cembalest gives us a true Outside the Box, with a more optimistic view than some of our other recent guests have had. But that’s the point of OTB, is it not, to think about what might be on the other side of the walls of the box we find ourselves in? I have shared his work before and find it well thought out. He is one of the true bright lights in the major investment bank research world. That’s my take, at least.

I write this introduction from the air in “flyover country,” heading back home from rural Minnesota. I flew to Minneapolis to look at a private company that is actually well down the road to creating hearts and livers and kidneys and skin and other parts of the body that can be grown and then put into place. It will not be too many years before that rather sci-fi vision becomes reality, if what I saw is any indication. This group is focused and has what it takes in terms of management and science.

When you hold the beating, pumping scaffolding for a heart in your hand and know that it will soon be a true heart – albeit for a test animal at this point, though human trials are not that far off – then you can well and truly feel that we are entering a new era. I declined to pick up a rather huge liver, but the chief scientist handled it like it was just another auto part. Match these “parts” with young IPS cells, and we truly will have replacement organs ready for us when we need them, if we can wait another decade or so (or maybe half that time for some organs!). My friend and editor of Transformational Technology Alert, Patrick Cox, toured the place with me and will write about it in a few weeks. (You will be able to see his complete analysis of this company for free in his monthly letter on new technologies. You can subscribe here.)

Ukraine and Gaza are epic tragedies, but gods, what wonders we humans can create when we pursue life rather than death. It just makes you want to take some people by the back of the neck and shake some sense into them.

And now a brief but enlightening tale from … The Road. It’s about the Code of the Road Warrior. The Road can be a lonely place, soul-searing in its weariness, with only brief moments of pleasure. But you have to do it because that is what the job requires. And there are lots of us out there. You see the look, you recognize yourself in the other person. If you can help, you do. It’s the unwritten Code that we all come to realize you must live by. It has nothing to do with race, religion, sexual alignment, or political persuasion. You help fellow Road Warriors on the journey.

As do we all, you seek out your favorite airline club in airports (for me it’s the American Airlines Admirals Club) and know you are “home.” A comfortable chair for your back, a plug for your tools, a drink to quench your thirst, and peace for your soul. But then there are the times when you are in an airport where there is no home for you.

Over the years, I have invited dozens of fellow Road Warriors to be my “guest” in a club. No true cost to me, just a courtesy you give a fellow Roadie. Today, I arrived at the Minneapolis airport, and there Delta and United rule. My companion, Pat Cox, was traveling on Delta back to Florida, so I thought I would see if my platinum card would get us into the Delta lounge. Turns out it would, but only if I was on Delta. I was getting ready to limp away to seek some other place of solace for a few hours when a fellow Road Warrior behind me said, “He is my guest.”

The lady behind the counter said, “That’s fine, but you can only have one guest.” Then the next gentleman looked at Pat in his Hawaiian shirt and flip-flops and said, “He is my guest.” The lady at the counter smiled, knowing she was faced with the Code of the Road Warrior, and let us in.

You have to understand that Pat is nowhere close to being a Road Warrior. He agrees with cyberpunk sci-fi author William Gibson that “Travel is a meat thing.” He indulged me for this trip. I will admit to being meat. I like to meet meat face to face when I can.

So Pat was somewhat puzzled, and he turned to our two benefactors and asked, “Do you know him?” (referring to me). Pat assumed they had recognized me, which sometimes does happen in odd places. But no, they had no idea. I told him I would explain the Code of the Road Warrior to him when we sat down, and everyone grinned at Pat’s astonishment over a random act of kindness. So we said thank you to our Warrior friends, whom we will likely never meet again, and entered into the inner sanctum. With electrical outlets.

The Road can be lonely, but many of us share that space. If you are one of us, then make sure you obey the Code. Someday, it will bring help to you, too. And as I write this, my AA travel companion on the flight back, an exec who runs a large insurance company, who was trying to figure out what the heck today’s court ruling might do to the 70,000 subsidized policies they sold, noticed I did not have the right connection and dug through his bag and found the right plug for me. It’s a Code thing. I knew him only as Ken, and he knew me as John. We then both hunched over our computers and worked.

Have a great week. And maybe commit a random act of kindness, even if you are not on The Road.

Your smiling as he writes analyst,

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

 

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Geopolitics and markets; red flags raised by the Fed and the BIS on risk-taking

Michael Cembalest, J.P. Morgan Asset Management

Eye on the Market, July 21, 2014

You can be forgiven for thinking that the world is a pretty terrible place right now: the downing of a Malaysian jetliner in eastern Ukraine and escalating sanctions against Russia, the Israeli invasion of Gaza, renewed fighting in Libya, civil wars in Syria, Afghanistan, Iraq and Somalia, Islamist insurgencies in Nigeria and Mali, ongoing post-election chaos in Kenya, violent conflicts in Pakistan, Sudan and Yemen, assorted mayhem in central Africa, and the situation in North Korea, described in a 2014 United Nations Human Rights report as having no parallel in the contemporary world. Only in Colombia does it look like a multi- decade conflict is finally staggering to its end. For investors, strange as it might seem, such conflicts are not affecting the world’s largest equity markets very much. Perhaps this reflects the small footprint of war zone countries within the global capital markets and global economy, other than through oil production.

The limited market impact of geopolitics is nothing new. This is a broad generalization, but since 1950, with the exception of the Israeli-Arab war of 1973 (which led to a Saudi oil embargo against the US and a quadrupling of oil prices), military confrontations did not have a lasting medium-term impact on US equity markets. In the charts below, we look at US equities before and after the inception of each conflict in three different eras since 1950. The business cycle has been an overwhelmingly more important factor for investors to follow than war, which is why we spend so much more time on the former (and which is covered in the latter half of this note).

As for the war-zone countries of today, one can only pray that things will eventually improve. Seventy years ago as the invasion of Normandy began, Europe was mired in the most lethal war in human history; the notion of a better day arising out of misery is not outside the realm of possibility.

Soviet invasions of Hungary and Czechoslovakia did not lead to a severe market reaction, nor did the outbreak of the Korean War or the Arab-Israeli Six-Day War.

We did not include the US-Vietnam war, since it’s hard to pinpoint when it began. One could argue that Vietnam-era deficit spending eventually led to rising inflation (from 3% in 1967 to 5% in 1970), a rise in the Fed Funds rate from 5% in 1968 to 9% in 1969, and a US equity market decline in 1969-1970 (this decline shows up at the tail end of the S&P series showing the impact of the Soviet invasion of Czechoslovakia).

The Arab-Israeli war of 1973 led to an oil embargo and an energy crisis in the US, all of which contributed to inflation, a severe recession and a sharp equity market decline. Pre-existing wage and price controls made the situation worse, but the war/embargo played a large role. Separately, markets were not adversely affected by the Falklands War, martial law in Poland, the Soviet war in Afghanistan, or US invasions of Grenada or Panama. The market decline in 1981 was more closely related to a double-dip US recession and the anti-inflation policies of the Volcker Fed.

Equity market reactions to US invasions of Kuwait and Iraq, and the Serbian invasion of Kosovo, were mild. There was a sharp market decline after the September 11th attacks, but it reversed within weeks. The subsequent market decline in 2002 was arguably more about the continued unraveling of the technology bust than about aftershocks from the Sept 11th attacks and Afghan War. As for North Korea, in a Nov 2010 EoTM we outlined how after North Korean missile launches, naval clashes and nuclear tests, South Korean equities typically recover within a few weeks.

Prophet warnings. So far, the year is turning out more or less as we expected in January: almost everything has risen in single digits (US, European and Emerging Markets stocks, fixed-rate and inflation linked government bonds, high grade and high yield corporate bonds, and commodities). What made last week notable: concerns from the Fed and the Bank for International Settlements (a global central banking organization) regarding market valuations. The BIS hit investors with a 2-by-4, stating that “it is hard to avoid the sense of a puzzling disconnect between the market’s buoyancy and underlying economic developments globally”. The Fed also weighed in, referring to “substantially stretched valuations” of biotech and internet stocks in its Monetary Policy Report submitted to Congress. What should one make of these prophet warnings?

Let’s put aside the irony of Central Banks expressing concern about whether their policies are contributing to aggressive risk-taking. They know they do, and relied on such an outcome when crafting monetary policy post-2008. Instead, let’s look at measures of profits and how markets are valuing them.           The first chart shows how P/E multiples have risen in recent months, including in the Emerging Markets. The second chart shows valuations on internet and biotech stocks referred to in the Fed’s Congressional submission. The third chart shows forward and median multiples, an important complement to traditional market-cap based multiples.

Are these valuations too high? Triangulating the various measures, US valuations are close to their peaks of prior mid-cycle periods (ignoring the collective lapse of judgment during the dot-com era). We see the same general pattern in small cap. On internet and biotech, valuations have begun to creep up again after February’s correction, and I would agree that investors are paying a LOT of money for the presumption that internet/biotech revenue growth is “secular” and less explicitly linked to overall economic growth.

As a result, we believe earnings growth is needed to drive equity markets higher from here. On this point, we see the glass half-full, at least in the US. After a poor Q1 and a partial rebound in Q2, US data are improving such that we expect to see the elusive 3% growth quarter this year (only 6 of 20 quarters since Q2 2009 have exceeded 3%). With new orders rising and inventories down, the stage is set for an improvement. Other confirming data: vehicle sales, broad-based employment gains, hours worked, manufacturing surveys, homebuilder surveys, a rise in consumer credit, capital spending, etc. If we get a growth rebound, the profits impact could be meaningful. The second chart shows base and incremental profit margins. Incremental margins measure the degree to which additional top-line sales contribute to profits. After mediocre profits growth of 5%-7% in 2012/2013, we could see faster profits growth later this year. With 83 companies reporting so far, Q2 S&P 500 earnings are up 9% vs. 2013.

Accelerated monetary tightening could derail interest-rate sensitive sectors of the economy, so we’re watching the Fed along with everybody else. Perhaps it’s a reflection of today’s circumstances, but like Bernanke before her, Yellen appears to see the late 1930s as a huge policy fiasco: when premature monetary and fiscal tightening threw the US back into recession. That’s what Yellen’s testimony last week brings to mind: she gave a cautious outlook, cited “mixed signals” and previous “false dawns”, and downplayed the decline in unemployment and recent rise in inflation. In other words, she’s prepared to wait until the US expansion is indisputably in place before tightening.

An important sub-plot for the Fed: where are all the discouraged workers? For Fed policy to remain easy, as the economy improves, the pace of unemployment declines will have to slow and wage inflation will have to remain in check. The Fed believes discouraged workers will re-enter the labor force in large numbers, holding down wage inflation. Fed skeptics point out that so far, labor participation rates have not risen, creating the risk of inflation sooner than the Fed thinks. It’s all about the “others” in the chart, since disabled and retired persons rarely return to work. If “others” come back, it would show that there hasn’t been a structural decline in the pool of available workers. The Fed believes they will eventually return, and so do we.

Europe

Germany and France are slowing; not catastrophically, but by more than markets were expecting. This has contributed to a decline in European earnings expectations for the year. As shown on page 2, Europe was priced for a return to normalcy, and with inflation across most of the Eurozone converging to 1%, things are decidedly not that normal. Markets are not priced for any negative surprises, which is why an issue with a single Portuguese bank contributed to a sharp decline in banks stocks across the entire region.

Emerging Markets

The surprise of the year, if there is one, is how emerging markets equities have rebounded. As we wrote in March 2014, the history of EM equities shows that after substantial currency declines, industrial activity often stabilizes. Around that same time, we often see equity markets stabilize as well, even before visible improvements in growth, inflation and exports. This pattern appears to be playing itself again: the 4 EM Big Debtor countries (Brazil, India, Indonesia and Turkey) have experienced equity market rallies of 20%+ despite modest improvement in economic data (actually, things are still getting worse in Brazil and Turkey).

There’s also some good news on the EM policy front. In Mexico, it appears that the oil and natural gas sector is being opened up after a 25% decline in oil production since 2004. This would effectively end the 75-year monopoly that Pemex has over oil production. Other energy–related positives: Mexico has shifted the bulk of its electricity reliance from oil to cheaper natural gas over the last decade, giving it low electricity costs along with its competitive labor costs. Factoring in new energy investment, new telecommunications and media projects opened to foreign investment and support from both private and public credit, we can envision a 2% boost to Mexico’s GDP growth rate in the years ahead. This can not come soon enough for Mexico: casualties in its drug war rival some of the war zone countries on page 1.

Now for the challenges. Brazil has bigger problems right now than its mauling at the World Cup. With goods exports, manufacturing and industrial confidence slowing and wage/price inflation rising, Brazil is about to experience a modest bout of stagflation. Markets don’t appear to care (yet).

As for China, growth has stabilized (7%-8% in Q2) but we should be under no illusion as to why: credit growth is rising again. China ranks at the top of list of countries in terms of corporate debt/GDP. I don’t know what the breaking point is, but we’re a long way from pre-crisis China when GDP growth was organically driven and less reliant on expansion of household and corporate debt1. There’s some good news regarding the composition of growth: investment is slowing in manufacturing and real estate, and increasing in infrastructure; and while capital goods imports are flat, consumer goods imports are rising, suggesting a modest transition to more consumer-led growth. But for investors, the debt overhang of state-owned enterprises and its impact on the economy is the dominant story to watch. That explains why Chinese equity valuations are among the lowest of EM countries (only Russia is lower; for more on its re- militarization, economy and natural gas relations with Europe, see “Eye on the Russians”, April 29, 2014).

On a global basis, demand and inventory trends suggest a pick-up in economic activity in the second half of the year. If so, our high single digit forecast for 2014 equity market returns should be able to withstand the onset of (eventually) tighter monetary policy in the US. The ongoing M&A boom probably won’t hurt either.

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Important Disclosures

The article Outside the Box: Geopolitics and Markets was originally published at mauldineconomics.com.

Thoughts from the Frontline: GDP: A Brief But Affectionate History

 

“Measurement theory shows that strong assumptions are required for certain statistics to provide meaningful information about reality. Measurement theory encourages people to think about the meaning of their data. It encourages critical assessment of the assumptions behind the analysis.

“In ‘pure’ science, we can form a better, more coherent, and objective picture of the world, based on the information measurement provides. The information allows us to create models of (parts of) the world and formulate laws and theorems. We must then determine (again) by measuring whether these models, hypotheses, theorems, and laws are a valid representation of the world.”

Gauri Shankar Shrestha

“In science, the term observer effect refers to changes that the act of observation will make on a phenomenon being observed. This is often the result of instruments that, by necessity, alter the state of what they measure in some manner.

“It was, perhaps, the most unusual episode in the long running duel between the two giants of twentieth century economic thought. During World War Two, John Maynard Keynes and Friedrich Hayek spent all night together, alone, on the roof of the chapel of King’s College, Cambridge. Their task was to gaze at the skies and watch for German bombers aiming to pour incendiary bombs upon the picturesque small cities of England….

“Night after night the faculty and students of King’s, armed with shovels, took it in turns to man the roof of the ornate Gothic chapel, whose foundation stone was laid by Henry VI in 1441. The fire watchmen of St. Paul’s Cathedral in London had discovered that there was no recourse against an exploding bomb, but if an incendiary could be tipped over the edge of the parapet before it set fire to the roof, damage could be kept to a minimum. And so Keynes, just short of sixty years old, and Hayek, aged forty-one, sat and waited for the impending German onslaught, their shovels propped against the limestone balustrade. They were joined by a common fear that they would not emerge brave nor nimble enough to save their venerable stone charge.”

– Nicholas Wapshot in Keynes Hayek: The Clash That Defined Modern Economics

The problem we have today in economics is that many people, and not a few economists, seem to regard economics as “pure science,” as described above by Gauri Shankar Shrestha. If you delve deep into measurement theory, you find that all too often the way in which you measure something determines the results obtained from your experimental model. How you measure the effectiveness of a drug can sometimes determine whether it gets approved – apart from whether it actually does any good. The FDA actually works rather hard at measurement theory.

And if you’re using models, as we do in economics, to determine policies that govern nations, your efforts can result in economic misdirection that seems for a time to work but that all too often can lead to a disastrous Endgame. A short-sighted economic policy is not unlike a drug that makes one feel good for a period of time but ultimately leads to further weakness or collapse.

In this week’s letter we look at the construction of gross domestic product (GDP). As we will see, GDP is a relatively late-to-the-party statistic, thoroughly malleable in its construction and often quite contentious in its application. Yet the mainstream media regularly releases GDP numbers with the implicit assumption that they are in fact an accurate reflection of the general economy. We shall soon see that GDP is instead a fuzzy reflection of the economy, derived from a model that is continually readjusted in a well-intentioned effort to understand the scope of the economy.

GDP is one economic model among several that could serve the purpose, but its use conveniently leads to policies that reflect the thinking of a particular school of economic monetary and fiscal policy advocates.

We all know that in operating a business we need to be able to measure the profits of our company and then adjust our prices and production to make sure that there are enough profits to adequately fund the company. That is a relatively straightforward process, since the amount of money in the bank at the end of the month is a real number.

Hayek versus Keynes

When most people see the release of the GDP number, they equate the precision of that statistic with the bottom right-hand number in their bank accounts. And news anchors and journalists rarely acknowledge the rather significant caveats that the Bureau of Labor Statistics publishes along with that data.

What we are going to find is that developing the concept of gross domestic product was more than a dry economic and accounting undertaking. At its very core, GDP is John Keynes versus Friedrich Hayek writ large. And their debate explains a great deal of the current tension between those who would make final consumption – or what we call consumer spending – the be-all and end-all of economic policy, and those who feel that productivity and income should instead be the focus. The very act of measuring GDP as we do gives the high and easy intellectual ground to those of the Keynesian persuasion.

Let me hasten to note that I have no problem with the concept or the calculation of GDP in general. It is absolutely a number that we need to have in order to understand the workings of a part of the economy. But it is just one tool in the economic toolbox. If the only tool you use to affect (determine, guide – choose your word) economic growth and the creation of jobs is the hammer of GDP, the world ends up being a very strange-looking, rather deformed nail, bent time and time again by the imprecise blows of those wielding the hammer.

GDP is an important concept, perhaps one of the more important that we have looked at in quite a few years. I urge you not to roll your eyes at the attempt to understand yet another dry economic statistic, but instead to look deeply at how the attempt to measure GDP affects everything in our lives.

But before we jump deeper into our topic, let me call your attention to a Mauldin Circle Member Exclusive. We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. Two weeks ago we made select presentations from the Strategic Investment Conference, including those of Kyle Bass and David Rosenberg, available to Mauldin Circle members. This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world. Both Newt’s insights into the opportunities offered by the remarkable technological evolution underway (and the roadblocks to progress thrown up by our bureaucracies) and Niall’s analysis of the monetary and geopolitical “tapering” currently in progress are well worth a watch.

You can access both videos, absolutely free, just by becoming a Mauldin Circle member. In addition to these select videos, you’ll get access to summaries and presentations of many more speakers from the conference. In order to join, you must be an accredited investor. Register here to be qualified by my partners at Altegris and added to the subscriber roster. Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from selected speakers at our 2014 conference.

If you are already a Mauldin Circle member, simply log in to the “members only” area of the Altegris website at http://www.altegris.com. Click on the “SIC 2014” link in the upper left corner to view the videos and more. If you have forgotten your login information, simply click “Forgot Login?” and your information will be sent to you. And now back to our letter.

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.

Important Disclosures

Thoughts from the Frontline: GDP: A Brief But Affectionate History

 

“Measurement theory shows that strong assumptions are required for certain statistics to provide meaningful information about reality. Measurement theory encourages people to think about the meaning of their data. It encourages critical assessment of the assumptions behind the analysis.

“In ‘pure’ science, we can form a better, more coherent, and objective picture of the world, based on the information measurement provides. The information allows us to create models of (parts of) the world and formulate laws and theorems. We must then determine (again) by measuring whether these models, hypotheses, theorems, and laws are a valid representation of the world.”

Gauri Shankar Shrestha

“In science, the term observer effect refers to changes that the act of observation will make on a phenomenon being observed. This is often the result of instruments that, by necessity, alter the state of what they measure in some manner.

“It was, perhaps, the most unusual episode in the long running duel between the two giants of twentieth century economic thought. During World War Two, John Maynard Keynes and Friedrich Hayek spent all night together, alone, on the roof of the chapel of King’s College, Cambridge. Their task was to gaze at the skies and watch for German bombers aiming to pour incendiary bombs upon the picturesque small cities of England….

“Night after night the faculty and students of King’s, armed with shovels, took it in turns to man the roof of the ornate Gothic chapel, whose foundation stone was laid by Henry VI in 1441. The fire watchmen of St. Paul’s Cathedral in London had discovered that there was no recourse against an exploding bomb, but if an incendiary could be tipped over the edge of the parapet before it set fire to the roof, damage could be kept to a minimum. And so Keynes, just short of sixty years old, and Hayek, aged forty-one, sat and waited for the impending German onslaught, their shovels propped against the limestone balustrade. They were joined by a common fear that they would not emerge brave nor nimble enough to save their venerable stone charge.”

– Nicholas Wapshot in Keynes Hayek: The Clash That Defined Modern Economics

The problem we have today in economics is that many people, and not a few economists, seem to regard economics as “pure science,” as described above by Gauri Shankar Shrestha. If you delve deep into measurement theory, you find that all too often the way in which you measure something determines the results obtained from your experimental model. How you measure the effectiveness of a drug can sometimes determine whether it gets approved – apart from whether it actually does any good. The FDA actually works rather hard at measurement theory.

And if you’re using models, as we do in economics, to determine policies that govern nations, your efforts can result in economic misdirection that seems for a time to work but that all too often can lead to a disastrous Endgame. A short-sighted economic policy is not unlike a drug that makes one feel good for a period of time but ultimately leads to further weakness or collapse.

In this week’s letter we look at the construction of gross domestic product (GDP). As we will see, GDP is a relatively late-to-the-party statistic, thoroughly malleable in its construction and often quite contentious in its application. Yet the mainstream media regularly releases GDP numbers with the implicit assumption that they are in fact an accurate reflection of the general economy. We shall soon see that GDP is instead a fuzzy reflection of the economy, derived from a model that is continually readjusted in a well-intentioned effort to understand the scope of the economy.

GDP is one economic model among several that could serve the purpose, but its use conveniently leads to policies that reflect the thinking of a particular school of economic monetary and fiscal policy advocates.

We all know that in operating a business we need to be able to measure the profits of our company and then adjust our prices and production to make sure that there are enough profits to adequately fund the company. That is a relatively straightforward process, since the amount of money in the bank at the end of the month is a real number.

Hayek versus Keynes

When most people see the release of the GDP number, they equate the precision of that statistic with the bottom right-hand number in their bank accounts. And news anchors and journalists rarely acknowledge the rather significant caveats that the Bureau of Labor Statistics publishes along with that data.

What we are going to find is that developing the concept of gross domestic product was more than a dry economic and accounting undertaking. At its very core, GDP is John Keynes versus Friedrich Hayek writ large. And their debate explains a great deal of the current tension between those who would make final consumption – or what we call consumer spending – the be-all and end-all of economic policy, and those who feel that productivity and income should instead be the focus. The very act of measuring GDP as we do gives the high and easy intellectual ground to those of the Keynesian persuasion.

Let me hasten to note that I have no problem with the concept or the calculation of GDP in general. It is absolutely a number that we need to have in order to understand the workings of a part of the economy. But it is just one tool in the economic toolbox. If the only tool you use to affect (determine, guide – choose your word) economic growth and the creation of jobs is the hammer of GDP, the world ends up being a very strange-looking, rather deformed nail, bent time and time again by the imprecise blows of those wielding the hammer.

GDP is an important concept, perhaps one of the more important that we have looked at in quite a few years. I urge you not to roll your eyes at the attempt to understand yet another dry economic statistic, but instead to look deeply at how the attempt to measure GDP affects everything in our lives.

But before we jump deeper into our topic, let me call your attention to a Mauldin Circle Member Exclusive. We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. Two weeks ago we made select presentations from the Strategic Investment Conference, including those of Kyle Bass and David Rosenberg, available to Mauldin Circle members. This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world. Both Newt’s insights into the opportunities offered by the remarkable technological evolution underway (and the roadblocks to progress thrown up by our bureaucracies) and Niall’s analysis of the monetary and geopolitical “tapering” currently in progress are well worth a watch.

You can access both videos, absolutely free, just by becoming a Mauldin Circle member. In addition to these select videos, you’ll get access to summaries and presentations of many more speakers from the conference. In order to join, you must be an accredited investor. Register here to be qualified by my partners at Altegris and added to the subscriber roster. Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from selected speakers at our 2014 conference.

If you are already a Mauldin Circle member, simply log in to the “members only” area of the Altegris website at http://www.altegris.com. Click on the “SIC 2014” link in the upper left corner to view the videos and more. If you have forgotten your login information, simply click “Forgot Login?” and your information will be sent to you. And now back to our letter.

GDP: A Brief But Affectionate History

The title of this week’s letter is taken from the title of a recent book by Diane Coyle. (For economic wonks, she writes an interesting blog at http://www.enlightenmenteconomics.com.)

GDP: A Brief But Affectionate History is a fascinating 140-page book that I cannot recommend highly enough. This is simply the best book on GDP that I’ve ever seen. You can read it on a few hours’ plane ride or a lazy Sunday afternoon. And Ms. Coyle actually makes a relatively dry subject interesting and at times a page-turner. She has a true gift. (Now that she has conquered the GDP mountain, might I suggest she move on to CPI?)

Ms. Coyle starts with the predecessors to Adam Smith and takes us through the 17th century right up until today with the development of GDP, so we see the ebb and flow of ideas through time. Who knew the early developers of the model did not want to include defense spending, as they saw it as a wasteful, nonproductive activity? Or that Adam Smith thought the inclusion of services in the concept was misleading. “The provision of more services was a cost to the national economy, in his view. A servant was a cost to his employer, and did not create anything. Importantly, money spent on warfare or the interest on government debt was also being used unproductively. The nation’s wealth was its stock of physical assets less the national debt. National income was what derived from the national wealth.”

(I read this book on my iPad using my Kindle app, an extremely useful tool. As it turns out, if you highlight passages in the book you read [and even make notes and comments], you can go to your Kindle web page and see all the passages you highlighted. I regularly do that now and find it an extremely useful exercise, one that I would suggest to any serious researcher, as notes in a book tend to get buried and lost; and often you just can’t quite (at least at my age) remember those connections five or ten years later, especially if you’re reading more than a few books a year. Now my notes are in the cloud. Wow. And when I access the notes, I can touch a link to go back to the original passage in the book, making sure I have the context. How cool is that?

I found myself highlighting more than the normal number of passages, as seemingly every page had something I wanted to be able to remember for future use. Just for fun I cut and pasted my highlights into a Word doc and found that they ran to some 15 pages, or more than 10% of the book.)

And while I would suggest you read Coyle’s book, I know that many of you don’t have the time or inclination, so I’m going to try to summarize the highlights and arguments and quote somewhat freely from the text here and there. (Unless otherwise noted, all quotations below are from the book.)

Will the Real GDP Please Stand Up?

Let me note up front that Ms. Coyle takes us through not just the development of GDP but also the problems inherent in the concept. She delves into its misses and its misfires, some regularly discussed in public circles and a few new to me.

There is no such entity out there as GDP in the real world, waiting to be measured by economists. It is an abstract idea…. I also ask whether GDP alone is still a good enough measure of economic performance – and conclude not. It is a measure designed for the twentieth-century economy of physical mass production, not for the modern economy of rapid innovation and intangible, increasingly digital, services. How well the economy is doing is always going to be an important part of everyday politics, and we’re going to need a better measure of “the economy” than today’s GDP.

GDP is a huge undertaking, full of rules, with almost as many exceptions to the rules, changes, fixes, and qualifications, so that, as one Amazon reviewer noted, GDP is in reality so complex there are only a handful of people in the world who fully understand it, and that does not include the commentators and politicians who pontificate about it almost daily. The quarterly release of GDP statistics is more akin to a religious service than anything resembling a scientific study. The awe and breathlessness with which the number is discussed is somewhat amusing to those who understand the sausage-making process that goes into producing the number. Whether the GDP reading is positive or negative, it often changes less in a given quarter than the margin of error in the figure itself, and it can be and generally is revised significantly – often many years later when almost no one is paying attention. When’s the last time the mainstream media reported a five-year-old revision?

If you pay someone to mow your lawn and report wages paid, that adds to GDP. If you pay that person under the table, it doesn’t. If you pay your maid to clean your house, it adds to GDP. Except if you marry her, then it doesn’t. Unless of course she gets access to the credit card, in which case spending probably increases GDP dramatically. In England, sex with your wife does not add to GDP, but sex with a prostitute does – even if it is unreported. Go figure. There are so many jokes and one-liners that I could add to this litany, but I’m going to resist. Okay, just one. Can you imagine the reception if you came home with a blonde hair on your dark suit and your excuse was, “Honey, I was just doing my bit for the national economy. We all have to make sacrifices.”

Housekeeping, cleaning, cooking, and other such duties do not get counted in GDP, although without them GDP would suffer significantly. Perhaps that is because when the original discussions about what constituted GDP were underway, “woman’s work” was significantly undervalued.

But we are getting ahead of ourselves. Before we discuss how GDP is constructed (and abused), let’s take a look at the history of how it came about. It will not surprise most readers to know that governments decided they need to know what the gross domestic product of the country was in order to be able to both tax that productivity and decide about a nation’s capabilities to wage (and pay the wages of) war.

Ms. Coyle starts her book with the rather dramatic story of the calculation (or rather the miscalculation) of Greek GDP upon that country’s entry into the European Union. The Greek group responsible for creating such numbers worked in a dusty old apartment without any computers and seemingly engaged in little activity. The real work was done by politicians, who did not appear to feel the need to be burdened by anything so aggravating as actual numbers. When the European Commission and the IMF decided to send someone to create an actual statistical agency in Greece, they selected a well-respected Greek economist, who within a year was charged by the Greek government with the crime of betraying the national interest, an offense that theoretically carries a life sentence. Essentially, he was charged for not cooking the books, which the Greeks had perfected as an art form. Evidently, in Greece economics is a full-contact sport, and the “calculation” of GDP had real-world implications for whether the government would get desperately needed money from its Eurozone lenders and for how many government workers would lose their jobs, not to mention the impact it would have on the living standards of millions of Greeks.

GDP is the way we measure and compare how well or badly countries are doing. But this is not a question of measuring a natural phenomenon like land mass or average temperature to varying degrees of accuracy. GDP is a made-up entity. The [current] concept dates back only to the 1940s….

According to Benjamin Mitra-Kahn, “The Wealth of Nations introduced a new idea of the economy, and through the effort of Adam Smith’s students and admirers, it was adopted almost instantly.” In Smith’s own words: ‘There is one sort of labour which adds to the value of the subject upon which it is bestowed: There is another which has no such effect. The former, as it produces a value, may be called productive; the latter, unproductive labour. Thus the labour of a manufacturer adds, generally, to the value of the materials which he works upon, that of his own maintenance, and of his master’s profit. The labour of a menial servant, on the contrary, adds to the value of nothing…. A man grows rich by employing a multitude of manufacturers: He grows poor, by maintaining a multitude of menial servants.’ The idea of a distinction between productive and unproductive activity, adopted by Adam Smith, dominated economic debate and measurement until the late nineteenth century.”

(A side note: Karl Marx agreed with Adam Smith, and up until the collapse of communism in 1989, the Soviet Union’s economic statistics ignored service activities. Go figure.)

Simon Kuznets was a Russian-American economist and a true giant in the field. Much of what we regard as economics today was developed under his aegis. Wikipedia notes: “His name is associated with the formation of the modern economic science … as an empirical discipline, the development of statistical methods of research, and the emergence of quantitative economic history. Kuznets is credited with revolutionising econometrics, and this work is credited with fueling the so-called Keynesian revolution” (even though Kuznets had significant disagreements with Keynes). Kuznets himself was influenced by Schumpeter, Pigou, and Pareto; and he early on introduced Kondratiev to the West.

Kuznets, when he originally developed an approach for measuring GDP for the American economy, did not want to include expenses on “… armaments, most of the outlays on advertising, a great many of the expenses involved in financial and speculative activities, and much of government activity,” including the building of subways, expensive housing, etc.

Such thinking could not stand the scrutiny of politicians, however:

With this aim, in fact, Kuznets was out of tune with his times. Welfare was a peacetime luxury. This passage [and his early work on GDP] was written in 1937, when his first set of accounts was presented to Congress. Before long, the president would want a way of measuring the economy that did indicate its total capacity to produce but did not show additional government expenditure on armaments as reducing the nation’s output. The trouble with the prewar definitions of national income was precisely that, as constructed, they would show the economy shrinking if private output available for consumption declined, even if the government spending required for the war effort was expanding output elsewhere in the economy. The Office of Price Administration and Civilian Supply, established in 1941, found that its recommendation to increase government expenditure in the subsequent year was rejected on this basis. Changing the definition of national income to the concept of GDP, rather than something more like Kuznets’s original proposal, overcame this hurdle.

There was a “heated debate between Kuznets and other economists, especially Milton Gilbert of the Commerce Department, about the right approach. The discussions were highly technical, but the underlying issue was profound: what was the meaning of economic growth and why were statisticians measuring it? Gilbert and his colleagues were clear that the aim was to construct a measurement that would be useful to the government in running its fiscal policy.”

The inclusion of business taxes and depreciation [in GNP measured at market prices] resulted in a production measure that was more appropriate for analysis of the war program’s burden on the economy. Kuznets was highly skeptical: “He argued that Commerce’s method tautologically ensured that fiscal spending would increase measured economic growth regardless of whether it actually benefited individuals’ economic welfare.” In the policy tussle in Washington, Kuznets lost and wartime realpolitik won. [And that those arguing against Kuznets were heavily influenced by Keynes is rather difficult to deny. –JM]

… This decision was a turning point in the measurement of national income, and it meant that GNP (or later GDP) would be a concept strikingly different from the way the economy had been thought about from the dawn of modern industrial growth in the early eighteenth century until the early twentieth century. For two centuries, “the economy” was the private sector. Government played a small role in economic life, and featured mainly because it looked to raise taxes to pay for wars. Its role expanded steadily over the centuries, however. In Victorian times this began to extend to the provision of other services, those we take for granted now such as roads and water as well as the historic government roles of defense and justice.”

Keynes himself, on the other side of the Atlantic, was arguing for an extended role for statistical analysis in government planning. He set forth his case in a 1940 pamphlet called How to Pay for the War.

Coyle notes (emphasis mine):

Crucially, the development of GDP, and specifically its inclusion of government expenditure, winning out over Kuznets’s welfare-based approach, made Keynesian macroeconomic theory the fundamental basis of how governments ran their economies in the postwar era. The conceptual measurement change enabled a significant change in the part governments were to play in the economy. GDP statistics and Keynesian macroeconomic policy were mutually reinforcing. The story of GDP since 1940 is also the story of macroeconomics. The availability of national accounts statistics made demand management seem not only feasible but also scientific.

Understand what this means. One thing that Paul Krugman and I can agree on (and I say this with utmost confidence) is that we both believe that real economic growth is necessary to get us out of our current situation. (I am sure there are some other things that we could agree on, such as our mutual love for science fiction, but nothing else leaps to mind just yet.)

However, if your measure of economic growth overweights the contribution of government spending to growth and underweights private production by focusing on final consumption, then when you are looking for “policy dials” to turn on the economic control panel in order to increase growth, the dials you reach for will be the two largest ones in your equation for measuring success: final consumption and government spending.

GDP Is a Political Construction

Coyle underlines the inherently political nature of GDP measurement:

We are now awash with macroeconomic models and forecasts, published by official agencies and central banks, by investment banks, by think tanks and researchers, as well as by commercial forecasters such as DRI’s successors. Indeed, the idea of the economy as a machine, regulated by appropriate policy levers, took firm hold….

Debate rages in particular about the multiplier, because the issue of whether extra government spending or tax cuts (a “fiscal stimulus”) will boost GDP growth turns on its size. If it is greater than one, a stimulus will help growth, while austerity measures will hurt it. Its actual size is hotly contested among macroeconomists, especially in the context of the present political debate about how much “fiscal stimulus” the government should be applying to get the economy growing faster. There is an unsurprising alignment in the “multiplier wars” between macroeconomists’ answer to the technical question about the size of the multiplier and their political sympathies….

It will be clear by now that the ambition of measuring national income has a long history, with correspondingly many changes in how people have thought about it. As Richard Stone put it, national income is not a “primary fact” but an “empirical construct”: “To ascertain income it is necessary to set up a theory from which income is derived as a concept by postulation and then associate this concept with a certain set of primary facts.” There is no such entity as GDP out there in the real world waiting to be measured by economists. It is an abstract idea, and one that after a half century of international discussion and standard-setting has become extremely complicated. [emphasis mine]

Today, as Coyle notes, the process of comprehending GDP is somewhat akin to what happens when my kids play a videogame. The basic concepts are simple, but as you master each level and move on to the next, complexity increases almost ad infinitum. There is now an entire international community of statisticians (a surprisingly small one at that) that actually determine what is accepted as statistically relevant to GDP. The first United Nations guide on national accounts was 50 pages. The latest edition has 722.

It should not surprise readers that every few years new rules are created for the figuring of GDP. British statisticians just this year declared the UK economy to be 5% bigger than previously thought. What brought about this magical boost in productivity? There was no discovery of buried treasure hidden away in the vaults of the Bank of England. Instead, statisticians turned to counting the economic contribution of prostitution and illegal drugs (along with a few other odds and ends). If you are borrowing money and your creditworthiness depends on cash flow and your debt-to-GDP ratio, you tend to look for sources of income that weren’t previously accounted for.

Did the size of the US economy increase by 3% last summer? According to the statisticians it did. They decided to include music and entertainment and make adjustments to how we deal with investments. These changes were then calculated for all previous years, and suddenly the economy was 3% bigger! Small positive annual changes can add up over 40 years.

GDP has always been a political construction, subject to the ebb and flow of the intellectual and political climate, the need to raise taxes, and the military needs of the day. It is also a tool used to argue for or against income inequality (depending on what country you’re in).

GDP is particularly bad at detecting innovation, as George Gilder’s powerhouse work Knowledge and Power explains. There is a clear consensus emerging in economic circles about that weakness in the formula for calculating GDP, but there is nothing approaching consensus on how you might actually measure the contribution of innovation to GDP. How do you measure the value of Google maps? The voice recognition software that I’m using right now has made me significantly more productive, but how do we measure that?

And somewhat provocatively, there is growing disagreement over the contribution of the financial services sector. Depending on how you measure it, you can even determine that the actual contribution of the financial services sector is negative, although I would not make that argument. But was the contribution of financial services in 2005-2006 as positive as their impact on GDP suggests? Or was it part of the destructive process?

GDP is a financial construct at its heart, a political and philosophical abstraction. It is a necessary part of the management of the country, because, as with any enterprise, if you can’t measure it you can’t determine if what you are doing is productive. That said, the act of measuring GDP precipitates the observer effect writ large.

But as we will see next week, there are additional (note, I am not saying alternative) ways to measure growth and the size of the economy. Those measures would actually lead to policies more favored by Hayek, as the largest “dials” on the control panel would become productivity and income rather than consumer spending and government.

Conveniently, the Bureau of Economic Analysis will be giving us a new “Hayekian” statistic in its release next Friday. I am looking forward to seeing what this new measure says about the growth of the economy in the first quarter. Stay tuned as next week we ponder the question of “How in the name of all that is righteous and holy could Hayek lose the argument?” His proponents are right to argue that the match was rigged and the judges were bought. If you have a few minutes, watch these two brilliantly done, hilarious, and instructive YouTube videos, here and here. I think you will come away smiling but also gain an understanding of the true terms of the debate. At the end of the day, I keep coming back to how central the arguments between Hayek and Keynes are to almost every economic discussion.

Minneapolis, Vancouver, and Maine

Wasn’t it just a few weeks ago that I was talking about how much time I would get to spend at home this summer? Monday I will leave for a day trip to Minneapolis to do an on-site visit with my friend Pat Cox, who writes our Transformational Technology Alert letter. It’s really an easy trip, and Minneapolis is nice this time of year. Then, as a last-minute thing, I will leave on Thursday evening to spend the weekend with Louis Gave and his friends to celebrate his 40th birthday and christen his new home in Whistler, a few hours north of Vancouver. I always enjoy my time with Louis, as he is one of the most intellectually stimulating thinkers I know and a genuinely nice guy. I’m sure many of my friends will be flying in from around the world as well.

My only problem with Louis is that this is just his 40th birthday. I hadn’t even figured out where the restroom was in the economics building when I was 40. I’m not sure what kind of inequality this is, but it just doesn’t seem fair. Admittedly, he did grow up with one of the finest French economists this century has seen (and one of the few), his father Charles. That might have been a small advantage. He says he is going to make me do something called rope climbing. It can’t be any worse than the hour I spent “boxing” with The Beast this afternoon. It’s a good thing I use voice recognition to do this letter, because my arms are too weak to type.

Then I am back for a few days before I leave with my young son Trey to go to Maine for our annual fishing trip at Camp Kotok.

I’m not quite sure how to deal with how pleasant the weather is here in Dallas in July. The highs the last two days have been in the mid-70s. That is some 20°+ below the average high at this time of year.

I spent my days in New York this past week, meeting with my partners in Mauldin Economics (and George Gilder drove down to meet with us) and outlining a new documentary we want to do on Bitcoin. I had extensive meetings with new team members and potential partners who will be part of a major project with me, one I’ve been working on for several years that is getting close to the point where I can actually talk about it in public.

All in all, this has been a great week, and I expect an even better one next week. New friends, old friends, and a few challenges. I’m curious as to what a ropes course is. And whether someone my age should be doing something like that. I have always been somewhat “coordinationally challenged” (to use a polite term). Since it would be rather bad form for Louis to have his guests come away plastered with bandages or hobbling on crutches, I am going to assume the best. You have a great week.

Your thinking about the The Road to Serfdom analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Outside the Box: Hoisington Investment Management: Quarterly Review and Outlook, Second Quarter 2014

 

This week’s Outside the Box is from an old friend to regular readers. It’s time for our Quarterly Review & Outlook from Lacy Hunt of Hoisington Investment Management, who leads off this month with a helpful explanation of the relationship between the US GDP growth rate and 30-year treasury yields. That’s an important relationship, because long-term interest rates above nominal GDP growth (as they are now) tend to retard economic activity and vice versa.

The author adds that the average four-quarter growth rate of real GDP during the present recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions; and despite six years of federal deficits totaling $6.27 trillion and another $3.63 trillion in quantitative easing by the Fed, the growth rate of the economy continues to erode.

So what gives? We’re simply too indebted, says Lacy; and too much of the debt is nonproductive. (Total US public and private debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.) And as Hyman Minsky and Charles Kindleberger showed us, higher levels of debt slow economic growth when the debt is unbalanced toward the type of borrowing that doesn’t create an income stream sufficient to repay principal and interest.

And it’s not just the US. Lacy notes that the world’s largest economies have a higher total debt-to-GDP ratio today than at the onset of the Great Recession in 2008, and foreign households are living farther above their means than they were six years ago.

Simply put, the developed (and much of the developing) world is fast approaching the end of a 60-year-long debt supercycle, as I (hope I) conclusively demonstrated in Endgame and reaffirmed in Code Red.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

Some readers may have noticed that there was no Thoughts from the Frontline in their inboxes this weekend. As has happened only once or twice in the last 14 years, I found myself in an intellectual cul-de-sac, and there was not enough time to back out. Knowing that I was going to be involved in a fascinating conference over the weekend, I had planned to do a rather simple analysis of a new book on how GDP is constructed. But as I got deeper into thinking about the topic and doing more research, I remembered something I read 20 years ago about the misleading nature of GDP, and I realized that a simple analysis just wouldn’t cut it.

Rather than write something that would’ve been inadequate and unsatisfying, I decided to just put it off till next week. Your time and attention are quite valuable, and I try not to waste them. But there will be no excuses this weekend.

The conference I attended was organized by Great Point Partners, a hedge fund and private equity firm focusing on medical and biotechnology. I really had not seen the program until I arrived and did not realize what a powerful lineup of industry leaders would be presenting on some of the latest technologies and research. The opportunity was too good to pass up, as it is so rare that any of us get to sit down with people who are responsible for the science we all read about.

I had breakfast with a small group of 11 readers/investors one morning and learned a lot by asking them what their favorite investing passion was. Although everyone had concerns, they all had areas in which they were quite bullish. I find that everywhere I go. It was interesting, in that they all expected me to be far more negative about things than I am. I guess when you write about macroeconomics as much as I do, and there’s as much wrong with it as there is, you kind of end up being labeled as a Gloomy Gus. I am actually quite optimistic about the long-term future of humanity, but I’ll admit there will be a few bumps along the way. Given how many bumps there have already been, just in my own lifetime, and given that we seem to have gotten through them, I can’t help but be optimistic that we’ll get through the next round.

It was a fascinating weekend, made all the more so by my very gracious hosts, Jeff Jay and David Kroin, Managing Directors of Great Point. They and their staff made sure I could enjoy my time on Nantucket Island. It was my first visit to the area, and I hope it won’t be the last.

Last night I had dinner with Art Cashin, Barry Ritholtz, Jack Rivkin, and Dan Greenhaus. It was a raucous, intellectually enlivening evening, and our conversation ranged from macroeconomics to our favorite new technologies. Jack Rivkin is involved with Idealab, and one of his favorites is that he sees the eventual end of Amazon as 3-D printing becomes more available. Given how Bezos has adapted over the years, I’m not so sure. Jack and Barry will join me in Maine in a few weeks, where we will again join the debate about bull and bear markets.

Now let’s go to Lacy and think about the intersection of velocity and money supply and what it says about future growth potential. I have two full days of meetings with my partners and others here in New York before I return to Dallas, and then I get to stay home for a few weeks. There are lots of new plans in the works. And lots of reading to do between meetings. Have a great week!

Your hoping to be able to stay optimistic analyst,

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

 

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Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2014

Treasury Bonds Undervalued

Thirty-year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top-line” GDP expansion of only 2.9%, while the bond yield remains close to 3.4%. Knut Wicksell (1851-1926) noted that the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the top-line growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. Wicksell preferred to use, not a risk free rate of interest such as thirty-year treasury bonds, but a business rate of interest such as BAA corporates.

As chart one attests, interest rates below nominal GDP growth helps to accelerate economic activity and vice versa. Currently the higher interest rates are retarding economic growth, suggesting the next move in interest rates is lower.

To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions.

Fisher’s Equation of Exchange

Slow nominal growth is not surprising to those who recall the American economist Irving Fisher’s (1867-1947) equation of exchange that was formulated in 1911. Fisher stated that nominal GDP is equal to money (M) times its turnover or velocity (V), i.e., GDP=M*V. Twelve months ago money (M) was expanding about 7%, and velocity (V) was declining at about a 4% annual rate. If you assume that those trends would remain in place then nominal GDP should have expanded at about 3% over the ensuing twelve months, which is exactly what occurred. Projecting further into 2014, the evidence of a continual lackluster expansion is clear. At the end of June money was expanding at slightly above a 6% annual rate, while velocity has been declining around 3%. Thus, Fisher’s formula suggests that another twelve months of a 3% nominal growth rate is more likely than not. With inflation widely expected to rise in the 1.5% to 2.0% range, arithmetic suggests that real GDP in 2014 will expand between 1.0% and 1.5% versus the average output level of 2013. This rate of expansion will translate into a year-over-year growth rate of around 1% by the fourth quarter of 2014. This is akin to pre-recessionary conditions.

An Alternative View of Debt

The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.

Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non-productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).

In concert with this view, but pinpointing the negative aspect of debt, contemporary economic research has corroborated the views of Hyman Minsky (1919-1996) and Charles Kindleberger (1910-2003) that debt slows economic growth at higher levels when it is skewed toward the type of borrowing that will not create an income stream sufficient to repay principal and interest.

Scholarly studies using very sophisticated analytical procedures conducted in the U.S. and abroad document the deleterious effects of high debt ratios. However, the use of a balance sheet measure can be criticized in two ways. First, income plays a secondary role, and second, debt ratios are not an integral part of Keynesian economic theory.

We address these two objections by connecting the personal saving rate (PSR) which is at the core of Keynesian economic analysis, and the private debt to GDP ratio that emerges from non-Keynesian approaches. Our research indicates that both the “Non-Keynesian” private debt to GDP ratios, as well as the “Keynesian” PSR, yield equivalent analytical conclusions.

The Personal Saving Rate (PSR) and the Private Debt Linkage

The PSR and the private debt to GDP ratio should be negatively correlated over time. When the PSR rises, consumer income exceeds outlays and taxes. This means that the consumer has the funds to either acquire assets or pay down debt, thus closely linking the balance sheet and income statement. When the PSR (income statement measure) rises, savings (balance sheet measure) increases unless debt (also a balance sheet measure) declines, thus the gap between the Keynesian income statement focus and the non-Keynesian debt ratio focus is bridged.

The PSR and private debt to GDP ratio are, indeed, negatively correlated (Chart 2). The correlation should not, however, be perfect since the corporate sector is included in the private debt to GDP ratio while the PSR measures just the household sector. We used the total private sector debt ratio because the household data was not available in the years leading up to the Great Depression.

The most important conceptual point concerning the divergence of these two series relates to the matter of the forgiveness of debt by the financial sector, which will lower the private debt to GDP ratio but will not raise the PSR. The private debt to GDP ratio fell sharply from the end of the recession in mid-2009 until the fourth quarter of 2013, temporarily converging with a decline in the saving rate. As such, much of the perceived improvement in the consumer sector’s financial condition occurred from the efforts of others. The private debt to GDP ratio in the first quarter of 2014 stood at 275.4%, a drop of 52.5 percentage points below the peak during the recession. The PSR in the latest month was only 1.7 percentage points higher than in the worst month of the recession. Importantly, both measures now point in the direction of higher leverage, with the PSR showing a more significant deterioration. From the recession high of 8.1%, the PSR dropped to 4.8% in April 2014.

Historical Record

The most recently available PSR is at low levels relative to the past 114 years and well below the long-term historical average of 8.5% (Chart 3). The PSR averaged 9.4% during the first year of all 22 recessions from 1900 to the present. However this latest reading of 4.8% is about the same as in the first year of the Great Depression and slightly below the 5% reading in the first year of the Great Recession.

In Dr. Martha Olney’s (University of California, Berkeley and author of Buy Now, Pay Later) terminology, when the PSR falls households are buying now but will need to pay later. Contrarily, if the PSR rises households are improving their future purchasing power. A review of the historical record leads to two additional empirical conclusions. First, the trend in the PSR matters. A decline in the PSR when it has been falling for a prolonged period of time is more significant than a decline after it has risen. Second, the significance of any quarterly or annual PSR should be judged in terms of its long- term average.

For example, multi-year declines occurred as the economy approached both the Great Recession of 2008 and the Great Depression of 1929. In 1925 the PSR was 9.2%, but by 1929 it had declined by almost half to 4.7%. The PSR offered an equal, and possibly even better, signal as to the excesses of the 1920s than did the private debt to GDP ratio. Both the level of PSR and the trend of its direction are significant meaningful inputs.

John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over-saving. What Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.

Keynes, along with his most famous American supporter, Alvin Hansen (1887-1975), argued that the U.S. economy would face something he termed “an under-employment equilibrium.” They believed the U.S. economy would return to the Great Depression after World War II ended unless the federal government ran large budget deficits to offset weakness in consumer spending. The PSR averaged 23% from 1942 through 1946, and the excessive indebtedness of the 1920s was reversed. Consumers had accumulated savings and were in a position to fuel the post WWII boom. The economy enjoyed great prosperity even though the budget deficit was virtually eliminated. The concerns about the under-employment equilibrium were entirely wrong. In Keynes’ defense, the PSR statistics cited above were not known at the time but have been painstakingly created by archival scholars since then.

Implications for 2014-2015

In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs also indicate that foreign households are living further above their means than six years ago. According to the OECD, Japan’s PSR for 2014 will be 0.6%, virtually unchanged from 2008. The OECD figure is likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect, and a negative PSR for the year should not be ruled out. In addition, Japan’s PSR is considerably below that of the U.S. The Eurozone PSR as a whole is estimated at 7.9%, down 1.5 percentage points from 2008. Thus, in aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery. [reference: Atif Mian and Amir Sufi,. House of Debt, University of Chicago Press 2014]

Japan confirms the experience in the United States because their PSR has declined from over 20% in the financial meltdown year of 1989 to today’s near zero level. Japan, unlike the U.S. in the 1940s, has moved further away from financial stability. Despite numerous monetary and fiscal policy maneuvers that were described as extremely powerful, the end result was that they have not been successful.

U.S. Yields Versus Global Bond Yields

Table one compares ten-year and thirty-year government bond yields in the U.S. and ten major foreign economies. Higher U.S. government bond yields reflect that domestic economic growth has been considerably better than in Europe and Japan, which in turn, mirrors that the U.S. is less indebted. However, the U.S. is now taking on more leverage, indicating that our growth prospects are likely to follow the path of Europe and Japan.

With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty-year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty-year yields in the Japanese and German economies, respectively, currently stand.

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

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Thoughts from the Frontline: Central Bank Smackdown

 

Smackdown: smack·down, ˈsmakˌdoun/, noun, US informal
1.  a bitter contest or confrontation.
“the age-old man versus Nature smackdown”
2.  a decisive or humiliating defeat or setback.

The term “smackdown” was first used by professional wrestler Dwayne Johnson (AKA The Rock) in 1997. Ten years later its use had become so ubiquitous that Merriam-Webster felt compelled to add it to their lexicon. It may be Dwayne Johnson’s enduring contribution to Western civilization, notwithstanding and apart from his roles in The Fast and The Furious movie series. All that said, it is quite the useful word for talking about confrontations that are more for show than actual physical altercations.

And so it is that on a beautiful July 4 weekend we will amuse ourselves by contemplating the serious smackdown that central bankers are visiting upon each other. If the ramifications of their antics were not so serious, they would actually be quite amusing. This week’s shorter than usual letter will explore the implications of the contretemps among the world’s central bankers and take a little dive into yesterday’s generally positive employment report.

BIS: The Opening Riposte

The opening riposte came from the Bank for International Settlements, the “bank for central banks.” In their annual report, released this week, they talked about “euphoric” financial markets that have become detached from reality. They clearly – clearly in central banker-speak, that is – fingered the culprit as the ultralow monetary policies being pursued around the world. These are creating capital markets that are “extraordinarily buoyant.”

The report opens with this line: “A new policy compass is needed to help the global economy step out of the shadow of the Great Financial Crisis. This will involve adjustments to the current policy mix and to policy frameworks with the aim of restoring sustainable and balanced economic growth.”

The Financial Times weighed in with this summary: “Leading central banks should not fall into the trap of raising rates ‘too slowly and too late,’ the BIS said, calling for policy makers to halt the steady rise in debt burdens around the world and embark on reforms to boost productivity. In its annual report, the BIS also warned of the risks brewing in emerging markets, setting out early warning indicators of possible banking crises in a number of jurisdictions, including most notably China.”

“The risk of normalizing too late and too gradually should not be underestimated,” the BIS said in a follow-up statement on Sunday. “Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on,” the BIS report said.

The Financial Times noted that the BIS “has been a longstanding sceptic about the benefits of ultra-stimulative monetary and fiscal policies, and its latest intervention reflects mounting concern that the rebound in capital markets and real estate is built on fragile foundations.”

The New York Times delved further into the story:

There is a disappointing element of déjà vu in all this,” Claudio Borio, head of the monetary and economic department at the BIS, said in an interview ahead of Sunday’s release of the report. He described the report “as a call to action.”

The organization said governments should do more to improve the performance of their economies, such as reducing restrictions on hiring and firing. The report also urged banks to raise more capital as a cushion against risk and to speed efforts to deal with past problems. Countries that are growing quickly, like some emerging markets, must be alert to the danger of overheating, the group said.

The signs of financial imbalances are there,” Mr. Borio said. “That’s why we are emphasizing it is important to take further action while the time is still there.”

The B.I.S. report said debt levels in many emerging markets, as well as Switzerland, “are well above the threshold that indicates potential trouble.” (Source: New York Times)

Casual observers will be forgiven if they come away with the impression that the BIS document was seriously influenced by supply-siders and Austrian economists. Someone at the Bank for International Settlements seems to have channeled their inner Hayek. They pointed out that despite the easy monetary policies around the world, investment has remained weak and productivity growth has stagnated. There is even talk of secular (that is, chronic) stagnation. They talk about the need for further capitalization of many banks (which can be read, of European banks). They decry the rise of public and private debt.

Read this from their webpage introduction to the report:

To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective – one in which the financial cycle takes centre stage. They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.

“Good policy is less a question of seeking to pump up growth at all costs than of removing the obstacles that hold it back,” the BIS argued in the report, saying the recent upturn in the global economy offers a precious opportunity for reform and that policy needs to become more symmetrical in responding to both booms and busts.

Does “responding to both booms and busts” sound like any central bank in a country near you? No, I thought not. I will admit to being something of a hometown boy. I pull for the local teams and cheered on the US soccer team. But given the chance, based on this BIS document, I would replace my hometown team – the US Federal Reserve High Flyers – with the team from the Bank for International Settlements in Basel in a heartbeat. These guys (almost) restore my faith in the economics profession. It seems there is a bastion of understanding out there, beyond the halls of American academia. Just saying…

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.

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