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

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

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

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

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

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

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

Strict Standards: Declaration of mystique_PageWalker::end_el() should be compatible with Walker::end_el(&$output, $object, $depth = 0, $args = Array) in /home3/mmsuser/public_html/wp-content/themes/mystique/lib/core.php on line 127
Archive for April 2015

Archive for April, 2015

Thoughts from the Frontline: The Third and Final Transformation of Monetary Policy

 

The law of unintended consequences is becoming ever more prominent in the economic sphere, as the world becomes exponentially more complex with every passing year. Just as a network grows in complexity and value as the number of connections in that network grows, the global economy becomes more complex, interesting, and hard to manage as the number of individuals, businesses, governmental bodies, and other institutions swells, all of them interconnected by contracts and security instruments, as well as by financial and information flows.

It is hubris to presume, as current economic thinking does, that the entire economic world can be managed by manipulating one (albeit major) subset of that network without incurring unintended consequences for the other parts of the network. To be sure, unintended consequences can be positive or neutral or negative. This letter you are reading, which I’ve been writing for over 15 years and which reaches far more people than I would have ever dreamed possible, is partially the result of a serendipitous unintended consequence.

But as every programmer knows, messing with a tiny bit of the code in a very complex program can have significant ramifications, perhaps to the point of crashing the program. I have a new Microsoft Surface Pro 3 tablet that I’m trying to get used to, but somehow my heretofore reliable Mozilla Firefox browser isn’t playing nice with this computer. I’m sure it’s a simple bug or incompatibility somewhere, but my team and I have not been able to isolate it.

However, that’s a relatively minor problem compared to the unintended consequences that spill from quantitative easing, ZIRP, and other central bank shenanigans. We have discussed the problem of how the Federal Reserve has pushed dollars on the rest of the world and is playing havoc with dollar inflows and outflows from emerging markets. More than one EM central banker is complaining aggressively.

My good friend Dr. Woody Brock makes the case that an unintended consequence of QE is that the Federal Reserve’s normal transmission of monetary policy through periodic changes in the fed funds rate has been vitiated. He contends that soon we will no longer care about the fed funds rate and will be focused on other sets of rates.

This is an important issue and one that is not well understood. Woody has given me permission to reproduce his quarterly profile. For Woody, this is actually a fairly short piece; but as usual with Woody’s work, you will probably want to read it twice.

Woody is one of the most brilliant economists I know, and I make a point of spending time with him as our schedules permit. We are making plans to get together at his Massachusetts retreat in August. He is restructuring his business in order to spend more time writing and less time traveling, and he intends to lower the price of his subscription. It will still be pricey for the average reader, but for funds and institutions it should be a staple. You can find his website at www.SEDinc.com or email him at SED@SEDinc.com

Before we go to Woody’s letter, if you’re going to be at my conference this coming week, you’ve already made arrangements. I know a lot of people wanted to go but just couldn’t work it into their schedules. I won’t say it’s the next best thing to being there, but you can follow me on Twitter, where my team and I will be sending out real-time tweets about the important ideas and concepts we are hearing, not just from the speeches but from all the conversations that spring up during the day and late into the evening. If you’re curious as to who will be there, here’s a page with the speakers. If you’re at the conference, look me up.

The Fed Funds Rate: R.I.P.
‒ The Third and Final Transformation of Monetary Policy

By Woody Brock, Ph.D.
Strategic Economic Decisions, Inc.

The policy announcements of the US Federal Reserve Board are dissected and analyzed more closely than any other global financial variable. Indeed, during the past thirty years, Fed‐Watching became a veritable industry, with all eyes on the funds rate. Within a few years, this term will rarely appear in print. For the Fed will now be targeting two new variables in place of the funds rate. One result is that forecasting Fed policy will be more demanding.

To make sense of this observation, a bit of history is in order. During the last nine years, US monetary policy has been transformed in three ways. To date, only the first two have been widely discussed and are now well understood. The third development is only now underway, and is not well understood at all. To review:

First, the Fed lowered its overnight Fed funds rate to essentially zero, not only during the Global Financial Crisis of 2008–2009, but throughout nearly six years of economic recovery thereafter. The average level of the funds rate at the current stage of recovery was about 4% during the past dozen business cycles. It was never 0% as it is in this cycle. In past essays, we have argued that this overutilization of “ultra‐easy monetary policy” reflected the failure of the government to utilize fiscal policy correctly (profitable infrastructure spending with a high jobs multiplier), and to introduce long‐overdue incentive structure reforms. It was thus left to monetary policy to pick up the pieces after the global crisis of 2008. This development was true in most other G‐7 nations, not just in the US.

Second, the Fed inaugurated its policy of Quantitative Easing whereby it increased the size of its balance sheet five‐fold from $900 billion to $4,500 billion. Such an expansion would have been inconceivable to Fed watchers during the decades prior to the Global Financial Crisis. In the US, QE is now dormant, and the only remaining question (answered below) is how and when the Fed will shrink its bloated balance sheet back to more normal levels.

Third, the way in which the Fed conducts standard monetary policy (periodic changes in the funds rate) is currently undergoing a complete makeover. In particular, the traditional tool of changing the funds rate via Open Market operations carried out by the desk of the New York Fed no longer works. For as will be seen, the vast expansion of the size of its balance sheet (bank reserves in particular) has rendered traditional policy unworkable. From now on, therefore, the Fed will conduct monetary policy via two new tools that were not even on the drawing board of the Fed prior to 2008.

Summary: In this PROFILE, we explain in Part A why traditional (non‐QE) monetary policy has been vitiated by QE. In Parts B and C respectively, we discuss the two new tools that will be used in the future to conduct standard (non‐QE) monetary policy: what exactly are these tools, and how do they work? In Part D, we discuss why these new tools will not be required by the European Central Bank, which has a different institutional structure than the US Fed. Finally, in Part E, we turn to QE and discuss when and how the Fed will shrink its balance sheet back to a more traditional size in the years ahead.

In this write‐up, we largely rely on the remarks set forth in a recent paper by Fed Vice Chairman Stanley Fischer, formerly chief economist of the IMF, Governor of the Central Bank of Israel, and professor of economics at MIT. We also benefitted from clarifications by Professor Benjamin Friedman at Harvard University.

Part A: So Long to Setting the Funds Rate via Open Market Operations

Prior to the financial crisis, bank reserve balances with the Fed averaged about $25 billion. With such a low level of reserves, a level controlled solely by the Fed, minor variations in the amount of reserves via Fed open market sales/purchases of securities sufficed to move the Fed funds rate up or down as desired. Analytically, the market for bank reserves (Fed funds) consisted of a demand curve for bank reserves reflecting the nation’s demand for loans, and a supply curve reflecting the supply of reserves by the Fed. The so‐called Fed funds rate is the point of intersection of these two curves (the interest rate). If the Fed targeted, say a 2% funds rate, it achieved and maintained this rate by shifting the supply curve left or right by adding to/subtracting from the quantity of reserves. As the Fed was a true monopolist in the creation/extinction of reserves, it could always target and sustain any funds rate it chose.

These operations constituted “monetary policy” for many decades. But this is no longer the case, as was first made clear in a FOMC policy pronouncement of September 2014. To quote Dr. Fischer in his 2015 speech, “With the nearly $3 trillion in free bank reserves (up from pre‐crisis reserves averaging $25 billion), the traditional mechanism of adjustments in the quantity of reserve balances to achieve the desired level of the Federal funds rate may not be feasible or sufficiently predictable.” What new mechanisms will replace it? There are two.

Part B: The Use of Interest Rates Paid by the Fed on Free Bank Reserves

“Instead of the funds rate, we will use the rate of interest paid on excess reserves as our primary tool to move the Fed funds rate.” The ability of the Fed to pay banks an interest rate on their free reserves dates back to legislation of October 2008. This rate has been set at 0.25% during the past few years. (“Excess” or “free” bank reserves are defined as the arithmetic difference between total reserves and required reserves. Currently, as of March 30, required reserves were $142 billion, and total reserves were $2.79 trillion.)

The Logic: Whatever the level of the reserve interest rate that the Fed chooses, banks will have little if any incentives to lend to any private counterparty at a rate lower than the rate they can earn on their free reserve balances maintained at the Fed. The higher the reserve remuneration rate is, the greater will be the upward pressure on a whole range of short‐term rates.

Part C: The Use of the Reverse Repo Rate

“Because not all institutions have access to the excess reserves interest rate set by the Fed, we will also utilize an overnight reverse repurchase purchase agreement facility, as needed. In a reverse repo operation, eligible counterparties may invest funds with the Fed overnight at a given interest rate. The reverse repo counterparties include 106 money market funds, 22 broker‐dealers, 24 depository institutions, and 12 government‐sponsored enterprises, including several Federal Home Loan Banks, Fannie Mae, Freddie Mac, and Farmer Mac.”

The Logic: Fischer continues: “This facility should encourage these institutions to be unwilling to lend to private counterparties in money markets at a rate below that offered on overnight reverse repos by the Fed. Indeed, testing to date suggests that reverse repo operations have generally been successful in establishing a soft floor for money market interest rates.”

Summary

Due to the explosion of the size of its balance sheet (bank reserves in particular), the Fed has been forced to abandon management of the Fed funds rate via traditional open market operations. This activity is now being replaced by two new policy tools, both of which are somewhat “softer” than the older tool. First, bank’s free reserves now earn an interest rate on excess bank reserves which is available to banks with access to the Fed’s reserve facility. Second, financial institutions such as money market funds lacking access to the reserve facility will be able to lodge funds overnight (not necessarily merely one night) at the Fed and receive the reverse repo rate offered by the Fed.

Part D: Irrelevance of these Developments to the European Central Bank

Interestingly, the European Central Bank does not need and will probably not implement the policy innovations now being implemented by the US Fed. The reason is that in Europe, lending is dominated by banks far more than here in the US. Moreover, most all European financial institutions can in effect deposit funds with the central bank. Finally, the ECB has long been able to vary the reserve remuneration (interest) rate that it pays for excess reserves. As a result, the ECB does not need to utilize the reverse repo rate tool that the Fed is introducing.

One final point should be made. Whereas Professor Fischer above asserts that the primary tool of the Fed will be variations in the reserve remuneration rate applicable to banks, other scholars believe it is the reverse repo rate that will be the primary tool of US monetary policy. This is partly because of the ongoing reduction of the role of banks in lending to private sector borrowers, a longstanding development that has accelerated with the new regulations imposed on banks since the Global Financial Crisis.

Part E: Will the Fed Shrink its Balance Sheet Back Down? If So, How?

Professor Fischer answers this point directly. Yes, the Fed will shrink its balance sheet, but not to the size of yesteryear. More specifically:

“With regard to balance sheet normalization, the FOMC has indicated that it does not anticipate outright sales of agency mortgage‐backed securities, and that it plans to normalize the size of the balance sheet primarily by ceasing reinvestment of principal payments on our existing securities holdings when the time comes… Cumulative repayments of principal on our existing securities holdings from now through the end of 2025 are projected to be $3.2 trillion. As a result, when the FOMC chooses to cease reinvestments of principal, the size of the balance sheet will naturally decline, with a corresponding reduction in reserve balances.”

Hopefully these remarks have helped clarify past and future changes in Fed policy—changes that amount to a thoroughgoing transformation of US monetary policy that would have been unimaginable a decade ago.

In the future, we suspect that the press will refer to the Fed’s targeting of the “reverse repo rate” in place of the Federal funds rate when analyzing prospective monetary policy.

 

San Diego, Raleigh, Atlanta, New York, New Hampshire, and Vermont

I am excited about going to the 2015 Strategic Investment Conference on Tuesday. If for some reason you get there early on Wednesday, I intend to be in the gym at the hotel about 2:30, so come by and let’s work out together. Again, don’t forget to follow me on Twitter while I’m at the conference.

In the middle of May I go to Raleigh to speak for the Investment Institute and then on to Atlanta, where I’m on the board of Galectin Therapeutics. I’m going to New York the first week of June, then up to New Hampshire, where I will be speaking with a number of friends at a private retreat. I will then somehow get to Stowe, Vermont, to meet with my partners at Mauldin Economics. The rest of the summer looks pretty easy, with a few trips here and there.

Next week I intend to share my speech at the conference, or at least the gist of it. I have been thinking about it and working on it for some time. I had dinner this week with Mari Kooi, former fund manager who has become deeply imbedded with the Santa Fe Institute, an intellectual hotspot famous for its maverick scientists and interdisciplinary work on the science of complexity. Some of their people are working on something called complexity economics, which is an attempt to move on from the neoclassical view of general equilibrium. If you wonder why the theories and models don’t work, it is because traditional economists are still busy trying to describe a vastly complex system by assuming away all the change except for that they believe they can control with the knobs they twist and pull. Their model of the economy resembles some vast Rube Goldberg machine where, if you put X money in here at Y rate, it will produce Z outcome over there. Except that they don’t really know how the actions of the market will play out, since the market is made up of hundreds of millions of independent agents, all of whom change their behavior on the fly based on what the other agents are doing. Not to mention the effects of herding behavior and incentive structures and a dozen things beyond the ken or control of economists. There is only equilibrium in theory.

And that’s why it is becoming increasingly difficult to predict the future. The agents of change are multiplying and changing faster than we can keep up. But next week I will throw caution to the wind (unless I give up in despair), and we’ll see what my very cloudy crystal ball suggests lies in our future.

I am really looking forward to seeing old friends and making new ones at the conference. Have a great week.

Your trying to find simple in a complex world analyst,

John Mauldin
subscribers@mauldineconomics.com

Thoughts from the Frontline: The Third and Final Transformation of Monetary Policy

 

The law of unintended consequences is becoming ever more prominent in the economic sphere, as the world becomes exponentially more complex with every passing year. Just as a network grows in complexity and value as the number of connections in that network grows, the global economy becomes more complex, interesting, and hard to manage as the number of individuals, businesses, governmental bodies, and other institutions swells, all of them interconnected by contracts and security instruments, as well as by financial and information flows.

It is hubris to presume, as current economic thinking does, that the entire economic world can be managed by manipulating one (albeit major) subset of that network without incurring unintended consequences for the other parts of the network. To be sure, unintended consequences can be positive or neutral or negative. This letter you are reading, which I’ve been writing for over 15 years and which reaches far more people than I would have ever dreamed possible, is partially the result of a serendipitous unintended consequence.

But as every programmer knows, messing with a tiny bit of the code in a very complex program can have significant ramifications, perhaps to the point of crashing the program. I have a new Microsoft Surface Pro 3 tablet that I’m trying to get used to, but somehow my heretofore reliable Mozilla Firefox browser isn’t playing nice with this computer. I’m sure it’s a simple bug or incompatibility somewhere, but my team and I have not been able to isolate it.

However, that’s a relatively minor problem compared to the unintended consequences that spill from quantitative easing, ZIRP, and other central bank shenanigans. We have discussed the problem of how the Federal Reserve has pushed dollars on the rest of the world and is playing havoc with dollar inflows and outflows from emerging markets. More than one EM central banker is complaining aggressively.

My good friend Dr. Woody Brock makes the case that an unintended consequence of QE is that the Federal Reserve’s normal transmission of monetary policy through periodic changes in the fed funds rate has been vitiated. He contends that soon we will no longer care about the fed funds rate and will be focused on other sets of rates.

This is an important issue and one that is not well understood. Woody has given me permission to reproduce his quarterly profile. For Woody, this is actually a fairly short piece; but as usual with Woody’s work, you will probably want to read it twice.

Woody is one of the most brilliant economists I know, and I make a point of spending time with him as our schedules permit. We are making plans to get together at his Massachusetts retreat in August. He is restructuring his business in order to spend more time writing and less time traveling, and he intends to lower the price of his subscription. It will still be pricey for the average reader, but for funds and institutions it should be a staple. You can find his website at www.SEDinc.com or email him at SED@SEDinc.com

Before we go to Woody’s letter, if you’re going to be at my conference this coming week, you’ve already made arrangements. I know a lot of people wanted to go but just couldn’t work it into their schedules. I won’t say it’s the next best thing to being there, but you can follow me on Twitter, where my team and I will be sending out real-time tweets about the important ideas and concepts we are hearing, not just from the speeches but from all the conversations that spring up during the day and late into the evening. If you’re curious as to who will be there, here’s a page with the speakers. If you’re at the conference, look me up.

The Fed Funds Rate: R.I.P.
‒ The Third and Final Transformation of Monetary Policy

By Woody Brock, Ph.D.
Strategic Economic Decisions, Inc.

The policy announcements of the US Federal Reserve Board are dissected and analyzed more closely than any other global financial variable. Indeed, during the past thirty years, Fed‐Watching became a veritable industry, with all eyes on the funds rate. Within a few years, this term will rarely appear in print. For the Fed will now be targeting two new variables in place of the funds rate. One result is that forecasting Fed policy will be more demanding.

To make sense of this observation, a bit of history is in order. During the last nine years, US monetary policy has been transformed in three ways. To date, only the first two have been widely discussed and are now well understood. The third development is only now underway, and is not well understood at all. To review:

First, the Fed lowered its overnight Fed funds rate to essentially zero, not only during the Global Financial Crisis of 2008–2009, but throughout nearly six years of economic recovery thereafter. The average level of the funds rate at the current stage of recovery was about 4% during the past dozen business cycles. It was never 0% as it is in this cycle. In past essays, we have argued that this overutilization of “ultra‐easy monetary policy” reflected the failure of the government to utilize fiscal policy correctly (profitable infrastructure spending with a high jobs multiplier), and to introduce long‐overdue incentive structure reforms. It was thus left to monetary policy to pick up the pieces after the global crisis of 2008. This development was true in most other G‐7 nations, not just in the US.

Second, the Fed inaugurated its policy of Quantitative Easing whereby it increased the size of its balance sheet five‐fold from $900 billion to $4,500 billion. Such an expansion would have been inconceivable to Fed watchers during the decades prior to the Global Financial Crisis. In the US, QE is now dormant, and the only remaining question (answered below) is how and when the Fed will shrink its bloated balance sheet back to more normal levels.

Third, the way in which the Fed conducts standard monetary policy (periodic changes in the funds rate) is currently undergoing a complete makeover. In particular, the traditional tool of changing the funds rate via Open Market operations carried out by the desk of the New York Fed no longer works. For as will be seen, the vast expansion of the size of its balance sheet (bank reserves in particular) has rendered traditional policy unworkable. From now on, therefore, the Fed will conduct monetary policy via two new tools that were not even on the drawing board of the Fed prior to 2008.

Summary: In this PROFILE, we explain in Part A why traditional (non‐QE) monetary policy has been vitiated by QE. In Parts B and C respectively, we discuss the two new tools that will be used in the future to conduct standard (non‐QE) monetary policy: what exactly are these tools, and how do they work? In Part D, we discuss why these new tools will not be required by the European Central Bank, which has a different institutional structure than the US Fed. Finally, in Part E, we turn to QE and discuss when and how the Fed will shrink its balance sheet back to a more traditional size in the years ahead.

In this write‐up, we largely rely on the remarks set forth in a recent paper by Fed Vice Chairman Stanley Fischer, formerly chief economist of the IMF, Governor of the Central Bank of Israel, and professor of economics at MIT. We also benefitted from clarifications by Professor Benjamin Friedman at Harvard University.

Part A: So Long to Setting the Funds Rate via Open Market Operations

Prior to the financial crisis, bank reserve balances with the Fed averaged about $25 billion. With such a low level of reserves, a level controlled solely by the Fed, minor variations in the amount of reserves via Fed open market sales/purchases of securities sufficed to move the Fed funds rate up or down as desired. Analytically, the market for bank reserves (Fed funds) consisted of a demand curve for bank reserves reflecting the nation’s demand for loans, and a supply curve reflecting the supply of reserves by the Fed. The so‐called Fed funds rate is the point of intersection of these two curves (the interest rate). If the Fed targeted, say a 2% funds rate, it achieved and maintained this rate by shifting the supply curve left or right by adding to/subtracting from the quantity of reserves. As the Fed was a true monopolist in the creation/extinction of reserves, it could always target and sustain any funds rate it chose.

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: Half a Bubble Off Dead Center

 

I can sense a growing unease as I talk with investors and other friends, from professional market watchers and traders to casual observers. What in the Wide World of Sports is going on? It is not just that markets are behaving in an unusual and volatile manner (see chart below showing multiple double-digit moves in the last few months); it’s that the data seems to be so conflicting. One day we get data that shows the economies of the developed world to be slowing, and the next day we get positive numbers. The ship of the economy seems to be drifting rudderless.

My dad used to say about a situation that just didn’t seem quite right that things were “about a half a bubble off dead center.” (This was back in the days when we used bubble levels to determine whether something was level or plumb – before today’s fancy digital gadgets.)

There is a reason, I think, that everything seems just a little out of kilter. I believe that central banks, in their valiant, unceasing efforts to restore liquidity and growth, have unleashed numerous unintended consequences that are beginning to show up in earnest. Today we are going to review the well-meaning behavior of central banks for clues about our near future.

But first, let me take one final opportunity to invite you to come to the 2015 Strategic Investment Conference. We’ve assembled an amazing cast of speakers who will delve deeply into what is really driving the world’s economy. I have some of the finest experts on China from around the world, central bankers, some very powerful analysts whose work commands the attention of the biggest institutions and hedge funds in the world (and whose work costs 20 times or more the price of my conference). Market analysts, geopolitical wizards, and futurists will be on hand, too. This is really the finest gathering of minds I have been pleased to assemble for a Strategic Investment Conference. Click on the link above and peruse the lineup and schedule. The conference starts in a little over a week, on the evening of April 29, and lasts through May 2 at noon. Between those times we will wine and dine you as you feast on powerful ideas, one after another. You will come away with a much better grasp of our near-term future, including when and how the Fed will raise rates, what will happen to China, how Europe will evolve (or devolve), and what the overall geopolitical outlook for the world is. All in one place with some of the smartest and friendliest attendees you’ll ever find.

Almost everyone who attends these conferences say they are the best they’ve ever been to, and I work hard to make sure they can say that every year. This year I believe they will be able to say it again. Make a last-minute decision to come – you’ll be glad you did. To make your decision easier, we are holding the current registration price of $2,195 through the rest of the week.

Now let’s look at what central banks are doing to us.

Stuck in a Liquidity Trap?

A few years ago, Jonathan Tepper and I wrote a book called Endgame, in which we talked about liquidity traps developing at the end of debt supercycles. And we certainly did have a liquidity trap, all over the world. The major central banks came up with rather radical policies to deal with it, and those were necessary at the time. But then, like the proverbial Energizer Bunny, they just kept going and going and going.

Central banks have proven that they can make money cheap and plentiful, but the money they’ve created isn’t moving around the economy or stimulating demand. It’s like a car. Our central banker can put the pedal to the metal and flood the engine with gas; but because the transmission is busted, it’s hard to shift gears, and power isn’t delivered to the wheels. Without a transmission mechanism, monetary policy is ineffective. Study after study has shown that quantitative easing didn’t produce the “bang for the buck” that central bankers hoped it would. After a credit crisis like last decade’s, central bankers can cut the nominal interest rate all the way to zero and still not be able to get their economies in gear. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning).

The Great Recession plunged us into a liquidity trap the likes of which the world hadn’t seen since the Great Depression, although Japan has been more or less mired in a liquidity trap since their bubble burst in 1989.

Economists who study liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy.

In fact, if you look at recessions that followed on the heels of debt crises, growth was almost always very slow. For example, a study by Oscar Jorda, Moritz Schularick, and Alan Taylor found that recessions that occurred after years of rapid credit growth were almost always worse than garden-variety recessions. One of the key findings of their study is that it is very difficult to restore growth after a debt bubble.

Yet Paul Krugman took a victory lap this week on behalf of the reigning economic paradigm and its role in the US recovery. While he was at it, he chided Europe for not pursuing the same policies:

It’s true that few economists predicted the crisis. The clean little secret of economics since then, however, is that basic textbook models, reflecting an approach to recessions and recoveries that would have seemed familiar to students half a century ago, have performed very well. The trouble is that policy makers in Europe decided to reject those basic models in favor of alternative approaches that were innovative, exciting and completely wrong.

Actually the difference in the performance of the US and European economies was almost all attributable to our shale oil revolution. Without it, US growth would have been closer to 1% than our recent anemic 2% average (and likely to be 1% for the recent quarter).

Was it really central bank policy that made the difference? Let’s examine.

Central banks in the US, Europe, and Japan want to create modest inflation and thereby reduce the real value of debt, but they’re having trouble doing it. Creating inflation isn’t quite as simple as printing money or keeping interest rates very low. Most Western central banks have built up a very large store of credibility over the past few decades. The high inflation of the 1970s is a very distant memory to most investors nowadays, and almost no one seriously believes in hyperinflation. The UK has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the US – when the Continental Congress printed a boatload of money to pay for the Revolutionary War. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall… coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts….”) Japan and Germany have not had hyperinflation for over 60 years.

Today’s central bankers want what they consider mild inflation (~2%) but only in the short run. (They would probably tolerate 3 to 4% before they leaned heavily against it in today’s economic environment.)

As Janet Yellen has recognized, central banks with established reputations have a credibility problem when it comes to committing to future inflation. If people believe deep down that central banks will try to kill inflation if it ever gets out of hand, then it becomes very hard for those central banks to generate inflation. And the answer to that problem from many economists is that central bankers should be even bolder and crazier – sort of like everyone’s mad uncle – or, to put it more politely, they should be “responsibly irresponsible,” as Paul McCulley has quipped. And yet there is a growing chorus of serious economists beginning to suggest that keeping rates at 0% for six years is just about irresponsible enough.

In a liquidity trap, the rules of economics change. Things that worked in the past don’t work in the present. Central bankers’ economic models, iffy in the best of times, become even less reliable. In fact they sometimes suggest actions that are quite destructive. So why aren’t the models working?

Sometimes the best way to understand a complex subject is to draw an analogy. So with an apology to all the true mathematicians among our readers, I want to revisit what I call the Economic Singularity. I must confess that when I coined the term in 2012 I had no idea how accurate the description would become in the past few quarters.

The Economic Singularity

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

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

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

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

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

We are fast reaching the point where markets are crossing the event horizon, where mathematical investment analysis no longer makes sense. We read that some 25% of bonds in Europe now offer negative interest rates. How do your value equations work in an environment of negative yields? It becomes mathematically impossible for pensions and insurance companies to meet their goals, given their investment mandates, in a world of negative interest rates. While economists may applaud negative rates, those who will need their annuities and pensions are probably not yet aware that their futures have been mortgaged for a set of narrow economic goals, which look as though they are not being fulfilled at any rate. When the bill comes due in 10 years, those in charge today will have moved on to other more lucrative opportunities, and pensioners will realize how screwed they have been.

German bonds have negative yields out to the eight-year mark, as yields have steadily dropped for the last three years:

Switzerland is now issuing 10-year bonds at negative rates. Has lending returned to Europe? If you squint real hard, you might be able to detect an uptick in the next chart.

However, when you take a closer look, you find that the recent uptick is almost all in finance (in just two financial corporations, to be specific) and not in the household and business sectors, which are seeing credit lines being close to them. (Hat tip Alhambra Partners.)

I believe the world will soon find out that by holding interest rates down and allowing sovereign debts to accumulate past the point of rational expectation for being paid, in one country in Europe after another (Greece is just the first), central banks have pushed us past the event horizon, believing they have supernatural powers that will let the global economy escape the debt black hole that has been created by and for governments.

The Minsky Moment

Debt (leverage) can be a very good thing when used properly. For instance, if debt is used to purchase an income-producing asset, whether a new machine tool for a factory or a bridge to increase commerce, then debt can be net-productive.

Hyman Minsky, one of the greatest economists of the last century, saw debt in three forms: hedge, speculative, and Ponzi. Roughly speaking, to Minsky, hedge financing occurred when the profits from purchased assets were used to pay back the loan; speculative finance occurred when profits from the asset simply maintained the debt service and the loan had to be rolled over; and Ponzi finance required the selling of the asset at an ever higher price in order to make a profit.

Minsky maintained that if hedge financing dominated, then the economy might well be an equilibrium-seeking, well-contained system. On the other hand, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy would be what he called a deviation-amplifying system. Minsky’s Financial Instability Hypothesis suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by (stable) hedge finance to a structure that increasingly emphasizes (unstable) speculative and Ponzi finance.

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

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

In Endgame I explored the idea of a debt supercycle, the culmination of decades of borrowing that finally ends in a dramatic bust. At the time I wrote the book, I felt that much of the developed world was at the end of the 60-year-long debt supercycle and approaching the event horizon of a global economic singularity.

The Event Horizon

A business-cycle recession is a fundamentally different thing than the end of a debt supercycle, such as much of Europe is tangling with, Japan will soon face, and the US can only avoid with concerted action in the next few years. A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past or in a manner that the models would predict, which is precisely what we’re seeing today.

There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Raising taxes or cutting spending to reduce debt will have an almost immediate impact on economic growth.

But there is a limit to how much money a government can borrow. Although that limit can vary significantly from country to country, to suggest there is no limit puts you squarely in the camp of the delusional.In our analogy, the event horizon is relatively easy to pinpoint. It is what Rogoff and Reinhart call the “Bang!” moment, when a country loses the confidence of the bond market. For Russia it came at 57% of debt-to-GDP in 1998. Japan is at 250% of debt-to-GDP and rising, even as its population falls – the “Bang!” moment has arrived, and Japan is now monetizing debt at a rate that is unprecedented for a developed country in modern history. Obviously, Greece had its first such moment several years ago and is now getting ready to experience another such painful moment. Spain lost effective access to the bond market a few years ago and survived only because of European Central Bank intervention, as did Italy. If there is further contagion from Greece, will these and other southern- and eastern-tier European countries go Bang?

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

The problem of too much debt is not new. Rogoff and Reinhart’s epic research highlights 266 crises over the last few hundred years; and if they were writing their book today, they would be able add a few new ones. I believe there will be even more such events within the next five to ten years.

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

The problem is not merely one of insufficient spending; the key problem is insufficient income. By definition, income has to come before spending. You can take money from one source and give it to another, but that is not organic growth. We typically think of organic growth as only having to do with individual companies, but I like to think the concept also applies to countries. The organic growth of a country can come from natural circumstances like ample energy resources or an equable climate or land conducive to agricultural production, or it can come from developing an educated populace. There are many sources of potential organic growth: energy, tourism, technology, manufacturing, agriculture, trade, banking, etc.

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

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

Deficit spending can be a useful tool in countries with a central bank and an independent currency, such as the US. But at what point does borrowing from the future (that is, from our children) become a failure to deal with our own lack of political will in regards to our spending and taxation policies? There is a difference, as I think Hyman Minsky would point out, between borrowing money for infrastructure spending that will benefit our children and borrowing money to spend on ourselves today, with no future benefit. And for countries without a central bank, that are already trapped in a debt black hole, adding more debt just worsens the problem. Ask Greece.

Where Does Growth Come From?

While it may seem odd to shift directly from a discussion of debt to one about growth, the above question is actually at the heart of the matter. Paul Krugman and I would readily agree that growth of the type we experienced in the ’80s and ’90s is the best cure for too much debt. Nominal GDP growth at 6 to 7% with deficits rising no more than 2 to 3% (or even a surplus!) can quickly reduce a country’s debt burden. Growth not only eases the debt burden, it produces jobs and a better standard of living for everyone. Growth is the equivalent of an economic magic elixir.

What causes growth? As noted above, Krugman wrote:

The clean little secret of economics since then, however, is that basic textbook models, reflecting an approach to recessions and recoveries that would have seemed familiar to students half a century ago, have performed very well.

The problem is that the models tend to confuse correlation with causation. The “textbook models” note that growth appears when rates are low and money is easier to find. Thus, when a central bank lowers its rates, it expects to see higher growth. It also wants to see an increase in jobs, and that is in fact what seems to happen.

I would not dispute that lower rates can for a time be a stimulus. But lower rate certainly weren’t much of a stimulus in Japan and have not been all that successful in Europe over the last few years. There is something going on that a simple easy-money policy cannot address.

What happens after a recession is that companies adjust their business models. Initially this may mean cutting costs by reducing jobs and lowering overhead. Eventually, businesses start to be profitable again. Most companies try to take some of that profit and increase their business. It is the natural state of things that free entrepreneurs will figure out how to grow their businesses. The individual actions of almost 7 million businesses and 22 million self-employed workers trying to improve their lot in life create growth in the aggregate.

There is a fabulous infographic at Business Insider, detailing the statistics on the state of US small businesses. It’s way too long to reproduce here, but those who are interested can click on the link.

A few facts:

  • 50% of the working population of the US works in small business.
  • There are over 22 million self-employed workers, and the remaining almost 7 million businesses have almost 100 million employees.
  • Small businesses have generated over 65% of the net new jobs since 1995.
  • An astounding 543,000 businesses get started each month; and, for decades, more businesses would open than close. That has changed, and we are now closing more businesses than we are opening new ones. We have shut down the engine for the source of new jobs.
  • Starting a new business is very risky. Only 7 out of 10 new employer firms survived at least 2 years, half last at least 5 years, a third make it for 10 years, and only a quarter stay in business 15 years or more. These are actually better odds than when I was researching and writing about the topic in the ’80s. Perhaps that is because 52% of all small businesses are now home-based, with lower overhead and clearly different business models than were prevalent 30 years ago.
  • That self-employed market contributes over 6% of GDP.

The growth of an economy after a recession is the result of tens of millions of small and large businesses figuring out how to improve their lot. To credit a central bank and its monetary policy as the primary forces in bringing about prosperity is misguided at best and disingenuous at worst. It is giving credit to the cart for delivering the package rather than to the horse that pulled it.

If we want growth, then we need more small businesses. Elon Musk employs 6000 employees, on his way to 10,000+; but his business started with a few people sitting around a table trying to figure out how to make it happen. Same with Google. Or Amazon. Or any big business.

You don’t get big businesses with large numbers of employees without having an active pool of new businesses being created. The simple fact is that regulations and a complicated tax code have made starting a new business more difficult.

Economic Distortions and Unintended Consequences

The Federal Reserve policy of holding rates too low for too long in the middle of the last decade clearly helped create the environment for the housing bubble and the distortions in the financial markets that were at the root of the Great Recession. The Federal Reserve is once again making the mistake of leaving interest rates too low for too long and bringing about distortions that are creating bubbles all over the world, especially in the emerging markets.

By encouraging a reach for yield in riskier investments because interest rates are abnormally low, the Fed has created an environment in which far more risk is being taken than is normal and healthy. It is as if the central bankers and economists have decided that individuals are not smart enough to do what is in their own best interests and think they need to be encouraged to make riskier investments. The problem is that many of those riskier investments are now being made with funds that should in be lower-risk investments meant to sustain people well into their retirement years.

Most retirement money should be put to work in lower-risk investments meant for the long term. Now that investors have been forced into seeking higher-yielding, higher-risk investments, at the first sign of danger they will be emotionally driven to withdraw their funds at just the wrong time, as they did during the Great Recession. Central bank policy, even if well-meant, has created an environment of risk that monetary policy cannot resolve. We have sown the seeds of the next crisis throughout the economies of the world by distorting markets with low rates and encouraging $9 trillion of dollar-denominated debt to flow into emerging markets.

Further, rather than reforming their labor and regulatory markets and unleashing their entrepreneurs, Japan and now Europe are engaged in what amounts to a currency war waged under the guise of trying to engender inflation.

The central banks of the major developed economies have once again dangerously distorted the real economy. It strains credulity to say that slowly raising rates by as little as 2% would somehow make it impossible for businesses to make money. A business that survives only because of 0% interest rates is a zombie business that is incapable of surviving in a normal economy. Repressing savers and destroying the income of those who have saved for a lifetime seems a very high price to pay to support businesses that would fail in normal times. Thwarting savers greatly reduces the consumption those savers would have been able to contribute to the real economy. And to prop up the very financial institutions that were part and parcel of the last crisis? The income inequality that so many in academic circles decry is actually a studied result of current thinking about monetary policy.

We have once again entered dangerous ground where central banks with their low rate policies have distorted the economy. Yes, the near-zero rate policies of central banks have benefited financial businesses and large corporations that can take advantage of access to low-interest-rate financing, but they have not spurred the development of new businesses. Monetary policy does not create jobs. Businesses create jobs.

In addition, we have put in place onerous new banking regulations that are being thrust upon small banks, taking away their power to lend money to good businesses. We are strangling the real economy with easy-money policies and encouraging financial transactions that look a lot like Ponzi, as opposed to hedge, financing.

The total amount of global debt has risen by 33% in just the last seven years, that is, by a staggering $57 trillion. How much of the $57 trillion was pursued as hedge finance rather than Minsky’s speculative or Ponzi finance? I fear that we are once again facing a Minsky Moment, when our accumulated debt and the continued distortion of the economy by central banks will create another financial crisis.

Is it 2005 all over again, so that we can expect another few years before the piper must be paid? Or is it mid-2007, so that we need to be preparing for another global crisis? In both cases the markets were telling us things were okay, but in 2007 we were beginning to notice signs of increased volatility, and growth seem to be weakening. What do you see when you look around? Does it feel like 2005, or 2007?

To me, the world feels like it’s about half a bubble off dead center.

San Diego, Raleigh, Atlanta, and New York

I am home next week before heading over to San Diego a few days early for the Strategic Investment Conference. If you are around Wednesday afternoon (the 29th), look me up in the gym. Once the conference starts Wednesday night, I will have very little time Thursday and Friday to catch my breath, let alone get into the gym. Maybe Saturday afternoon, if I have any energy left.

The middle of May sees me going to Raleigh for an institutional investment conference before participating in a board meeting for Galectin Therapeutics in Atlanta. In early June I have a trip scheduled to New York and then New Hampshire. I will likely drive from there up to Stowe, Vermont, where my Mauldin Economics partner Olivier Garret has his offices. I’m sure a few other trips will come along in the meantime.

My friends know that I enjoy a great science fiction book. I’ve been reading science fiction for well over 50 years. I’m really not sure how many thousands of books I’ve read in that span of time. Lately, not as many as I would like, as there is so much other material that I feel compelled to read. The really good writers (not just of science fiction) not only grip you tight with a well-told story, they seem to be able to throw in plot twists that open up new horizons for the protagonists and engender wonder and joy in the reader. Most of the time, at least. George R. R. Martin (best known for Game of Thrones) is notorious for plot twists that kill off main characters just as you have come to really feel that you know and like them. It does allow him to take his plot in unexpected directions, though.

Just when I thought I could see how things would progress into my own near future, there has lately been a plot twist or two in my life (fortunately no one has been sacrificed for the enhancement of my personal plot). I choose to see them as opening up new possibilities, and now find myself wondering what other opportunities are out there. Like any good novelist, I will make sure my character moves forward, taking his chances just over the next pass or out beyond the next star. How much more fun can you have than getting to write your own story? It’s been a pretty good one so far. Let’s see if this writer can keep it up.

Right now, though, I have to focus on finishing the final edits on a new book and putting the details into my speech for San Diego. New storylines will have to wait a few weeks. I hope you’re having a great week. May all your plot twists be good ones.

Your wondering what genre of fiction I live in analyst,

John Mauldin
subscribers@mauldineconomics.com

Thoughts from the Frontline: Half a Bubble Off Dead Center

 

I can sense a growing unease as I talk with investors and other friends, from professional market watchers and traders to casual observers. What in the Wide World of Sports is going on? It is not just that markets are behaving in an unusual and volatile manner (see chart below showing multiple double-digit moves in the last few months); it’s that the data seems to be so conflicting. One day we get data that shows the economies of the developed world to be slowing, and the next day we get positive numbers. The ship of the economy seems to be drifting rudderless.

My dad used to say about a situation that just didn’t seem quite right that things were “about a half a bubble off dead center.” (This was back in the days when we used bubble levels to determine whether something was level or plumb – before today’s fancy digital gadgets.)

There is a reason, I think, that everything seems just a little out of kilter. I believe that central banks, in their valiant, unceasing efforts to restore liquidity and growth, have unleashed numerous unintended consequences that are beginning to show up in earnest. Today we are going to review the well-meaning behavior of central banks for clues about our near future.

But first, let me take one final opportunity to invite you to come to the 2015 Strategic Investment Conference. We’ve assembled an amazing cast of speakers who will delve deeply into what is really driving the world’s economy. I have some of the finest experts on China from around the world, central bankers, some very powerful analysts whose work commands the attention of the biggest institutions and hedge funds in the world (and whose work costs 20 times or more the price of my conference). Market analysts, geopolitical wizards, and futurists will be on hand, too. This is really the finest gathering of minds I have been pleased to assemble for a Strategic Investment Conference. Click on the link above and peruse the lineup and schedule. The conference starts in a little over a week, on the evening of April 29, and lasts through May 2 at noon. Between those times we will wine and dine you as you feast on powerful ideas, one after another. You will come away with a much better grasp of our near-term future, including when and how the Fed will raise rates, what will happen to China, how Europe will evolve (or devolve), and what the overall geopolitical outlook for the world is. All in one place with some of the smartest and friendliest attendees you’ll ever find.

Almost everyone who attends these conferences say they are the best they’ve ever been to, and I work hard to make sure they can say that every year. This year I believe they will be able to say it again. Make a last-minute decision to come – you’ll be glad you did. To make your decision easier, we are holding the current registration price of $2,195 through the rest of the week.

Now let’s look at what central banks are doing to us.

Stuck in a Liquidity Trap?

A few years ago, Jonathan Tepper and I wrote a book called Endgame, in which we talked about liquidity traps developing at the end of debt supercycles. And we certainly did have a liquidity trap, all over the world. The major central banks came up with rather radical policies to deal with it, and those were necessary at the time. But then, like the proverbial Energizer Bunny, they just kept going and going and going.

Central banks have proven that they can make money cheap and plentiful, but the money they’ve created isn’t moving around the economy or stimulating demand. It’s like a car. Our central banker can put the pedal to the metal and flood the engine with gas; but because the transmission is busted, it’s hard to shift gears, and power isn’t delivered to the wheels. Without a transmission mechanism, monetary policy is ineffective. Study after study has shown that quantitative easing didn’t produce the “bang for the buck” that central bankers hoped it would. After a credit crisis like last decade’s, central bankers can cut the nominal interest rate all the way to zero and still not be able to get their economies in gear. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning).

The Great Recession plunged us into a liquidity trap the likes of which the world hadn’t seen since the Great Depression, although Japan has been more or less mired in a liquidity trap since their bubble burst in 1989.

Economists who study liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy.

In fact, if you look at recessions that followed on the heels of debt crises, growth was almost always very slow. For example, a study by Oscar Jorda, Moritz Schularick, and Alan Taylor found that recessions that occurred after years of rapid credit growth were almost always worse than garden-variety recessions. One of the key findings of their study is that it is very difficult to restore growth after a debt bubble.

Yet Paul Krugman took a victory lap this week on behalf of the reigning economic paradigm and its role in the US recovery. While he was at it, he chided Europe for not pursuing the same policies:

It’s true that few economists predicted the crisis. The clean little secret of economics since then, however, is that basic textbook models, reflecting an approach to recessions and recoveries that would have seemed familiar to students half a century ago, have performed very well. The trouble is that policy makers in Europe decided to reject those basic models in favor of alternative approaches that were innovative, exciting and completely wrong.

Actually the difference in the performance of the US and European economies was almost all attributable to our shale oil revolution. Without it, US growth would have been closer to 1% than our recent anemic 2% average (and likely to be 1% for the recent quarter).

Was it really central bank policy that made the difference? Let’s examine.

Central banks in the US, Europe, and Japan want to create modest inflation and thereby reduce the real value of debt, but they’re having trouble doing it. Creating inflation isn’t quite as simple as printing money or keeping interest rates very low. Most Western central banks have built up a very large store of credibility over the past few decades. The high inflation of the 1970s is a very distant memory to most investors nowadays, and almost no one seriously believes in hyperinflation. The UK has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the US – when the Continental Congress printed a boatload of money to pay for the Revolutionary War. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall… coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts….”) Japan and Germany have not had hyperinflation for over 60 years.

Today’s central bankers want what they consider mild inflation (~2%) but only in the short run. (They would probably tolerate 3 to 4% before they leaned heavily against it in today’s economic environment.)

As Janet Yellen has recognized, central banks with established reputations have a credibility problem when it comes to committing to future inflation. If people believe deep down that central banks will try to kill inflation if it ever gets out of hand, then it becomes very hard for those central banks to generate inflation. And the answer to that problem from many economists is that central bankers should be even bolder and crazier – sort of like everyone’s mad uncle – or, to put it more politely, they should be “responsibly irresponsible,” as Paul McCulley has quipped. And yet there is a growing chorus of serious economists beginning to suggest that keeping rates at 0% for six years is just about irresponsible enough.

In a liquidity trap, the rules of economics change. Things that worked in the past don’t work in the present. Central bankers’ economic models, iffy in the best of times, become even less reliable. In fact they sometimes suggest actions that are quite destructive. So why aren’t the models working?

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: First Quarter 2015

 

I think it was almost two years ago that I was in Cyprus. Cyprus had just come through its crisis and was still in shell shock. I was there to get a feel for what it was like, and a number of my readers had courteously arranged for me to meet with all sorts of people and do a few presentations. A local group arranged for me to speak at the lecture hall of the Central Bank of Cyprus in Nicosia.

There were about 50 people in the room. I was busily working on Code Red at the time and had money flows, quantitative easing, and currency wars at the front of my brain. As part of my presentation, I talked about how countries would seek to use currency devaluation in order to gain an advantage over other countries – that we were getting ready to enter an era of currency wars, which would be disguised as monetary policy trying to create economic growth. Which is exactly what we have today. Every now and then I get a few things right.

After my short presentation, during the question and answer period, I pointed to a distinguished-looking gentleman to ask the fourth question. Before he could get his question out, my host stood up and said, “John, I just want to give you fair warning. This is Christopher Pissarides. He recently won the Nobel Prize in economics and is a professor at the London School of Economics, as well as being a Cypriot citizen.”

Professor Pissarides preceded his question by citing a great deal of literature, some of it his own, which showed that a country could not gain a true advantage by engaging in currency manipulation. “So why do you think there would be currency wars? What would it gain anybody?” he asked.

We proceeded to have a conversation that basically boiled down to the old Yogi Berra maxim: In theory, theory and practice are the same thing. In practice they differ.

Dr. Pissarides was of course absolutely right. Beggar-thy-neighbor policies end up making everybody worse off at the end of the day. However, there is a short-term first-mover advantage. In a short-term world, people do things to show they are being “proactive.” And in a world of “every central banker for himself,” where central banks are essentially trying to position their countries to prosper, you wind up having multiple iterations of tit for tat.

And that is just one of the points that our old friend Lacy Hunt of Hoisington Management makes in this week’s Outside the Box:

In our review of historical and present cases of over-indebtedness, we noticed some overlapping tendencies with less regularity that are important to mention.

First, when all major economies face severe debt overhangs, no one country is able to serve as the world’s engine of growth. This condition is just as much present today as it was in the 1920-30s.

Second, currency depreciations result as countries try to boost economic growth at the expense of others. Countries are forced to do this because monetary policy is ineffectual.

Third, devaluations do provide a lift to economic activity, but the benefit is only transitory because other countries that are on the losing end of the initial action retaliate. In the end every party is in worse condition, and the process destabilizes global markets.

Fourth, historically advanced economies have only cured over-indebtedness by a significant multi-year rise in the saving rate or austerity. Historically, austerity arose from one of the following: self-imposition, external demands or fortuitous circumstances.

I’m increasingly convinced that central banks have distorted the entire macroeconomic landscape to such an extent that we have entered uncharted waters. That will be the theme of my letter this upcoming weekend, but Lacy’s quarterly serves as a good introduction.

The weather has turned exceedingly nice in Dallas, Texas. The trees have filled out, the flowers are blooming, and we have had enough rain (thank goodness) to make everything green.

I pretty much enjoy all sports, and Dallas is generally blessed with having one or two of our teams actually play well in any given year. I think I like professional basketball the most. At the professional level it is the most beautiful of all sports. For a brief time in their life, these young gods of the court can do things that mere mortals can never experience. But it is such a joy to watch. I’ve had season tickets for 32 years, and in the last few years have finally have been able to work my way down from the very top-corner row to where my seats are now “most excellent.”

Tonight is the unofficial beginning of the NBA playoffs for the Western Conference. I say “unofficial” because, technically, the playoffs start this weekend; but only two teams in the West actually know their seed positions. Dallas is locked in at number seven, but there are still four mathematical possibilities for the number-two seed to face us. It all comes down to who wins and loses tonight. This is the closest basketball race that I can remember. Two or three teams vying for a playoff spot, sure, that’s common. But there are seven or eight teams in the conference this year that could get hot during the playoffs and make it to the top. The Mavericks have the deepest bench of any team in the NBA, but there are a lot of new players who have been added recently, and it sometimes feels like you want to introduce them to each other. We could be one and done or go all the way. It’s just really hard to figure this team out from night to night. But that’s what makes it fun.

Have a great week, and I wherever you are, I hope your weather is treating you well, too. I guess we should be grateful that a group of 12 people don’t get to sit around a big conference table and vote on what the weather should be like and then try to adjust it. Actually, that’s a good analogy. Think about it.

You’re hoping to be watching playoffs in late May analyst,

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

 

Stay Ahead of the Latest Tech News and Investing Trends…

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.


Hoisington Quarterly Review and Outlook – First Quarter 2015

Characteristics of Extremely Over-Indebted Economies

Over the more than two thousand years of economic history, a clear record emerges regarding the relationship between the level of indebtedness of a nation and its resultant pace of economic activity. The once flourishing and powerful Mesopotamian, Roman and Bourbon dynasties, as well as the British empire, ultimately lost their great economic vigor due to the inability to prosper under crushing debt levels. In his famous paper “Of Public Finance” (1752) David Hume, the man some consider to have been the intellectual leader of the Enlightenment, wrote about the debt problems of Mesopotamia and Rome. The contemporary scholar Niall Ferguson of Harvard University also described the over-indebted conditions in all four countries mentioned above. Through the centuries there are also numerous cases of less prominent countries that suffered a similar fate of economic decline resulting from too much debt as a percent of total output.

The United States has experienced four bouts of great indebtedness: the 1830-40s, the 1860- 70s, the 1920-30s and the past two decades. Japan has been suffering the consequences of a massive debt over-hang for the past three decades. In its first of three thorough studies of debt, the McKinsey Global Institute (MGI) identified 32 cases of extreme indebtedness from 1920 to 2010. Of this group, 24 were advanced economies of their day.

The countries identified in the study, as well as those previously cited, exhibited many idiosyncratic differences. Some were monarchies or various forms of dictatorships. Others were democracies, both nascent and mature. Some countries were on the Gold Standard, while others had paper money. Some had central banks and some did not. In spite of these technical and structural differentiations, the effect of high debt levels produced the clear result of diminished economic growth. Indeed, the fact that the debt impact shows through in these diverse circumstances is a clear indication of the powerful deleterious impact of too much debt. Six characteristics seem to be uniform in all circumstances of over-indebtedness in historical studies, and these factors are evident in contemporary times in the U.S., Japanese and European economies.

Six Characteristics

  1. Transitory upturns in economic growth, inflation and high-grade bond yields cannot be sustained because debt is too much of a constraint on economic activity.
     
  2. Due to inherently weak aggregate demand, economies are subject to structural downturns without the typical cyclical pressures such as rising interest rates, inflation and exhaustion of pent-up demand.
     
  3. Deterioration in productivity is not inflationary but just another symptom of the controlling debt influence.
     
  4. Monetary policy is ineffectual, if not a net negative.
     
  5. Inflation falls dramatically, increasing the risk of deflation.
     
  6. Treasury bond yields fall to extremely low levels.

The Non-Sustainability of Transitory Gains

Nominal GDP is the most reliable of all the economic indicators since, as the sum of cash register receipts, it constitutes the top line revenues of the economy. From this stream, everything must be paid. Current nominal GDP growth shows the economy’s inability to sustain progress in growth (Chart 1). The change over the four quarters ending December 31, 2014 was only 3.7%, which is barely above the average entry point for all recessions since 1948.

Nominal GDP can be sub-divided into two parts. First is the implicit price deflator, which measures price changes in the economy, and the second is real GDP, which is the change in the volume of goods. Both of these components are volatile, but the recent data shows a lack of strong momentum in economic activity. The year-over-year change in the deflator has accelerated briefly in this expansion, but the peak remained below the cyclical highs of all the expansions in every decade since the 1930s (Chart 2).

In the past fifteen years, real per capita GDP (nominal GDP divided by the price deflator and population) grew a paltry 1% per annum. This subdued growth rate should be compared to the average expansion of 2.5%, which has been recorded since 1940. The reason for the remarkably slow expansion over the past decade and a half has to do with the accumulation of too much debt. Numerous studies indicate that when total indebtedness in the economy reaches certain critical levels there is a deleterious impact on real per capita growth. Those important over-indebtedness levels (roughly 275% of GDP) were crossed in the late 1990s, which is the root cause for the underperformance of the economy in this latest expansion.

It is interesting to note that in this period of slower growth and lower inflation, long-term Treasury bond yields did rise for short periods as inflationary psychology shifted higher. However, the slow growth meant that the economy was too weak to withstand higher interest rates, and the result was a shift to lower rate levels as the economy slowed. Since the U.S. economy entered the excessive debt range, eight episodes have occurred in which this yield gained 84 basis points or more (Chart 3). Nevertheless, none of these rate surges presaged the start of an enduring cyclical rise in interest rates.

Downturns Without Cyclical Pressures

Many assume that economies can only contract in response to cyclical pressures like rising interest rates and inflation, fiscal restraint, over-accumulation of inventories, or the stock of consumer and corporate capital goods. This idea is valid when debt levels are normal but becomes problematic when debt is excessively high.

Large parts of Europe contracted last year for the third time in the past four years as interest rates and inflation plummeted. The Japanese economy has turned down numerous times over the past twenty years while interest rates were low. Indeed, this has happened so often that nominal GDP in Japan is currently unchanged for the past twenty-three years. This is confirmation that after a prolonged period of taking on excessive debt additional debt becomes counterproductive.

Faltering Productivity is Not Inflationary

Falling productivity does not cause faster inflation. The weaker output per hour is a consequence of the over-indebtedness as much as the other five characteristics mentioned above. Productivity is a complex variable impacted by many cyclical and structural influences. Productivity declines during recessions and declines sharply in deep ones. Nonfarm business productivity has grown at an average rate of 2.2% per annum since the series originated in 1952 (Chart 4). As a general rule the growth rate was above the average during economic expansions and lower than the average in recessions.

Over the past four years, nonfarm productivity growth has slumped to its lowest levels since 1952, with the exception of the severe recession of 1981- 82. Such a pattern is abnormally weak. Interestingly, the Consumer Price Index was unchanged in the past twelve-month period (Chart 5). In an economy purely dominated by cyclical forces, as opposed to one that is highly leveraged, both productivity and inflation would not be depressed.

Monetary Policy Is Ineffectual

Monetary policy impacts the overall economy in two areas – price effects and quantity effects. Price effects, or changes in short-term interest rates, are no longer available because rates are near the zero bound. This is a result of repeated quantitative easing by central banks. It is an attempt to lift overly indebted economies by encouraging more borrowing via low interest rates, thus causing even greater indebtedness.

Quantity effects also don’t work when debt levels are excessive. In a non-debt constrained economy, central banks have the capacity, with lags, to exercise control over money and velocity. However, when the debt overhang is excessive, they lose control over both money and velocity. Central banks can expand the monetary base, but this has little or no impact on money growth. Further, central banks cannot control the velocity of money, which declines when there is too much unproductive debt. This happened in the1920s and again after 1997 and is continuing to decline today (Chart 6).

Monetary policy can be used to devalue a country’s currency, but this benefit is short-lived, and to the extent that it works, conditions in other countries are destabilized causing efforts at currency devaluation to invoke retaliation from trading partners.

Inflation Falls So Much That Deflation Risk Rises

Extremely high levels of public and private debt relative to GDP greatly increase the risk of deflation. Deflation, in turn, serves to destabilize an economy that is over-indebted since the borrowers have to pay back loans in harder dollars, which transfers income and wealth from borrowers and creditors.

Such a deflation risk is present in the United States and other important economies of the world. During and after the mild recessions of 1990-91 and 2000-01, the rate of inflation in Europe and the United States fell by an average of 2.5%. With inflation near zero in both economies today, even a mild recession would put both in deflation.

Real Treasury Bond Yields

In periods of extreme over-indebtedness Treasury bond yields can fall to exceptionally low levels and remain there for extended periods. This pattern is consistent with the Fisher equation that states the nominal risk-free bond yield equals the real yield plus expected inflation (i=r+E*). Expected inflation may be slow to adjust to reality, but the historical record indicates that the adjustment inevitably occurs.

The Fisher equation can be rearranged algebraically so that the real yield is equal to the nominal yield minus expected inflation (r=i–E*). Understanding this is critical in determining how unleveraged investors fare. Suppose that this process ultimately reduces the bond yield to 1.5% and expected inflation falls to -1%. In this situation the real yield would be 2.5%. The investor would receive the 1.5% coupon but the coupon income would be supplemented since the dollars received will have a greater purchasing power. A 1.5% nominal yield with real income lift might turn out to be an excellent return in a deflationary environment. Contrarily, earnings growth is problematic in deflation. Businesses must cut expenses faster than the prices of goods or services fall. Firms do not have experience with such an environment because deflation episodes are infrequent. If this earnings squeeze eventuated, then a 1.5% nominal bond yield and 2.5% real yield might be very attractive versus equity returns.

Global Concerns

In our review of historical and present cases of over-indebtedness, we noticed some overlapping tendencies with less regularity that are important to mention.

First, when all major economies face severe debt overhangs, no one country is able to serve as the world’s engine of growth. This condition is just as much present today as it was in the 1920-30s.

Second, currency depreciations result as countries try to boost economic growth at the expense of others. Countries are forced to do this because monetary policy is ineffectual.

Third, devaluations do provide a lift to economic activity, but the benefit is only transitory because other countries that are on the losing end of the initial action retaliate. In the end every party is in worse condition, and the process destabilizes global markets.

Fourth, historically advanced economies have only cured over-indebtedness by a significant multi-year rise in the saving rate or austerity. Historically, austerity arose from one of the following: self-imposition, external demands or fortuitous circumstances.

Overview of Present Conditions

Our expectations for the economy in 2015 are that nominal GDP should grow no more than 3% this year. M2 appears to be expanding around a 6% rate, and velocity is falling at a trend rate of 3%. The risk is that velocity will be even weaker this year; thus, 3% nominal GDP growth may be too optimistic. The ratio of public and private debt to GDP rose last year and economic growth softened. The budget deficit was lower in 2014 than 2013, but gross government debt rose again last year and a further increase is likely in 2015. This is not a positive signpost for velocity. The slower pace in nominal GDP in 2015 would continue the pattern of the past two years when nominal GDP decelerated from 4.6% in 2013 to 3.7% in 2014 on a fourth quarter to fourth quarter basis. Such slow top line growth suggests that both real growth and inflation should be slower than last year.

Many factors can cause intermittent increases in Treasury yields, but economic and inflation fundamentals are too weak for yields to remain elevated. Therefore, the environment for holding long-term Treasury bond positions should be most favorable in 2015.

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

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

Important Disclosures

Outside the Box: Germany’s Trade Surplus Is a Problem

 

In Code Red I wrote a great deal about trade imbalances among the various European countries, which were at the heart of the European sovereign debt problem. As the peripheral countries have tried to rebalance their trade deficits with Northern Europe and especially with Germany, they have seen their relative wages fall and deflation become a problem. Greece is the poster child.

The north-south imbalance in the Eurozone is still a problem today. In this week’s Outside the Box, I highlight a recent blog on that topic from none other than former Fed Chairman Ben Bernanke. He first published his blog on March 30, and it appears he is going to post to three times a week. It’s a very thoughtful commentary, and I will admit to having subscribed. He is going back to his “professor” style and communicates very clearly.

I find it useful to get a handle on what the economic elite are thinking and discussing, and Bernanke’s blog is going to be one of the ways I can keep up. His ongoing debate with Larry Summers over secular stagnation is fascinating, although I think they both miss the point on structural growth. Monetary policy and fiscal policy lag behind other drivers of growth in terms of importance.

That fact was brought home to me at lunch today, when Woody Brock met me over at Ocean Prime for some fish and wisdom. Woody is simply one of the smartest economists on the planet and knows the gamut of the literature as well as anyone. “It’s the incentive structure that is the driver,” he told me; “that’s what I was trying to explain in my recent debate with Larry Summers.” There are times when I wish I could just be a fly on the wall, and that would have been one of them.

Everyone responds to incentives, no matter what the country or type of government. Setting incentives to maximize entrepreneurial activity will produce the most growth and jobs. Of course, it is always a balancing act.

It is my day for friends coming to Dallas. Tonight Steve Moore (WSJ and now with the Heritage Foundation) is in town for a speech, and he is hanging around to go to the Dallas Mavericks game with me. We’ll talk productivity and politics over steaks at Nick and Sam’s before we head to the game and again after the game at his hotel, where, randomly, my doctor, Mike Roizen (chief wellness officer at the Cleveland Clinic) is also staying the night for a speech. So a little health and politics late at night. What a great day.

You have a great week as well, and think through what Bernanke is saying. Do you really think Germany will follow through on his suggestions, as reasonable as they are? Me neither. Europe is well and truly hosed. They have just not figured out yet that they need to hit the reset button. Not just on monetary or fiscal policy (which are secondary), but on the entire incentives (regulations and labor-reform) environment.

Your incentivized to give you the best I can analyst,

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

 

Stay Ahead of the Latest Tech News and Investing Trends…

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.


Germany’s Trade Surplus Is a Problem

By Ben S. Bernanke
April 3, 2015

In a few weeks, the International Monetary Fund and other international groups, such as the G20, will meet in Washington. When I attended such international meetings as Fed chairman, delegates discussed at length the issue of “global imbalances”—the fact that some countries had large trade surpluses (exports much greater than imports) and others (the United States in particular) had large trade deficits. (My recent post discusses the implications of global imbalances from a savings and investment perspective.) China, which kept its exchange rate undervalued to promote exports, came in for particular criticism for its large and persistent trade surpluses.

However, in recent years China has been working to reduce its dependence on exports and its trade surplus has declined accordingly. The distinction of having the largest trade surplus, both in absolute terms and relative to GDP, is shifting to Germany. In 2014, Germany’s trade surplus was about $250 billion (in dollar terms), or almost 7 percent of the country’s GDP. That continues an upward trend that’s been going on at least since 2000 (see below).

Why is Germany’s trade surplus so large? Undoubtedly, Germany makes good products that foreigners want to buy. For that reason, many point to the trade surplus as a sign of economic success. But other countries make good products without running such large surpluses. There are two more important reasons for Germany’s trade surplus.

First, although the euro—the currency that Germany shares with 18 other countries—may (or may not) be at the right level for all 19 euro-zone countries as a group, it is too weak (given German wages and production costs) to be consistent with balanced German trade. In July 2014, the IMF estimated that Germany’s inflation-adjusted exchange rate was undervalued by 5-15 percent (see IMF, p. 20). Since then, the euro has fallen by an additional 20 percent relative to the dollar. The comparatively weak euro is an underappreciated benefit to Germany of its participation in the currency union. If Germany were still using the deutschemark, presumably the DM would be much stronger than the euro is today, reducing the cost advantage of German exports substantially.

Second, the German trade surplus is further increased by policies (tight fiscal policies, for example) that suppress the country’s domestic spending, including spending on imports.

In a slow-growing world that is short aggregate demand, Germany’s trade surplus is a problem. Several other members of the euro zone are in deep recession, with high unemployment and with no “fiscal space” (meaning that their fiscal situations don’t allow them to raise spending or cut taxes as a way of stimulating domestic demand). Despite signs of recovery in the United States, growth is also generally slow outside the euro zone. The fact that Germany is selling so much more than it is buying redirects demand from its neighbors (as well as from other countries around the world), reducing output and employment outside Germany at a time at which monetary policy in many countries is reaching its limits.

Persistent imbalances within the euro zone are also unhealthy, as they lead to financial imbalances as well as to unbalanced growth. Ideally, declines in wages in other euro-zone countries, relative to German wages, would reduce relative production costs and increase competitiveness. And progress has been made on that front. But with euro-zone inflation well under the European Central Bank’s target of “below but close to 2 percent,” achieving the necessary reduction in relative costs would probably require sustained deflation in nominal wages outside Germany—likely a long and painful process involving extended high unemployment.

Systems of fixed exchange rates, like the euro union or the gold standard, have historically suffered from the fact that countries with balance of payments deficits come under severe pressure to adjust, while countries with surpluses face no corresponding pressure. The gold standard of the 1920s was brought down by the failure of surplus countries to participate equally in the adjustment process. As the IMF also recommended in its July 2014 report, Germany could help shorten the period of adjustment in the euro zone and support economic recovery by taking steps to reduce its trade surplus, even as other euro-area countries continue to reduce their deficits.

Germany has little control over the value of the common currency, but it has several policy tools at its disposal to reduce its surplus—tools that, rather than involving sacrifice, would make most Germans better off. Here are three examples.

  1. Investment in public infrastructure. Studies show that the quality of Germany’s infrastructure—roads, bridges, airports—is declining, and that investment in improving the infrastructure would increase Germany’s growth potential. Meanwhile, Germany can borrow for ten years at less than one-fifth of one percentage point, which, inflation-adjusted, corresponds to a negative real rate of interest. Infrastructure investment would reduce Germany’s surplus by increasing domestic income and spending, while also raising employment and wages.
     
  2. Raising the wages of German workers. German workers deserve a substantial raise, and the cooperation of the government, employers, and unions could give them one. Higher German wages would both speed the adjustment of relative production costs and increase domestic income and consumption. Both would tend to reduce the trade surplus.
     
  3. Germany could increase domestic spending through targeted reforms, including for example increased tax incentives for private domestic investment; the removal of barriers to new housing construction; reforms in the retail and services sectors; and a review of financial regulations that may bias German banks to invest abroad rather than at home.

Seeking a better balance of trade should not prevent Germany from supporting the European Central Bank’s efforts to hit its inflation target, for example, through its recently begun quantitative easing program. It’s true that easier monetary policy will weaken the euro, which by itself would tend to increase rather than reduce Germany’s trade surplus. But more accommodative monetary policy has two offsetting advantages: First, higher inflation throughout the euro zone makes the adjustment in relative wages needed to restore competitiveness easier to achieve, since the adjustment can occur through slower growth rather than actual declines in nominal wages; and, second, supportive monetary policies should increase economic activity throughout the euro zone, including in Germany.

I hope participants in the Washington meetings this spring will recognize that global imbalances are not only a Chinese and American issue.

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

Important Disclosures

Outside the Box: Germany’s Trade Surplus Is a Problem

 

In Code Red I wrote a great deal about trade imbalances among the various European countries, which were at the heart of the European sovereign debt problem. As the peripheral countries have tried to rebalance their trade deficits with Northern Europe and especially with Germany, they have seen their relative wages fall and deflation become a problem. Greece is the poster child.

The north-south imbalance in the Eurozone is still a problem today. In this week’s Outside the Box, I highlight a recent blog on that topic from none other than former Fed Chairman Ben Bernanke. He first published his blog on March 30, and it appears he is going to post to three times a week. It’s a very thoughtful commentary, and I will admit to having subscribed. He is going back to his “professor” style and communicates very clearly.

I find it useful to get a handle on what the economic elite are thinking and discussing, and Bernanke’s blog is going to be one of the ways I can keep up. His ongoing debate with Larry Summers over secular stagnation is fascinating, although I think they both miss the point on structural growth. Monetary policy and fiscal policy lag behind other drivers of growth in terms of importance.

That fact was brought home to me at lunch today, when Woody Brock met me over at Ocean Prime for some fish and wisdom. Woody is simply one of the smartest economists on the planet and knows the gamut of the literature as well as anyone. “It’s the incentive structure that is the driver,” he told me; “that’s what I was trying to explain in my recent debate with Larry Summers.” There are times when I wish I could just be a fly on the wall, and that would have been one of them.

Everyone responds to incentives, no matter what the country or type of government. Setting incentives to maximize entrepreneurial activity will produce the most growth and jobs. Of course, it is always a balancing act.

It is my day for friends coming to Dallas. Tonight Steve Moore (WSJ and now with the Heritage Foundation) is in town for a speech, and he is hanging around to go to the Dallas Mavericks game with me. We’ll talk productivity and politics over steaks at Nick and Sam’s before we head to the game and again after the game at his hotel, where, randomly, my doctor, Mike Roizen (chief wellness officer at the Cleveland Clinic) is also staying the night for a speech. So a little health and politics late at night. What a great day.

You have a great week as well, and think through what Bernanke is saying. Do you really think Germany will follow through on his suggestions, as reasonable as they are? Me neither. Europe is well and truly hosed. They have just not figured out yet that they need to hit the reset button. Not just on monetary or fiscal policy (which are secondary), but on the entire incentives (regulations and labor-reform) environment.

Your incentivized to give you the best I can analyst,

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

 

Stay Ahead of the Latest Tech News and Investing Trends…

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.


Germany’s Trade Surplus Is a Problem

By Ben S. Bernanke
April 3, 2015

In a few weeks, the International Monetary Fund and other international groups, such as the G20, will meet in Washington. When I attended such international meetings as Fed chairman, delegates discussed at length the issue of “global imbalances”—the fact that some countries had large trade surpluses (exports much greater than imports) and others (the United States in particular) had large trade deficits. (My recent post discusses the implications of global imbalances from a savings and investment perspective.) China, which kept its exchange rate undervalued to promote exports, came in for particular criticism for its large and persistent trade surpluses.

However, in recent years China has been working to reduce its dependence on exports and its trade surplus has declined accordingly. The distinction of having the largest trade surplus, both in absolute terms and relative to GDP, is shifting to Germany. In 2014, Germany’s trade surplus was about $250 billion (in dollar terms), or almost 7 percent of the country’s GDP. That continues an upward trend that’s been going on at least since 2000 (see below).

Why is Germany’s trade surplus so large? Undoubtedly, Germany makes good products that foreigners want to buy. For that reason, many point to the trade surplus as a sign of economic success. But other countries make good products without running such large surpluses. There are two more important reasons for Germany’s trade surplus.

First, although the euro—the currency that Germany shares with 18 other countries—may (or may not) be at the right level for all 19 euro-zone countries as a group, it is too weak (given German wages and production costs) to be consistent with balanced German trade. In July 2014, the IMF estimated that Germany’s inflation-adjusted exchange rate was undervalued by 5-15 percent (see IMF, p. 20). Since then, the euro has fallen by an additional 20 percent relative to the dollar. The comparatively weak euro is an underappreciated benefit to Germany of its participation in the currency union. If Germany were still using the deutschemark, presumably the DM would be much stronger than the euro is today, reducing the cost advantage of German exports substantially.

Second, the German trade surplus is further increased by policies (tight fiscal policies, for example) that suppress the country’s domestic spending, including spending on imports.

In a slow-growing world that is short aggregate demand, Germany’s trade surplus is a problem. Several other members of the euro zone are in deep recession, with high unemployment and with no “fiscal space” (meaning that their fiscal situations don’t allow them to raise spending or cut taxes as a way of stimulating domestic demand). Despite signs of recovery in the United States, growth is also generally slow outside the euro zone. The fact that Germany is selling so much more than it is buying redirects demand from its neighbors (as well as from other countries around the world), reducing output and employment outside Germany at a time at which monetary policy in many countries is reaching its limits.

Persistent imbalances within the euro zone are also unhealthy, as they lead to financial imbalances as well as to unbalanced growth. Ideally, declines in wages in other euro-zone countries, relative to German wages, would reduce relative production costs and increase competitiveness. And progress has been made on that front. But with euro-zone inflation well under the European Central Bank’s target of “below but close to 2 percent,” achieving the necessary reduction in relative costs would probably require sustained deflation in nominal wages outside Germany—likely a long and painful process involving extended high unemployment.

Systems of fixed exchange rates, like the euro union or the gold standard, have historically suffered from the fact that countries with balance of payments deficits come under severe pressure to adjust, while countries with surpluses face no corresponding pressure. The gold standard of the 1920s was brought down by the failure of surplus countries to participate equally in the adjustment process. As the IMF also recommended in its July 2014 report, Germany could help shorten the period of adjustment in the euro zone and support economic recovery by taking steps to reduce its trade surplus, even as other euro-area countries continue to reduce their deficits.

Germany has little control over the value of the common currency, but it has several policy tools at its disposal to reduce its surplus—tools that, rather than involving sacrifice, would make most Germans better off. Here are three examples.

  1. Investment in public infrastructure. Studies show that the quality of Germany’s infrastructure—roads, bridges, airports—is declining, and that investment in improving the infrastructure would increase Germany’s growth potential. Meanwhile, Germany can borrow for ten years at less than one-fifth of one percentage point, which, inflation-adjusted, corresponds to a negative real rate of interest. Infrastructure investment would reduce Germany’s surplus by increasing domestic income and spending, while also raising employment and wages.
     
  2. Raising the wages of German workers. German workers deserve a substantial raise, and the cooperation of the government, employers, and unions could give them one. Higher German wages would both speed the adjustment of relative production costs and increase domestic income and consumption. Both would tend to reduce the trade surplus.
     
  3. Germany could increase domestic spending through targeted reforms, including for example increased tax incentives for private domestic investment; the removal of barriers to new housing construction; reforms in the retail and services sectors; and a review of financial regulations that may bias German banks to invest abroad rather than at home.

Seeking a better balance of trade should not prevent Germany from supporting the European Central Bank’s efforts to hit its inflation target, for example, through its recently begun quantitative easing program. It’s true that easier monetary policy will weaken the euro, which by itself would tend to increase rather than reduce Germany’s trade surplus. But more accommodative monetary policy has two offsetting advantages: First, higher inflation throughout the euro zone makes the adjustment in relative wages needed to restore competitiveness easier to achieve, since the adjustment can occur through slower growth rather than actual declines in nominal wages; and, second, supportive monetary policies should increase economic activity throughout the euro zone, including in Germany.

I hope participants in the Washington meetings this spring will recognize that global imbalances are not only a Chinese and American issue.

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

Important Disclosures

Thoughts from the Frontline: Economists in Glass Houses

 

For many economists, the chicken and egg question is, which came first, consumption or production? What drives growth? Let’s continue with our series on debt, in which I have been contrasting my views with those of Paul Krugman.

Our differences aside, what Paul and I readily agree on is that the solution to our current economic dilemma is more and higher-quality growth. There is nothing like 5–7% nominal growth to tackle a problem of too much debt. And if the real growth is 3–4%, then so much better, as employment and wages will rise as well. But what drives growth? That’s actually a complex question with multiple answers. There is simply no one magic policy that you can pursue that is sufficient in and of itself to create growth. I would think Krugman and I also would agree that the stimulation of growth requires a whole bunch of smart policies, and we would likely agree on what some of those policies should be. Our policy disagreement stems from our differing views on fundamental economic questions as opposed to any simplistic analysis of today’s numbers.

Economists in Glass Houses

Last week we looked at some of the differences between Paul’s presuppositions and mine, presuppositions that most people might think of as being more philosophical than analytical in nature. That letter generated more response than any other letter I’ve written in a very long time. Most of the comments were really very thoughtful, and I appreciate them. We’re going to look at one reply in particular, because the writer offers legitimate criticisms and asks a number of questions that I believe deserve answers – and these are questions I get everywhere I go. Let’s look at the comment from Thomas Willisch:

Hi John: There is a saying: let those who live in glass houses not throw the first stone. Does either Paul Krugman or you live in a glass house? First, it is important to understand why Paul, and others of his economic point of view, believe that taking on additional debt in the form of fiscal stimulus is desirable when the private sector is in severe economic contraction. Then we will be in position to determine whether the argument in favor of such is compelling or weak. You look to answer this question but I don’t believe really so. Pointing to Paul’s supposed presuppositional preference for government or contentions about the significance of owing money to ourselves does not really answer the question.

Among others, Paul’s arguments – semi mock him as “Homo neo-keynesianis” if you wish, but please interact with the substance of his central arguments – are that the accumulation of additional debt in fiscal stimulus is an effective temporary tool to stave off a much deeper economic collapse when widespread private consumption and investment have fallen off a cliff and unemployment is skyrocketing. In times of recovery, when stimulus should be reigned in (and Paul does believe stimulus should be reigned in in these circumstances), the burden of the debt stabilizes and eventually shrinks relative to the resulting higher GDP, potentially more so than would have been the case with less aggregate debt absent the stimulus but debt measured against collapsed tax receipts and collapsed GDP. Paul lays out his arguments in chapter and verse, in books and in peer reviewed economic papers, with much greater depth and expertise than I can pretend to do in a paragraph quickly written here. In important respects your and Paul’s views overlap, for example in your mention of the value of government infrastructure spending and scientific research, both of which Paul strongly supports, yet which your Republican party constantly undermines.

On the other side of the coin, my second point is that, in order to fairly weigh whether you live in more or less of a glass house than Paul, we first must know what your policy response would have been as opposed to Paul’s in response to the collapse of the Great Recession. While criticizing Paul, you continue to not clearly articulate his own policy recommendation, here or in prior newsletters. Saying that “too much” debt is undesirable and countries tend to eventually default when debt becomes too high, while true with the caveat of properly nuanced context, is hardly explicatory enough. Nor does it weigh against the alternatives from which some course of action had to be selected. Do you believe there should have been no fiscal stimulus? What should have taken its place? For how long? Do you believe in “expansionary austerity”? Should the economy have been allowed to completely implode and unemployment skyrocket much higher than it actually did, in the name of letting the private sector have its just dessert?

Paul’s argument is that there is a time when government intervention is necessary in order to stave off an economic collapse brought on by the private sector, because such collapse would be enormously deeper and impoverish many more people in its wake without the government intervention the nature of which he has detailed. John, what was your prescription, so that it can be set beside Paul’s? Once your own solution to how the 2008 downturn should have been met is cogently presented, readers should study Paul for themselves, not just encounter him through the eyes of an opponent (never a good approach in any intellectual debate), and also study Richard Koo’s books on balance sheet recessions for one, then decide whose house is made of what.

The Purpose of a Central Bank

Thomas, thanks for your comments, and I appreciate you outlining Krugman’s basic views so succinctly. Let me answer your second point first, as I think doing so will lead naturally into a response to your first point. (Readers please note that this is a short answer laying out principles that I would adhere to, rather than a full treatise.)

I’ve been quite clear over the years that I believe the primary purpose of a central bank, other than its mundane purpose as a clearing house, is to provide liquidity in times of a liquidity crisis. Central banks should follow Bagehot’s rule, which can be summarized as: “Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”

A little history lesson is in order, from Kurt Schuler, writing at Alt-M:

Walter Bagehot (1826-1877) was the most famous editor of The Economist. (His last name, by the way, is pronounced “BADGE-it.”) For his wisdom on financial matters, he was dubbed “the spare chancellor,” a reference to the Chancellor of the Exchequer, the British minister of finance. His book Lombard Street (1873), named after the English equivalent of Wall Street, criticized the Bank of England for not using its powers to alleviate financial crises. Bagehot argued that the Bank’s monopoly position gave it both the responsibility and the ability to do so, and that the Bank should not conduct itself as if it were an ordinary commercial bank. For its explanation of how the Bank of England should act, Lombard Street became the foundation document of modern central banking. (Schuler)

The causes of the Great Recession were many, and there were numerous culprits. Many, but by no means all, of the problems can be laid at the feet of government. However, that does not answer your question as to what we should do when we find ourselves in a crisis. I believe it was entirely appropriate for the Federal Reserve to step in and provide liquidity. As odious as it was, the Fed had to bail out the banks; or, as you say, the system would have collapsed. I would have wiped out shareholders of the major insolvent banks along with investors in junior debt, rather than bail them out. Because of the peculiar situation of senior debt in US banking, it would probably have cost as much or more to wipe out those who held it as it would to simply guarantee it, and failure to cover it would have potentially posed even greater systemic risk. Still, I would have had to hold my nose while covering it. The four or five banks that would have been taken over took on 30:1 leverage with the permission of the government. Clearly that was unwise, and to bail out management and investors, let alone reward them for imprudent decisions, is not proper.

That said, a complete guarantee of bank deposits had to be made. Otherwise we would have fallen into the abyss. The insolvent banks should have been recapitalized and sold by the FDIC, just as every insolvent bank has been for the last 50 years. It is likely that the FDIC would have been forced to break up the banks into smaller pieces in order for them to be absorbed and sold. If we had done that, we would probably not now have five even larger banks posing systemic risk.

On a side note, I had a lengthy conversation a few years ago with current Speaker of the House John Boehner. It was his forcefully argued view that his big mistake was to bail out the banks and their shareholders. When asked what he would do next time, he very graphically (in his colorful style) stated that shareholders and bank management operated at their own risk.

As to whether I would favor stimulus, that is a more nuanced question. Of course we maintain a safety net for individuals and families who fall on hard times, and that commitment certainly increases the deficit significantly. Much of the other stimulus that we did provide was generally a waste. It financed current consumption but provided no longer-term value.

As you noted, I would be in favor, if it were necessary, of providing stimulus for the funding of infrastructure projects during a recession. A couple of thoughts on that process. Even though we are some two to three trillion dollars behind in maintaining our nation’s core infrastructure, there were distressingly few “shovel-ready” projects available at the time of the Great Recession. Let me think outside my conservative box for a moment and offer the following possibilities.

There is always another recession in our future; we just don’t know when it will hit. When it does, it will in fact reduce GDP and increase unemployment. Further, we know that we need to spend several trillion dollars on infrastructure upgrades in the coming decades. The reigning economic paradigm suggests that we need to “lean against” a recession by spending money. If that is the case, then let’s at least spend the money to get something that will be useful to our kids, since, when they grow up to be taxpayers, they will be paying part of that money back.

I would suggest that Congress today allocate $250 million (or whatever makes sense) of matching funds for infrastructure planning projects. Cities, counties, and states could access these funds for the planning required to refurbish their infrastructure: water systems, power grids, bridges, roads, etc. Then, when we do in fact hit the next recession, there will be an adequate number of shovel-ready projects. Congress can decide how much to allocate to implement those projects and determine what projects should take priority. Congress can even authorize the Federal Reserve to use quantitative easing if it so desires to help fund the projects.

Any such projects could be financed at low rates for 40 years and would require the borrowing entities to pay off the bonds during those 40 years. Congressional approval for such bonds should require a 60% supermajority. (For the record, Thomas, I’m in favor of a balanced-budget amendment that would require 60% supermajority approval to run a deficit. I would also like to see an amendment that would require a 60% supermajority to raise taxes.)

The Keynesian Conundrum

And that brings us to what I call the “Keynesian Conundrum,” which is at the heart of your first question. John Keynes suggested running deficits in times of recession but also advocated paying down that debt after a recession is over. I could get my head around that if I could ever get someone on the Keynesian side to say when exactly it is time to pay the debt back. Mr. Krugman, while giving lip service to paying the debt back, never actually articulates what that process would look like. To pay the debt back, you have to run surpluses or, at a very minimum, run deficits that are less than nominal GDP, so that the debt relative to the size of GDP is reduced.

I want to express a large quibble. People are constantly writing me and talking about “your Republicans” doing this or that as if somehow or another I approve of all things done by Republican officeholders. Let me state once again that I believe that what the second Bush administration did was categorically, unequivocally, emphatically wrong. We wasted the budget compromise of the Clinton/Gingrich years, which was actually paying down the debt. If we had continued to hold the line on spending, we would have gone into the Great Recession with very little debt, and a stimulus of a few trillion dollars here or there would not have done much damage. We have now run up a truly massive debt; and if we were to run into another recession, the felt need would be to run up even more debt, well past the 100% of GDP range.

We are not now in recession, yet Krugman argues that to hold the line on spending is somehow a resumption of what he calls austerity. I call it living with a budget. Running a surplus certainly did not hurt the economy during the late ’90s. We had a recession in the 2000s because of a stock market bubble collapsing. That collapse was compounded by 9/11. That recession had nothing to do with budget surpluses or “austerity.” If the United States were now to freeze spending for a few years, we would once again be back in balance. There is nothing austere about the size of our federal government.

Yes, the deficits have been coming down, and that is a good thing. But that misses the point. We could have easily afforded the deficit spending we incurred during the Great Recession if we had gone into the recession with little or no debt. There has to be some type of disciplined process to keep a country from accumulating too much debt. Generally, the process is the market itself, which begins to ask for higher interest rates for perceived risk. Of course the United States could run more debt than any other country, because we are not perceived as being a risk. But just because we can run up a large debt doesn’t mean we should.

As the McKinsey report I cited last week demonstrates and a large body of other research confirms, outsized debt at some point becomes a drag on growth. Just because we aren’t there yet doesn’t mean it’s okay to pile up debt until we stop growing.

At a certain size relative to the ability to pay, debt is like a black hole. If it gets too big, it sucks in everything around it.

What Drives Growth?

“High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions.”

– The McKinsey Institute, “Debt and (not much) deleveraging

In very simplistic terms, Keynesians today assume that consumption is the driver of the economy. For them, it is all about empowering the consumer, even if consumption is driven by debt, whether the debt is absorbed by individuals or created (more preferably in their view) by the government.

Thus, they perceive that the remedy to a recession is to run deficits in order to increase consumption, which will stimulate production, which will create jobs.

On the other side of the economic fence, “Austrian” economist Friedrich Hayek asserted that it is actually production that stimulates the economy and drives consumption. An entrepreneur sees a need and figures out a way to fulfill that need. It may even be a need that no one realizes they have until they see the product that addresses it. For Hayek it is production that sets the wheels of the economy spinning, and increased production comes about because of innovation and free capital markets. Economic cause and effect become far more complicated than that very quickly as you drill down into actual history and real data. Schumpeter took our understanding further with his research on creative destruction and the process of competition.

The next graph shows the rise of global economic growth in recent centuries, and the following one depicts per capita GDP in certain Asian countries compared to the US. I don’t think there’s any dispute that it was not an increase in government spending or consumption but rather it was innovation and enhanced production that drove the remarkable growth of GDP that we’ve seen in the last 250 years.

Niall Ferguson ascribes that growth to what he calls the “six killer apps of prosperity”:

1. competition
2. the scientific revolution
3. property rights
4. modern medicine
5. the consumer society
6. the work ethic

(You can see his quite revolutionary and unsettling Ted talk here.)

Ferguson’s first app is competition. You asked me if I believe in “expansionary austerity.” I guess we have to lay out definitions. I’ve already said that we do not need budget deficits in order to create an expansion in GDP. What is being tried in Europe (and is ridiculed as expansionary austerity), has nothing to do with expansion and everything to do with dealing with debt.

Austerity didn’t work in Greece not because they didn’t spend enough money but because the country itself is riddled with impediments to competition. Government has locked in numerous duopolies and erects all kinds of impediments in the way of launching new businesses. Greece is the ultimate in crony capitalism. Further, government direct participation is a huge drag on the economy. Greece has one of the most inefficient governments in the developed world. When I was there a few years ago, literally half of the country’s workers simply did no work; they just took checks as cogs in a system where politicians procured jobs for friends and relatives as favors for their votes and financial support. Taxes aren’t collected, books aren’t balanced – I could go on and on, but the incompetence of Greek government is legendary. Borrowing more money to spend on such inefficiency does nothing to increase GDP.

There will be no economic renaissance in Greece (or in any part of peripheral Europe for that matter) unless there are true labor reforms, a radical reorganization of the government, a complete overhaul of the regulatory environment, and an end to allowing government to favor certain businesses. Growth comes in very great part from innovative, competitive private production, but government can inhibit the environment for the growing of new businesses, which are the wellspring of growth. Eurozone rules and regulations stifle growth at every turn.

I could go on and on about Greece, but running large budget deficits will not solve their problems. The irony is that the majority of Greeks believe in the need for reform (a common belief in Europe). The Greeks are an inherently entrepreneurial people; it’s just that their entrepreneurs have migrated to other countries (to the great benefit of America and the rest of the world). Now, the Greeks want the rest of Europe to continue to lend them money that cannot be paid back so they can maintain their lifestyles without having to reform their economy. Yes, they offer token reforms but nothing that gets to the real issues. And the rest of Europe doesn’t want to press them too much on the real issues because they have the same problems in their own countries.

It does no good to balance a budget when competition and productivity are not allowed to flourish. For that matter it does no good to run a deficit under the same conditions, because eventually you will pile up an unsustainable amount of debt.

Sad to say, but much of Europe is well and truly hosed (a technical economics term) until they reform their labor markets and regulatory environment. The Greek crisis is just the opening act in what will be a long-running and intensifying drama.

Since you want to know what policies I would like to see enacted, Thomas, I can tell you that I am working on a short op-ed-type essay with Steve Moore (formerly of the Wall Street Journal and now with the Heritage Foundation), outlining a specific set of guidelines for serious reform of the regulatory process (across all industries and services), a radical restructuring of the tax code, and an overhaul of the bureaucracy. We have allowed our economy to be overwhelmed by a mishmash of bureaucratic policies, almost every one of which some interest group will push hard to keep. There will be something in our essay that is guaranteed to upset nearly everyone.

When GDP figures come out in a month, we’re going to learn that the first quarter was weak. I wrote last year, as oil prices were collapsing, that they would have a significant impact on the growth of the US economy. Without the growth that has comes from the revolution in US oil production, our GDP in the first half of this decade would have looked more like that of Europe. Now, with oil prices in the dumps, we’re about to find out how true that is.

This last chart is one of the most alarming I’ve seen in years. It’s from a May 2014 study by the Brookings Institution. The authors found declining business dynamism across all regions and states. It is difficult to imagine sustained economic growth if this trend is not reversed.          

It’s time to close out this week’s look at debt, but before I hit the send button I want to talk about a very special friend and a powerful new book I’m reading.

The Last Warrior

Remember those picture problems we had to solve when we were in elementary school? They would give us six pictures and ask us, which one doesn’t belong? I often feel like that odd picture, out of place but still on the page. There are moments when I feel like I’m really living in a dream, that I will wake up and find myself back in some mundane existence. Lately (in the past few years) I have often found myself in the company of truly extraordinary people and later wondered why I have been privileged to be there.

A few weeks ago I was invited to a small reception in Washington DC for Andrew Marshall. Andy Marshall, 93½ years old, was director of the United States Department of Defense’s Office of Net Assessment, the Pentagon’s internal think tank, under 12 defense secretaries and 8 administrations. Appointed to the position in 1973 by President Richard Nixon, Marshall was reappointed by every president that followed. He is the longest-serving and oldest federal employee in history.

The reception was to honor him on his recent retirement. To say that he has been the most influential person in US defense and intelligence thinking in the last 50 years is no exaggeration. It is almost impossible to overstate his influence. He was at the heart of US nuclear strategy in the ’50s and ’60s and was the first to recognize that the CIA assessment of Russia was incorrect in the mid-’70s. He developed the concept of “net assessment,” and Nixon created an office in the Pentagon just for him to pursue that work. In the late ’80s, as we were still faced off with Russia (which is the stance he had urged in the ’70s), he began to beat the drum that China would be our chief preoccupation in the next decade.

In the ’80s he was beginning to talk about the need to shift to precision warfare. He saw that need before any of the generals did, as he has almost every other shift in weaponry. He was on top of everything. His sources were legendary. He is one of the most amazing futurists on the planet. He truly seems to possess the ability to tease out significant insights regarding the future direction not just of defense systems but also of markets and national trends from seemingly unrelated data. The Russians were obsessed with his thinking. Even the Chinese have officially recognized that he was “one of the most important and influential figures” in changing their thinking about defense in the 1990s and 2000s.

He has served both Republican and Democratic administrations, quietly and in the background. The strong odds are that you have never heard of him. But, no matter where you live in the world, you have been influenced by his thinking. And you have heard of the names of those who went to school at what is called “St. Andrews Prep.” As recently as 2012, Foreign Policy named Marshall among its “Top 100 Global Thinkers,” “for thinking way, way outside the Pentagon box.” Try being named a top global thinker at any time in your life, let alone at age 90 years.

I looked around the room at the reception and saw a lot of faces I recognized. Some were from the two weeklong summer events I participated in at the Naval War College, where we debated and theorized with Andy Marshall about possible contingent events that might happen to the United States in the future and how the country should prepare for the occurrence of non-consensus events.

As people were later introduced, though, I realized that I recognized only those associated with Republican administrations. Talk about a personal bias – there were probably as many people in attendance from Democratic administrations.

I recognized Vice-President Cheney, Paul Wolfowitz, and various secretaries, deputy secretaries, assistant secretaries, and deputy assistant secretaries of the Defense Department. As I was talking with Mr. Wolfowitz, he introduced me to Scooter Libby, whom I did not recognize, I’m embarrassed to say. Libby is a man who was as unjustly persecuted as any man in the history of this country, in my humble opinion. They couldn’t get to Cheney, so they went after Scooter for very obscure and who-gives-a-damn reasons. Collateral damage and all that. I hate that partisan bullshit, no matter which side shovels it on.

Andy Marshall, however, didn’t care what your politics were; he just wanted you to think about what was best for the country.

I’ve often been somewhat puzzled as to why Mr. Marshall invited me into his coterie. We initially met at two three-hour-long discussion groups where he listened to a number of economists and well-known money managers talk about the future of the world. Most were names you would recognize. I’m certainly not a name-brand economist, nor can I even rightly be called an economist – I’m more of a dilettante – but I got invited back for private meetings and then to additional meetings and to the weeks at the War College.

At the reception, one of the secretaries of defense, in noting the rather odd nature of the gathered group, said that Andy’s unique talent was in pulling together people with eclectic, if not downright eccentric,  thinking. There was a rather knowing laugh as everyone looked around and realized that the word eccentric defined those people in attendance they knew and maybe even themselves. Some of us were the people who helped Andy uncover obscure and counterintuitive facts and trends, and others were those he trained to use them in making assessments and charting strategy.

The next morning, Andy invited me to come by his apartment in Alexandria for a chat. Honored, I adjusted travel times and showed up on time. He started the conversation by reminding me that I had at one time asked him how he came to question the consensus thinking about the Soviet Union in the ’70s. He then proceeded to give me a tutorial on how to question orthodox thinking. His own investigation gave him facts that didn’t square with CIA thinking. “How did you know that?” I would ask. He would explain, and then like some five-year-old kid I would ask that question again and again, trying to understand how he came to the next insight. We kept deep diving until it became apparent that he was looking at some of the most obscure references and piecing together bits and pieces of information to complete a picture that nobody else saw. He referenced obscure German publications, interviews with the sons of Russian diplomats, and conversations with major and minor Russian leaders. He would commission studies of what it actually cost the Russians to build particular pieces of gear. For instance, Russian ferries were also designed as troop transport and military ships, with EMP-protected controls. That configuration drove the cost up and was not part of the CIA assessment. As it turned out, there was a lot the CIA missed. The actual cost of Soviet defense was double what the CIA thought. And the consensus Soviet GDP that not only the CIA but everybody else was operating by was actually 30 to 40% too high. Thus, in the mid-’70s Andy and then Secretary of Defense James Schlesinger began to realize that the Russians could not afford to keep up their massive defense spending.

“Aaah,” I said, “then you passed that information on to Reagan.” “No,” he said, “Reagan came to that conclusion on his own.” “Really?” I questioned. We went back and forth on how a Republican governor and former actor could arrive at such a non-consensus conclusion that was absolutely, totally correct. I kept insisting that somebody had to have given him an inside view. Andy confessed that he didn’t know how Reagan came to his conclusion, other than that he came into the White House with it. Remember, Andy served under every president from Truman onward and I assume was personally acquainted with every president after Nixon. Andy then told me that Scooter Libby was doing research and developing a paper on how Reagan came to that conclusion. It is truly one of the defining moments in American history and one that has remained a complete mystery, at least to me. Maybe the answer is as simple as that it was a presupposition: communists can’t win. I really want to get an early copy of Libby’s paper.

As we were wrapping up our talk, I looked over to Andy’s desk and saw a book titled The Last Warrior: Andrew Marshall and the Shaping of Modern American Defense Strategy. “When did this come out?” I asked him. “Last month,” he said.

It was his biography, which he had finally allowed to be published after he retired. He was gracious enough to autograph a copy for me, which I will proudly display in my library; but I immediately downloaded a copy to my Surface Pro on the subway ride back to Reagan Airport and began to read it on the plane. It is not a simple biography but rather an analysis of the intellectual journey of a man who came of age in the ’40s and who learned to question orthodox thinking in a manner that nobody had done before. He literally invented new forms of analysis. The book is causing me to rethink my approach to analyzing data and how it impacts our view of the future. It is a total mental reset. I’m going to have to make another trip to Washington DC for a few follow-up questions.

For the record, the title The Last Warrior is not a description of Andy’s personality, which is as decidedly low-key and non-combative as that of any person I’ve met. He is truly an analytical thinker with a quiet, thoughtful demeanor. I don’t think of the word warrior when I think of Andy. But he was part of what Tom Brokaw called “the Greatest Generation,” and at almost 94 he is truly one of the Last Warriors. Even today, he still goes in to the office a few days a week. I am honored to call him friend.

San Diego, Raleigh, and Atlanta

I am home for the next few weeks, except for some short personal one-day trips, getting a new speech ready for the Strategic Investment Conference at the end of the month. Then later in May I will do a speech at the Investors Institute in Raleigh before going to a Galectin Therapeutics board meeting in Atlanta. Right now there is a potential for a few days in New York City before I head up to Maine in early June for another presentation.

I was greatly saddened to get the news last night that my friend Kiron Sarkar passed away while he was visiting his home in India. I have used his work frequently in this letter and Over My Shoulder and have been corresponding with him several times a week for the past few years on various aspects of markets and investments. He was wise counsel and always a source of great insights. He will be missed.

It is time to hit the send button. I hope your week is going well.

Your wondering if I can work till I’m 93 analyst,

John Mauldin
subscribers@mauldineconomics.com

Thoughts from the Frontline: Economists in Glass Houses

 

For many economists, the chicken and egg question is, which came first, consumption or production? What drives growth? Let’s continue with our series on debt, in which I have been contrasting my views with those of Paul Krugman.

Our differences aside, what Paul and I readily agree on is that the solution to our current economic dilemma is more and higher-quality growth. There is nothing like 5–7% nominal growth to tackle a problem of too much debt. And if the real growth is 3–4%, then so much better, as employment and wages will rise as well. But what drives growth? That’s actually a complex question with multiple answers. There is simply no one magic policy that you can pursue that is sufficient in and of itself to create growth. I would think Krugman and I also would agree that the stimulation of growth requires a whole bunch of smart policies, and we would likely agree on what some of those policies should be. Our policy disagreement stems from our differing views on fundamental economic questions as opposed to any simplistic analysis of today’s numbers.

Economists in Glass Houses

Last week we looked at some of the differences between Paul’s presuppositions and mine, presuppositions that most people might think of as being more philosophical than analytical in nature. That letter generated more response than any other letter I’ve written in a very long time. Most of the comments were really very thoughtful, and I appreciate them. We’re going to look at one reply in particular, because the writer offers legitimate criticisms and asks a number of questions that I believe deserve answers – and these are questions I get everywhere I go. Let’s look at the comment from Thomas Willisch:

Hi John: There is a saying: let those who live in glass houses not throw the first stone. Does either Paul Krugman or you live in a glass house? First, it is important to understand why Paul, and others of his economic point of view, believe that taking on additional debt in the form of fiscal stimulus is desirable when the private sector is in severe economic contraction. Then we will be in position to determine whether the argument in favor of such is compelling or weak. You look to answer this question but I don’t believe really so. Pointing to Paul’s supposed presuppositional preference for government or contentions about the significance of owing money to ourselves does not really answer the question.

Among others, Paul’s arguments – semi mock him as “Homo neo-keynesianis” if you wish, but please interact with the substance of his central arguments – are that the accumulation of additional debt in fiscal stimulus is an effective temporary tool to stave off a much deeper economic collapse when widespread private consumption and investment have fallen off a cliff and unemployment is skyrocketing. In times of recovery, when stimulus should be reigned in (and Paul does believe stimulus should be reigned in in these circumstances), the burden of the debt stabilizes and eventually shrinks relative to the resulting higher GDP, potentially more so than would have been the case with less aggregate debt absent the stimulus but debt measured against collapsed tax receipts and collapsed GDP. Paul lays out his arguments in chapter and verse, in books and in peer reviewed economic papers, with much greater depth and expertise than I can pretend to do in a paragraph quickly written here. In important respects your and Paul’s views overlap, for example in your mention of the value of government infrastructure spending and scientific research, both of which Paul strongly supports, yet which your Republican party constantly undermines.

On the other side of the coin, my second point is that, in order to fairly weigh whether you live in more or less of a glass house than Paul, we first must know what your policy response would have been as opposed to Paul’s in response to the collapse of the Great Recession. While criticizing Paul, you continue to not clearly articulate his own policy recommendation, here or in prior newsletters. Saying that “too much” debt is undesirable and countries tend to eventually default when debt becomes too high, while true with the caveat of properly nuanced context, is hardly explicatory enough. Nor does it weigh against the alternatives from which some course of action had to be selected. Do you believe there should have been no fiscal stimulus? What should have taken its place? For how long? Do you believe in “expansionary austerity”? Should the economy have been allowed to completely implode and unemployment skyrocket much higher than it actually did, in the name of letting the private sector have its just dessert?

Paul’s argument is that there is a time when government intervention is necessary in order to stave off an economic collapse brought on by the private sector, because such collapse would be enormously deeper and impoverish many more people in its wake without the government intervention the nature of which he has detailed. John, what was your prescription, so that it can be set beside Paul’s? Once your own solution to how the 2008 downturn should have been met is cogently presented, readers should study Paul for themselves, not just encounter him through the eyes of an opponent (never a good approach in any intellectual debate), and also study Richard Koo’s books on balance sheet recessions for one, then decide whose house is made of what.

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: Central Banks, Credit Expansion, and the Importance of Being Impatient

 

We live in a time of unprecedented financial repression. As I have continued writing about this, I have become increasingly angry about the fact that central banks almost everywhere have decided to address the economic woes of the world by driving down the returns on the savings of those who can least afford it – retirees and pensioners.

This week’s Outside the Box, from my good friend Chris Whalen of Kroll Bond Rating Agency, goes farther and outlines how a low-interest-rate and massive QE environment is also destructive of other parts of the economy. Counterintuitively, the policies pursued by central banks are actually driving the deflationary environment rather than fighting it.

This is a short but very powerful Outside the Box. And to further Chris’s point I want to share with you a graph that he sent me, from a later essay he wrote. It shows that the cost of funds for US banks has dropped over $100 billion since the financial crisis, but their net interest income is almost exactly the same. What changed? Banks are now paying you and me and businesses $100 billion less. The Fed’s interest-rate policy has meant a great deal less income for US savers.

It is of the highest irony that Keynesians wanted to launch a QE policy that would increase the value of financial assets (like stocks), which they claimed would produce a wealth effect. I made fun of this policy some five years ago by calling it “trickle-down monetary policy.” Subsequent research has verified that there is no wealth effect from QE. Well, it did make our stocks go up, on the backs of savers. We’ve transferred interest income from savers into the stock market. We’ve made retirement far riskier for our older pensioners than it should be.

As Chris writes:

Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries [brokers, investment advisors and managers of pension funds and annuities] to meet the beneficiaries’ future investment return target needs through the prudent buying of securities.

Everywhere I go I talk with investment advisors and brokers who are scratching their heads trying to figure out how to create retirement portfolios that provide sufficient income without significantly moving out the risk curve at precisely the wrong time in their client’s lives. It is a conundrum that has been made for more difficult by Federal Reserve policy.

Economics Professor Larry Kotlikoff (Boston University) and our mutual friend syndicated financial columnist Scott Burns came by to visit me last week. I have talked with Larry on and off over the last few years, and Scott and I go back literally decades. A few years ago, Scott and Larry wrote a very good book called The Clash of Generations. Now, Larry has branched off on his own and written a really powerful manual on Social Security called Get What’s Yours: The Secrets to Maxing Out Your Social Security.

I will admit I have not paid much attention to Social Security. I just assumed I should start mine when I’m 70, as so many columns I have read suggested. Larry and I recently spent an hour discussing the Social Security system (or perhaps it would be better to call it the Social Security Maze). Three thousand pages of law and tens of thousands of regulations and so many nuances and “gotchas” that it is really difficult to understand what might be best in your particular circumstances. Larry asked me questions for about two minutes and then proceeded to make me $40,000 over the next five years. It turns out I qualify for an obscure (at least to me) regulation that allows me to get some Social Security income for four years prior to turning 70 without affecting my post-70 benefits. There are scores of such obscure rules.

Larry says it is more often the case than not that he can sit down with somebody and make them more money than they thought they were going to get. As one reviewer says:

This book is necessary for three reasons: Social Security is not intuitive, and sometimes makes no sense at all. Two, Americans act against their best interests, leaving all kinds of money on the table. Three, there is usually a “however” with Social Security rules. Worse, Social Security is now up to three million requests every week, but Congress keeps cutting back budget, staff, hours and whole offices. Combine that with the complexity factor, and the authors conclude you cannot trust what Social Security advises. Great.

If you or your parents are on Social Security or you are approaching “that age,” you really should get this book. Did you know that if you are divorced you can get a check for half of your former spouse’s Social Security income without affecting their income at all? But you can’t know whether this is a good strategy unless you look at other options.

How many retirees or those nearing retirement know about such Social Security options as file and suspend (apply for benefits and then don’t take them)? Or start stop start (start benefits, stop them, then restart them)? Or– just as important – when and how to use these techniques? Get What’s Yours covers the most frequent benefit scenarios faced by married retired couples, by divorced retirees, by widows and widowers, among others. It explains what to do if you’re a retired parent of dependent children, disabled, or an eligible beneficiary who continues to work, and how to plan wisely before retirement. It addresses the tax consequences of your choices, as well as the financial implications for other investments.

The book is written in Larry’s usual easy-to-read style, and you can jump to the sections that might be most relevant to you. The book is $11 on Kindle and under $15 at Amazon. This might be some of the better financial advice that you get from reading my letter: go get a copy of Get What’s Yours.

I can’t guarantee it will make you $40,000 in five minutes, but it can show you how to navigate the system. Larry also has a website with some inexpensive software to help you maximize your own Social Security. Seeing as how Social Security is the largest source of income for most US retirees, this is something everyone should pay attention to.

It is time to hit the send button. Quickly, we finalized the agenda for the 2015 Strategic Investment Conference. You can see it by clicking on the link. Then go ahead and register before the price goes up. This really is the best economic conference that I know of anywhere this year.

Your wondering how long they’ll pay me Social Security analyst,

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

 

Stay Ahead of the Latest Tech News and Investing Trends…

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.


Central Banks, Credit Expansion, and the Importance of Being Impatient

This research note is based on the presentation given by Christopher Whalen, Kroll Bond Rating Agency (KBRA) Senior Managing Director and Head of Research, at the Banque de France on Monday, March 23, 2015, for an event organized by the Global Interdependence Center (GIC) entitled New Policies for the Post Crisis Era.” KBRA is pleased to be a sponsor of the GIC.

Summary

Investors are keenly focused on the Federal Open Market Committee (FOMC) to see whether the U.S. central bank is prepared to raise interest rates later this year – or next. The attention of the markets has been focused on a single word, “patience,” which has been a key indicator of whether the Fed is going to shift policy after nearly 15 years of maintaining extraordinarily low interest rates. This week, the Fed dropped the word “patience” from its written policy guidance, but KBRA does not believe that the rhetorical change will be meaningful to fixed income investors. We do not expect that the Fed will attempt to raise interest rates for the balance of 2015.

This long anticipated shift in policy guidance by the Fed comes even as interest rates in the EU are negative and the European Central Bank has begun to buy securities in open market operations mimicking those conducted by the FOMC over the past several years. Investors and markets need to appreciate that, regardless of what the FOMC decides this month or next, the global economy continues to suffer from the effects of the financial excesses of the 2000s.

The decision by the ECB to finally begin U.S. style “quantitative easing” (QE) almost eight years after the start of the subprime financial crisis in 2007 speaks directly to the failure of policy to address both the causes and the terrible effects of the financial crisis. Consider several points:

  • QE by the ECB must be seen in the context of a decade long period of abnormally low interest rates. U.S. interest rate policy has been essentially unchanged since 2001, when interest rates were cut following the 9/11 attack. The addition of QE 1-3 was an effort at further monetary stimulus beyond zero interest rate policy (ZIRP) meant to boost asset prices and thereby change investor tolerance for risk.
     
  • QE makes sense only from a Keynesian/socialist perspective, however, and ignores the long-term cost of low interest rate policies to individual investors and financial institutions. Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries to meet the beneficiaries’ future investment return target needs through the prudent buying of securities. (See John Dizard, “Embrace the contradictions of QE and sell all the good stuff,” Financial Times, March 14, 2015.)
     
  • The downside of QE in the U.S. and EU is that it does not address the core problems of hidden off- balance sheet debt that caused the massive “run on liquidity” in 2008. That is, banks and markets in the U.S. globally face tens of trillions of dollars in “off-balance sheet” debt that has not been resolved. The bad debt which is visible on the books of U.S. and EU banks is also a burden in the sense that bank managers know that it must eventually be resolved. Whether we talk of loans by German banks to Greece or home equity loans in the U.S. for homes that are underwater on the first mortgage, bad debt is a drag on economic growth.
     
  • Despite the fact that many of these debts are uncollectible, governments in the U.S. and EU refuse to restructure because doing so implies capital losses for banks and further expenses for cash- strapped governments. In effect, the Fed and ECB have decided to address the issue of debt by slowly confiscating value from investors via negative rates, this because the fiscal authorities in the respective industrial nations cannot or will not address the problem directly.
     
  • ZIRP and QE as practiced by the Fed and ECB are not boosting, but instead depressing, private sector economic activity. By using bank reserves to acquire government and agency securities, the FOMC has actually been retarding private economic growth, even while pushing up the prices of financial assets around the world.
     
  • ZIRP has reduced the cost of funds for the $15 trillion asset U.S. banking system from roughly half a trillion dollars annually to less than $50 billion in 2014. This decrease in the interest expense for banks comes directly out of the pockets of savers and financial institutions. While the Fed pays banks 25bp for their reserve deposits, the remaining spread earned on the Fed’s massive securities portfolio is transferred to the U.S. Treasury – a policy that does nothing to support credit creation or growth. The income taken from bond investors due to ZIRP and QE is far larger.
     
  • No matter how low interest rates go and how much debt central banks buy, the fact of financial repression where savers are penalized to advantage debtors has an overall deflationary impact on the global economy. Without a commensurate increase in national income, the elevated asset prices resulting from ZIRP and QE cannot be validated and sustained. Thus with the end of QE in the U.S. and the possibility of higher interest rates, global investors face the decline of valuations for both debt and equity securities.
     
  • In opposition to the intended goal of low interest rate and QE policies, we also have a regressive framework of regulations and higher bank capital requirements via Basel III and other policies that are actually limiting the leverage of the global financial system. The fact that banks cannot or will not lend to many parts of society because of harsh new financial regulations only exacerbates the impact of financial repression. Thus we take income from savers to advantage debtors, while limiting credit to society as a whole. Only large private corporations and government sponsored enterprises with access to equally large banks and global capital markets are able to function and grow in this environment.

So what is to be done? KBRA believes that the FOMC and policy makers in the U.S. and EU need to refocus their efforts on first addressing the issue of excessive debt and secondly rebalancing fiscal policies so as to boost private sector economic activity. Low or even negative interest rate policies which punish savers in order to pretend that bad debts are actually good are only making things worse and accelerate global deflation. Around the globe, nations from China to Brazil and Greece are all feeling the adverse effects of excessive debt and the related decline in commodity prices and overall economic activity. This decline, in turn, is being felt via lower prices for both commodities and traded goods – that is, deflation.

In the U.S., sectors such as housing and energy, the effects of weak consumer activity and oversupply are combining into a perfect storm of deflation. For example, The Atlanta Fed forecast for real GDP has been falling steadily as the underlying Blue Chip economic forecasts have also declined. The drop in capital expenditures related to oil and gas have resulted in a sharp decline in related economic activity and employment. Falling prices for oil and other key industrial commodities, weak private sector credit creation, falling transaction volumes in the U.S. housing sector, and other macroeconomic indicators all suggest that economic growth remains quite fragile.

To deal with this dangerous situation, the FOMC should move to gradually increase interest rates to restore cash flow to the financial system, following the famous dictum of Adam Smith that the “Great Wheel” of circulation is the means by which the flow of goods and services moves through the economy:

“The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them” (Smith 1811: 202).

Increased regulation and a decrease in the effective leverage in many sectors of banking and commerce have contributed to a slowing of credit creation and economic activity overall. And most importantly, the issue of unresolved debt, on and off balance sheet, remains a dead weight retarding economic growth. For this reason, KBRA believes that investors ought to become impatient with policy makers and encourage new approaches to boosting economic growth.

Related Publications:

Analytical Contact: Christopher Whalen, Senior Managing Director cwhalen@kbra.com, (646) 731-2366

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

Important Disclosures