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Archive for February 2015

Archive for February, 2015

Outside the Box: Shovelin’ Schmitt Against the Tide

 

There is an obsession in the marketplace over the date when the Fed will once again begin to raise rates. As if another 25 basis points is going to change the economics on tens of trillions of dollars of investments. But as we reflect on the issue more deeply, it becomes obvious that a minor bump in the fed funds rate will indeed change a great deal of economics all over the world.

No, it won’t do much to the cap rate on your latest real estate purchase, but it is likely to greatly affect the pricing of the currency and commodity markets. And those markets will affect corporate profits, which will affect the stock market. It’s all connected.

And what if the Fed has lost control? What if they are in a no-win situation where raising rates will cause reactions they don’t want, but not raising rates will result in equally unpleasant reactions?

A big part of the problem lies in what we analysts call divergent and convergent monetary policies. With Japan mounting an unprecedented quantitative easing attack on currencies everywhere and Europe getting ready to join in, with smaller nations all over the world lowering their interest rates, if the US were to raise rates, that move would strengthen the dollar even more. But that would mean even more deflation imported into the US.

Today we find that the headline CPI was -0.7% for January, coming on the heels of two previous months at -0.3%. The year-over-year rate slipped into negative numbers for the first time since October 2009, when we were still reeling from a deep recession. The Fed typically raises rates when it wants to lean into inflation, not when inflation is falling. Yes, I know that Yellen in her testimony and in recent Fed releases has said the Fed is confident that inflation will once again rise to 2%. And that, even if you take out food and energy, inflation has still risen at 1.6% over the last 12 months.

I want to thank Joan McCullough for allowing me to use the essay she wrote yesterday morning, which is the single best description of the dilemma facing the Federal Reserve that I’ve read in some time. It’s not all that long, and it has Joanie’s irreverent humor sprinkled liberally throughout, so it’s not only a short read, it’s fun.

So our economy will be impacted negatively not by official interest rates; the multinationals also come to mind for the stock pickers. Because we already know that the entire interest-rate, fiscal position, underlying economic metrics relationship has been decommissioned. By the tidal wave of printed money. That has us comin’ and goin’ at the moment. With the present “beneficiary,” the US Dollar. We started it. We flooded it. We yanked it back. It’s their turn now.

The situation with the Fed and its impact on the global economy is starting to get really interesting. I am really looking forward to my conference, where I will have both those who believe the Fed can control things and others who are equally convinced that the world is about to change profoundly no matter what the Fed does. I intend to get them up on the stage together and throw them raw meat – like the piece you are going to read today – and see what ensues. It will be fun theater; but even more importantly, it will help us understand the realities of the world we live in.

You can still get the early-bird pricing for this year’s Strategic Investment Conference by going to this link. You really do want to try to get to this conference.

We actually had a little bit of winter here in Texas this past week. Not a whole lot, but ice and snow, and enough to close the schools for a few days, so all the kids were happy. But we still had a good-sized gathering on Monday when I invited the boards of the various Ashford companies, which are all involved with hotel REITs in one way or another. Full disclosure: I have joined the board of Ashford Inc., partly because Monty Bennett is my very good friend and fun to work with, and partly because it exposes to me to a business that is very sensitive to the economy and thus gives me a little more insight into what’s really happening in the world. There has been a great deal to learn about Ashford’s business, and it’s been quite fun.

I am on one other public board (Galectin Therapeutics or GALT), and the two businesses could hardly be more different. And then I think what it would be like to be involved with any number of other interesting businesses I’m familiar with, and I realize again the enormous complexity of our capitalist system. I am invited to speak at various corporate gatherings and board meetings from time to time and try to learn a little bit about their industries when I have the opportunity. I remember speaking to a group that did what was basically property insurance, which I thought was mundane going in. Then in the course of interacting with them I realized that there were 1,000 intricate moving parts necessary to simply allow me to have property insurance. And the mind boggles at what it takes to bring some of the technology that’s on my desk to the marketplace, let alone to sell it substantially more cheaply every year.

Every bit of the far-flung capitalist enterprise has to be executed against the backdrop of the Federal Reserve’s manipulating the marketplace, screwing (that’s about as nice a term as one should use in referring to financial repression) savers and fixed-income investors, creating chaos in the pension fund world, and roiling the currency markets with their decisions. Seventeen people sitting around a table thinking they have enough understanding to set interest rates for a market of one million companies whose complexities are staggering. The mind reels.

The good news is that I will get to ponder some of this while reading a book by the pool in Orlando this weekend, where I’ll speak on behalf of my friends at Altegris Investments to the American Bankers Association, yet another extremely complex business. Have a great week and look for my letter over the weekend, where we will further explore the explosion of debt in the world over the last eight years.

Your getting off his soapbox analyst,

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

 

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Shovelin’ Schmitt Against the Tide

By Joan McCullough

I used to be quite sure that raising rates was a sure-fire way of slowing an economy.

Given the worldwide printing orgy currently being staged by the central banks … with China reiterating a need for more participation overnight … I wonder now. If official rates amount to a tinker’s dam. 

You remember official rates, right? Often called “base rates” because it was upon this first step that the cost of money going forward was supposed to be priced. 

But the size of the largesse both extant and anticipated is such that the protocols as we knew them have been battered into nonexistence.

So given the investor response to the printing jamboree which has become frenzied to the extent that Germany is negative now out thru 7 years. And 10-year paper issued by the Portuguese government is trading this a.m. at least 10 bps cheaper than the yield on US paper. I wonder aloud if the entire relationship between interest rates, fiscal position and underlying economic metrics has not been permanently abolished. As the seemingly never-ending flow of printed money has out of necessity crowding outoverflowed into corporate issuance from investment grade right on down to toilet paper. Blurring all lines as the ability to assign value has likewise been washed away in the flood.

The visual is of a tidal wave; origin an unnecessary detail. Flowing around the global markets. Hot spots, of course, are the currently-targeted sovereign issues with overflow driven by gravity at this stage.

These thoughts occurred to me having reread Yellen’s testimony and reviewed the Q&As which followed both days.

Conclusion: Let there be no further pretense of the superiority of any US recovery; any pretense about the effectiveness of ZIRP and QE are likewise dispensed with.

The FED is about to be hoisted way high up. By its own petard.

They had one tool left for all intents and purposes. The tinkering with interest rates. 

So as the global currency war went full swing, they had the option of accepting the deflation being sent their way by the other sovereigns or deflecting it. 

To accept the deflation, they would tighten. To deflect it, they would ease. Standing pat? While under suspicion of a tightening bent or when backing away from same during Congressional testimony, standing pat does not exist. As innuendo alone acts on rates. In both directions. Which the buck follows obediently.

Until the FED loses control of the buck as well. This is where we are at the moment.

The FED was first to unleash a tsunami of free money on the world. The withdrawal of that flow via the demise of QE3 was felt to be sure. The deflation of China as evidenced by the rout in commodities which followed is proof. Of the beginning of the end.

In response to that withdrawal which was announced under the guise of an improving US economy, the global economies took a defensive tack. The majors conjured up their own printing operations which engendered bigger trade imbalances, which of course led to the current forex war, the hallmark of which is the quest to debase one’s currency and in so doing, gain a trade advantage.

Any control of the Dollar is about to be snatched back from the FED. By a sequence of events set in motion by the FED itself.

As the effect of the global tidal wave of free money. Which arose out of necessity when the FED tapered QE into silence. Heads now for these shores. 

Lifting the buck aloft. Accepting the deflation (which I prefer to call “negative inflation” at this juncture) without raising an official interest-rate finger. Because that m.o. has been rendered obsolete! Or if you prefer, just accept that any FED moves would be tantamount to shovelin’ schmitt against the tide [of printed money]. 

Please take a look at commodities if you need confirmation. Crude is leading the way lower. 

All this relegates the FOMC to a new role as observers. Because they will be powerless to do anything much but watch. As the fruits of their toxic labor come home to roost. 

QE1, 2 and 3 ran from late 2008 thru 2014. 

During that period, the buck was under pressure, bouncing around. And intermittently bottoming vs. the Euro around the 1.50 level. It wasn’t until mid-2014 that the Euro had its last hurrah at 1.40. And then the buck finally got solid legs and has been rallying steadily from May of last year. Pretty much 1.40 to 1.13.

To the printer, then, goes the weak currency. And as we saw with the ECB, this is clearly by design.

As mentioned already, let’s dispense with the pretense of a solid US recovery. That’s hogwash, particularly the baloney about the tightening of the labor market. Housing’s punk state is self-evident and the slippage in consumer confidence, unnerving.

The FED is in a corner. They cannot raise rates. But because of the backlash comin’ at us now, the buck continues on a tear higher. They cannot control it. 

So our economy will be impacted negatively not by official interest rates; the multinationals also come to mind for the stock pickers. Because we already know that the entire interest-rate, fiscal position, underlying economic metrics relationship has been decommissioned. By the tidal wave of printed money. That has us comin’ and goin’ at the moment.

With the present “beneficiary” the US Dollar.

We started it. We flooded it. We yanked it back. It’s their turn now. 

Bend over, Rover. Any questions?

JMcC

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Thoughts from the Frontline: Debt Be Not Proud

 

Some things never change. Here is Eugen von Böhm-Bawerk, one of the founding intellectuals of the Austrian school of economics, writing in January 1914, lambasting politicians for their complicity in the corruption of monetary policy:

We have seen innumerable variations of the vexing game of trying to generate political contentment through material concessions. If formerly the Parliaments were the guardians of thrift, they are today far more like its sworn enemies. Nowadays the political and nationalist parties … are in the habit of cultivating a greed of all kinds of benefits for their co-nationals or constituencies that they regard as a veritable duty, and should the political situation be correspondingly favorable, that is to say correspondingly unfavorable for the Government, then political pressure will produce what is wanted. Often enough, though, because of the carefully calculated rivalry and jealousy between parties, what has been granted to one has also to be conceded to others — from a single costly concession springs a whole bundle of costly concessions. [emphasis mine]

That last sentence is a key to understanding the crisis that is unfolding in Europe. Normally, you would look at a country like Greece – with 175% debt-to-GDP, mired in a depression marked by -25% growth of GDP (you can’t call what they’re going through a mere recession), with 25% unemployment (50% among youth), bank deposits fleeing the country, and a political system in (to use a polite term) a state of confusion – and realize it must be given debt relief.

But the rest of Europe calculates that if they make concessions to Greece they will have to make them to everybody else, and that prospect is truly untenable. So they have told the poor Greeks to suck it up and continue to toil under a mountain of debt that is beyond Sisyphean, without any potential significant relief from a central bank. This will mean that Greece remains in almost permanent depression, with continued massive unemployment. While I can see a path for Greece to recover, it would require a series of significant political and market reforms that would be socially and economically wrenching, almost none of which would be acceptable to any other country in Europe.

Sidebar: Japan would still be mired in a depressionary deflation if its central bank were not able to monetize the country’s debt. As Eurozone members the Greeks have no such option .

However, the rest of Europe is not without its own rationale. To grant Greece the debt relief it needs without imposing market reforms would mean that eventually the same relief would be required for every peripheral nation, ultimately including France. Anyone who thinks that Europe can survive economically without significant market reforms has no understanding of how markets work. Relief without reforms would be as economically devastating to the entirety of Europe as it would be to Greece alone. Ultimately, for the euro to survive as a currency, there must be a total mutualization of Eurozone debt, a concept that is not politically sellable to a majority of Europeans. (The European Union can survive quite handily as a free trade zone without the euro and would likely function much better than it does now.)

Kicking the debt relief can down the road is going to require a great deal of dexterity. The Greeks haven’t helped their cause with their abysmal record of avoiding taxes and their rampant, all-too-easily-observed government corruption, including significant public overemployment.

In this week’s letter we will take a close look at the problem that is at the core of Europe’s ongoing struggle: too much debt. But to simply say that such and such a percentage of debt to GDP is too much doesn’t begin to help you understand why debt is such a problem. Why can Japan have 250% debt-to-GDP and seemingly thrive, while other countries with only 70 or 80% debt-to-GDP run into a wall?

Debt is at the center of every major macroeconomic issue facing the world today, not just in Europe and Japan but also in the US, China, and the emerging markets. Debt (which must include future entitlement promises) is a conundrum not just for governments; it is also significantly impacting corporations and individuals. By closely examining the nature and uses of debt, I think we can come to understand what we will have to do in order to overcome our current macroeconomic problems.

But first, two announcements. At the end of the letter is a link to the website for my 2015 Strategic Investment Conference in San Diego, April 29 – May 2. There is a terrific lineup, and you can sign up now and get the early-bird discount through the end of the month. Ours is simply the best speaker lineup at any conference in the country that discusses economics and investing. You really should make an effort to attend.

And I’m pleased to announce the launch of Mauldin Pro, our new service for professional investors. We’ve been working on this for months. You’ll likely remember a few Outside the Box editions featuring a brilliant young global macro investor by the name of Jawad Mian. Jawad has brought his excellent Stray Reflections letter to Mauldin Economics as part of our Pro service. In addition, we have Over My Shoulder and World Money Analyst, an interview series called Mauldin Conversations, and – perhaps the best part – our Pro Sessions. These will be a traveling series of seminars with SIC-level speakers, but in a more intimate setting. We’ll get together for a few hours of intense discussion and then relax with a drink and get to know each other. Our first session is being organized now and will be held in New York City. If you are a financial advisor, portfolio manager, or other type of investment professional, this service is for you. Check it out here.

Now let’s think about debt.

Debt Be Not Proud

Debt is future consumption brought forward, as von Böhm-Bawerk taught us. It is hard for me to overemphasize how important that proposition is. If you borrow money to purchase something today, that money will have to be paid back over time and will not be available for other purchases. Debt moves future consumption into the present. Sometimes this is a good thing, and sometimes it is merely stealing from the future.

This is a central concept in proper economic thinking but one that is all too often ignored. Let’s tease out a few ideas from this concept. Please note that this letter is trying to simply introduce the (large) topic of debt. It’s a letter, not a book. In this section we’ll deal with some of the basics, for new readers.

First off, debt is a necessary part of any society that has advanced beyond barter or cash and carry. Debt, along with various forms of insurance, has made global finance and trade possible. Debt fuels growth and allows for idle savings accrued by one person to be turned into useful productive activities by another. But too much debt, especially of the wrong kind, can also be a drag upon economic activity and, if it increases too much, can morph into a powerful force of destruction.

Debt can be used in many productive ways. The first and foremost is to use debt to purchase the means of its own repayment. You can borrow in order to buy tools that give you the ability to earn higher income than you can make without them. You can buy on credit a business (or start one) that will produce enough income over time to pay off the debt. You get the idea.

Governments can use debt to build roads, schools, and other infrastructure that are needed to help grow the society and enhance the economy, thereby increasing the ability of the government to pay down that debt.

Properly used, debt can be your friend, a powerful tool for growing the economy and improving the lives of everyone around you.

Debt can be created in several ways. You can loan money to your brother-in-law directly from your savings. A corporation can borrow money (sell bonds) to individuals and funds, backed by its assets. No new money needs to be created, as the debt is created from savings. Such lending almost always involves the risk of loss of some or all of the loan amount. Typically, the higher the risk, the more interest or return on the loan is required.

Banks, on the other hand, can create new money through the alchemy of fractional reserve banking. A bank assumes that not all of its customers will need the immediate use of all of the money they have deposited in their accounts. The bank can loan out the deposits in excess of the fraction they are required to hold for depositors who do want their cash. This lets them make a spread over what they pay depositors and what they charge for loans. The loans they make are redeposited in their bank or another one and can be used to create more loans. One dollar of base money from a central bank (sometimes called high-powered money) can over time transform itself into $8-10 of actual cash.

A government can create debt either directly or indirectly, by borrowing money from its citizens (through the sale of bonds) or by directing its central bank to “print” or create money. The money that a central bank creates is typically referred to as the monetary base.

Debt can be a substitute for time. If I want a new car today, I can borrow the money and pay for the car (which is a depreciating asset) over time. Or I can borrow money to purchase a home and use the money I was previously paying in rent to offset some or all of the cost of the mortgage, thereby slowly building up equity in that home (assuming the value of my home goes up).

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

Outside the Box: What Uber Could Teach the American Economy

 

When I travel around the country, one of the questions that comes up often in conversation is, where will the jobs of the future come from? I have a stock answer that I glibly offer:

In 1980, the Japanese were beating our brains out. Inflation was well into the double digits, as was unemployment. Finding a job was hard (I know), as one industry after another was being reconfigured and jobs seemed to be disappearing left and right. The answer to the question “Where will the jobs come from?” back then was “I don’t know, but they will.”

And they did. Whole new industries were built around personal computer hardware and software; new service categories appeared; and eventually the Internet emerged. Some 25% of the job categories in the government statistics did not exist in 1970 (if I remember correctly – it’s somewhere in that neighborhood). If you go back to the late 1800s, farmers were still more than 40% of the labor force. Fast-forward 100 years and that figure was less than 3%, but the remaining farmers were producing vastly more, feeding not only the US but much of the rest of the world. Meanwhile, most of the people displaced from farms had to find jobs that had not been invented in 1900.

The twentieth century was a good time for middle America. A lot of the new manufacturing jobs paid reasonable middle-class wages. Like me, many of you grew up in those middle-class homes (though mine was decidedly on the lower end of the scale). It was a good life and a great time to grow up.

I had lunch yesterday with Travis Briggs, one of the partners in Robostox, an index and ETF firm that specializes in an index that tracks stocks in the robotics and automation space. As you might imagine, it is been a good space to be in over the last 15 years. (Full disclosure: I am a low-single-digit, very minority owner of the index firm.)

Prior to our lunch, I had just read the essay that is this week’s Outside the Box and was in a reflective mood. While it is easy for me to glibly talk about how entrepreneurs will create the jobs of the future, it becomes a little bit more personal when I think about my seven kids and now six grandkids and what their jobs might look like. We are clearly watching what we’ve called the “middle class” shrink. There appears to be a bifurcation between those jobs for which high-level skills are required and those that can be easily filled by just about anyone – or by a more or less intelligent machine.

Yes, there is a rise in small, artisanal, entrepreneurial businesses like bakeries and breweries, but those don’t create large numbers of middle-class or high-paying jobs.

Further, for the first time in American history we are now seeing more businesses close their doors than open them in a given year. We have made the barriers to creating new businesses so high that we are choking off the lifeblood of future employment, which is the wellspring from which a society creates value and opportunity for all of its citizens.

Travis and I talked about the tremendous opportunities in robotics and automation and the almost mind-boggling advances that are being made each year. We are truly entering a Brave New World, but it is one that is disintermediating jobs almost as fast as the McCormick reaper and the tractor and other agricultural technologies did.

In the past, increased productivity and new technologies created whole new areas of employment. While I am the most optimistic guy in the room about the future of the human experiment, there are times when I wonder whether the future might not look like something out of the novels of William Gibson, the creator of dystopian cyberpunk fiction. I hope not. I hope that Ian Banks is right instead, and the future holds fabulous opportunities and essential abundance for all. I certainly think that the basic necessities of life, including healthcare, are going to be relatively inexpensive in the future, much as our telecommunications have become, as costs have plummeted in the past couple decades.

Just as our phones became digital and cheap, healthcare will become digital and easily available. Maybe not as soon as we would like, but that is the future we’re heading toward.

But what do jobs look like in that world? In his essay called “What Uber Could Teach the American Economy,” my friend Sam Rines speculates that the world of work will look quite different in the future. His essay is not that long, but this week’s Outside the Box will really push you to think.

I am back in Dallas, and tonight I will go with Worth Wray to attend Kyle Bass’s Hayman Capital annual client dinner, where there will be lots of discussion about the future as well as about today’s markets. Tomorrow I give a speech for S&P here in Dallas, where we will be discussing the future of the investment industry. The glib, short take is that the industry will be better, cheaper, and faster, and in 10 years will look quite different. That’s good for customers but not so good for brokers and advisors who don’t change with the times. That automation I was talking about? It’s coming to an investment firm near you. The old models are going to give way to new ones. If you are in the business of running money, you need to be figuring out how to create the changes, not be run over by them. Stay tuned.

Have a great week. I am already thinking about this week’s Thoughts from the Frontline, where we’ll be talking about the growing amount of debt in the world and its impact on future global growth. It’s not just robots that we need to be worried about.

Your thinking about change agents analyst,

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

 

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What Uber Could Teach the American Economy

By Samuel Rines
January 26, 2015

America’s employment picture has certainly improved — but major challenges related to wage growth and part-time work remain. Yet, one company has an employment and pricing model that might offer solutions. 

The ride-sharing technology company Uber understands more about the U.S. economy than it is given credit for. Consider Uber’s use of surge pricing. Sometimes you need surge pricing and surge pay to balance supply and demand. Surge pricing gets more drivers on the road, and makes people think twice before requesting a ride. It also allows the Uber driver to determine to a great extent when, how long and where they work. Traditional businesses do not have surge pay to adapt to increases in demand and attract workers—overtime and signing bonuses do not adjust supply in real time.

Unfortunately, the United States as a whole is not as nimble an operator as Uber. The labor market is an intriguing mix of good and bad news. On the positive side, the unemployment rate is 5.6 percent, employment is above the pre-Great Recession peak, and employment growth has been steadily increasing for a couple years. Worryingly, the JOLTS report indicates the United States has 5 million job openings, the United States is facing stagnant wage growth, a plummeting labor-force participation rate and part-time employment remains a stubbornly large portion of the labor force. There seems to be phenomena at play not receiving attention—the interaction between the contestability of jobs and the complacency of jobs.

The “complacency of jobs” refers to the lack of incentive to work for lower wages than a worker’s perceived skill set deserves. Someone who lost a relatively high-paying job during the Great Recession might be less likely to accept a low wage simply for the sake of having a job. A lack of motivation, or holding out for a higher wage may begin to explain the declining unemployment rate and the plummeting labor-force participation rate the United States has today. The lack of financial incentive to take a job leaves both the person out of work (and either in the ranks of the unemployed or out of the labor force) and the company with a job opening. A refusal to work for a perceived low wage should eventually have the effect of pushing wages higher, but this has not been the case so far.

There are other factors working against the numbers as well. In a “normal” economic recovery, there is the expectation that as the labor market tightens, wages increase. This encourages people to switch jobs or even reenter the labor force. Theoretically, the job opening above would increase the salary or hourly until it was filled. But wages do not seem to be moving even as the unemployment rate falls. This is why contestability matters.

Jobs are lost en masse during recessions. Companies shed workers to remain profitable (or solvent) in the downturn, and some get hired back. This may be changing, though. As a wide array of U.S. and developed-world jobs come under attack from automation, global high-speed internet connectivity, and the emerging cheap but highly educated labor force willing to perform skilled work for low wages, many people are simply not going to be paid as much to do what they are doing. This is exacerbated by a strengthening U.S. dollar that makes foreign labor appear more attractive. Labor is being priced on the world market, not the local market. And this suppresses wages below where they would be in a closed economy.

The global economy is setting a wage ceiling in many U.S. jobs, and recruiters and hiring managers understand that many jobs can be filled abroad. The contestability of labor is keeping wages low, even as unemployment falls, because many jobs can be automated or outsourced if wages rise too much. Wages are pressured, even as fewer workers are chasing the same job in the United States, because there is a global workforce chasing those jobs as well.

There is another factor at work in the United States—part-time employment—and its multidecade rise as a proportion of the labor force. Typically, the U.S. economy could rely on increased productivity to pick up the slack from fewer workers. The growth equation of more workers making more and more stuff per hour appears to be slowing. The shifting composition of the labor force with more part-time and fewer full-time employees could explain some of the slowdown in productivity. Part-time employees may be less efficient and have lower levels of productivity. And part-time employment increased during the Great Recession and remains high today.

In many ways, the United States is fertile ground for the kind of jobs created by Uber. Uber allows for part-time and flexible hours, the jobs are noncontestable (at least until there are self-driving cars), and the complacency factor is counteracted by surge pricing.

A recent Economist article suggested the world is divided “between people who have money but no time and people who have time but no money.” Without an emphasis on creating low-contestability jobs (like construction and those in the oil patch—you cannot replace an oil worker with a robot—yet) that are low complacency (oil-field jobs also pay a lot relative to other jobs requiring a similar skill set), it is difficult to see how this trend reverses. Instead, the U.S. labor market is reacting rationally to a changing world—one where wages feel little pressure and people hold out for better jobs. The equilibrium between wages, employment and participation will eventually be found. For now, though, the United States is becoming increasingly idle.

Samuel Rines is an economist with Chilton Capital Management in Houston, TX. Follow him on Twitter@samuelrines.

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Important Disclosures

Thoughts from the Frontline: Mamas, Don’t Let Your Babies Grow Up to Be Pension Fund Managers

 

We do not have to look to Greece to find massively underfunded obligations. Here in the US we can find hundreds of examples, willingly created by politicians and businessmen who proclaim they are working for the public good. We call them pension funds, but they’re just another form of unfunded debt. A sovereign bond is a promise to pay a certain amount of money over time. A defined-benefit pension fund is a promise to pay a certain amount of income over time. The value of either is determined by the ability of the government or the pension fund (or its sponsor) to pay.

I am in the Cayman Islands as I write this letter, to speak at an alternative investment conference attended by the management of some of the largest pension funds in the US and Europe, both public and private. Being here has motivated me to write this week’s letter on the problems that pension funds face. The pension fund managers I have talked with take their fiduciary obligations seriously, and they face some serious challenges.

I was on the stage with Nouriel Roubini (who makes me come off as the optimist), and we were talking about macroeconomic risks. I was asked what other sorts of risks people should be thinking about, and I cited a recent report about how pension fund obligations had dramatically increased because of a small change in mortality tables. There has been a very steady increase in life expectancy over the last almost 100 years. It is a fairly well-defined trend. The actuarial accountants whose responsibility it is to track these things updated the life expectancy tables for a 65-year-old male, who can now expect to live an additional 21.6 years, two years longer than in the old table. I pointed out that this trend toward longevity is very well established and is likely to accelerate as new technologies and medicines become available, which means that underfunded pension plans are even more underfunded than we think.

I pointed out that while living longer is a very high-quality personal problem to deal with, if your pension plan doesn’t live as long as you do, that could be an issue. Some pension plan managers approached me afterwards to talk about this issue, and it is apparent that others are confronting it head on. Matt Botein, global co-head and CIO, BlackRock Alternative Investors, later talked about how he helped pension funds to hedge their “mortality risk” (the odds that pensioners will live longer) by buying a large life insurance company. The value and profits of a life insurance company will rise if the people they have insured live longer. That is a very creative way to deal with the exposure that pension funds have to the obligations imposed by longer lifespans.

Mamas, Don’t Let Your Babies Grow Up to Be Pension Fund Managers

Today we briefly look at four very large problems facing pension funds. With a nod to Willie Nelson, I’m not sure I want my babies to grow up to be pension fund managers. It’s going to be a very challenging occupation, given all the headwinds they face. Not that the ones I know don’t seem relatively happy and well-adjusted, but they do face a Sisyphean task.

Expected Returns, Realistic Expectations

Most public and private pension funds project returns of between 7½ and 8% on their investment portfolios. Let’s analyze how realistic that is.

First, if you look back over the last six years, pension funds actually returned 6.8%. Not bad until you consider that we’ve been in a roaring bull market for the entirety of those six years. The average return for the largest public pension funds in the US in the recent decade was closer to 3.2%. Pension fund returns are highly correlated to stock market indexes, which is not surprising when you look at the typical allocation pattern of pension funds. This survey is from publicfundsurvey.org.

Note that hedge funds have recently underperformed equities; but on average they do somewhat better over the long term, depending, of course, upon which funds you are in. Accounting for the equity-like returns that many hedge funds achieve and the fixed-income returns that many real estate portfolios yield, the typical public pension fund portfolio looks like 55 to 60% equities, 30% fixed-income, and 10 to 15% alternatives.

As every prospectus states, and as I remind readers all the time, past performance is not indicative of future results. Jeremy Grantham at GMO has given us a forecast for seven-year real returns of various asset classes. This chart is as of December 31, 2014. Note that the long-term real return for US equities has been 6.5% (for newbies, when we say “real” return we mean net adjusted for inflation. Got it?)

Such forecasts are made in various ways but are generally based on how a particular asset class performed at a given level of valuation. It is well understood that if stocks at the beginning of a period have a lower valuation (there are several different ways to measure valuation, but generally we think of the price-to-earnings ratio), then their longer-term returns are going to be higher, often significantly higher, than the returns when equity valuations are high at the beginning of a period. Equity valuations are generally in the high range today (though not in historical nosebleed range – there is room for them to go higher).

Thus GMO’s forecasts are not very optimistic in terms of equity returns. And neither do they expect much from bonds.

This does not bode well for pension funds, which are heavily weighted to US equities. Given that the 10-year US Treasury is yielding under 2% and that some of us feel it may approach 1% before the end of the decade, the probability that any fund will be able to obtain 7-8% total returns over the next seven years doesn’t seem very high. Even hoping to get 4% might be stretching it.

If this all sounds pessimistic, I suggest you go to www.CrestmontResearch.com and look at historical returns on the equity and bond markets for the last 100 years. There were periods when US equity returns were negative for 20 years.

Further, it has been almost seven years since the last recession. Given that the longest we’ve gone without a recession is close to 10 years, it seems likely that we will see a recession within the next five years. The average stock market correction in a recession is in the 40% range, and recessions almost always mean that interest rates go even lower, which makes the challenge of achieving even 4% over the next seven years even more daunting.

The difference between compounding at 4% and 8% is huge. You can go to various websites that will help you calculate compound interest rates on your assets over time. I went to money-rates.com. The difference between compounding at 4% and 8% for 10 years is impressive: $1,000 grows to $1,480 at 4% and to $2,159 at 8%.

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

Outside the Box: Hoisington Quarterly Review and Outlook: Fourth Quarter 2014

 

Forecasting is a singularly difficult task and is more often than not fraught with failure. The Federal Reserve has some of the smartest economists in the world, and yet their forecasts are so wrong so often (as in, they almost never get it right) that some have pointed out that it’s almost statistically impossible to be as bad as the Fed. Yet they continue to issue such forecasts and to base economic and monetary policy on them. Go figure.

Their forecasts, like most economic predictions, are based on past performance. Intricate economic models look at history to try to determine the future relationships among economic determinants. I really shouldn’t pick on the Fed so much as point out that almost all of us in the forecasting business have dismal track records. The world has grown so complex that it is singularly difficult to understand the interrelationships of the million-odd factors that determine the outcome of an economy.

This is especially true during those periods when we see economic regime change. Not only is using past performance and relationships difficult, it can actually be misleading, as what is going to happen in a uniquely turbulent future has not been modeled in the past. I have been suggesting for some time that we are coming to the end of a long cycle and entering a period where past relationships will no longer hold. I have likened this to what happens when one approaches the boundary of a black hole in space. All known physical relationships are turned on their heads, and the math that works in the rest of the universe no longer applies.

For me, the massive amount of debt we have accumulated in our own planetary confines is the ecoomic equivalent of a black hole, and we are approaching the point at which that debt will implode if it is not resolved. As with Greece, the ability of players large and small to pay debt off in a global deflationary environment has been greatly compromised. I’m not certain how this will end. Maybe everyone will sit down and hammer out something like a Plaza Accord to resolve the debt, by which I mean dilute it, destroy it, make it go away, restructure it – whatever it takes. Of course, history suggests that we will do such a thing only in the middle of or immediately following a crisis.

Today’s Outside the Box is from our old friend Dr. Lacy Hunt of Hoisington Asset Management. He muses on the effects of debt and takes us back to the ’20s and ’30s, when there were similar problems with debt in countries that had engaged in currency wars for over a decade.

Clearly the policies of yesteryear and the present are forms of “beggar-my-neighbor” policies, which the MIT Dictionary of Modern Economics explains as follows: “Economic measures taken by one country to improve its domestic economic conditions … have adverse effects on other economies. A country may increase domestic employment by increasing exports or reducing imports by … devaluing its currency or applying tariffs, quotas, or export subsidies. The benefit which it attains is at the expense of some other country which experiences lower exports or increased imports.… Such a country may then be forced to retaliate by a similar type of measure.”

The existence of over-indebtedness, and its resulting restraint on growth and inflation, has forced governments today, as in the past, to attempt to escape these poor economic conditions by spurring their exports or taking market share from other economies. As shown above, it is a fruitless exercise with harmful side effects.

This is an important OTB, and it behooves us to pay attention, because Lacy has been one of the most accurate forecasters of interest rates for the last 20 to 30 years. He will also be at our conference in San Diego, where he is always one of the most highly rated speakers. And I want to express my appreciation to Lacy for once again letting us reproduce his work.

I send this Outside the Box to you from Little Cayman Island, where I am visiting my friend Raoul Pal at his beach house, which he just finished building. It is at the “far end” of a ten-mile-long by one-mile-wide island that is a libertarian paradise in that there is no government. Just some hundred-odd neighbors taking care of what needs to be done. With 10 MB broadband. Little Cayman is a bit of an island oddity, in that it is the tippy-top ridge of a very tall undersea mountain; just off the beaches, the Cayman Trench plunges to a depth of 25,000 feet, the deepest water in the Caribbean and one of the deeper trenches in the world. It is a scuba diver’s paradise, which pretty much drives the economy of the island.

While I was working, my companion went snorkeling some 20 feet off the beach from Raoul’s home. After she raved about the beauty and all the fish, I donned a little gear and for the first time in my life went snorkeling. I need to work on my snorkeling technique, but if Raoul invites us back, I will be better prepared. It was indeed a beautiful experience.

Raoul will also be presenting, along with his partner Grant Williams (of Things That Make You Go Hmmm… fame) at my conference, and he outlined what he thinks their presentation will cover. As is typical with Raoul and Grant, their approach to this talk is very fresh and different, focused on where global growth will go in the next few decades. Not exactly were you might expect it to go. I will be in the front row.

Raoul and Grant are the founders of RealVision TV, where they present in-depth interviews with famous investors. One of their concepts is to create a chain letter of sorts, by having a person who is interviewed find another fascinating person to interview. The interviewee then becomes the interviewer in the next round, and one great mind leads to another. Raoul led off by engaging Kyle Bass in a long-form interview that is fascinating. You can see it for free right here. There is also a special introductory price for Mauldin Economics readers to subscribe to RealVision.

Finally, I know there are many people who wonder about the lives of those of us who write about macroeconomics and investments for a living. Here is a picture of two of us (Raoul would be the handsome one) in typical working attire. It’s a hard-knock life.

As it turns out, I am actually hitting the send button from Grand Cayman Island, as we were summoned and rushed to the “airport” on Little Cayman to take a helicopter flight over to a nearby island where larger planes could land, because the small plane that usually services Little Cayman had broken down. Not a big deal, and as a bonus we had a helicopter tour of Little Cayman. I speak at the iCIO gathering this afternoon (hosted by Mark Yusko) and then speak at the Cayman Alternative Investment Summit tomorrow morning, where my good friend Nouriel Roubini and I will trade ideas in front of 650 attendees. It should prove to be fun. Then we’ll have a few days of R&R (hopefully) and then head back to Dallas on Sunday. You have a great week.

Your wondering why I don’t work from a beach sometimes analyst,

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

 

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Hoisington Quarterly Review and Outlook – Fourth Quarter 2014

Deflation

“No stock-market crash announced bad times. The depression rather made its presence felt with the serial crashes of dozens of commodity markets. To the affected producers and consumers, the declines were immediate and newsworthy, but they failed to seize the national attention. Certainly, they made no deep impression at the Federal Reserve.” Thus wrote author James Grant in his latest thoroughly researched and well-penned book, The Forgotten Depression (1921: The Crash That Cured Itself).

Commodity price declines were the symptom of sharply deteriorating economic conditions prior to the 1920-21 depression. To be sure, today’s economic environment is different. The world economies are not emerging from a destructive war, nor are we on the gold standard, and U.S. employment is no longer centered in agriculture and factories (over 50% in the U.S. in 1920). The fact remains, however, that global commodity prices are in noticeable retreat. Since the commodity index peak in 2011, prices have plummeted. The Reuters/Jefferies/CRB Future Price Index has dropped 39%. The GSCI Nearby Commodity Index is down 48% (Chart 1), with energy (-56%), metals (-36%), copper (-40%), cotton (-73%), WTI crude (-57%), rubber (-72%), and the list goes on. In some cases this broad-based retreat reflects increased supply, but more clearly it indicates weakening global demand.

The proximate cause for the current economic maladies and continuing downshift of economic activity has been the over- accumulation of debt. In many cases debt funded the purchase of consumable and non- productive assets, which failed to create a future stream of revenue to repay the debt. This circumstance means that existing and future income has to cover, not only current outlays, but also past expenditures in the form of interest and repayment of debt. Efforts to spur spending through relaxed credit standards, i.e. lower interest rates, minimal down payments, etc., to boost current consumption, merely adds to the total indebtedness. According to Deleveraging? What Deleveraging? (Geneva Report on the World Economy, Report 16) total debt to GDP ratios are 35% higher today than at the initiation of the 2008 crisis. The increase since 2008 has been primarily in emerging economies. Since debt is the acceleration of current spending in lieu of future spending, the falling commodity prices (similar to 1920) may be the key leading indicator of more difficult economic times ahead for world economic growth as the current overspending is reversed.

Currency Manipulation

Recognizing the economic malaise, various economies, including that of the U.S., have instituted policies to take an increasing “market share” from the world’s competitive, slow growing marketplace. The U.S. fired an early shot in this economic war instituting the Federal Reserve’s policy of quantitative easing. The Fed’s balance sheet expansion placed downward pressure on the dollar thereby improving the terms of trade the U.S. had with its international partners (Chart 2).

Subsequently, however, Japan and Europe joined the competitive currency devaluation race and have managed to devalue their currencies by 61% and 21%, respectively, relative to the dollar. Last year the dollar appreciated against all 31 of the next largest economies. Since 2011 the dollar has advanced 19%, 15% and 62%, respectively, against the Mexican Peso, the Canadian Dollar and the Brazilian Real. Latin America’s third largest economy, Argentina, and the 15th largest nation in the world, Russia, have depreciated by 115% and 85%, respectively, since 2011.

The competitive export advantages gained by these and other countries will have adverse repercussions for the U.S. economy in 2015 and beyond. Historical experience in the period from 1926 to the start of World War II (WWII) indicates this process of competitive devaluations impairs global activity, spurs disinflationary or deflationary trends and engenders instability in world financial markets. As a reminder of the pernicious impact of unilateral currency manipulation on global growth, a brief review of the last episode is enlightening.

The Currency Wars of the 1920s and 1930s

The return of the French franc to the gold standard at a considerably depreciated level in 1926 was a seminal event in the process of actual and de facto currency devaluations, which lasted from that time until World War II. Legally, the franc’s value was not set until 1928, but effectively the franc was stabilized in 1926.

France had never been able to resolve the debt overhang accumulated during World War I and, as a result, had been beset by a series of serious economic problems. The devalued franc allowed economic conditions in France to improve as a result of a rising trade surplus. This resulted in a considerable gold inflow from other countries into France. Moreover, the French central bank did not allow the gold to boost the money supply, contrary to the rules of the game of the old gold standard. A debate has ensued as to whether this policy was accidental or intentional, but it misses the point. France wanted and needed the trade account to continue to boost its domestic economy, and this served to adversely affect economic growth in the UK and Germany. The world was lenient to a degree toward the French, whose economic problems were well known at the time.

In the aftermath of the French devaluation, between late 1927 and mid-1929, economic conditions began to deteriorate in other countries. Australia, which had become extremely indebted during the 1920s, exhibited increasingly serious economic problems by late 1927. Similar signs of economic distress shortly appeared in the Dutch East Indies (now Indonesia), Finland, Brazil, Poland, Canada and Argentina. By the fall of 1929, economic conditions had begun to erode in the United States, and the stock market crashed in late October.

Additionally, in 1929 Uruguay, Argentina and Brazil devalued their currencies and left the gold standard. Australia, New Zealand and Venezuela followed in 1930. Throughout the turmoil of the late 1920s and early 1930s, the U.S. stayed on the gold standard. As a result, the dollar’s value was rising, and the trade account was serving to depress economic activity and transmit deflationary forces from the global economy into the United States.

By 1930 the pain in the U.S. had become so great that a de facto devaluation of the dollar occurred in the form of the Smoot-Hawley Tariff of 1930, even as the United States remained on the gold standard. By shrinking imports to the U.S., this tariff had the same effect as the earlier currency devaluations. Over this period, other countries raised tariffs and/or imposed import quotas. This is effectively equivalent to currency depreciation. These events had consequences.

In 1931, 17 countries left the gold standard and/or substantially devalued their currencies. The most important of these was the United Kingdom (September 19, 1931). Germany did not devalue, but they did default on their debt and they imposed severe currency controls, both of which served to contract imports while impairing the finances of other countries. The German action was undeniably more harmful than if they had devalued significantly. In 1932 and early 1933, eleven more countries followed. From April 1933 to January 1934, the U.S. finally devalued the dollar by 59%. This, along with a reversal of the inventory cycle, led to a recovery of the U.S. economy but at the expense of trade losses and less economic growth for others.

One of the first casualties of this action was China. China, on a silver standard, was forced to exit that link in September 1934, which resulted in a sharp depreciation of the Yuan. Then in March 1935, Belgium, a member of the gold bloc countries, devalued. In 1936, France, due to massive trade deficits and a large gold outflow, was forced to once again devalue the franc. This was a tough blow for the French because of the draconian anti-growth measures they had taken to support their currency. Later that year, Italy, another gold bloc member, devalued the gold content of the lira by the identical amount of the U.S. devaluation. Benito Mussolini’s long forgotten finance minister said that the U.S. devaluation was economic warfare. This was a highly accurate statement. By late 1936, Holland and Switzerland, also members of the gold bloc, had devalued. Those were just as bitter since the Dutch and Swiss used strong anti- growth measures to try to reverse trade deficits and the resultant gold outflow. The process came to an end, when Germany invaded Poland in September 1939, as WWII began.

It is interesting to ponder the ultimate outcome of this process, which ended with World Ware II. The extreme over-indebtedness, which precipitated the process, had not been reversed. Thus, without WWII, this so-called “race to the bottom” could have continued on for years.

In the United States, the war permitted the debt overhang of the 1920s to be corrected. Unlike the 1930s, the U.S. could now export whatever it was able to produce to its war torn allies. The income gains from these huge net trade surpluses were not spent as a result of mandatory rationing, which the public tolerated because of almost universal support for the war effort. The personal saving rate rose as high as 28%, and by the end of the war U.S. households and businesses had a clean balance sheet that propelled the postwar economic boom.

The U.S., in turn, served as the engine of growth for the global economy and gradually countries began to recover from the effects of the Great Depression and World War II. During the late 1950s and 1960s, recessions did occur but they were of the simple garden-variety kind, mainly inventory corrections, and they did not sidetrack a steady advance of global standards of living.

2015

As noted above, economic conditions, framework and circumstances are different today. The gold standard in place in the 1920s has been replaced by the fiat currency regime of today. Additionally, imbalances from World War I that were present in the 1920s are not present today, and the composition of the economy is different.

Unfortunately, there are parallels to that earlier period. First, there is a global problem with debt and slow growth, and no country is immune. Second, the economic problems now, like then, are more serious and are more apparent outside the United States. However, due to negative income and price effects on our trade balance, foreign problems are transmitting into the U.S. and interacting with underlying structural problems. Third, over- indebtedness is rampant today as it was in the 1920s and 1930s. Fourth, competitive currency devaluations are taking place today as they did in the earlier period. These are a combination of monetary and/or fiscal policy actions and also, with floating exchange rates, a consequence of shifting assessments of private participants in the markets.

Clearly the policies of yesteryear and the present are forms of “beggar-my-neighbor” policies, which The MIT Dictionary of Modern Economics explains as follows: “Economic measures taken by one country to improve its domestic economic conditions … have adverse effects on other economies. A country may increase domestic employment by increasing exports or reducing imports by … devaluing its currency or applying tariffs, quotas, or export subsidies. The benefit which it attains is at the expense of some other country which experiences lower exports or increased imports … Such a country may then be forced to retaliate by a similar type of measure.”

The existence of over-indebtedness, and its resulting restraint on growth and inflation, has forced governments today, as in the past, to attempt to escape these poor economic conditions by spurring their exports or taking market share from other economies. As shown above, it is a fruitless exercise with harmful side effects.

Interest Rates

The downward pressure on global economic growth rates will remain in place in 2015. Therefore record low inflation and interest rates will continue to be made around the world in the new year, as governments utilize policies to spur growth at the expense of other regions. The U.S. will not escape these forces of deflationary commodity prices, a worsening trade balance and other foreign government actions.

U.S. nominal GDP in this economic expansion since 2008 has experienced the longest period of slow growth of any recovery since WWII (Chart 3). Typical of the disappointing expansion, the fourth quarter to fourth quarter growth rate slowed from 4.6% in 2013 to 3.8% in 2014. A further slowing of nominal economic growth to around 3% will occur over the four quarters of 2015. The CPI will subside from the 0.8% level for the period December 2013 to December 2014 (Chart 4), registering only a minimal positive change for 2015. Conditions will be sufficiently lackluster that the Federal Reserve will have little choice in their overused bag of tricks but to stand pat and watch their previous mistakes filter through to worsening economic conditions. Interest rates will of course be volatile during the year as expectations shift, yet the low inflationary environment will bring about new lows in yields in 2015 in the intermediate- and long-term maturities of U.S. Treasury securities.

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

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Important Disclosures

Thoughts from the Frontline: The Eurozone: Collateral Damage

 

Collateral damage. Unintended consequences. Friendly fire. Certainly no one intended to have a global banking meltdown when they let Lehman Bros. go under.

Now we’re watching another Greek drama that could have significant unintended consequences – far beyond anything the market has priced in today. Then again, maybe not. Maybe the market is right this time. When we enter unknown territory, who knows what we will find? Fertile valleys and treasure, or deserts and devastation? Today we look at the situation in Europe and ponder what we don’t know. Greece provides a wonderful learning opportunity.

At the end of this letter I’ll mention our Strategic Investment Conference, which will be in San Diego, April 30–May 2. This week we have confirmations from George Friedman of Stratfor and Bill White, former chief economist at the Bank for International Settlements. The conference is shaping up to be the best ever. You can see the rest of the speakers at the end of the letter.

Greece in a Nutshell

Let’s see if we can briefly summarize the situation in Greece. When Greece plunged into crisis three to four years ago, its debt-to-GDP ratio was about 120%. Greek interest rates rose precipitously as investors began to be concerned as to whether they would actually get their money back. The interest rate on the Greek 10-year bond went to 48.6%.

Everybody agreed that Greece couldn’t actually pay that debt; and since so much of it was owed to French and German banks (with not an insubstantial amount owed to Italian banks and those in other countries), the Eurozone decided to bail out Greece, which was a backdoor way of bailing out their own banks. (Seriously, you can go to the IMF minutes, in which they admit that the bailout was about saving the banks and the rest of Europe, not about Greece. Cyprus was cut loose when it would have been a rounding error for the EU to save it – but there were no European banks involved. (The lesson every politician should learn from this is that if you think you’re going to need a bailout someday, make sure your banks owe everybody else a lot of money.)

Everyone breathed a sigh of relief, and Greek interest rates fell to even lower levels than before the crisis, as you can see on the chart above. Meanwhile, because the solution forced Greece into a depression that reduced GDP by 25%, saw unemployment rise to 25% (nearly 60% among youth), forced Greeks (at least some of them) pay their taxes, and obliged the Greek government to try to balance its budget (kind of, sort of), the debt simply got worse. Now debt-to-GDP is 175%. If the Greeks couldn’t pay their debt at 120%, they have zero chance of paying it at 175%.

Eventually, Greek voters noticed that the agreement with the Troika (the ECB, the IMF, and the European Commission) didn’t seem to be working for them, so last month they voted in a new government that promised to change the agreement. The party that won the election, Syriza, had made lots and lots of promises about how they would make those mean old Germans back down and fork over the money. If we threaten to not pay the debt, the new government assured its citizens, the Europeans will give us more money, and we can even make them change the agreement. Of course, if the Greeks don’t get more money their system will be completely bankrupt, and their economy will collapse even further. (The technical economics term is that their economy will be screwed.)

This threat is somewhat like holding a gun to your own head and threatening to commit suicide if you don’t get your way. This is generally not a workable strategy when you are asking the politicians of other countries to pay a lot of money to keep you alive, especially when you are not very popular with the voters who elected those politicians. However, the new Greek government seems to think this is a perfectly reasonable bargaining tactic. Their new finance minister has written five books on game theory. It seems he has negotiating theory down pat, but in practice things are not working out according to his theory.

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

Outside the Box: The Preface from Flashpoints

 

All eyes are focused on Europe this week as another Greek drama plays itself out. I have to admit that in my student days I was forced to sit through a number of Greek dramas, which are admittedly a fine part of our cultural heritage; but while I can appreciate their time and place in history, I really can’t say that I enjoyed them all that much.

And while I can appreciate the passions involved in the unfolding Greek melodrama that is sweeping Europe, I must admit that I’m a bit weary of little Greece commanding center stage in the long-running Eurozone tragicomedy – or maybe we should just call it what it is: a parody of human relations. Mr. Yanis Varoufakis, the left-wing Keynesian economist who most recently taught at the University of Texas (irony intended) is now Greece’s finance minister. He is finding out that his theories about how finance should work in Europe are not how things work in practice. We are getting some pretty nice press-conference rhetoric and inflammatory speeches, though: here’s what Ambrose Evans-Pritchard shared on the topic today:

Mr Varoufakis is braced for an arid meeting on Thursday with his German counterpart and long-time nemesis Wolfgang Schäuble, a man he once accused – borrowing from Tacitus – of reducing Europe to a desert and calling it peace.

“I will try to be as charming as I can in Berlin. I will tell Mr Schäuble that we may be a Left-wing riff-raff but he can count on our Syriza movement to clear away Greece’s cartels and oligarchies, and push through the deep reforms of the Greek state that governments before us refused to do,” he said.

“But I will also tell him that we are going to end the debt-deflation spiral and do what should have been done five years ago. That is not negotiable. We have a democratic mandate to challenge the whole philosophy of austerity,” he said.

The Greeks run out of money in a few weeks, and right now the mood in Frankfurt and Brussels seems to be that no extension is possible without Greece’s agreeing to abide by the previous government’s commitments, with a few concessions (the ones being offered to the side of the table seem to be pretty serious, but who knows?).

And that brings us to today’s Outside the Box. My very good friend George Friedman (no stranger to longtime readers) has written what I think is one of the best books on Europe I have ever read. It is called Flashpoints, and it will be in your local bookstore or on Amazon.

To my mind, this is George’s best-written book. What he does is explore the idea that beneath the surface of sweetness and light in Europe there simmers a millennium of geopolitical issues. He calls these issues “flashpoints.” This is not an academic book but rather a fabulous story of nations and peoples and cities, a history of the world that many of us came from, but few of us understand.

I cannot recommend this book strongly enough. It helps put into context the present smoldering issues in Europe. These are not the issues of the European elite, who tend to want to dismiss them as remnants from an ancient past, but rather they are issues that are driven by the emotions of a significant fraction, if not a majority, of the voting population. We are now seeing the very real potential for populist movements on both the left and the right (depending on the country) to sweep the current management out of their offices.

George does not predict this will happen, but he points out that, given the power of the emotions and the realities of history, it is a possibility. If you want to understand Europe and both to take advantage of the potential and to avoid the problems that Europe poses for your portfolio, this is a book you should read. It gives you context.

George has allowed me to share the preface from Flashpoints as this week’s Outside the Box. I think you will find it intriguing. George is the founder of Stratfor and one of the premier geopolitical thinkers of our time. I’m excited that he has just agreed to speak at our upcoming conference. If you didn’t see my description of the other speakers, you can read it here in last week’s Thoughts from the Frontline.

I will wrap this up quickly as I see my gym time is approaching, as well as the deadline to get this to my team to send on to you. Have a great week.

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

 

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The Preface from Flashpoints

By George Friedman, Stratfor

Between 1914 and 1945 roughly 100 million Europeans died from political causes: war, genocide, purges, planned starvation, and all the rest. That would be an extraordinary number of deaths anywhere and any time. It was particularly striking in Europe, which had, over the course of the previous four hundred years, collectively conquered most of the world and reshaped the way humanity thought of itself.

The conquest of the world was accompanied by the transformation of everyday life. Music was once something that you could hear only if you were there in person. Literacy was useless for most of human history as books were rare and distant. The darkness was now subject to human will. Men lived twice as long as they had previously and women no longer died in childbirth as a matter of course. It is difficult to comprehend the degree to which, by 1914, Europe had transformed the very fabric of life, not only in Europe but in the rest of the world.

Imagine, in 1913, attending a concert in any European capital. Mozart and Beethoven would be on the program. It may be a cold winter night, but the hall is brilliantly lit and warm with women elegantly but lightly dressed. In that grand room, winter has been banished. One of the men has just sent a telegram to Tokyo, ordering silks to be shipped and arrive in Europe within a month. Another couple has traveled a hundred miles in three hours by train to attend the concert. In 1492, when Europe’s adventure began, none of this was possible.

There is no sound like Mozart and Beethoven played by a great European symphony orchestra. Mozart allows you to hear sounds not connected to this world. Beethoven connects each sound to a moment of life. Someone listening to Beethoven’s Ninth Symphony must think of revolution, republicanism, reason, and, truth  be told, of man as God. The art of Europe, immanent and transcendent, the philosophy and the politics, all have taken humanity to a place it has not been before. To many, it seemed as if they were at the gates of heaven. I think, had I been alive then, I would have shared that feeling.

No one expected this moment to be the preface to hell. In the next thirty-one years, Europe tore itself apart. The things that had made it great—technology, philosophy, politics—turned on the Europeans, or more precisely, the Europeans turned  them on each other and themselves. By the end of the thirty-one years, Europe had become a graveyard of ruined cities, shattered lives. Its hold on the world was cracked. The “Ode to Joy” from Beethoven’s Ninth Symphony was no longer a celebration of European life, but an ironic mockery of its pretensions.

Europe is not unique in this. Other civilizations have undergone turmoil, war, and savagery. But the unexpectedness, the intensity, the rapidity, and the consequences for the entire world were distinctive. And most distinctive was that this particular civilization should be capable of self-immolation. There may have been hints of this in the cruelty of colonialism, the deep inequality of European society, and its fragmentation into many pieces. But still, the connection between European high culture and death camps is surprising at the very least.

The Europeans conquered the world while conducting an internal civil war throughout  the centuries. The European empire was built on a base of shifting sand. The real mystery is why European unity was so elusive. Europe’s geography makes unity difficult. Europe does not consist of a single, undifferentiated landmass. It has islands, peninsulas, and peninsulas on peninsulas—and mountains blocking the peninsulas. It has seas and straits, enormous mountains, deep valleys, and endless plains. Europe’s rivers don’t flow together into a single, uniting system as do America’s. They flow separately, dividing rather than uniting.

No continent is as small and fragmented as Europe. Only Australia is smaller, yet Europe today consists of fifty independent nations (including Turkey and the Caucasus, for reasons explained later). Crowded with nations, it is also crowded with people. Europe’s population density is 72.5 people per square kilometer. The European Union’s density is 112 people per square kilometer. Asia has 86 people per square kilometer. Europe is crowded and fragmented.

Europe’s  geography means  it  can’t  be united  through  conquest. It means that small nations survive for a very long time. The map of Europe in 1000 is similar to the map of 2000. Nations exist next to other nations for a long time, with long memories that make trust and forgiveness impossible. As a result, Europe has been a place where wars repeated themselves endlessly. The wars of the twentieth century were different only in that this time technology and ideology led to a continental catastrophe.

Europe is divided into borderlands, where nations, religions, and cultures meet and mix. There is frequently a political border within, but the borderland itself is wider and in many ways more significant. Consider the border between Mexico and the United States; it is a clear line. But Mexican influence, language, and people spread far north of the border, and likewise, American culture and business spread far south. In Mexico those who live in the states bordering the United States are seen as having absorbed American culture, making them alien to the rest of Mexico. Culture north of the borderland has transformed itself from Anglo to a strange mixture with a language of its own, Spanglish. The people living in these borderlands are unique, sometimes sharing more with each other than with those in their own countries.

I live south of Austin, Texas, where place-names are Anglo or German—the Germans settled the area west of Austin. When I drive south on I-35, towns tend to have German names like New Braunfels. As I get closer to San Antonio, they become Spanish, and sometimes I feel as though I am in Mexico. In a way I am, but the border is more than a hundred miles farther south, and that still has meaning.

Europe is filled with such borderlands, but the most important one divides the European peninsula from the European mainland, the West from Russia. It is a vast area that encompasses entire countries like Ukraine, Belarus, and Lithuania. Over the past century, we’ve seen the political border sweep far to the west, with Russia absorbing the borderland, or now far to the east, creating independent countries. No matter where the border may lie at any moment, this is a region whose people have more in common with each other than with Russia or the West. Indeed, the word Ukraine means “on the edge,” or borderland.

This is not the only borderland, although it defines European history. There is a borderland between the French and German worlds, stretching from the North Sea to the Alps. The Balkans are the borderland between Central Europe and Turkey. The Pyrenees are the borderland between the Iberians and the rest of Europe. There are even smaller ones surrounding Hungary, where Hungarians live under the rule of Romanian and Slovakian states. There is even a water border, so to speak—the English Channel, separating Britain from the Continent. In such a small area, crowded and filled with ancient grievances, there will always be borderlands, and no place demonstrates this more clearly than Europe.

Borderlands are where cultures mingle and where smuggling can be a respectable business, but it can also be the place where wars are fought. These are flashpoints. The Rhineland is now quiet, but that was not always the case. Since 1871, three wars have broken out in the area between the Rhine and the French-speaking regions. They were flashpoints then because there were deep and serious issues dividing France and Germany. And when the flashpoint sparked, the region caught fire. Today, the borderland west of Russia has become a flashpoint. It is igniting and fires have started, but, as yet, the tinder has not caught everywhere and there is no general conflagration.

In World War I and World War II all the borderlands in Europe became flashpoints that sparked and set off fires that grew and spread. The world has rarely, if ever, seen the kind of general European firestorm that was set off in 1914, calmed briefly, and then raged again in 1939. People overflowed with terrible memories and fears, and when those sentiments ignited, the borderland was consumed and all the fires converged into a single holocaust.

Europe rebuilt itself with difficulty and with help was given back its sovereignty by the actions of others. Out of this shambles came a single phrase: “Never Again.” This phrase represents the Jewish commitment to ensuring that their slaughter would never be permitted to happen again. The Europeans as a whole don’t use this phrase, but its sentiment shapes everything they do. Those who lived through the thirty-one years then had to live through the Cold War, where the decision of war and peace, the decision that would determine if they lived or died, would be made in Moscow and Washington. That there was no war in Europe is worth considering later, but as the threat receded the European commitment was that the thirty-one years never be repeated. Europeans ceded their empire, their power, even in some ways their significance, to the principle that they should never again experience the horror  of those years nor live on its precipice as they did in the Cold War.

The institution  created to ban their nightmares was the European Union. Its intent was to bond European nations so closely together in such a prosperous enterprise that no nation would have any reason to break the peace or fear another. Ironically, Europe had struggled for centuries to free nations from oppression by other nations and make national sovereignty and national self-determination possible. They would not abandon this moral imperative, even though they had seen where its reductio ad absurdum might take them. Their goal was for the sovereignty of all to be retained, but constrained in such a way that no one could take it away. The anthem of the European Union is Beethoven’s “Ode to Joy,” cleansed of its irony.

The most important  question in the world is whether conflict and war have actually been banished or whether this is merely an interlude, a seductive illusion. Europe is the single most prosperous region in the world. Its GDP collectively is greater than that of the United States. It touches Asia, the Middle East, and Africa. Another series of wars would change not only Europe, but the world. The answer to the question of whether Europe has overcome not only the thirty-one years, but the long millennia of conflict that preceded it, is at the center of any consideration of the future.

That’s the reason I’ve written this book. In many ways this is the subject that has shaped my life and thoughts. I was born in Hungary in 1949 to parents born in 1912 and 1914. My family was shaped in the horrors and terrors of Europe, not only in the thirty-one years, but in their aftermath. We left Europe because my parents were convinced that there was a deep corruption in the European soul that could be hidden for a while but would always show itself eventually. As an American, I lived in a world where all things flow from decisions. As a European I lived in a world where decisions mean nothing when the avalanche of history overwhelms you. As an American I learned to confront the world. As a European I learned to evade it. My search for the answer to Europe’s riddle flowed directly from the conversations of my parents at the dinner table, and the sounds of their nightmares at night. My identity crisis— a term that already tells you how American I am now—was caused by the fact that a European’s approach to life was utterly different from an American’s. I was both, so who was I? I have boiled this down to a single question: Has Europe really changed or is Europe fated to constantly be mocked by the “Ode to Joy”?

As a young man I chose to study political philosophy because I wanted to confront this question at the highest level possible. In my mind, the most fundamental questions of the human condition are ultimately political. Politics is about community—the obligations, rights, enemies, and friends that a community gives you. Philosophy is a dissection of the most natural things. It forces you to confront the familiar and discover it is a stranger. For me, that was the path to understanding.

Life is never that simple. In graduate school I focused on German philosophy. As a Jew I wanted to understand where men who could kill children as deliberate national policy came from. But it was the Cold War era, and I knew the European question was really now the Soviet question, and the Soviets had affected my life almost as much as the Germans. Karl Marx seemed the perfect point of entry. And since what was called the New Left (communists who hated Stalin) was at its height, I chose to study it.

In doing so I returned to Europe on numerous occasions and formed close friendships among the European New Left. I wanted to understand its philosophers—Althusser, Gramsci, Marcuse—but I couldn’t sit in the library. There was too much going on outside. For most, the New Left was a way to get dates, a hip social movement. To a smaller group it was a profoundly serious attempt to understand the world and to find the lever for changing it. For a small handful, it became an excuse and obligation to undertake violence.

It is not always remembered that Europe in the 1970s and 1980s had become increasingly violent, and that terrorism predated al Qaeda. In most European countries, terrorist cells emerged, assassinating or kidnapping people and blowing up buildings. The terroristic Left existed in the United States as well, but only in a minor way. These limited groups fascinated me the most—the reemergence of political violence in Europe within the context of a movement that occasionally spoke of class struggle but didn’t mean it.

One habit that emerged was “kneecapping” enemies. This meant firing a bullet into their knees. I could never figure out if crippling someone rather than killing him was an act of kindness or cruelty. For me these people were the ones to watch because in my mind they were the heirs of the thirty-one years. They were the ones who took their moral obligations seriously and rejected the values of the community, which freed them to do terrible things. In encountering some, I noted that they did not really expect to change anything. Their action was pure anger at the world they were born to, and contempt for those leading ordinary lives. They saw evil in these people and they had appointed themselves the avengers.

My time among these people made me much less at home with the growing self-confidence in Europe that the past was behind them. It seemed to me that, like cancer when the surgeon misses a few cells, given the right circumstances the disease recurs. In the 1990s, two areas of Europe, the Balkans and the Caucasus, exploded in war. Europeans dismissed these as not representative. They dismissed the left-wing terrorists as not representative. Today they dismiss the new right-wing thugs as not representative. This view, representative of  Europe’s pride and selfconfidence, may be correct, but this is not self-evident.

We are now living through Europe’s test. As all human institutions do, the European Union is going through a time of intense problems, mostly economic for the moment. The European Union was founded for “peace and prosperity.” If prosperity disappears, or disappears in some nations, what happens to peace? I note that unemployment in several southern European countries is now at or higher than the unemployment rate in the United States during the Great Depression. What does that mean?

That is what this book is about. It is partly about the sense of European exceptionalism, the idea that they have solved the problems of peace and prosperity that the rest of the world has not. This may be true, but it needs to be discussed. If Europe is not exceptional and is in trouble, what will follow? The question is posed in three parts. First, why was Europe the place in which the world discovered and transformed itself? How did this happen? Second, given the magnificence of European civilization, what flaw was there in Europe that led it to the thirty-one years? Where did that come from? Finally, once we have thought about these things we can consider not only Europe’s future but its potential flashpoints.

If Europe has transcended its history of bloodshed, that is important news. If it has not, that is even more important news. Let’s begin by considering what it meant to be European in the last five hundred years.

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Outside the Box: The Preface from Flashpoints

 

All eyes are focused on Europe this week as another Greek drama plays itself out. I have to admit that in my student days I was forced to sit through a number of Greek dramas, which are admittedly a fine part of our cultural heritage; but while I can appreciate their time and place in history, I really can’t say that I enjoyed them all that much.

And while I can appreciate the passions involved in the unfolding Greek melodrama that is sweeping Europe, I must admit that I’m a bit weary of little Greece commanding center stage in the long-running Eurozone tragicomedy – or maybe we should just call it what it is: a parody of human relations. Mr. Yanis Varoufakis, the left-wing Keynesian economist who most recently taught at the University of Texas (irony intended) is now Greece’s finance minister. He is finding out that his theories about how finance should work in Europe are not how things work in practice. We are getting some pretty nice press-conference rhetoric and inflammatory speeches, though: here’s what Ambrose Evans-Pritchard shared on the topic today:

Mr Varoufakis is braced for an arid meeting on Thursday with his German counterpart and long-time nemesis Wolfgang Schäuble, a man he once accused – borrowing from Tacitus – of reducing Europe to a desert and calling it peace.

“I will try to be as charming as I can in Berlin. I will tell Mr Schäuble that we may be a Left-wing riff-raff but he can count on our Syriza movement to clear away Greece’s cartels and oligarchies, and push through the deep reforms of the Greek state that governments before us refused to do,” he said.

“But I will also tell him that we are going to end the debt-deflation spiral and do what should have been done five years ago. That is not negotiable. We have a democratic mandate to challenge the whole philosophy of austerity,” he said.

The Greeks run out of money in a few weeks, and right now the mood in Frankfurt and Brussels seems to be that no extension is possible without Greece’s agreeing to abide by the previous government’s commitments, with a few concessions (the ones being offered to the side of the table seem to be pretty serious, but who knows?).

And that brings us to today’s Outside the Box. My very good friend George Friedman (no stranger to longtime readers) has written what I think is one of the best books on Europe I have ever read. It is called Flashpoints, and it will be in your local bookstore or on Amazon.

To my mind, this is George’s best-written book. What he does is explore the idea that beneath the surface of sweetness and light in Europe there simmers a millennium of geopolitical issues. He calls these issues “flashpoints.” This is not an academic book but rather a fabulous story of nations and peoples and cities, a history of the world that many of us came from, but few of us understand.

I cannot recommend this book strongly enough. It helps put into context the present smoldering issues in Europe. These are not the issues of the European elite, who tend to want to dismiss them as remnants from an ancient past, but rather they are issues that are driven by the emotions of a significant fraction, if not a majority, of the voting population. We are now seeing the very real potential for populist movements on both the left and the right (depending on the country) to sweep the current management out of their offices.

George does not predict this will happen, but he points out that, given the power of the emotions and the realities of history, it is a possibility. If you want to understand Europe and both to take advantage of the potential and to avoid the problems that Europe poses for your portfolio, this is a book you should read. It gives you context.

George has allowed me to share the preface from Flashpoints as this week’s Outside the Box. I think you will find it intriguing. George is the founder of Stratfor and one of the premier geopolitical thinkers of our time. I’m excited that he has just agreed to speak at our upcoming conference. If you didn’t see my description of the other speakers, you can read it here in last week’s Thoughts from the Frontline.

I will wrap this up quickly as I see my gym time is approaching, as well as the deadline to get this to my team to send on to you. Have a great week.

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

 

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The Preface from Flashpoints

By George Friedman, Stratfor

Between 1914 and 1945 roughly 100 million Europeans died from political causes: war, genocide, purges, planned starvation, and all the rest. That would be an extraordinary number of deaths anywhere and any time. It was particularly striking in Europe, which had, over the course of the previous four hundred years, collectively conquered most of the world and reshaped the way humanity thought of itself.

The conquest of the world was accompanied by the transformation of everyday life. Music was once something that you could hear only if you were there in person. Literacy was useless for most of human history as books were rare and distant. The darkness was now subject to human will. Men lived twice as long as they had previously and women no longer died in childbirth as a matter of course. It is difficult to comprehend the degree to which, by 1914, Europe had transformed the very fabric of life, not only in Europe but in the rest of the world.

Imagine, in 1913, attending a concert in any European capital. Mozart and Beethoven would be on the program. It may be a cold winter night, but the hall is brilliantly lit and warm with women elegantly but lightly dressed. In that grand room, winter has been banished. One of the men has just sent a telegram to Tokyo, ordering silks to be shipped and arrive in Europe within a month. Another couple has traveled a hundred miles in three hours by train to attend the concert. In 1492, when Europe’s adventure began, none of this was possible.

There is no sound like Mozart and Beethoven played by a great European symphony orchestra. Mozart allows you to hear sounds not connected to this world. Beethoven connects each sound to a moment of life. Someone listening to Beethoven’s Ninth Symphony must think of revolution, republicanism, reason, and, truth  be told, of man as God. The art of Europe, immanent and transcendent, the philosophy and the politics, all have taken humanity to a place it has not been before. To many, it seemed as if they were at the gates of heaven. I think, had I been alive then, I would have shared that feeling.

No one expected this moment to be the preface to hell. In the next thirty-one years, Europe tore itself apart. The things that had made it great—technology, philosophy, politics—turned on the Europeans, or more precisely, the Europeans turned  them on each other and themselves. By the end of the thirty-one years, Europe had become a graveyard of ruined cities, shattered lives. Its hold on the world was cracked. The “Ode to Joy” from Beethoven’s Ninth Symphony was no longer a celebration of European life, but an ironic mockery of its pretensions.

Europe is not unique in this. Other civilizations have undergone turmoil, war, and savagery. But the unexpectedness, the intensity, the rapidity, and the consequences for the entire world were distinctive. And most distinctive was that this particular civilization should be capable of self-immolation. There may have been hints of this in the cruelty of colonialism, the deep inequality of European society, and its fragmentation into many pieces. But still, the connection between European high culture and death camps is surprising at the very least.

The Europeans conquered the world while conducting an internal civil war throughout  the centuries. The European empire was built on a base of shifting sand. The real mystery is why European unity was so elusive. Europe’s geography makes unity difficult. Europe does not consist of a single, undifferentiated landmass. It has islands, peninsulas, and peninsulas on peninsulas—and mountains blocking the peninsulas. It has seas and straits, enormous mountains, deep valleys, and endless plains. Europe’s rivers don’t flow together into a single, uniting system as do America’s. They flow separately, dividing rather than uniting.

No continent is as small and fragmented as Europe. Only Australia is smaller, yet Europe today consists of fifty independent nations (including Turkey and the Caucasus, for reasons explained later). Crowded with nations, it is also crowded with people. Europe’s population density is 72.5 people per square kilometer. The European Union’s density is 112 people per square kilometer. Asia has 86 people per square kilometer. Europe is crowded and fragmented.

Europe’s  geography means  it  can’t  be united  through  conquest. It means that small nations survive for a very long time. The map of Europe in 1000 is similar to the map of 2000. Nations exist next to other nations for a long time, with long memories that make trust and forgiveness impossible. As a result, Europe has been a place where wars repeated themselves endlessly. The wars of the twentieth century were different only in that this time technology and ideology led to a continental catastrophe.

Europe is divided into borderlands, where nations, religions, and cultures meet and mix. There is frequently a political border within, but the borderland itself is wider and in many ways more significant. Consider the border between Mexico and the United States; it is a clear line. But Mexican influence, language, and people spread far north of the border, and likewise, American culture and business spread far south. In Mexico those who live in the states bordering the United States are seen as having absorbed American culture, making them alien to the rest of Mexico. Culture north of the borderland has transformed itself from Anglo to a strange mixture with a language of its own, Spanglish. The people living in these borderlands are unique, sometimes sharing more with each other than with those in their own countries.

I live south of Austin, Texas, where place-names are Anglo or German—the Germans settled the area west of Austin. When I drive south on I-35, towns tend to have German names like New Braunfels. As I get closer to San Antonio, they become Spanish, and sometimes I feel as though I am in Mexico. In a way I am, but the border is more than a hundred miles farther south, and that still has meaning.

Europe is filled with such borderlands, but the most important one divides the European peninsula from the European mainland, the West from Russia. It is a vast area that encompasses entire countries like Ukraine, Belarus, and Lithuania. Over the past century, we’ve seen the political border sweep far to the west, with Russia absorbing the borderland, or now far to the east, creating independent countries. No matter where the border may lie at any moment, this is a region whose people have more in common with each other than with Russia or the West. Indeed, the word Ukraine means “on the edge,” or borderland.

This is not the only borderland, although it defines European history. There is a borderland between the French and German worlds, stretching from the North Sea to the Alps. The Balkans are the borderland between Central Europe and Turkey. The Pyrenees are the borderland between the Iberians and the rest of Europe. There are even smaller ones surrounding Hungary, where Hungarians live under the rule of Romanian and Slovakian states. There is even a water border, so to speak—the English Channel, separating Britain from the Continent. In such a small area, crowded and filled with ancient grievances, there will always be borderlands, and no place demonstrates this more clearly than Europe.

Borderlands are where cultures mingle and where smuggling can be a respectable business, but it can also be the place where wars are fought. These are flashpoints. The Rhineland is now quiet, but that was not always the case. Since 1871, three wars have broken out in the area between the Rhine and the French-speaking regions. They were flashpoints then because there were deep and serious issues dividing France and Germany. And when the flashpoint sparked, the region caught fire. Today, the borderland west of Russia has become a flashpoint. It is igniting and fires have started, but, as yet, the tinder has not caught everywhere and there is no general conflagration.

In World War I and World War II all the borderlands in Europe became flashpoints that sparked and set off fires that grew and spread. The world has rarely, if ever, seen the kind of general European firestorm that was set off in 1914, calmed briefly, and then raged again in 1939. People overflowed with terrible memories and fears, and when those sentiments ignited, the borderland was consumed and all the fires converged into a single holocaust.

Europe rebuilt itself with difficulty and with help was given back its sovereignty by the actions of others. Out of this shambles came a single phrase: “Never Again.” This phrase represents the Jewish commitment to ensuring that their slaughter would never be permitted to happen again. The Europeans as a whole don’t use this phrase, but its sentiment shapes everything they do. Those who lived through the thirty-one years then had to live through the Cold War, where the decision of war and peace, the decision that would determine if they lived or died, would be made in Moscow and Washington. That there was no war in Europe is worth considering later, but as the threat receded the European commitment was that the thirty-one years never be repeated. Europeans ceded their empire, their power, even in some ways their significance, to the principle that they should never again experience the horror  of those years nor live on its precipice as they did in the Cold War.

The institution  created to ban their nightmares was the European Union. Its intent was to bond European nations so closely together in such a prosperous enterprise that no nation would have any reason to break the peace or fear another. Ironically, Europe had struggled for centuries to free nations from oppression by other nations and make national sovereignty and national self-determination possible. They would not abandon this moral imperative, even though they had seen where its reductio ad absurdum might take them. Their goal was for the sovereignty of all to be retained, but constrained in such a way that no one could take it away. The anthem of the European Union is Beethoven’s “Ode to Joy,” cleansed of its irony.

The most important  question in the world is whether conflict and war have actually been banished or whether this is merely an interlude, a seductive illusion. Europe is the single most prosperous region in the world. Its GDP collectively is greater than that of the United States. It touches Asia, the Middle East, and Africa. Another series of wars would change not only Europe, but the world. The answer to the question of whether Europe has overcome not only the thirty-one years, but the long millennia of conflict that preceded it, is at the center of any consideration of the future.

That’s the reason I’ve written this book. In many ways this is the subject that has shaped my life and thoughts. I was born in Hungary in 1949 to parents born in 1912 and 1914. My family was shaped in the horrors and terrors of Europe, not only in the thirty-one years, but in their aftermath. We left Europe because my parents were convinced that there was a deep corruption in the European soul that could be hidden for a while but would always show itself eventually. As an American, I lived in a world where all things flow from decisions. As a European I lived in a world where decisions mean nothing when the avalanche of history overwhelms you. As an American I learned to confront the world. As a European I learned to evade it. My search for the answer to Europe’s riddle flowed directly from the conversations of my parents at the dinner table, and the sounds of their nightmares at night. My identity crisis— a term that already tells you how American I am now—was caused by the fact that a European’s approach to life was utterly different from an American’s. I was both, so who was I? I have boiled this down to a single question: Has Europe really changed or is Europe fated to constantly be mocked by the “Ode to Joy”?

As a young man I chose to study political philosophy because I wanted to confront this question at the highest level possible. In my mind, the most fundamental questions of the human condition are ultimately political. Politics is about community—the obligations, rights, enemies, and friends that a community gives you. Philosophy is a dissection of the most natural things. It forces you to confront the familiar and discover it is a stranger. For me, that was the path to understanding.

Life is never that simple. In graduate school I focused on German philosophy. As a Jew I wanted to understand where men who could kill children as deliberate national policy came from. But it was the Cold War era, and I knew the European question was really now the Soviet question, and the Soviets had affected my life almost as much as the Germans. Karl Marx seemed the perfect point of entry. And since what was called the New Left (communists who hated Stalin) was at its height, I chose to study it.

In doing so I returned to Europe on numerous occasions and formed close friendships among the European New Left. I wanted to understand its philosophers—Althusser, Gramsci, Marcuse—but I couldn’t sit in the library. There was too much going on outside. For most, the New Left was a way to get dates, a hip social movement. To a smaller group it was a profoundly serious attempt to understand the world and to find the lever for changing it. For a small handful, it became an excuse and obligation to undertake violence.

It is not always remembered that Europe in the 1970s and 1980s had become increasingly violent, and that terrorism predated al Qaeda. In most European countries, terrorist cells emerged, assassinating or kidnapping people and blowing up buildings. The terroristic Left existed in the United States as well, but only in a minor way. These limited groups fascinated me the most—the reemergence of political violence in Europe within the context of a movement that occasionally spoke of class struggle but didn’t mean it.

One habit that emerged was “kneecapping” enemies. This meant firing a bullet into their knees. I could never figure out if crippling someone rather than killing him was an act of kindness or cruelty. For me these people were the ones to watch because in my mind they were the heirs of the thirty-one years. They were the ones who took their moral obligations seriously and rejected the values of the community, which freed them to do terrible things. In encountering some, I noted that they did not really expect to change anything. Their action was pure anger at the world they were born to, and contempt for those leading ordinary lives. They saw evil in these people and they had appointed themselves the avengers.

My time among these people made me much less at home with the growing self-confidence in Europe that the past was behind them. It seemed to me that, like cancer when the surgeon misses a few cells, given the right circumstances the disease recurs. In the 1990s, two areas of Europe, the Balkans and the Caucasus, exploded in war. Europeans dismissed these as not representative. They dismissed the left-wing terrorists as not representative. Today they dismiss the new right-wing thugs as not representative. This view, representative of  Europe’s pride and selfconfidence, may be correct, but this is not self-evident.

We are now living through Europe’s test. As all human institutions do, the European Union is going through a time of intense problems, mostly economic for the moment. The European Union was founded for “peace and prosperity.” If prosperity disappears, or disappears in some nations, what happens to peace? I note that unemployment in several southern European countries is now at or higher than the unemployment rate in the United States during the Great Depression. What does that mean?

That is what this book is about. It is partly about the sense of European exceptionalism, the idea that they have solved the problems of peace and prosperity that the rest of the world has not. This may be true, but it needs to be discussed. If Europe is not exceptional and is in trouble, what will follow? The question is posed in three parts. First, why was Europe the place in which the world discovered and transformed itself? How did this happen? Second, given the magnificence of European civilization, what flaw was there in Europe that led it to the thirty-one years? Where did that come from? Finally, once we have thought about these things we can consider not only Europe’s future but its potential flashpoints.

If Europe has transcended its history of bloodshed, that is important news. If it has not, that is even more important news. Let’s begin by considering what it meant to be European in the last five hundred years.

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Important Disclosures

Thoughts from the Frontline: Portfolio Strategies 2015: Investing in an Age of Divergence

 

With all the negative news out of Europe, how do you find a positive story? Is there a way to structure a portfolio that gives you permission to be more aggressive when there are danger signs all around? Everyone is worried about being blindsided by a significant downdraft in the markets when maybe we should be thinking about making sure we don’t miss a bull market somewhere. These and several dozen other topics were on the table when the Mauldin Economics writing team gathered here in Dallas for 3½ days of intensive talk, interviews, and planning. Today we’ll go over a few of the highlights of this last week, and I’ll share a few reasons to be optimistic about 2015.

2015 Strategic Investment Conference

But first, we are finally ready to take reservations for our 2015 Strategic Investment Conference, which will be in San Diego, California, April 29 through May 2. (Note that this year the conference is open to everyone and not just to accredited investors, which makes me very happy.) While I am still finalizing the last few speakers with my conference cohosts, Altegris Investments, we’ve already secured an outstanding lineup. The plan is for my old friend David Rosenberg to once again take the position of leadoff hitter. The last few years he has come up with surprises to share with the audience, and I suspect he will do the same this year. Then, I’m excited that we have been able to persuade Peter Briger, the head of $66 billion+ Fortress Investment Group, one of the largest private-credit groups in the world. In 2014, Fortress Investment Group was named “Hedge Fund Manager of the Year” by Institutional Investor and “Management Firm of the Year” by HFMWeek. Briger knows as much about credit around the world as anyone I know.

Longtime readers and conference attendees know how powerful Dr. Lacy Hunt’s presentations are. Then, I’ve persuaded Grant Williams and his partner in Real Vision TV, Raoul Pal, to join us. Raoul is not a household name to most investors, unless you are an elite hedge fund (and can afford his work), and then you know that he is an absolute treasure trove of ideas and insights. If you are looking for an edge, Raoul is at the very tip. Paul McCulley, now back with PIMCO, will be returning for his 12th year. David Harding, who runs $25 billion Winton Capital Management, which trades on over 100 global futures markets, will tell us about the state of the commodity markets. My good friend Louis Gave will drop in from Hong Kong to help round out the first day. Louis never fails to come up with a few ideas that run against mainstream thinking. I can’t get enough of Louis.

The next day my fishing buddy Jim Bianco, one of the world’s best bond and market analysts, will join us. I have long wanted to have him at my conference. I get the benefit of his thinking every summer, and I’m excited to be able to share it with you. Larry Meyer, former Fed governor currently running the prestigious firm Macroeconomic Advisers, will be there to tell us when the Fed will actually raise rates. He is a true central bank insider and will be flying in from a just-concluded Fed meeting. He is the go-to guy on Fed policy and thinking for some of the world’s greatest and largest investors. Then the intrepid and never-shy-with-his-opinion Jeff Gundlach, maybe the hottest bond manager in the country, will regale us with his insights. Is anybody more on top of his game than Jeff has been lately?

They will be followed by Stephanie Pomboy, whom I have wanted to have at the conference for years. She is one of the truly elite macroeconomic analysts, known primarily in the institutional and hedge fund world, and over the last few years her insights have been a regular feature in Barron’s. My friend Ian Bremmer, the brilliant geopolitical analyst and founder of Eurasia Group, who is consistently one of the conference favorites (and whose latest book we will try to have for you if it is off the press in time), will join, us followed by David Zervos of Jefferies, former Fed economist and fearless prognosticator, who has an enviable track record since he joined Jefferies five years ago. He is currently quite bullish on Europe (for some of the same reasons I outline below).

The next day we will have Michael Pettis flying in from China to give us his views on how Asia rebalances and China manages its transition. Michael has been one of the most consistently on-target analysts on China and is wired into the thought leaders in the country. And what fun would the conference be without Kyle Bass of Hayman Advisors offering us his latest ideas? We are finalizing agreements with another four to five equally well-known speakers, which will include a few surprises, as well as rounding out the panels. I will share those names with you as we nail them down.

Since the first year of the Strategic Investment Conference, my one rule has been to create a conference that I want to attend. Unlike many conferences, there are no sponsors who pay to speak. Normal conferences have a few headliners to attract a crowd and then a lot of fill-ins. Everyone at my conference is an A-list speaker I want to hear, who would headline anywhere else. And because all the speakers know the quality of the lineup, they bring their A games.

Attendees routinely tell me that this is the best conference anywhere every year. And most of the speakers hang around to hear what is being said, which means you get to meet them at breaks and dinners. Plus, this year I am arranging for quite a number of writers and analysts to show up just to be there to talk with you. And I must say that the best part of the conference is mingling with fellow attendees. You will make new friends and be able to share ideas with other investors just like yourself. I really hope you can make it.

Registration is simple. Use this link: https://www.etouches.com/2015sicmauldin. While the conference is not cheap, the largest cost is your time, and I try to make it worth every minute. There are also two private breakfasts where hedge funds will be presenting. Altegris will contact you to let you know the details.

And now let’s think about investing in an age of divergence.

Don’t Miss the Melt-Up

Jared Dillian (who writes the free Mauldin Economics letter The 10th Man and is the editor of Bull’s Eye Investing) really got me thinking this week as he argued that most people try to hedge for the downside, buying puts and other hedges to make sure they don’t lose money in a market meltdown.

But as he showed us, it is actually far cheaper to buy long-term out-of-the-money calls to make sure that you catch a “melt-up.” If you had bought long-term calls in 2010 on the possibility that the market would double, you would be up a lot more than 100%. For whatever reason, the cost of betting on a bull market is much lower than trying to protect from a bear market. You have to work a little bit more to find these plays and to make sure you get the right price. Getting my 10-year options on the yen took a little time, but they are starting to pay off. For whatever reason, the cost premium relative to the strike price and recent movement in the yen-dollar cross is actually cheaper than it was when I bought a year ago. I have no idea why that would be, but markets can get to be strangely priced. (And yes, I am tempted to add to my position because of that price structure, even though I have a reasonable position already.)

Jawad Mian argued that Europe is going to be the place to be over the next year. Long-term readers can guess that I was quite skeptical of that view, as I see nothing but problems in Europe; but as the days went on I began to see the trading wisdom in his thinking, especially relative to the US.

First off, the US market is simply looking “toppy” to me. That doesn’t mean there is a crash or a bear market in the future (although that is a real possibility), but the outsized returns of the last four or five years are unlikely to be repeated. Will Denyer and Tan Kai Xian of Gavekal have made the case that it no longer makes sense to overweight US equities, which had been the firm’s position for many years:

Our issue is that three key drivers of US equity outperformance are going into reverse:

1) In recent years the Federal Reserve was the most aggressive liquidity provider in the world — this is no longer the case. In fact, the Fed is making moves toward tightening, while everyone else is easing.

2) In recent years the US benefitted from an extraordinarily competitive currency — this is no longer the case. In a very short period, the US dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, to now being overvalued against the likes of the euro and the yen.

3) In recent years US equities were attractively priced — this is no longer the case. On a number of measures the market is stretched.

Even though the Federal Reserve rate hike has probably been pushed off into the third quarter, it will soon be priced into the market. Fed rate hikes usually lead to price-to-earnings (P/E) compression, whether or not there are strong earnings. But since almost half of S&P 500 earnings come from outside the US, a strong dollar is going to weigh heavily on those earnings. Procter & Gamble has said currency costs will reduce their earnings by $1.4 billion after-tax this year. They are not alone.

Further, more than half of S&P 500 companies have P/Es over 20; and, to put it bluntly, bull markets do not begin from valuations at this level. The Russell small-company index is down for the last year, quarter, month, week, and day. Small companies in general are in a bear market (though numerous small companies, typically ones that are tech-focused in some way, are having a banner year).

So, where do you go if you are taking money off the table from the US? Counterintuitively, the coming Greek crisis suggests that we might want to look to Europe. To understand why, let’s review what’s going on in Greece.

The Euro-Positive Greek Crisis?

As we read the headlines, it would appear that Europe is heading for a major confrontation over Greece. The Germans and other Europeans have made it very clear that there will be no haircut on Greece’s debt. Tsipras and his left-leaning coalition party, Syriza, were elected on the basis that there would have to be major haircuts in the Greek debt, as well as relief from the austerity requirements imposed by the Troika (the ECB, IMF, and European Commission) in the wake of the last Greek bailout.

Within a few weeks, Greece will need significant loans to make its debt payments and to pay its bills. The requirement for getting those loans is that Greece must adhere to the regime that was agreed to by the previous government. Tsipras and company have made it quite clear that they do not intend to do so. If they don’t, it is highly unlikely that they will get the Emergency Lending Assistance (ELA) from the European Central Bank that would be needed to bail out their banks. Money appears to be leaving Greece, and deposits are at their lowest levels since 2012.

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: Portfolio Strategies 2015: Investing in an Age of Divergence

 

With all the negative news out of Europe, how do you find a positive story? Is there a way to structure a portfolio that gives you permission to be more aggressive when there are danger signs all around? Everyone is worried about being blindsided by a significant downdraft in the markets when maybe we should be thinking about making sure we don’t miss a bull market somewhere. These and several dozen other topics were on the table when the Mauldin Economics writing team gathered here in Dallas for 3½ days of intensive talk, interviews, and planning. Today we’ll go over a few of the highlights of this last week, and I’ll share a few reasons to be optimistic about 2015.

2015 Strategic Investment Conference

But first, we are finally ready to take reservations for our 2015 Strategic Investment Conference, which will be in San Diego, California, April 29 through May 2. (Note that this year the conference is open to everyone and not just to accredited investors, which makes me very happy.) While I am still finalizing the last few speakers with my conference cohosts, Altegris Investments, we’ve already secured an outstanding lineup. The plan is for my old friend David Rosenberg to once again take the position of leadoff hitter. The last few years he has come up with surprises to share with the audience, and I suspect he will do the same this year. Then, I’m excited that we have been able to persuade Peter Briger, the head of $66 billion+ Fortress Investment Group, one of the largest private-credit groups in the world. In 2014, Fortress Investment Group was named “Hedge Fund Manager of the Year” by Institutional Investor and “Management Firm of the Year” by HFMWeek. Briger knows as much about credit around the world as anyone I know.

Longtime readers and conference attendees know how powerful Dr. Lacy Hunt’s presentations are. Then, I’ve persuaded Grant Williams and his partner in Real Vision TV, Raoul Pal, to join us. Raoul is not a household name to most investors, unless you are an elite hedge fund (and can afford his work), and then you know that he is an absolute treasure trove of ideas and insights. If you are looking for an edge, Raoul is at the very tip. Paul McCulley, now back with PIMCO, will be returning for his 12th year. David Harding, who runs $25 billion Winton Capital Management, which trades on over 100 global futures markets, will tell us about the state of the commodity markets. My good friend Louis Gave will drop in from Hong Kong to help round out the first day. Louis never fails to come up with a few ideas that run against mainstream thinking. I can’t get enough of Louis.

The next day my fishing buddy Jim Bianco, one of the world’s best bond and market analysts, will join us. I have long wanted to have him at my conference. I get the benefit of his thinking every summer, and I’m excited to be able to share it with you. Larry Meyer, former Fed governor currently running the prestigious firm Macroeconomic Advisers, will be there to tell us when the Fed will actually raise rates. He is a true central bank insider and will be flying in from a just-concluded Fed meeting. He is the go-to guy on Fed policy and thinking for some of the world’s greatest and largest investors. Then the intrepid and never-shy-with-his-opinion Jeff Gundlach, maybe the hottest bond manager in the country, will regale us with his insights. Is anybody more on top of his game than Jeff has been lately?

They will be followed by Stephanie Pomboy, whom I have wanted to have at the conference for years. She is one of the truly elite macroeconomic analysts, known primarily in the institutional and hedge fund world, and over the last few years her insights have been a regular feature in Barron’s. My friend Ian Bremmer, the brilliant geopolitical analyst and founder of Eurasia Group, who is consistently one of the conference favorites (and whose latest book we will try to have for you if it is off the press in time), will join, us followed by David Zervos of Jefferies, former Fed economist and fearless prognosticator, who has an enviable track record since he joined Jefferies five years ago. He is currently quite bullish on Europe (for some of the same reasons I outline below).

The next day we will have Michael Pettis flying in from China to give us his views on how Asia rebalances and China manages its transition. Michael has been one of the most consistently on-target analysts on China and is wired into the thought leaders in the country. And what fun would the conference be without Kyle Bass of Hayman Advisors offering us his latest ideas? We are finalizing agreements with another four to five equally well-known speakers, which will include a few surprises, as well as rounding out the panels. I will share those names with you as we nail them down.

Since the first year of the Strategic Investment Conference, my one rule has been to create a conference that I want to attend. Unlike many conferences, there are no sponsors who pay to speak. Normal conferences have a few headliners to attract a crowd and then a lot of fill-ins. Everyone at my conference is an A-list speaker I want to hear, who would headline anywhere else. And because all the speakers know the quality of the lineup, they bring their A games.

Attendees routinely tell me that this is the best conference anywhere every year. And most of the speakers hang around to hear what is being said, which means you get to meet them at breaks and dinners. Plus, this year I am arranging for quite a number of writers and analysts to show up just to be there to talk with you. And I must say that the best part of the conference is mingling with fellow attendees. You will make new friends and be able to share ideas with other investors just like yourself. I really hope you can make it.

Registration is simple. Use this link: https://www.etouches.com/2015sicmauldin. While the conference is not cheap, the largest cost is your time, and I try to make it worth every minute. There are also two private breakfasts where hedge funds will be presenting. Altegris will contact you to let you know the details.

And now let’s think about investing in an age of divergence.

Don’t Miss the Melt-Up

Jared Dillian (who writes the free Mauldin Economics letter The 10th Man and is the editor of Bull’s Eye Investing) really got me thinking this week as he argued that most people try to hedge for the downside, buying puts and other hedges to make sure they don’t lose money in a market meltdown.

But as he showed us, it is actually far cheaper to buy long-term out-of-the-money calls to make sure that you catch a “melt-up.” If you had bought long-term calls in 2010 on the possibility that the market would double, you would be up a lot more than 100%. For whatever reason, the cost of betting on a bull market is much lower than trying to protect from a bear market. You have to work a little bit more to find these plays and to make sure you get the right price. Getting my 10-year options on the yen took a little time, but they are starting to pay off. For whatever reason, the cost premium relative to the strike price and recent movement in the yen-dollar cross is actually cheaper than it was when I bought a year ago. I have no idea why that would be, but markets can get to be strangely priced. (And yes, I am tempted to add to my position because of that price structure, even though I have a reasonable position already.)

Jawad Mian argued that Europe is going to be the place to be over the next year. Long-term readers can guess that I was quite skeptical of that view, as I see nothing but problems in Europe; but as the days went on I began to see the trading wisdom in his thinking, especially relative to the US.

First off, the US market is simply looking “toppy” to me. That doesn’t mean there is a crash or a bear market in the future (although that is a real possibility), but the outsized returns of the last four or five years are unlikely to be repeated. Will Denyer and Tan Kai Xian of Gavekal have made the case that it no longer makes sense to overweight US equities, which had been the firm’s position for many years:

Our issue is that three key drivers of US equity outperformance are going into reverse:

1) In recent years the Federal Reserve was the most aggressive liquidity provider in the world — this is no longer the case. In fact, the Fed is making moves toward tightening, while everyone else is easing.

2) In recent years the US benefitted from an extraordinarily competitive currency — this is no longer the case. In a very short period, the US dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, to now being overvalued against the likes of the euro and the yen.

3) In recent years US equities were attractively priced — this is no longer the case. On a number of measures the market is stretched.

Even though the Federal Reserve rate hike has probably been pushed off into the third quarter, it will soon be priced into the market. Fed rate hikes usually lead to price-to-earnings (P/E) compression, whether or not there are strong earnings. But since almost half of S&P 500 earnings come from outside the US, a strong dollar is going to weigh heavily on those earnings. Procter & Gamble has said currency costs will reduce their earnings by $1.4 billion after-tax this year. They are not alone.

Further, more than half of S&P 500 companies have P/Es over 20; and, to put it bluntly, bull markets do not begin from valuations at this level. The Russell small-company index is down for the last year, quarter, month, week, and day. Small companies in general are in a bear market (though numerous small companies, typically ones that are tech-focused in some way, are having a banner year).

So, where do you go if you are taking money off the table from the US? Counterintuitively, the coming Greek crisis suggests that we might want to look to Europe. To understand why, let’s review what’s going on in Greece.

The Euro-Positive Greek Crisis?

As we read the headlines, it would appear that Europe is heading for a major confrontation over Greece. The Germans and other Europeans have made it very clear that there will be no haircut on Greece’s debt. Tsipras and his left-leaning coalition party, Syriza, were elected on the basis that there would have to be major haircuts in the Greek debt, as well as relief from the austerity requirements imposed by the Troika (the ECB, IMF, and European Commission) in the wake of the last Greek bailout.

Within a few weeks, Greece will need significant loans to make its debt payments and to pay its bills. The requirement for getting those loans is that Greece must adhere to the regime that was agreed to by the previous government. Tsipras and company have made it quite clear that they do not intend to do so. If they don’t, it is highly unlikely that they will get the Emergency Lending Assistance (ELA) from the European Central Bank that would be needed to bail out their banks. Money appears to be leaving Greece, and deposits are at their lowest levels since 2012.

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