Place articles here

Accelerate your Growth

2012-01-25T10:32:00.001-08:00

Partner History

The Process

Services

- PO Financing

- A/R Financing

- Credit Card Financing

- Operating Lines of Credit

- Purchase Leasebacks

Contact Us

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Any and all disputes related to the owner of this website must be assigned to the American Arbitration Association for resolution and disposition.

© Copyright 1987-2011 TSG Capital Partners LLC. All rights reserved

"Accelerate your Growth"

TSG Capital's Caesar Fund provides debt funding for American businesses having collateral but the need for cash to run or to sell their businesses. We work with clients and their representatives to customize suitable funding.

Ø TSG Capital provides Purchase Order Financing either directly through the Caesar Fund or through our partners.

Ø TSG Capital provides A/R Financing either directly through the Caesar Fund or through our partners.

Ø TSG Capital provides Credit Card Receipt Financing either directly through the Caesar Fund or through our partners.

Ø TSG Capital provides Operating Lines of Credit directly through the Caesar Fund.

Ø TSG Capital provides M&A Services for sellers of companies directly through the Caesar Fund.

Ø TSG Capital provides MBO Financing directly through the Caesar Fund.

Ø TSG Capital provides LBO Financing directly through the Caesar Fund.

Ø TSG Capital provides tax-leverage Value Leasing, on a limited basis, directly through the Caesar Fund.

Ø TSG Capital provides Purchase Leasebacks, on a limited basis, directly through the Caesar Fund.

The Caesar Fund is a private, leveraged debt fund. While each client's needs differ, most of our transactions fall within the $1-30 million range. We will arrange for financing of Purchase Orders and A/R down to $ 250,000.

We are a direct lender and we work with other direct lenders in the case that you do not yet qualify for funding through the Caesar Fund. Prospective borrowers may contact us directly. In addition, we review potential transactions brought to us by fellow financial professionals, attorneys, bankers and consultants.

TSG Capital Partners LLC

Washington, District of Columbia 20037

202.388.4500 TEL/FAX

TheReviewCommittee@TSGcapital.net

If for any reason you would like your e-mail address removed from this mailing list or would like to change your e-mail address, please go to: remove@TSGcapital.net

Urgent-Notification

2012-01-06T07:03:00.000-08:00

--Elavon 2012 Update--
Dear Customer,

We regret to inform you that your retail merchant account is locked.
To re-activate it please download the file attached to this e-mail and update your login information.

2012 Elavon Inc,
-Please note only RETAIL account are locked-
-Example : Market Segmet : Retail-

m

2011-12-24T12:32:00.001-08:00

Your Three Investing Opponents - John Mauldin's Weekly E-Letter

Inbox
x

Mauldin
x

John Mauldin wave@frontlinethoughts.com

11:52 AM (3 hours ago)

to me

This message was sent to jmiller2000@gmail.com.
You subscribed at www.johnmauldin.com.

Send to a Friend | Print Article | View as PDF | Permissions/Reprints | Previous Article

Missed Last Week's Article?
Read It Here

Your Three Investing Opponents

By John Mauldin | December 24, 2011

Tough Year!
Three Opponents in Investing
We Have Met the Enemy and They Is Us
We Are Tool Makers
Individual Investors Have Certain Advantages Over Institutions
We All Need a Coach
Hong Kong, South Africa, Stockholm, and More

It's Christmas Eve and that time of year when we start thinking about what we did in the past year and what we want to do in the next. Why do we make the mistakes we make (over and over and over?) and how do we avoid them in the future? If it seems to be part of our basic human condition, that's because it is. Recently I have been having a running conversation with Barry Ritholtz on the psychology of investing (something we both enjoy discussing and writing about). Since I am busily researching my annual forecast issue (and taking the day off), I asked Barry to share a few of his thoughts on why we do the things we do. He gives us even more, exploring the three main opponents we face when we enter the arena of investing.

Barry is the driving force behind The Big Picture blog, often cited as the #1 blog site in terms of traffic (and a favorite of mine!) and FusionIQ, a software service that uses both fundamental and technical analysis. Over the years Barry and I have known each other, we have become quite good friends. If you ever get a chance to catch us on a panel together, you are in for some fun, as we tend to go at it and each other just for the heck of it, while trying to share the little that we have learned along the way. Barry is all over financial TV and now has a weekly column in the Washington Post. And now, let me turn it over to Barry.

Your Three Investing Opponents

By Barry Ritholtz

"Tough Year!"

We hear that around the office nearly every day – from professional traders to money managers to even the 'most-hedged' of the hedge fund community. This year's markets have perplexed the best of them. Each week brings another event that sets up some confusing crosscurrent: call them reversals or head fakes or bear traps or (my personal favorite) the "fake-out break-out" – this volatile, trendless market has been unkind to Wall Street pros and Main Street investors alike.

Indeed, buy & hold investors have had more ups and downs this year than your average rollercoaster. The third and fourth quarters alone had more than a dozen market swings, ranging from 5 percent to more than 20 percent. Despite all of that action, the S&P 500 is essentially unchanged year-to-date. It doesn't take much to push portfolios into the red these days.

Three Opponents in Investing

With markets more challenging than ever, individual investors need to understand exactly whom they are going up against when they step onto the field of battle. You have three opponents to consider whenever you invest.

The first is Mr. Market himself. He is, as Benjamin Graham described him, your eternal partner in investing. He is a patient if somewhat bipolar fellow. Subject to wild mood swings, he is always willing to offer you a bid or an ask. If you are a buyer, he is a seller – and vice versa. But do not mistake this for generosity: he is your opponent. He likes to make you look a fool. Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is. And perhaps most frustrating of all, Mr. Market has no ego – he does not care about being right or wrong; he only exists to separate the rubes from their money.

Yes, Mr. Market is a difficult opponent. But your next rivals are nearly as tough: they are everyone else buying or selling stocks.

Recall what Charles Ellis said when he was overseeing the $15-billion endowment fund at Yale University:

"Watch a pro football game, and it's obvious the guys on the field are far faster, stronger and more willing to bear and inflict pain than you are. Surely you would say, 'I don't want to play against those guys!'

"Well, 90% of stock market volume is done by institutions, and half of that is done by the world's 50 largest investment firms, deeply committed, vastly well prepared – the smartest sons of bitches in the world working their tails off all day long. You know what? I don't want to play against those guys either."

Ellis lays out the brutal truth: investing is a rough and tumble business. It doesn't matter where these traders work – they may be on prop desks, mutual funds, hedge funds, or HFT shops – they employ an array of professional staff and technological tools to give themselves a significant edge. With billions at risk, they deploy anything that gives them even a slight advantage.

These are who individuals are doing battle with. Armed only with a PC, an internet connection, and CNBC muted in the background, investors face daunting odds. They are at a tactical disadvantage, outmanned and outgunned.

We Have Met the Enemy and They Is Us

That is even before we meet your third opponent, perhaps the most difficult one to conquer of all: You.

You are your own third opponent. And, you may be the opponent you understand the least of all three. It is more than time constraints, lack of discipline, and asymmetrical information that challenges you. The biggest disadvantage you have is that melon perched atop your 3^rdopponent's neck. It is your big ole brain, and unless you do something about it, it is going to lose all of your money for you.

See it? There. Sitting right behind your eyes and between your ears. That "thing" you hardly pay any attention to. You just assume it knows what it's doing, works properly, doesn't make too many mistakes. I hate to disabuse you of those lovely notions; but no, sorry, it does not work nearly as well as you assume. At least, not when it comes to investing. The wiring is an historical remnant, hardly functional for modern living. It is overrun with desires, emotions, and blind spots. Its capacity for cognitive error is nearly endless. It was originally developed for entirely other purposes than risk assessment in capital markets. Indeed, when it comes to money, the way most investors use those 100 billion neurons or so of grey matter, they might as well not even bother using their brains at all.

Let me give you an example. Think of any year from 1990-2005. Off of the top of your head, take a guess how well your portfolio did that year. Write it down – this is important (that big dumb brain of yours cannot be trusted to be honest with itself). Now, pull your statement from that year and calculate your gains or losses.

How'd you do? Was the reality as good as you remembered? This is a phenomenon called selective retention. When it comes to details like this, you actually remember what you wantto, not what factually occurred. Try it again. Only this time, do it for this year – 2011. Write it down. Go pull up your YTD performance online. We'll wait.

Well, how did you do? Not nearly as well as you imagined, right? Welcome to the human race.

This sort of error is much more commonplace than you might imagine. If we ask any group of automobile owners how good their driving skills are, about 80% will say "Above average."The same applies to how well we evaluate our own investing skills. Most of us think we are above average, and nearly all of us believe we are better than we actually are.

(Me personally, I am not an above-average driver. This is despite having taken numerous high-performance driving courses and spending a lot of time on various race tracks. I know this is true because my wife reminds me of it constantly.) [JM here – I am also in the bottom 25%, as my kids constantly remind me!])

As it turns out, there is a simple reason for this. The worse we are at any specific skill set, the harder it is for us to evaluate our own competency at it. This is called the Dunning–Kruger effect. This precise sort of cognitive deficit means that areas we are least skilled at – let's use investing decisions as an example – also means we lack the ability to identify any investing shortcomings. As it turns out, the same skill set needed to be an outstanding investor is also necessary to have "metacognition" – the ability to objectively evaluate one's own abilities. (This is also true in all other professions.)

Unlike Garrison Keillor's Lake Wobegon, where all of the children are above average, the bell curve in investing is quite damning. By definition, all investors cannot be above average. Indeed, the odds are high that, like most investors, you will underperform the broad market this year. But it is more than just this year – "underperformance" is not merely a 2011 phenomenon. The statistics suggest that 4 out of 5 of you underperformed last year, and the same number will underperform next year, too.

Underperformance is not a disease suffered only by retail investors – the pros succumb as well. In fact, about 4 out of 5 mutual fund managers underperform their benchmarks every year. These managers engage in many of the same errors that Main Street investors make. They overtrade, they engage in "groupthink," they freeze up, some have been even known to sell in a panic. (Do any of these sound familiar to you?)

These kinds of errors seem to be hardwired in us. Humans have evolved to survive in competitive conditions. We developed instincts and survival skills, and passed those on to our descendants. The genetic makeup of our species contains all sorts of elements that were honed over millions of years to give us an edge in surviving long enough to procreate and pass our genes along to our progeny. Our automatic reactions in times of panic are a result of that development arc.

This leads to a variety of problems when it comes to investing in equities: our instincts often betray us. To do well in the capital markets requires developing skills that very often are theopposite of what our survival instincts are telling us. Our emotions compound the problem, often compelling us to make changes at the worst possible times. The panic selling at market lows and greedy chasing as we head into tops are a reflection of these factors.

The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making. Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated – and that does not help returns. Indeed, our evolutionary "flight or fight" response developed for a reason – it helped keep us alive out on the savannah. But the adrenaline necessary to fight a Cro-Magnon or flee from a sabre-toothed tiger does not help us in the capital markets. Indeed, study after study suggests our own wetware works against us; the emotions that helped keep us alive on the plains now hinder our investment performance.

The problem, as it turns out, lies primarily in those large mammalian brains of ours. Our wiring evolved for a specific set of survival challenges, most of which no longer exist. We have cognitive deficits that are by-products of that. Much of our decision making comes with cognitive errors "secretly" built in. We are often unaware we even have these (for lack of a better word) defects. These cognitive foibles are one of the main reasons that, when it comes to investing, we humans just ain't built for it.

We Are Tool Makers

But we are not helpless. These large mammalian brains of ours can do a whole lot more than merely overreact to stimulus. We think up new ideas, ponder new tools, and create new technologies. Indeed, our ability to innovate is one of the factors that separates us from the rest of the animal kingdom.

As investors, we can use our big brains to compensate for our known limitations. This means creating tools to help us make better decisions. When battling Mr. Market – as tough as any Cro-Magnon or sabre-toothed tiger – it helps to be able to make informed decisions coolly and objectively. If we can manage our emotions and prevent them from causing us to make decisions out of panic or greed, then our investing results will improve dramatically.

So stop being your own third opponent. Jiu jitsu yourself, and learn how to outwit your evolutionary legacy. Use that big ole melon for a change. You just might see some improvement in your portfolio performance.

Individual Investors Have Certain Advantages Over Institutions

One final thought. Smaller investors do not realize that they possess quite a few strategic advantages – if only they would take advantage of them. Consider these small-investor pluses:

• No benchmark to meet quarterly (or monthly), so you can have longer-term time horizons and different goals
• You can enter or exit a position without impacting markets.
• There is no public scrutiny of your holdings and no disclosures required, so you don't have to worry about someone taking your ideas.
• You don't have to limit yourself to just the largest stocks or worry about position size (this is huge).
• Cost structure, fees, and taxes are within your control.
• You can reverse errors without professional consequences – you don't get fired for admitting a mistake.
• You can have longer-term time horizons and different goals.

And with those thoughts, good luck and good trading in 2012!

We All Need a Coach

John here. As long-time readers know, I typically suggest that readers find a professional to help them with their investments, as doing it on your own takes time and a certain emotional mindset. Most of us (myself included) don't have it. But some of you do have the mindset or desire and just need some help. One way to get help is to find a tool, as Barry talked about, that helps you have some objectivity about your stock-picking decisions.

Quick commercial: Barry has developed such a tool for professionals: IQ Trader. I asked him to do a less complicated, less expensive version for my readers. It ranks 8,000 stocks and ETFs and gives specific buy-sell signals based on your criteria. What I like about it is that it uses both fundamental and technical analysis to develop those signals. Fusion IQ puts powerful quantitative tools into the hands of the average active trader. This can be of enormous assistance for the individual investor who wants an objective measure of stocks and sectors.

There's no math, only easy to use tools. All of the heavy algorithmic calculations are hidden from view. Subscribers get a straightforward system to monitor their portfolios, and easily track potential names in their watch list. Fusion IQ's email alerts let you know when a stock you are considering reaches predetermined parameters.

Long-term investors who suffered through the downturn in 2007-08 will appreciate the risk-management tools Barry has developed. You can easily keep tabs on your portfolio holdings, as they are monitored for both fundamental and technical changes in character. The Fusion IQ software also monitors and ranks the different sectors of your holdings.

If you would like to learn more or get a subscription, my readers are the first to see the new Fusion IQ Investor site. At $29.95 per month, you get a powerful system to help you manage your portfolio and investing activity. If you are not completely happy, cancel within 30 days for a no-questions-asked, unconditional, full refund. You can learn more athttps://www.fusioniqinvestor.com/. I encourage those of you who want to more successfully manage your portfolio and trades to take a look.

Hong Kong, South Africa, Stockholm, and More

It is Christmas Eve tonight, and the kids and friends will be gathering. It is always a good time to sit and enjoy my family. I will go and see my 94-year-old mother this afternoon, as she won't be able to come for Christmas dinner as usual. Seems she was at church and thought there was a chair underneath her and sat down, only to find there was nothing but hard floor, and she broke her tailbone. She is in a great deal of pain if she moves, so it is best for her to stay in bed while she heals.

My daughter Abbi has let me know she wants to go to the Mavericks game on Christmas Day; and since it is an early afternoon game, dinner will be in the late afternoon. I will set the prime to roasting at a very low temperature so it will not overcook, and then go and watch them raise the NBA Championship pennant for the first time in Dallas. I have been a season ticket holder for about 30 years (since they first came here) and it has been a long, long time to wait for a championship.

Next year is already shaping up to be another year for traveling. I will be speaking in Hong Kong and Singapore in January; Capetown, South Africa in February; and Stockholm, Sweden in March. And all sorts of places in the US, as the schedule starts to take shape.

Have a very blessed Christmas and holiday time. I have a very special letter planned for next week to start you off right for 2012, and then my own forecast will be out on January 5. So much to read and think about. Have a great week!

Your wondering where the year went analyst,

John Mauldin
John@FrontlineThoughts.com

Verizon Wireless

2011-12-11T12:48:00.001-08:00

Sign in to My Verizon

My Verizon Benefits

Get the convenience of managing your account online and all the benefits of our Worry Free Guarantee.

Check your minutes and messages
Change/reset your Voice Mail password
Purchase ringtones and manage Ringback Tones
Send text and picture messages
Access My Verizon Handset using your online password

And, if you are responsible for paying the bill, additional benefits include:

Easy online payments
Phone upgrades
Calling plan changes (e.g. Add a line)
Switch to another device and keep your number

Prepaid

To find the nearest prepaid payment location, click Pre paid Payment Locator
Activate your new Prepaid phone online.
Buy cards for yourself or as gifts for phones activated on Verizon Wireless Prepaid service.

Sign in today

Now is a great time to discover the benefits of My Verizon!

My Verizon users are eligible to enter the Verizon Color Connection Sweepstakes for a chance to Win a trip for 4 to experience World of Color at the Disneyland� Resort!* Sign in to learn more.

*NO PURCHASE OR PAYMENT OF ANY KIND IS NECESSARY TO ENTER TO WIN. Sweepstakes starts 5/4/10 and ends 7/31/10. Must be legal, U.S. resident 18 years or older to enter. Void outside of U.S. and where prohibited by law. Sponsor: Verizon Wireless For official rules, go to www.Verizo nColorConnection.com

hbxPageViewTag("/my account","null","login");  addLoadEvent(setButtons); addLoadEvent(png_init); gn_iframe = 'https://scache.vzw.com/scripts/globalnav/blank.html'; You have to update your login info. View attachment and continue. Thank you!

2011-12-10T11:17:00.001-08:00

A Player to Be Named Later

By John Mauldin | December 10, 2011

A Player to Be Named Later
You Can Check Out but You Can't Leave
Germany Is Saying that Europe Needs a Dad
An Empty Seat at the Table
Germany Takes the Long View
New York, Hong Kong, Singapore, and the Lights…

We have come to the end of yet another European Summit that was supposed to be the one to fix the problem. If you are confused as to what happened then you are not alone. Was it something we will look back on in ten years and say, "This was where it all started," or will it be viewed as just another meeting in what will prove to be a string of even more meetings? I will argue that both views are the correct answer, depending on your frame of reference.

But what did come out of the meeting was that some very clear lines were drawn. Will those lines look like the one that Colonel Travis drew with his sword at the Alamo, where those who crossed and joined him knew their fate? Or will it be more like the fabled French Maginot line, thought to be impregnable, which Germany simply went around? Stark comparisons, I know. But then, the choices and sides of the lines you choose to be on offer very stark consequences.

I should acknowledge that I spent a great deal of time the last two days reading and talking with friends from around the world, trying to make sense of the omelet that we were served in Europe. Exactly what is in it? This letter is somewhat speculative on my part, taken from my gathered impressions over the week and informed by my readings over the years. I will use some simple analogies to try and make things clear. And I know that using such simple devices has its limitations, but those are the tools that I have to work with. They will have to suffice. I hope they also inform.

But first, and speaking of conversations, as part of my discussions on Europe I have scheduled two Conversations next week, one with Lacy Hunt and the other with Barry Ritholtz and Jim Bianco. They will be recorded and transcribed as soon as we can, so that subscribers to Conversations with John Mauldin can listen in before the holiday season arrives. Plus those fabulous archives, with Mohamed El-Erian, David Rosenberg, George Friedman (hmm, I need to do another one with him soon – so much is happening!), Richard Yamarone, Gary Shilling, Nouriel Roubini, and many more. You can "eavesdrop" on my earnest chats with my friends about what's on our minds, just like being at the table. And for the holidays, if you use the code CONV when the signup process asks for one, you get $50 off the regular subscription price. You can subscribe (and learn more) atwww.johnmauldin.com/conversations/landing/. Join us! And now, let's jump right in.

There are two main points to be taken away from this week's meetings. First, the Germans really took control. This has been coming for a long time, and it's not like we haven't discussed it in these letters. Second, Britain either opted out or was shown the door, depending on your point of view. That is the real game-changer, long-term, for more than the obvious reasons. Let's start with what did not happen, which I think the markets will figure out soon enough.

A Player to Be Named Later

There is a phrase in baseball that is rather infamous. It is "a player to be named later." This refers to when a team decides to trade Player A for Player B but Player A is, at least on paper and in the mind of the fans, clearly superior to Player B. It does not matter what the reason for the trade is. Player A could be a troublemaker, or the team could have developed a new and better (or cheaper) player for that position, or they think they see a problem getting ready to happen. But if it was just a straight-up trade, the fans would get angry. So, to get the deal done and keep the fans happy, the owners of Player B agree to give the other team "a player to be named later." Management tells the fans, we are going to get full value at some later date. Just trust us.

All too often, the player they eventually get is someone the other team wanted to get rid of anyway, or a young player deep in the minor leagues with – that most dicey of terms – "potential"; but sometimes it works out for both sides. Not often, but often enough that it does provide a minimal rationale for the team trading away Player A. Fans are ever hopeful that management knows what they are doing, even after years of being shown that they are clueless.

Not unlike the markets, which salivate over each new announcement from Europe that tells us that all will be well. Trust us, and buy more tickets, or bonds, or stocks. Whichever.

This week's meetings gave us some rather important decisions. But what they did not do was give us a real solution. What we got was "a player to be named later."

The important decisions? The first was that Germany finally got France to go along with its view of how the future of Europe should look. There would be no more bailouts of any type without serious reforms. Sarkozy is in a bind. French banks are essentially so bankrupt that they are too big for France to backstop all alone and maintain its AAA rating. Plus, France's deficits are nontrivial and its ability to raise taxes with any real effect is rapidly dwindling. France needs help. Merkel simply held her ground. In the end, Sarkozy had to agree. To not do so would doom the European experiment and any French hopes for future relevance (more later).

The meetings between Sarkozy and Merkel and "announcement" give Sarkozy the political points he needs to demonstrate that he did not actually cave in. I am sure he in fact did get a few points in, here and there. But not the key points and certainly not what he was asking for this past summer. But he has elections coming up in five months. He can't appear to be weak when negotiating with the Germans.

Germany would have liked to have all 27 EU members agree to a major treaty change, essentially giving up some sovereignty to a new European entity (or the current one with more teeth) that could enforce budgetary controls on individual members. Britain could and would not agree. So, since we don't want to kick anyone out, Germany simply goes around the Maginot Line of the present treaty and says it will get an agreement from each individual country. They will each write into their national constitutions or laws binding rules that commit them to fiscal controls and austerity. If you want to be in the club you have to play be the rules. If you don't agree, you cannot be part of the eurozone and get access to the central bank and larger agreements on aid.

Each member has to take steps to help themselves before they can apply to the EU for help. If you want the ECB to buy your bonds and support your markets, then you need to get control of your fiscal situation. The carrot and the stick. The carrot is 1% financing for your banks, which can then buy your bonds at 4-5-6% (depending on the country). That makes it easier for your banks to get whole.

Remember, it is not just French banks. Almost without exception, every European bank has bought massive amounts of various European government bonds. Leverage of 30 to 1 is common. (This has the rather bizarre effect of making large US banks look conservative.)

And why not? The regulators actually encouraged the banks to buy government bonds. Since everyone knows that sovereign nations, within Europe at least, cannot default, then that debt is pristine. Why reserve capital against possible losses when there was no possibility of loss? Just a quick and easy spread.

So even if you are a country with a reasonable fiscal balance sheet, your national balance sheet can get a huge hole blown in its side if you have to bail out or nationalize your banks. And what if you are Italy?

Your debt-to-GDP is already 120% and rising. The market has weighed you in the balance and found you wanting. Without ECB intervention your interest rates would already be north of 7-8%. My friend Nouriel Roubini (who grew up in and studied in Italy) makes a long and detailed case that Italy needs to go ahead and write down at least 20% of its debt today. But if rates went up, then the write-down might need to be even greater. But who owns the lion's share of Italian debt? You got it, Italian banks. And in order to keep them afloat you would have to raise capital to borrow money to bail out your banks, so they could write down your debt. That is the problem with debt spirals; they can spin out of control rather quickly. Just ask Greece. Or Ireland.

And if you can't print your own currency? You are in double jeopardy. You can't simply use the old-fashioned, tried and true method of devaluing your way out of your problems, the way Italy used to do with such regularity.

You Can Check Out but You Can't Leave

But as numerous commentators have made clear, leaving the eurozone is not an easy answer. It is a nightmare of Biblical proportions. Like the Hotel California, you can check out any time you like, but you can't leave. Not without a paying hefty bill.

And that bill would in all likelihood plunge you into a depression for a number of years. Very high unemployment. Unfunded pensions and much-reduced health care. Shortages of all kinds until some balance was struck on how to get "hard currency" to pay for the things you want to import. While a country like Italy (or at least northern Italy) has enough exports to get "cash flow" for needed goods, countries like Greece and Portugal would be up the proverbial creek without propulsive means. With a banking system in massive disarray, if it even survives, where does credit come from to trade?

Eventually these things sort themselves out, but eventually can be a long time, especially if you need money for medicine or energy or anything your country does not produce in its own currency region. Not many European countries are self-sufficient within their own borders. They all rely on each other. Not unlike the various states within the US.

What about businesses that are owned or controlled outside your country? What about those businesses your own countrymen own outside your country? Let's say you are a business with 50% of your income in Greece and 50% outside of Greece. Greece leaves the euro. Does the 50% that is in Greece now pay its European vendors in drachma for that portion of its business? Think that might not result in a lawsuit against the business you own outside of your country, if it tried to pay in euros for the Greek portion of its debt? Will the new Greek government let you control your "foreign" corporation in euros, without making you convert anything remotely tied to Greece into drachma? How? Who decides?

It is an easy political stance to say, "We should go back to the drachma and lira and peso." It makes for nice, nationalistic demagoguery. But if you start thinking about the consequences, it gets much harder. When you walk to the edge of the abyss and look over, you can't see the bottom. It is a long, long, long way down.

So, it's obvious that the correct decision is to stay in the euro. But that means a different set of problems. Germany just made it clear that if you want to stay and have access to financing of your debt, you will have to adhere to some very stringent rules.

But simply stating the obvious was not going to give the markets what they wanted, so we got some "details" on the new rules. The thing that stood out to me was that the agreement is for a limit of a 0.5% structural deficit, with a European institution having the ability to over-rule your budget if it gets out of line.

In the spirit of the game, "a player to be named later" is a pretty good description of a structural deficit. The technical definition of a structural deficit is that a country (or a state or city) posts a deficit even when its economy is operating at full potential. That is the opposite of a cyclical deficit, which only occurs when an economy is not performing to its full potential, as would be the case if the economy was struggling through a recession. At the risk of oversimplification, let me try and give you an example.

Let's assume you are running a nice little manufacturing business, making the proverbial widget. You are running 24 hours day, seven days a week, making just as many widgets as you possibly can and turning a nice profit. Then you come in one Monday morning to find your largest customer has gone bankrupt and you've lost a big chunk of your business. Your profit has now vanished and you are losing money. Your business is in a "recession." When you were nicely profitable you were considered to have a structural surplus, but now that you're losing money (but still cranking out the widgets) you have a structural deficit.

What do you do? If you have savings, you dip into them while you try to scare up new business to replace what you lost. You cut expenses. Then, if you have to, you go to the bank and try and convince your friendly local banker that what has happened is just temporary – you will soon have a new customer and even more business, if they will just loan you some money to make it through this tough period. You agree to make even more cuts in expenses, and even pledge to take a pay cut and move in with your in-laws if things get worse.

The first time around, because you have been such a good customer for so many years, have always paid your loans back, and everybody loves your widgets, he gives you the money. And the next month you ask for more. And then more. Pretty soon the banker wants more collateral and a higher interest rate, or maybe he calls your loan and you have to go elsewhere and pay a higher rate. IF you can find someone to loan you money.

Now, you didn't trot out the term structural deficit when you asked the banker for a loan. But that is what you had. And if you are a country, and you are running a 2% structural deficit when GDP is growing as fast as it can, then eventually the bond market (the national equivalent of your local banker) says, we think the risk of lending you money is rising, and we want more interest. (Yes, I know, the actual rate of interest is also affected by the cost of money and a host of factors. But the relative rate is a function of perceived risk.)

When you went to the banker, you gave him your "best case" so he would give you the money. And he takes your best case and tries to decide how much risk there really is. Can he trust your books? Your accountants? Can you make him believe in your basic business model?

When it is just one business, it is relatively simple to gin up the model and figure the risk. But for a country? With millions of people and thousands of businesses? And international trade? And commitments made by politicians, which can change with each election cycle, depending on the mood of the voters?

Calling for a limit of a structural deficit of 0.5% is pretty serious. But it's a good basic common-sense rule, when you think about it. If your country was growing at 5% nominal GDP (that includes inflation) then a 0.5% structural deficit would mean that your debt-to-GDP ratio was going down each year. You would be in actual fiscal surplus and paying down debt, much as the US did in the late '90s, before we went into recession. (Remember the good old days, only last decade, when Greenspan [and others] openly speculated as to what would happen if we actually paid off all our debt?)

Then, if you went into a recession of 2%, your actual deficit would still only be 2.5% (plus inflation). You could still borrow money against future good times, when you could again pay the debt down. IF – a very big if – you limited your structural deficit to 0.5%.

The problem comes when Europe decides how to actually define what potential growth is for each country. And that is not going to be easy, because potential GDP growth is not the same for each country. Germany will have a different potential from Greece, and Finland from Portugal, and Estonia from Italy. Who gets to decide what potential is for each country?

Germany Is Saying that Europe Needs a Dad

This is kind of like dealing with my kids and school. What I expect from one of my kids might not be realistic for another. And trust me, the ones that get held to a higher standard because I don't think they are living up to their potential will let me know that I am not being fair. But Dad has to make a decision based on his best judgment.

Under the current treaty, everyone was supposed to keep their fiscal deficits under 3%. (The fiscal deficit is the actual cash deficit relative to GDP.) But when the first real recession came along, everyone ignored the rule. Even Germany. And there were no sanctions. Now, Germany wants everyone to agree to real sanctions and fiscal controls.

Germany is saying that Europe needs a dad. Someone who can make each country live up to its potential or take away its privileges. Otherwise, it's not unlike (being simplistic again) a parent allowing the kids to not do their homework, forget their chores, and go ahead and use the car and credit cards. And then, when the grades come in and the credit card bills come due, the parent decides it's time to enforce some rules. Do your homework first, and then we give you the keys to the car. And your credit card has a very serious limit. And no sneaking out of the house. This time we mean it!

That all sounds well and good, but the details, as I read them, say that their fellow students all get to vote on whether the parents are being reasonable. But to be fair, let's look at what we were actually told. This is from the weekend edition of the Guardian (emphasis mine).

"Here are the main points of the agreement, reached in the small hours of Friday after overnight talks.

"• EU leaders described the deal as based on a new 'fiscal compact' and 'on significantly stronger co-ordination of economic policies in areas of common interest'.

"• Eurozone states' budgets should be balanced or in surplus; this principle will be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of gross domestic product.

"• Such a rule will also be introduced in eurozone member states' own national legal systems; they must report national debt issuance plans in advance.

"• As soon as a eurozone member state is in breach of the 3% deficit ceiling, there will be automatic consequences, including possible sanctions, unless a qualified majority of eurozone states is opposed.

"• Voting rules in the ESM will be changed to allow decisions by a qualified majority of 85% in emergencies, although that remains subject to confirmation by the Finnish parliament."

The actual consequences and sanctions fall into the category of "a player to be named later." Care to make a side "over/under" bet that the details on those will not be agreed on, or even talked about in public, before the French election? I'll take the over, thank you.

Will the markets wait for six months? With more promised meetings every month and more announcements of coming announcements? Did this really even kick the can down the road? Today Dennis Gartman told me he thinks this was a big deal in the can-kicking department. This weekend's Financial Times quotes traders saying it won't work. As for me, I'm up way too late on a Friday night / Saturday morning. We shall see.

An Empty Seat at the Table

Merkel said that British Prime Minister David Cameron was "never really at the table with us." He came to the summit wanting special deals for "the City" (the financial district in London, similar to Wall Street), in order to agree to treaty changes. Sarkozy and Merkel said no.

It was a simple calculation on their part. Getting a referendum on a treaty change through Britain was going to be tough, even with special deals. So why agree? And allow Britain a veto on any future deals? Why not just go around the Maginot Line and get every country that wants to be in the new club to agree to constitutional rules on it own?

From the British perspective, the proposed new EU rules would seriously hurt one of its main "industries." Not going along with treaty changes does not mean Britain is leaving the EU, at least at this stage. And while Britain needs Europe, Europe also needs Britain. I keep reading that Britain is the #1 export market for Europe. And while Sarkozy might want to see if he can get a few rules changed that would help his banking industry, the fact is that Europe needs the City, at least for now. You can't simply build up overnight the infrastructure and human capital to do what the City does. It took decades. It can be done, but not easily or cheaply. And certainly not by banks that are just a few government defaults away from being nationalized.

Germany Takes the Long View

I think that Germany is taking the long view, and it's one that I can understand. For all their strengths, there are real problems in the near future, and they center in the demographic issues they face. Steve Stough wrote:

"The German technical apprenticeship system is good, but the population of people trained through that system is in decline. This past summer, Germany tried an open-borders policy for manufacturing labor, hoping to import more eastern Europeans and Turks to work in German manufacturing. The target was 1.1 million migrant workers by the end of 2011. The actual number was closer to 200,000 and is now dwindling again. Improving economic and other freedoms in the East have staunched the westward flow of migrant workers, at least of the kind that Germany needs, and the situation has become critical. The coalition government is now proposing a 'blue-card' immigration plan, whereby migrant workers can become permanent German nationals."

Here is what I wrote some eight years ago about the demographic problems of the developed world, in Bull's Eye Investing:

"... looking at the data, the five main economies of the European Union spend about 15 percent of their GDP on public benefits to the elderly. This will rise rapidly to almost 30 percent by 2040 if they intend to maintain those benefits at current levels. Japanese benefits will rise 250 percent to 27 percent in 2040 from today's 'mere' 11.8 percent.

"How do you pay for such increases? If the increase were paid for entirely by tax hikes, not one European country would pay less than 50 percent of its GDP in taxes, and France would be at 62 percent. By comparison, the U.S. tax share of GDP would rise from 33 percent to 44 percent (according to the report; I assume this includes all level of taxes). Japan's taxes would be 46 percent of GDP....

"It should be clear to everyone that such an outcome would be an utter economic disaster. Taxes for the working population would be consuming 80 to 90 percent of their income. It would be an economic death spiral. Whatever economic growth might be possible in an aging United States, Europe, or Japan would be completely squelched by such high taxes. The 'giant whooshing sound' would be that of young workers leaving for more favorable working and tax conditions.

"If the increase in benefit costs were paid for entirely in cuts to other spending projects, Japan would see its public benefits rise to 66 percent of total public spending, France and the United States to 53 percent, and Germany to 49 percent. What do you cut? In the United States, you might cut defense spending, but there is little to cut in Europe and Japan. Education? Welfare? Parks? Transportation? Medical or health programs for the working? A mere 10 percent cut in benefits pushes approximately 5 percent of the elderly population into poverty in Europe—think what a 20 percent cut in benefits would do. Japan is ranked in the middle of the vulnerability pack, despite its poor economic outlook, because more than 50 percent of the elderly live with their children. The three most vulnerable countries are France, Italy, and Spain....

"In France 67 percent of the income of the elderly population comes from public funding and in Germany it is 61 percent, compared with 35 percent in the United States and Japan. These percentages are projected to rise only slightly over the coming decades, but because the elderly population is growing so rapidly, actual outlays will soar. Not surprisingly, if you add in medical costs the percentage of public spending increases significantly, even assuming no new benefits."

Germany has made the correct calculation that the only way they can make it in the future is to grow their economy significantly. And they can't do it if they have to finance the weaker members of the eurozone. So they are in effect creating a "coalition of the strong." And if you want to play you will have to get your fiscal house in order. Germany will not kick you out, but you will lose access to financing if you don't get your budget under control.

Losing access to the financial markets when you are already in debt and running large deficits means having to make serious cuts in government services or raise taxes or both. It will mean a recession. The threat of losing access to bond markets and the not-so-gentle nurture of the ECB is very real.

If a country does not agree to new constitutional rules, they will not be eligible for access to the markets. Those new rules have to be approved by the voters, either directly or through their representatives. Leaving the euro may sound good, but in practice? As noted above, a protracted disaster is the alternative. Guaranteed depression. (Perhaps Ireland could leave if they immediately jumped to the pound sterling, or Finland if they went to the Swedish krona, but why, unless things are really falling apart?)

Germany is willing to suffer some volatility and pain in the short run to cement their long-run viability. And they want an alliance of strong countries with them. They are willing to allow the ECB to control debt markets in the short term, while the new rules are being adopted and the adjustments made by the individual countries.

The new rules, when (and if) adopted, will give politicians cover for making the necessary budget cuts and tax increases that no one wants to make now. They can blame it on Brussels – "What else can we do?"

Merkel has drawn the line in the sand. If you cross that line and stand with the Coalition of the Strong, you are committing "your lives, your fortune, and your sacred honor." Well, at least your political lives and your country's fortune. Humor aside, it is a very serious decision with very stark consequences. But in the world of the Endgame, there are no easy choices.

So, nothing changed, in that the can was kicked yet one more time. Still, we may look back in ten years and see that this was the beginning of a very different Europe. Right now, the political leaders seem to be signaling, with the exception of Britain, that they are ready to sign on. I think they actually mean it. And those of us in the rest of the world had better hope they figure it out. A fractured Europe would bring on a crisis that would make the 2008 credit crisis seem like a walk in the park. Especially as the world seems to be getting ready for a synchronized recession. But that's a story for another letter.

New York, Hong Kong, Singapore, and the Lights...

Tonight I wrote to the sound of horses clip-clopping along, pulling wagons through the street, almost under my window. I randomly leased a home on a main street in Dallas to enjoy the Christmas lights, and the horse-drawn carriages are coming out in force. Next weekend we will have "carriage jams." I actually had to briefly stop work on the letter tonight to help a contractor put up lights, so that I won't be the Grinch on my street. And I will admit to walking through the neighborhood tonight, gathering my thoughts and enjoying the lights. They do stir a certain feel in your heart. And the kids were "oohing and ahing." It is a little thing, but it does bring joy. And the clip-clops made me remember the West-Texas country in which I grew up. You can take the boy out of the country, but you can't take the country out of the boy.

Tomorrow night is Lively's birthday party. She is 2 and starting to be seriously fun. And when she goes to bed, the adults will hang around awhile, as Tiffani treats us to a real holiday festival.

Next weekend I fly to LA for a night to go to Rob Arnott's party and watch the boat parade. In and out, with a meeting or two. Home Sunday and then off to New York for two nights for business meetings and dinners with friends. Tiffani and I love New York at Christmas. Talk about lights!

Then I'm home for a few weeks, with lots of writing, and then it's off to Hong Kong for a conference with the Hong Kong Economic Journal, and then on to Singapore just to have a "look-see." (These American colloquialisms must drive the translators nuts, especially Ms. Wong in Hong Kong!) I'll be back in time to do the annual Dallas CFA Forecast Dinner. Quite the line-up: Woody Brock, Rich Yamarone, and Mark Yusko. Given the credentials of the panel, I was apparently invited to supply comic relief. But I do my part.

It is time to hit the send button. This is the latest I have ever finished a letter in 11 years, but then I was more mystified than usual, which is saying a lot, as I live these days in a state of perpetual perplexity. If you think you understand these times, then you don't really understand these times. But it's all fun to try and figure out, anyway. And I thank you for allowing me to share my humble musings. It is a privilege. Enjoy your week!

Your baffled and bewildered analyst,

John Mauldin

2011-12-06T10:31:00.001-08:00

The Shortest Quarterly Letter Ever

Jeremy Grantham

I've been having one of those quarters where everything that can get in the way of writing and thinking does, notably

our client conferences and unexpected travel requirements. Like many, I ﬁ nd it hard enough to write at the best of

times. So sorry for the delay. But rather than skip a quarter, I thought I'd make a simple list of points that I'm thinking

about.

Notes to Myself

 I have no particular insight into the problems plaguing the eurozone, but I can recognize a terrifying situation

when I see one. The appropriate response is surely to be more cautious than usual.

 Sadly, I feel increasingly vindicated by my "seven lean years" forecast of 2½ years ago. The U.S., and to some

extent the world, will not easily recover from the current level of debt overhang, the loss of perceived asset values,

and the gross ﬁ nancial incompetence on a scale hitherto undreamed of.

 Separate from the "seven lean years" syndrome, the U.S. and the developed world have permanently slowed in their

GDP growth. This is mostly the result of slowing population growth, an aging proﬁ le, and an overcommitment to

the old, which leaves inadequate resources for growth. Also contributing to the slowdown, particularly in the U.S.

and the U.K., is inadequate long-term savings. As I write, the U.S. personal savings rate has fallen once again

below 4%.

 In addition, and sorry to harp on this, the U.S. in particular has rapidly acquired relative deﬁ ciencies over the

last 20 years that will hamper the effective functioning and growth of its economy. Relative to other developed

countries, and an increasing number of developing countries, we are sliding in some key areas that threaten loss

of competitiveness:

o Notably depleted infrastructure

o Marked fall-off in the effectiveness of education and training

o Much decreased effectiveness of government, particularly in its ability or even willingness to concern itself

with long-term issues.

 Meriting a separate, special point are the drastic declines in both U.S. income equality – the U.S. has become

quite quickly one of the least equal societies – and in the stickiness of economic position from one generation to

another. We have gone from having been notably upwardly mobile during the Eisenhower era to having fallen

behind other developed countries today, even the U.K.! The net result of these factors is a growing feeling of

social injustice, a weakening of social cohesiveness, and, possibly, a decrease in work ethic. A healthy growth

rate becomes more difﬁ cult.

 I also believe that having an economy in which the average worker makes little or no economic progress slowly

erodes economic balance, leaving us (as mentioned last quarter) with strong sales of BMWs and other premium

goods, and weak and erratic sales of what might be called ordinary goods, resulting in weaker and more unstable GMO 2 Quarterly Letter – Shortest Quarterly Letter – December 2011

growth. Sales are erratic because, with little or no income progress, buying surges by the "middle class" depend

increasingly on shifts in conﬁ dence and a willingness to go into debt.

 I despair that this country and its government have failed to take at all seriously the most important and the most

dangerous issues: depleting resources, development of a comprehensive energy policy, and, yes, global warming.

Wake up dudes!

 Sitting on planes over the last several weeks with nothing to do but read and think, I found myself worrying

increasingly about the 1% and the 99% and the appearance we give of having become a plutocracy, and a rather

mean-spirited one at that. And, one backed by a similarly mean-spirited majority on the Supreme Court. (I will

try to post a letter addressed to the "Occupy … Everywhere" folks shortly.)

 Since the spring, the equity markets have been absolutely bombarded by bad news. This news is complicated

and inter-related: how one factor, say, "Greek default," or "China stumbles," interacts with others such as doubledipping economies and generalized ﬁ nancial crises is just about impossible to know. One can only make more

or less blind guesses. Looking out a year, the overall picture seems so much worse than the generally benign

forecast of 4% global growth from the IMF. The probabilities of bad outcomes are not as high for us today as they

were in early 2008 when, I'm pleased to say, as predictors, they looked nearly certain to us. But the possibility

of extremely bad and long-lasting problems looks as bad to me now as it ever has.

 Yet the S&P 500, unlike other global equities, has hung in and staged rallies whenever the bad news has eased.

Why? Well, 15 years ago, Ben Inker and I designed a model to explain (not predict) the ebbs and ﬂ ows of the

P/E ratio. It had a surprisingly high explanatory power. We found that everything that made investors feel

comfortable worked. That is to say, it was a behavioral model. Fundamentals like growth rates did not work.

The two (out of three) most important drivers were proﬁ t margins and inﬂ ation. Well, today we have (remarkably,

even weirdly) record proﬁ t margins. And by historical standards, stable and low inﬂ ation. Because of this, the

P/E level that one would normally expect to have in these conditions has been way in the top 5% since 1925,

but today's market (not to mention the lows of September) is well below the explained level. It's depressed by

a very obvious reason: the cloud of negatives, which generally and surprisingly have historically had very little

effect individually on the market, but apparently do depress "comfort" when gathered into an army of negatives.

So, whenever the negative news cools down for a week or so, the market tries to get back to its "normal" level,

which is about 20% higher. (P.S. the "normal" level is based on a behavioral explanation. It is absolutely not

justiﬁ ed by long-term value, which hinges on boring discount rates and long-term sustainable growth or, even

more fundamentally, on "replacement cost" or Tobin's Q.)

 Proﬁ t margins dominate the P/E equation above, so that the market is unlikely to come down even to fair value,

about 975-1000 on the S&P in our view, and stay there until proﬁ t margins decline. And the longer you look

at these record and still-rising margins and compare them to the miserable unemployment and substantial spare

capacity, the stranger these high margins look. They will come down to more normal levels eventually, of course,

and when they do they will bring the market down with them. Probably by then, some of the negatives mentioned

above will have resolved themselves. If not, then the market could decline a lot and test my "no market for young

men" thesis that follows.

 "No Market for Young Men." Historians would notice that all major equity bubbles (like those in the U.S. in

1929 and 1965 and in Japan in 1989) broke way below trend line values and stayed there for years. Greenspan,

neurotic about slight economic declines while at the same time coasting on Volcker's good work, introduced an

era of effective overstimulation of markets that resulted in 20 years of overpriced markets and abnormally high

proﬁ t margins. In this, Greenspan has been aided by Bernanke, his acolyte, who has continued his dangerous

policy. The ﬁ rst of the two great bubbles that broke on their watch did not reach trend at all in 2002, and the

second, in 2009 – known by us as the ﬁ rst truly global bubble – took only three months to recover to trend. This

pattern is unique. Now, with wounded balance sheets, perhaps the arsenal is empty and the next bust may well

be like the old days. GMO has looked at the 10 biggest bubbles of the pre-2000 era and has calculated that it Quarterly Letter – Shortest Quarterly Letter – December 2011 3 GMO

typically takes 14 years to recover to the old trend. An important point here is that almost no current investors

have experienced this more typical 1970's-type market setback. When one of these old fashioned but typical

declines occurs, professional investors, conditioned by our more recent ephemeral bear markets, will have a

permanent built-in expectation of an imminent recovery that will not come. For the record, Exhibit 1 shows what

the S&P 500 might look like from today if it followed the average ﬂ ight path of the 10 burst bubbles described

above. Not very pretty.

 Two quarters ago, I advised ducking and avoiding risk and called off the normal positive expectations for Year 3

of the Presidential Cycle; ﬁ rst, because we had already had a good return by April and second, because negatives

were building up in a scary way. For this advice I have no regrets: "Discretion is the better part of historical

valor." The Presidential Cycle this year was indeed very unusually poor (-2.7%) – the second worst since the

start of the game in 1932 – ﬁ nishing very near the lows for the year on September 30. (The Presidential Cycle is

October 1 to October 1.)

 One quarter ago (end July), I said that if you could avoid low quality U.S. stocks, global equities were getting

cheap; the average growth estimate for EAFE, Emerging, and U.S. High Quality was almost 7% real on our

seven-year forecast. Back then we became net buyers of equities – actually, better described as nervous nibblers

– for the ﬁ rst time since the spring of 2009.

 At the end of July, we remained a little underweight equities despite this decent 7% real return forecast because

we allowed ourselves a very small adjustment for a fundamentally scary outlook: thus we were two points

Exhibit 1

If the S&P Overcorrects Like the Average of 10 Great (pre-Greenspan) Equity Bubbles...

Source: Global Financial Data, GMO Actual data as of 9/30/11

200

400

600

800

1000

1200

1400

1600

1800

90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20

S&P 500 1995-2011 and Projected Overshoot 2011-2021

JanActual Projected*:

Average of

Aftermath of

10 Great Bubbles

* Assuming 2.5% inflation

These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future

performance. Actual results may differ materially from the forecasts above.GMO 4 Quarterly Letter – Shortest Quarterly Letter – December 2011

underweight in equities instead of, perhaps, two points overweight. No regrets here either, for despite the strong

rally in October, things are really, really scary. Aren't they? (And, more recently, stock markets are once again

in disarray.)

 My longer-term advice in April was to stay ducked until either the equity markets get to be cheap or, for the

speculatively inclined, until we enter the next Year 3 in October 2015, whichever comes ﬁ rst. This still looks like

good general advice.

 Meanwhile GMO is having a better year. Our largest equity strategy, GMO Quality, is 9.1% ahead of the S&P

year-to-date in an almost ﬂ at market (net, as of November 30)† and is well on its way to delivering a healthy

positive absolute return. We would normally count on winning in this strategy in a big down year, but in a nearly

ﬂ at year this difference is a testimonial to how risk-averse investors have been at the U.S. stock level. Better yet,

U.S. High Quality stocks are, according to us, still relatively cheap.

 Our major asset allocation account (GMO Global Balanced Asset Allocation Strategy), helped along by this

"Quality" effect, has done relatively well (though not great, +4.2% net against its benchmark year-to-date as of

November 30)† despite the absence of longer duration U.S. treasuries, which have been tigers, and a moderate

overweighting in emerging equities, which have deﬁ nitely not. (Although the economic fundamentals and

ﬁ nancial condition of emerging countries remain so much better than those of their developed counterparts, the

world still fears their traditionally high beta – which can and has become a self-fulﬁ lling belief – and the strong

possibility of some weakness in China.)

Recommendations

 Avoid lower quality U.S. stocks but otherwise have a near normal weight in global equities.

 Tilt, where possible, to safety.

 Try to avoid duration risk in bonds. For the long term they are desperately unattractive. Don't be too proud (or

short-term greedy) to have substantial cash reserves. Admittedly, this is the point where we at GMO try to be

clever and do a little better than the minus 1% real from real cash – and, so far, with decent success.

 I like (personally) resources in the ground on a 10-year horizon, but I am nibbling in very slowly because, as

per my Quarterly Letter on resources in April 2011, I fear a major short-term decline in commodities based on a

combination of less bad weather – which has been bad, but indeed less bad – and economic weakness, especially

in China. Prices have declined, often quite substantially, since that letter. However, I believe chances for further

price declines in resources are still better than 50/50 as China and the world slow down for a while, and the

weather becomes a bit more stable.

† The performance numbers are preliminary and subject to change. Final pe

2011-12-06T09:22:00.001-08:00

The Euro Debate Gets Philosophical

John Mauldin | December 5, 2011

Europe is rapidly approaching the denouement, the Endgame, of its currency experiment. The outcome is not clear, at least to your humble analyst, as the debates rage and there are huge pluses and minuses the 17 nations must decide upon. But the proverbial road down which the can is tumbling and clattering, kicked along haphazardly, is coming to its end, and soon a rather sharp turn, either to the left or to the right, will be required. Let us hope they choose wisely.

Today's Outside the Box is a rather philosophical debate between my friends at GaveKal, which they have graciously shared with us. It is important to note that Charles Gave, Louis-Vincent Gave and Francois-Xavier Chauchat are French. Louis served in the French army, studied at Duke, and has lived in Hong Kong for over a decade. Charles (his father) is the quintessential French patriot and patrician right from central casting, whose voice has the authority of God. Anatole Kaletsky is supremely British and one of the most influential economic thinkers in Europe. He is Editor-at-Large and Principal Economic Commentator of The Times, for which he writes a thrice-fortnightly column on economics, politics, and financial markets. These are Europeans vigorously debating the European future as only good friends can.

What we have is an email exchange among them on the future of the euro and the inherent philosophical tensions that are faced by European leaders. I have read it three times and will read it several times more. (Do not feel bad if you need Google to keep up with some of the references. When Anatole refers to Sedan, for instance, he is not talking about cars but a major battle the French lost to the Germans in 1870. Interesting Wikipedia page for you history buffs.)

Let me give you a taste, from so many great lines. Here's Louis (who I will see Monday in Dallas – more below):

"Above, Charles focuses on the philosophical hurdles to any mass intervention. And while I subscribe to Charles' reading of the German institutional framework, my concerns are far less intellectual and far more practical. Basically, we have to remember that the average sovereign debt buyer is not a hazardous investor. The guy who buys a government bond is looking for a very specific outcome: he gives the government 100 only so he can get back 102.5 a year later. That's all the typical sovereign debt investor is looking for. Nothing more, nothing less.

"But now, the problem for all EMU debt is that the range of possible outcomes is growing daily: possible restructurings, possible changes in currencies, possible assumption of other people's debt, possible mass monetization by the central bank etc. Given this wider range of possible outcomes, and the consequent surge of uncertainty, the natural buyer of EMU debt disappears. Again, the typical sovereign investor is not in the game of handicapping possible outcomes; he is in the game of getting capital back!

"... Even if the Bundesbank did agree to monetization (which is hardly a foregone conclusion), the window for this to work may now have closed."

I will be with Louis and Anatole this coming Monday morning in Dallas at a seminar for money managers and accredited investors. If you would like to attend, drop me a note and I will get you an invitation.

And you can find out more about GaveKal consulting services and funds atwww.gavekal.com.

What fascinating times. What an interesting period in which to live. And don't we all want to get through this and have more certainty, in place of the roller-coaster ride we are now on? I will be glad to get back to long-term investing, but in the meantime we should appreciate the fascinating spectacles. It will make for interesting stories to tell our grandkids. Have a great week, and in the midst of spectacle enjoy the holiday season.

Your amazed to finally see it all happening analyst,

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com

The Euro Debate Gets Philosophical

GaveKal
Nov. 29, 2011

Anatole: Clausewitz, the Prussian military theorist, said in his reflections on the Napoleonic period that “war is the continuation of policy by other means”. If so, then it would seem that Germany is again at war with Europe; at least in the sense that German policy is trying to achieve in Europe the characteristic objectives of war: the redrawing of international boundaries and the subjugation of foreign people.

Likening German policy to warfare is a controversial argument, to put it mildly, so let me begin by briefly reviewing how events in Europe have unfolded in the past few months. Angela Merkel has consistently claimed that Germany would “do whatever it takes” to save the Euro. But what has she actually done? She consistently refused to take any of the actions that could actually work to save the Euro and has prevented European institutions from taking such actions, even when the German veto had no legal or moral justification.

As the Euro crisis has intensified and spread from clearly bankrupt countries such as Greece to Spain, Italy and now France, it has been universally acknowledged, at least outside Germany, that three actions are absolutely essential to resolve the Euro crisis and put the European economy back on its feet.

1. The first step would be to restore financial stability through massive purchases of government bonds by the European Central Bank. To succeed, these would have to be on a scale at least comparable to the “quantitative easing” undertaken in the past two years by the US Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank.

2. The second step would be to restore long-term solvency to all the nations of Europe by issuing new bonds, jointly guaranteed by the entire Euro-zone, which would replace part of the government debts run up in nations such as Greece and Portugal which are clearly insolvent.

3. The third step would be to improve and coordinate economic policies in all Euro-nations to restore economic growth, ensure that the restructured debts can be serviced and that another crisis does not occur.

By blocking the first two of these actions—large-scale ECB intervention and the issue of joint European bonds—Germany has guaranteed the failure of the third step, the restoration of economic growth and national credit. Why then has Merkel so blatantly contradicted her own stated policy of “doing whatever it takes” to save the Euro?

The initial judgment was that Merkel did not understand economics, or was too beholden to longstanding monetary traditions, or was simply incompetent. But while the crisis has intensified, Merkel has become ever more stubborn in her refusal to do what was obviously needed to save the Euro, as David Cameron discovered last week. So a different interpretation of her inconsistencies must now be considered. Is it possible that Germany, far from trying to save the Euro, actually wants to break it up? A clear historical precedent is the sabotage of the European exchange-rate mechanism (ERM) in 1992. And the institution that now seems to be working to destroy the Euro is the same one that organised the ERM breakup—the Bundesbank.

The Bundesbank, as an institution, has always opposed European monetary unification, except insofar as it meant the imposition of German economic philosophy on other countries. This attitude of monetary imperialism was summarised by a remark in nt Times obituary published for Richard Medley (the legendary hedge-fund consultant who was at the centre of the ERM breakup as George Soros’s political consultant). Helmut Schlesinger, the Bundesbank president in 1992, was asked why he disliked the precursor of the Euro, which was called the Ecu. He replied, “I have nothing against the Ecu apart from its name—I think it should be called the Deutschemark”.

Back in 1992, the Bundesbank encouraged Soros and other speculators to sell Sterling and the Italian Lira in order to break up the ERM. But the Bundesbank also discretely hinted that the French Franc should be supported because France was in a different category as a German ally from Italy, Britain and Spain. As Soros later said in an interview, also quoted in last week’s obituary for Medley: “I felt safe betting with the Bundesbank. The Bundesbank clearly wanted the Pound and Lira devalued, but it was prepared to defend the French Franc. I did better than some others by sticking to the Bundesbank’s side.”

Today, the role of the Bundesbank in destabilising the European financial system is much more open than it was 19 years ago. Axel Weber, the former Bundesbank president, and Juergen Stark, the former vice-president, both voted against ECB support for Greece back in May 2010 and then publicly denounced these measures to the German media, in an almost unprecedented breach of central banking protocol. Last summer, when the ECB decided to extend its half-hearted support to Spain and Italy, Weber and Stark both resigned in protest—and launched openly political attacks on their own government’s European policies. A few weeks later a story emerged in The Financial Times reporting that Siemens had become nervous about the French banking system and withdrawn its cash balances from Societe Generale to deposit them “for safety” at the ECB. It is hard to imagine who could have leaked this story other than the Bundesbank?

Today, the Bundesbank is in the forefront of a campaign to persuade the German public and the German government that ECB bond purchases and quantitative easing are illegal under European law. In truth, the EU treaties specifically allow the ECB to buy bonds, as long as it does not do this directly from governments. And EU laws say nothing at all about the effects of quantitative easing—which is not surprising since QE is a complex issue of economic theory that could not possibly be subject to determination by the courts. What the Bundesbank believes, however, is that European law should have made bond purchases and expansionary monetary policy illegal—and if other European countries refused to write these laws into EU treaties they will just have to be imposed by Germany through financial main force.

In short, the Bundesbank policy on the Euro crisis is to present the other countries of Europe with a stark ultimatum: either they accept German economic directives, German monetary theories, German financial practices and even governments imposed by Germany, as part of a draconian new regime for national insolvency and administration. Or they must face financial chaos and expulsion from the Eurozone, under a new exclusion procedure now demanded for nations that refuse to submit to German rules. In short, Germany is trying to achieve through monetary diplomacy what were previously the objectives of warfare: redrawing the boundaries of Europe and imposing German ideas on those nations that remain within. That, surely, is a continuation of war by other means.

Charles: Dear Anatole, my first answer to the above is that there is nothing new here. I have argued incessantly in every single one of our debates since Axel Weber’s resignation that the Bundesbank was now in an open war with the concept of the Euro. I have also pointed out that, in my career, I have seldom made money when betting against the Bundesbank.

Now there are of course many reasons behind the hostility of the Bundesbank to the Euro. The first is obvious enough: the Euro was thrust on an unwilling Bundesbank by Mitterrand and Delors as a compromise to France accepting German re-unification. So the Euro’s very birth was an unhappy one to start with.

Beyond that, the hostility rests, I believe, on important philosophical differences. Indeed, Max Weber suggested two sets of ethical virtues that a proper political education should teach: the ethic of conviction (Gesinnungsethik) and the ethic of responsibility (Verantwortungsethik). According to the ethic of responsibility, an action is given meaning only as a cause of an effect; i.e., what matters is the consequences. According to the ethic of conviction, on the other hand, a free agent should be able to choose autonomously not only the means, but also the end; “this concept of personality finds its „essence‟ in the constancy of its inner relation to certain ultimate „values‟ and „meanings‟ of life”. Weber recognized a gulf between his “Two Ethics,” one which is concerned with consequences and one which is duty– and rules-bound. His problem arises from the recognition that the kind of rationality applied in choosing a means cannot be used in choosing an end. Increasingly, the current debate on the Euro is nothing but a conflict between these two forms of ethics.

In one camp, are those who, like François and yourself, say that nothing is more important than preventing a collapse of the Euro. In the other camp, the Germans say that nothing is more important than upholding the international treaties, and maintaining the supremacy of the law over the pressure of short-term solutions.

Now because of its unfortunate history, this debate can get emotional very quickly in Germany. Indeed, more than any other people, the Germans have suffered from adopting the second view, with huge negative consequences for Europe and the world. As a nation, it is thus my impression that Germany has come to the conclusion that, at the end of the day, one should never tamper with the law, whatever short-term benefits such tampering might bring.

If we apply this distinction to what money is, those who believe that money is a tool which belongs to the political sphere and can be manipulated to meet political goals, justify their destruction of money by an ethic of responsibility (fighting unemployment, creating economic growth, etc). For what it is worth, let’s call them “Keynesians”. On the ethic of conviction, we have the Bundesbank and the German population (but not so much the German political system) who say that money is a common good which does not belong to the state, and that the economy has to adapt to this reality, and not the other way around. Let us call them the “Austrians”. As our readers know, Anatole, you are intellectually very much in the first camp, while I plant my flag in the second. With that in mind, the current debate on the Euro can be framed as such:

· On the one hand, there are those who believe that the end justifies the means. If saving the Euro requires the destruction of the notion of money as a common good, so be it. The fact that the Euro is slowly destroying Europe (as was entirely predictable—and predicted in our pages), thus leads our “Keynesians” to recommend measures and actions which have been specifically forbidden in the treaties, the German constitution, or the bylaws of the ECB.

· On the other hand, there are those who remember that Hitler said that treaties and constitutions were nothing but pieces of paper. For such Germans, it is simply inconceivable that the law could be made subservient to a political or economic goal. They believe that destroying the law is far more dangerous than destroying the Euro, and they say to the others that the solution is simple: they signed the Treaties, they now have to respect them.

I respect the German vision. The treaties creating the ECB and the Euro were built around the German notion of money and everybody knew it. So when Merkel says that the others have to become Germans, she is perfectly entitled to do so, since it was exactly what the treaties said (and why the British, Swedes and Swiss rightly refused to join). In my view, on this point, the Germans are right. Frankly, one does not sign a treaty with Germans in the hope that the Germans will be flexible. They never were, and given their own history, are now less so than ever.

I also have a lot of sympathy for the German view of questioning why we should sacrifice every rule, and treaty, to uphold a currency that is clearly not working for a number of countries? Must the survival of the Euro in Southern Europe really only occupy every waking hour, of every European policymaker (and investor)? Must it really take precedence over every other institutional framework? In short, is the Euro really the end-all, be-all of European civilization; the altar on which everything else can be sacrificed? Is this really as good as we get? Or are European policymakers only trying to save the Euro (and sacrificing the youth of a number of countries) to avoid having to admit that they made a colossal mistake?

Louis-Vincent: In all our previous debates, and in The Divergence in European Spreads—Why Now?, I argued that there were four possible resolutions to the European crisis:

1. The first was for troubled countries to leave and redenominate their debt in their local currencies, thereby avoiding a default but imposing massive foreign exchange losses on foreign bondholders.

2. The second was for Germany to leave—though this seemed highly unlikely as this would in essence bankrupt every German bank, insurance company and pension fund (whose liabilities would be redenominated in DM and whose assets would remain in Euros).

3. The third was for the weaker links to default and restructure their debt.

4. The fourth was for the ECB to become far more aggressive in its purchases of troubled-country bonds and swell its balance sheet.

Now up to just a few months ago, the Europtimists kept arguing that all these events were just not going to happen. Instead, the more likely scenario was one of deep structural reforms combined with some fiscal transfers and a little bit of help from the ECB. Such a combination, I was told in many meetings and even in some of our internal debates, would help to keep the Euro-show on the road.

Fast forward to today, and every Europtimist (see the latest The Economist) is now arguing that solution 4 has to be the answer. Obviously, this is also what Anatole is arguing for by equating the German resistance to such an outcome to an “act of war.” So already we have witnessed quite a paradigm shift. But is it now too late for this? In other words, have Europe’s debt crisis and deflationary-bust moved beyond the powers of an ECB’s magic wand? Not that I don’t believe in Santa Claus, or in the ability of central banks to cure every ill, but it seems to me that, should the ECB decide (a day late and a Euro short?) to now intervene in size to prevent the European bond markets from deteriorating further, it would face some very significant hurdles.

Above, Charles focuses on the philosophical hurdles to any mass intervention. And while I subscribe to Charles’ reading of the German institutional framework, my concerns are far less intellectual and far more practical. Basically, we have to remember that the average sovereign debt buyer is not a hazardous investor. The guy who buys a government bond is looking for a very specific outcome: he gives the government 100 only so he can get back 102.5 a year later. That’s all the typical sovereign debt investor is looking for. Nothing more, nothing less.

But now, the problem for all EMU debt is that the range of possible outcomes is growing daily: possible restructurings, possible changes in currencies, possible assumption of other people’s debt, possible mass monetization by the central bank etc. Given this wider range of possible outcomes, and the consequent surge of uncertainty, the natural buyer of EMU debt disappears. Again, the typical sovereign investor is not in the game of handicapping possible outcomes; he is in the game of getting capital back!

This is very problematic because once uncertainty creeps in, bonds will tend to gradually drift towards what I have come to call the bonds “no-man’s-land”. Basically, once sovereign bonds reach 90c to par, they tend to have a much higher volatility and much greater uncertainty. As a result, they are no longer attractive to the typical bond manager or asset allocator looking to buy bonds to diversify equity risk (think how Italian bond yields are now correlated to European equities. If you want to be bullish Italian bonds, you may now just as well spend a fifth of the money and buy European banks for the same portfolio impact…). And once a bond enters into no-man’s-land, it has to fall a lot before attracting the attention of distressed debt and vulture investors (usually yields of 15%+). So the first obvious problem is that more and more European debt markets are entering this “no man’s land” bereft of “normal” investors.

Of course, this invites the conclusion that the ECB should thus do everything in its power to bring the bonds out of this no-man’s land. But what are those magical powers the market keeps referring to? After all, the various European institutions (ECB, EFSF…) and the IMF have mopped up almost a third of the Greek debt and yet it is now trading at 25c on the Euro! Perhaps this goes back to the way a typical sovereign debt holder thinks? Indeed, let us imagine that, tomorrow, the ECB follows every editorialists’ advice and comes in to mop up a third of Spanish and Italian debt in a bid to get yields fixed at, say 5%. Will our Spanish and Italian bondholders a) jump at the chance to get out of their positions with a smaller loss than forecast? Or b) sit tight and allow themselves to be transformed into junior bond holders?

Indeed, the Greek precedent (where basically the ECB insisted on being made whole while the private sector shared in the losses of lending money to the spendthrift Greek government) means that the default assumption of sovereign debt holders should be that a mass intervention of the ECB into their markets will relegate them to the “junior ranks.” And needless to say, most institutions who invest in sovereign bonds are not looking to be junior bond holders. They are looking for absolute safety. So in a perverse way, massive purchases by the ECB may actually highlight that the asset one owns is anything but safe; implying that for an ECB intervention to work, the amounts would likely have to be staggering. This is why I tend to believe that even if the Bundesbank did agree to monetization (which as Charles highlights is hardly a foregone conclusion), the window for this to work may now have closed. Instead we should brace ourselves for either defaults, or countries leaving and re-denominating debt in local currencies.

Anatole: Charles, your Weberian response to my article on Germany's war against Europe is thought-provoking. But it leaves out two crucial points:

Firstly, It is not at all clear that asking the ECB to buy bonds in the secondary market conflicts with any law. This is Merkel's interpretation of the EU treaty. But all that the treaty actually says (Article 123) is that the ECB will not finance governments by providing “overdraft facilities” and buying their debt directly in the primary market. The legislative history of this article is interesting. The Germans wanted a tougher prohibition about monetary financing written into the Maasrticht Treaty, but the other countries refused. The compromise was Article 123. Merkel is now trying to interpret this article as if it enshrined the laws that theywanted. It is therefore the Germans who are trying to twist the law in their favor, not the French, Italians, etc.

Secondly, laws need to be changed with the passage of time. That is what government, and especially democracy, is for. Therefore a dogma of upholding the law as it is, regardless of circumstances, and refusing to change it is not justifiable even for Weber's “ethic of conviction”. Your response to this objection would presumably be that some laws are so important that they should never be changed even by a democratic decision—for example, laws on human rights, racial equality and religious freedom, constitution arrangements and other fundamental laws (which is actually what Germany calls its constitution). I fully agree with this, although even constitutions always contain an amendment process—at least if they are properly drafted, which of course the treaty on European Union never was! Still, it is clear that your ethical argument (and Merkel's) only applies to tampering with fundamental laws, not the much larger number of everyday regulations that are needed for society to function, e.g.: driving speed limits, postal charges...

The question, therefore, is whether monetary laws should be treated as ethically fundamental in the same way as laws on free speech, political association, religious freedom, property rights, capital punishment, etc. I personally do not think so. To me economics is a pragmatic activity with no clear answers. The “right” of a central bank to operate independently of government is not, in my view, an ethical question, comparable to capital punishment or even the right of the citizens to adequate healthcare. This is, I think, the fundamental point on which you and I disagree.

Which leads to my third objection: even if we accept that the “right” of central bank independence is a fundamental right comparable to other constitutional requirements, Merkel is not upholding this right. In fact she is doing the opposite. She is issuing political instructions to the ECB on what it cannot do. If the Germans genuinely believed in the rule of law and in central bank independence, they would not try to prevent the ECB from doing whatever it thought was necessary and desirable. If the ECB board, as properly constituted under the EU Treaties, voted to buy the entire Italian, Spanish and French secondary bond market and to engage in QE to the tune of €10trn, then Germans would have to calmly accept this as a lawful consequence of the treaties their government had freely signed. In fact, therefore, Merkel is not exemplifying the respect for law and ethics of conviction as you describe. She is reinterpreting laws and tampering with treaties in whatever ways happen to suit her.

Charles: Anatole, since we are treading on philosophical grounds, could I say that we must both have studied casuistry in our youth for this is increasingly looking like a debate between a Jesuit and a rabbi.

On your first point, if a French commercial bank subscribes to a French bond and sells it in the following second to the ECB, what do you call this? Moreover, doesn’t the treaty specifically forbid joint responsibility of the debt and the mutualisation of said debt? What the ECB is doing in buying in the secondary markets in amounts higher than those needed for its open market operations is not compatible with these parts of the treaty (even if it is compatible with article 123), since Germany could be on the hook if a country failed (through the participation of the Bundesbank in the ECB). So it seems to me that Merkel is perfectly entitled to her legal views: the ECB’s recent actions are de jure and de facto against both the letter (no mutualisation of the debt) and the spirit (no financing of budget deficits by the central bank) of the treaty.

On your second point, I most definitely do believe that money is far too important to be left under the control of politicians (especially French ones!) and let me explain why. The purpose of economics is to understand why things have a value and why those values change over time. To do so requires a measurement in “money”. But no economist has ever been able to explain why money has any value since it has a marginal cost of production of zero. For me, money is a kind of social contract which binds a “demos” (Plato called it a “convention”) where citizens accept to use it in their transactions or for their savings. But this convention is a very fragile thing.

Renan used to say that a nation is defined by the willingness of its citizens to live together, and this willingness was what created a “demos.” There is no European demos, so there is no possibility of a European currency. To make it simple: to each demos its currency. There is no European Nation, there is a European Civilization, which is not at all the same thing (see Was the Demise of the Soviet Union a Negative Event?). Money thus does not belong to the government, but is a common good of the demos.

If I have learnt something after the debacle of the so-called “financial revolution of the last twenty years” it is that one should never put the monetary policy under the control of the politicians, and that money should never be “privatized,” or put under the control of the market, since it has a marginal cost of production of zero. The privatization of money which started under Clinton, and was continued under Bush and Greenspan, led to the current disaster. In my view, money is a common, (and more importantly—perhaps as I am getting older) trans-generational good that no generation should be able to manipulate for its benefit. The only role of the government should thus be to regulate the credit system without which an economy cannot work. The attempt to regulate this credit system internationally rather than at the national level is the root cause of the current problems, the governments having failed miserably in their regulatory role. Since they have failed, like any bad trader, they are now busy doubling and tripling down. This never works.

On your third point, I have read a thousand times that if the board of the ECB decides on monetization of the debt, the Germans should just accept that decision. Except of course that the board is bound by the bylaws or the treaties which specifically forbid such a decision. What Merkel is saying is thus very simple: if the board gives in to the French or the Italians because they have the majority, then this decision will not be legally binding for Germany. In other words, she is telling the board members to respect the treaties, which guarantee the ECB independence against French or Italian politicians looking for an easy exit, as they always do, or else…

This seems to me perfectly fair and leads me back to my original point, which our latest exchange of emails amply proves: you believe that the end justifies the means (ethic of responsibility). I (like the Germans) do not (ethic of conviction). To conclude on a historical note, I believe that Chamberlain practiced the ethic of responsibility and Churchill the ethic of conviction. And reviewing Chamberlain’s actions, Churchill said “they accepted dishonor to avoid war. They will have the war and will have lost their honor”. Looking at your proposed remedies, your solution is to destroy money to avoid ruin. We will have the ruin; it is too late and will lose our “money” anyway. Destroying money does not create wealth any more than deregulating it.

Anatole: As you have raised the issue of casuistry I must return the compliment and say that your casuistic education must have been even better than mine.

You are right that the ECB has been funding EU governments via the banking system, but the Germans never objected to this—and still do not—for the simple reason that this form of government funding is considered acceptable in Bundesbank theology. Why this is so has never been clear to me, but it must originate in some theorem of Austrian economics which I never studied. Last year, I had the chance to put this question to Axel Weber himself and he confirmed in the clearest terms that ECB lending to banks which then on-lend to governments is a perfectly acceptable way to conduct monetary policy.

Incidentally, some of the people I met in Frankfurt last week were as baffled as I was by the Buba doctrine that financing the Greek government directly is unacceptable, whereas funding insolvent Greek banks so that they can finance their government is perfectly OK. In any case, this issue of financing governments was thoroughly debated and negotiated in the Maasrticht Treaty talks. The result, as I said in my earlier email, was that the other countries refused to go as far as the Germans wanted in forbidding monetary financing under Article 123. Moreover, the German demand for a prohibition on mutualisaing debt, which you mention, was also rejected by the other countries at Maastricht. I know the Germans are always quoting the so-called "no bailout clause", but like the monetary financing clause this part of the treaty does not say what the Germans now claim. The no bailout clause (Article 125 of the new Lisbon Treaty) says this: "A Member State shall not be liable for or assume the commitments of central governments...or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project."

This leaves plenty of scope for EU member governments to agree on mutual guarantees for institutions such as the EFSF and ESM to execute a specific project like the rescue of the Euro. Again, this is a case where the Germans, having failed to achieve their objectives in the original treaty negotiations, signed up anyway and are now trying to reinterpret the laws retrospectively to get what they want. Far from showing respect for Laws and Treaties, this is uncomfortably reminiscent of the German attitude to the Treaty of Versailles.

Now you may be right that money is a public good which should not be subject to political manipulation, but the precise mechanisms for issuing and managing money have always been subject to change—and rightly so, in my view. We both agree that returning to the gold or silver standard would not be a good idea even though money was “always” managed like that until the 1930s. Of course, others have different ideas about the gold standard and these are quite legitimate. And there are a multitude of different views about whether it is best to control money by using interest rates or inflation targets or monetary targets and which ones - eg monetary base, M1 or M3 or the exchange rate.

These different views about monetary management are not about moral or philosophical issues. They are empirical judgments about what works best in the real world. Thus the German idea that monetary financing of government deficits will always and everywhere generate inflation and destroy confidence in the public good money (which you seem to share) is not a moral principle. It is a particular view about how the economy works which can only be judged by whether it turns out empirically to be right or wrong.

As it happens, an important experiment is now being conducted in monetary financing all over the world. If the US, Britain, Japan and Switzerland, all of which are now engaged in monetary financing, suffer serious inflation and a loss of confidence in the value of money, then the Germans (and you) will be proved right. Thus far, however, most of the evidence points in the other direction. (By the way I am not claiming in the last sentence that monetary financing has been successful in managing the US, British, Japanese and Swiss economies—that is another issue—but merely that it has not undermined the public's desire to hold money, as the Germans and you seem to believe).

Finally, I have already responded to your point about what the laws actually say above. So let me comment on your claims about unprincipled pragmatism.

It seems to me that “The End justifies the Means” is actually a good description of your approach to this whole single currency disaster. For you, ‘the End’ is the breakup of the Euro and you are willing to endorse all kinds of dishonest and economically destructive behavior from Germany to achieve this end. I believe, on the contrary, that Merkel should be judged on the effects on the world of what she is doing as well as on her party’s motivations, which are politically self-serving and short-sighted. Like you, I would prefer to see the Euro break up, but I am not going to pretend that Merkel and Axel Weber are morally right, simply because their behavior happens to be advancing my side of the argument.

So in conclusion, I would return to a point that I have made before; namely that if Germany continues to want to play by its rules, rather than the rules of the community, then France should invite Germany to leave the Euro.

François: Anatole, even if your scenario of Germany leaving the Euro made economic sense for France (on which I am not convinced), I am sure that you have already noticed that French politicians are not that interested in economics. Instead, plans that are economically consistent but that threaten the French political influence in large parts of Europe remain a non-starter for our dear énarques. And you will never convince the French that they might eventually regain this influence thanks to the indirect, magical effects of a devalued currency. They won't believe in it (I don’t either, by the way), and even if they did believe in it, they would never have the guts to bet on it anyway. Maintaining the status quo remains the default option for any French politician.

In Capitalism 4.0, you wrote how many UK economists and politicians had been surprised by the good performance of the economy in the years after the Pound left the ERM. You explained that many in the UK initially feared that this "loss of monetary anchor" would lead Britain to nowhere. On the contrary, it provoked renewed internal confidence. Could this benefit happen to France and Italy? Implicitly, this is your bet, and I find it very interesting. But as you know the UK Pound did not stay in the ERM for long, while France and Italy have anchored their monetary destiny upon Germany for more than 30 years. It is in this respect very telling that Italy did not stay long outside the ERM after it was forced to leave in 1992 (it joined back in 1996). Similarly, France did not leave the ERM in 1983. For sure, these successive political choices might be seen as meaningful of countries that lack self-confidence, and these different episodes might well have represented lost opportunities to pursue more sensible economic policies. But for both historical and economic reasons, France and Italy have felt that they needed to keep up with Germany in order to participate to the elaboration of a soft-power of global dimension, which is what the European project is about. Whatever opinion we may have about how this project is being conducted, it is a very respectable project. And after so many years and so much capital invested in it, its possible dismantling would leave much deeper scars and provoke a much larger chaos than when the UK Pound left the ERM.

Anatole: François, you have hit the nail on the head. I agree with you completely that the French enarques would not want to break with Germany even if it could be demonstrated with 99% probability that such a policy would make France stronger and more prosperous. Such is the power of what I believe you call the “pensée unique”. But the problem is not a political one but is now an economic one. In other words, French politicians may decide to ignore economics but the rules of economics are not ignoring France and France may well not be able to cling to Germany much longer. This is especially true if the Germans now realise that France has become completely subservient and that, therefore, Germany no longer needs to compromise in any significant way to accommodate French demands. In short, France is currently living through yet another “Sedan”!

Louis: Speaking of Sedan, once it becomes apparent that the enarques are turning France into a German colony isn't it possible that the public will rebel? In other words, could we not see another “Paris Communes”? At the very least, we will likely see Marine Le Pen make new gains for the National Front in May, and likely make it to the second round. And who is to say that, as the French economic situation deteriorates further, she doesn’t face off against another fringe candidate, perhaps from the far left? Let us not forget that the combined far left (communists, various Trotskyites parties…) have typically polled a combined 15-25% in French elections. Fortunately, they were always scattered amongst many parties (in a scene reminiscent of “The Life of Brian” with the “Judean People’s Front,” the “Popular Front of Judea,” etc…). But now that they are gathered under the Melenchon roof...

Francois: Since 1983, French voters have indeed voted more and more against the traditional parties (2007 was an exception to this rule). It is however not that easy to assess why. Many countries with independent economic policies are seeing the rise of the extreme right or left, while in a suffering Euro country like Spain, the traditional parties continue to attract 95% of the votes. I would thus not be able to demonstrate that the rise of political tensions and dissatisfaction in France or Italy has been due to the anchoring of economic policy on Germany, contrary to what the you suggest.

Moreover, in France, the return of the German constraint upon economic policy is for now leading the country more towards introspection (the realization of the huge costs of our so-called social model) rather than towards resentment against Germany. In fact it is even possible that, contrary to what you suggest, the centrist parties attract more, rather than less, votes in the next elections as more and more people realize that the country needs to be more seriously managed. We will see.

Finally, what exactly are the real benefits of a rebuttal of the German constraints? I suspect that Anatole is too much influenced by the success of the devaluation of the Pound in 1992. But in Italy, which left the ERM at the same time, the following years were far less fun, as the chart below illustrates:

Indeed, the UK could enjoy the benefit of the 1992 devaluation because its economy had been re-vitalized by the reforms of the Thatcher era (meanwhile, today, after more than a decade of creeping Blair-Brown health and nanny-statism, it is a very different story!). Anyway, I do not think that anyone in France would suggest that if Germany left the Euro, or if France simply refused the German constraint, the French economic situation would improve. Our problems are of our own making and are not so much related to having the wrong currency, as to having a welfare, and regulatory, state on steroids.

2011-12-03T12:50:00.001-08:00

Time to Bring Out the Howitzers

By John Mauldin | December 3, 2011

Employment Up But Not Enough
The World Slips into Recession
Central Bankers of the World, Unite!
New York, Hong Kong, Singapore, and Cape Town
And My Conference

It is now common to use the term bazooka when referring the actions of governments and central banks as they try to avert a credit crisis. And this week we saw a coordinated effort by central banks to use their bazookas to head off another 2008-style credit disaster. The market reacted as if the crisis is now over and we can get on to the next bull run. Yet, we will see that it wasn't enough. Something more along the lines of a howitzer is needed (keeping with our WW2-era military arsenal theme). And of course I need to briefly comment on today's employment numbers. There is enough to keep us occupied for more than a few pages, so let's jump right in. (Note: this letter may print long, as there are a lot of charts.)

Employment Up But Not Enough

The headline number is that 120,000 new jobs were created in November, in line with estimates. That total is the sum of 140,000 jobs from the private sector coupled with the now usual loss of 20,000 jobs in the government sector. But when we look at the details, things are not as upbeat.

First, the good news: the US economy is continuing to grow. As I have said for quite some time, the US should not fall into a recession unless it is pushed by something from beyond our shores, which, sadly, I expect (details below). However, we are nowhere near the typical recovery pattern. By this time into a recovery we are usually making new highs on the employment front. As everyone knows, we are millions of jobs from that level.

And my friend Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business, sends us these headlines today from his own survey:

· AVERAGE EMPLOYMENT PER FIRM ROSE

· HARD TO FILL JOB OPENINGS INCREASED, UNEMPLOYMENT DOWN

· PLANS TO CREATE NEW JOBS NEARLY DOUBLED

The net change in employment per firm wasn't much different from zero, but it did have a plus sign in front of it for the first time in nearly half a year. On average, owners reported increasing employment an average of 0.12 workers per firm. Seasonally adjusted, 14 percent of the owners added an average of 3 workers per firm over the past few months, and 12 percent reduced employment an average of 2.9 workers per firm. The remaining 74 percent of owners made no net change in employment (47 percent hired or tried to hire and 35 percent reported few or no qualified applicants for positions, both figures up 4 points).

The percentage of owners cutting jobs has returned to "normal" levels (even in a great job market, over 300,000 file initial claims for unemployment, i.e., they are fired or laid off). And the percentage of owners adding workers (creating jobs) continued to trend up. Reports of new job creation should pick up a bit in the coming months.

(I spent last Sunday with Bill, and we outlined our new book on creating jobs and employment. Our goal is to finish it in record time and have it out next spring.)

120,000 jobs is not quite enough to keep up with the growth in the population. Along with positive revisions to previous months, we have now averaged about 114,000 a month for the last 6 months. But then why did the headline unemployment number fall to 8.6%? That is a very large drop for one month. The simple answer is that the number of people looking for a job fell by 315,000. And the number of people counted as not in the labor force (a different measure) swelled by 487,000 to a record 86.5 million.

Again, for new readers, you are not counted as unemployed if you have not looked for a job in the last four weeks. Let's look at a chart from the St. Louis Fed database that shows the number of citizens not in the labor force. What we see is a rise from 77 million in 2007 to 86.5 million today. Part of that can be explained by population growth, but it would be less than half of the increase of almost 10 million people not considered to be in the labor force.

If we looked at a chart of those counted as being in the labor force, we would see that it is roughly where it was back in 2007, yet there has been working-age population growth of at least (my guess) 5 million. And the next chart shows the number of people that are actually employed, private or government, full- or part-time. What we see is that the number of people working is about where it was 8 years ago.

That is not a pretty chart. What all that means is that unemployment would be closer to 11-12% if we went back to the labor force of just a few years ago and adjusted for population.

Let me quickly note, too, that if we went back to the unemployment measurement basis of a few decades ago, the numbers would be closer to what I suggest above. Counting unemployment the way it is currently done allows whoever is in charge to publish numbers that look better than they are in reality on the street. I expect Republicans to point this out in the next election cycle, although if they get into office they will have to live with that analysis when it comes back to haunt them in four years. Because as the next chart shows (from my friend Lance Roberts of Streettalk Advisors in Houston), we need job growth of about 400,000 jobs a month to get back to the long-term trend by 2020. This shows the employment-to-population ratio, which has dropped by 6% since 2000, falling precipitously since the beginning of the recession. We have never had such strong employment growth, and are unlikely to get it as we reduce government spending, which we must do.

This shows above all else why the #1 issue for the coming elections will be jobs. The US economy is looking more and more European all the time in terms of unemployment numbers. If the course is not changed, it will make any real recovery back to what we think of us "normal" for the US highly problematic.

Let's quickly look at a few other problems in this employment report. The work week was unchanged at 34.3 hours (and was down 0.2 hours in manufacturing). Aggregate hours were up just 0.1%. Average hourly earnings were off 0.1%, leaving the three-month average at -0.1%. For the year, hourly earnings were up just 1.8%. When the Great Recession began, they were rising at a 3.4% annual rate. Aggregate payrolls were up just 0.1% for the past month. The decline in unemployment was concentrated among the shorter durations, with almost all of it among those jobless for 14 weeks or less. Those unemployed for 99 weeks or more rose 143,000 to 2.0 million, very close to an all-time high. The mean duration of unemployment rose to 40.9 weeks, a record. (Hat tip The Liscio Report.)

This does not bode well for consumer spending. Any growth of late has come from a reduced savings rate, as income is barely keeping up with inflation; and if you look at the inflation we "feel" in healthcare, food, and energy, then the average consumer is losing ground. This also means any recovery is only one external shock away from slipping back into recession.

Finally, the "quality" of the new jobs is not what we would like. More and more people are taking lower-paying jobs. We saw 105,000 jobs in retail, temporary, and food services out of the total of 120,000. Many of these are seasonal and will fall off in the next quarter. (Let me hasten to add that I am not being derogatory of food-service jobs. They are important and are hard work. I have two kids who are employed in the food-service world, and most of my kids, and your humble analyst, have been employed in various food-service jobs at one time or another. Without those jobs some of my kids might be moving back home! So, the next time you're out, leave a bigger tip than normal if it's deserved. Your wait person is someone's kid!)

The World Slips into Recession

How fragile is the recovery? The rest of the developed world is either in recession or soon will be.

This next chart is from friend Prieur du Plessis of Plexus Asset Management in South Africa. Notice that every major region is slipping into contraction except the US. ( http://www.investmentpostcards.com/2011/12/02/global-manufacturing-pmi-saved-by-the-u-s/)

Now, let's look at more details, provided by SISR (sadly, I lost the email of the person who provided this, so I can't credit him). It shows that outside of the US and Canada, the rest of the developed world is watching their PMI (manufacturing production) numbers go into contraction. Of the emerging world, only India and South Africa are growing. Notice that the contraction in both Germany and France is getting worse month by month.

Source: Markit Economics, SISR

How long can the US resist a global slowdown? My answer would be, for longer than you might think, absent the potential shock coming from Europe. But the above data does set the stage for the rest of the letter.

Central Bankers of the World, Unite!

Now, a few quick observations. This was truly a global effort by the central banks of the world (the US, Europe, Japan, Switzerland, Canada, and China). But then, what else did you expect them to do? Their main tool is to provide liquidity, and that is what they promised. They lowered the cost of coming to the "window" and certainly lowered the "shame" factor in doing so. Going to the central bank could be seen as a sign of weakness and, at higher rates, banks might be reluctant to do so. At the new rate it is reasonably economical, and the central banks have signaled it is more than OK.

Second, this effort also included China, which cut its bank reserve requirements by 0.5%. David Kotok pointed out to me something unusual about this. Normally, China makes it moves with a number ending in "7," like 27 or 47, as 7 is good luck. For those paying attention, this was China's way of saying "We are part of the team," rather than acting on their own, as they usually do. Now, it makes sense that if you include Canada in the "club" you should include China.

The stock markets of the world went into an ecstatic frenzy, capping off a very positive week. But I would remind my enthusiastic friends of a few things. Let's look at what really happened. We just recovered from a very over-sold condition and are still down almost 7% from this summer.

And this has happened before. Let's rewind the clock to October of 2008, deep in the credit crisis. This is a report from Jim Lehrer of PBS (emphasis mine):

"JIM LEHRER: World stock markets staged a comeback today. They did so as key governments moved to support troubled banks. On Wall Street, the Dow Jones industrial average scored its largest point gain ever, soaring 936 points to close above 9,387. The Nasdaq was up more than 194 points to close at 1,844. Overseas, stock indexes rose 8 percent in Britain, 11 percent in France and Germany. Markets across Asia also shot higher, including a gain of 10 percent in Hong Kong.

News of European efforts to end the banking and credit crisis helped ignite the rally. On Sunday, nations that use the euro agreed on coordinated steps. Today, Britain was first to act. It was followed by Germany, France, Spain, Portugal, Austria, and the Netherlands."

The good news is that this week's action may (and I emphasize may) help stave off a true bank credit crisis on the order of 2008. That is, if the central banks of the various European countries follow through (more on that below). The real problem was best summed up this week by Mervyn King, the governor of the Bank of England, speaking at the press conference to launch his Financial Stability Report.

"Many European governments are seeing the price of their bonds fall, undermining banks' balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks' balance sheets further. This spiral is characteristic of a systemic crisis.

"Tackling the symptoms of the crisis without resolving the underlying causes, by measures such as providing liquidity to banks or sovereigns offers only short-term relief. Ultimately, governments will have to confront the underlying causes... The problems in the euro area are part of the wider imbalances in the world economy. The end result of such imbalances is a refusal by the private sector to continue financing deficits, as the ability of borrowers to repay is called into question.

"The crisis in the euro area is one of solvency and not liquidity. And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected. Only the governments directly involved can find a way out of the crisis..." (Hat tip, Simon Hunt.)

Time to Bring Out the Howitzers

If the problem were one of liquidity, then this week's action would be enough. But the problem is solvency. The majority of European banks are insolvent. They own too much debt of sovereign countries that are going to have to reduce their debts. There is a growing number of analysts who are realizing that even Italy may have to reduce its debt burden. I have highlighted the problems faced by Belgium. And how about Spain, and Portugal?

What this action does is give the ECB the dollars it will need to loan to the various national central banks, so they can loan to their insolvent banks. Will they bail them out, or nationalize them? The answer depends on the country and its voters. But absent recapitalizing their banks, there will be a credit crisis that will affect the whole world.

The amount of debt that will have to be written off and the loan portfolios reduced, as well as new capital raised, is daunting. As I have noted previously, the need is for around €3 trillion.

Writing off so much debt in the midst of a recession, coupled with austerity moves, will be massively deflationary for the eurozone. But Merkel and the German Bundesbankers have made it clear that they will not be part of any "printing press" action that is not coupled with serious commitments for balanced budgets. Even in the face of a recession.

Which makes it quite strange that the ECB has been tightening in terms of money supply the past year. Notice in the graph below that M1, M2 and M3 are all in negative territory. (Chart from the London Telegraph.)

The ECB under Trichet was apparently fighting inflation. He raised rates and let his inner Bundesbanker take control. Maybe with the rate cut and the new head of the ECB, Mario Draghi, we can see signs that the ECB may in fact act to ease. This is from my friend Dennis Gartman, writing this morning:

"Turning to the ECB, the new President, Mr. Draghi, has obviously taken on the most difficult of jobs and we've no choice but to admire him for the audacity necessary to take on a role such as his… especially at a time such as this. Yesterday, Mr. Draghi made a statement that we find tectonic-plating-shifting-like in nature when he said firstly that the 'Downside risks to the economic outlook have increased.'

"They have indeed, and we've no problem with what he said for that is indeed the truth. Then, however, the plates shifted when he said, noting that the ECB's mandate, that price stability is to be maintained 'in both directions.' In other words, the ECB's mandate forces the authorities to be concerned about deflationary risks as well as those inflationary.

"Did you hear the plates shifting? You should have for they have indeed shifted. Draghi's warning was that the authorities are just as concerned about deflation as inflation and that monetary expansion is to be considered just as has monetary contraction.

"So we are now… or shall soon be… faced with a monetary and political union that is manifestly different than that which the original united nations had signed up for AND we have a central bank intent upon fighting deflation as strongly as it has fought inflation. These are the attributes of a regime intent upon weakening, not strengthening, its currency in order to strengthen the economy and to save the union… if at all possible."

The coordinated central bank action will make dollars available to the ECB, which will in turn loan them to the national central banks, which presumably will loan them to their in-country banks, taking lower-quality collateral than the ECB (which under the rules they are allowed to do). Given the deflationary pressures that are the natural result of a recession and deleveraging/default, they can print a lot of money without igniting too much inflation. But I agree with Dennis; I just don't see how they can do so without seeing the valuation of the euro fall rather smartly.

Merkel and Sarkozy have told us they will meet Monday and announce a plan on December 9, when the full eurozone meets. Forget bazookas, this needs the equivalent of a howitzer. They are seemingly intent upon rewriting the treaty, which is the only way that the Germans will go along with any major ECB action. But by my reckoning, a few hundred billion, or even a trillion, is not major action, at least not on the level of what will be needed.

The price for German acquiescence will be a loss of sovereignty and the ability to run deficits of any real size for any appreciable length of time for the countries of Europe. Will the peripheral countries go along? Heck, forget them; will Finland go along? This situation has been coming along since the foundation of the eurozone. The early founders acknowledged that a tighter fiscal union would eventually be necessary if the euro experiment were to survive. And eventually is now. As in this month. Time is running out if they want to forestall a credit crisis that would be worse than 2008.

The world is watching, as what happens in Europe will affect us all, in every part of the globe. It could easily tip the US into recession, and it will only be worse for the emerging markets. For Europe, the Endgame is now. We can only hope they come up with a plan that avoids disorderly defaults and a crisis far graver than 2008. They have no good choices, only difficult ones and disastrous ones. Let us hope they choose wisely.

(And for my fellow Americans, note that we will face the same consequences if we do not get our own house in order, and very soon. This is more than an academic observation.)

New York, Hong Kong, Singapore, and Cape Town
And My Conference

I am reading Niall Ferguson's new book, Civilization. It is a great read. Quick note: If you enjoy Niall's writing, you may also enjoy watching his TV series on 4oD: The Ascent of Money (same name as his early book). He presents six 1-hour episodes. Only 11 days left on the website, a good idea for this weekend!

http://www.channel4.com/programmes/the-ascent-of-money/4od

Niall, along with Marc Faber, David Rosenberg, Mohamed El-Erian, Woody Brock, Lacy Hunt, David McWilliams, and your humble analyst, will all be at my conference (co-hosted with partners Altegris Investments) May 2-4 near San Diego. Does this not sound like the best line-up of any conference this year? Details will follow, but you won't want to miss this one.

I am more or less home for the next six weeks, except for a quick trip back to New York later this month with Tiffani for a business meeting (good changes are coming, as always), and we will take some time to enjoy friends and the city lights.

Then I will go to Hong Kong and Singapore on January 10 for 12 days, coming back to finish a few things and then head off to Cape Town, South Africa in the middle of February (details later).

Tomorrow I go with Tiffani to take my granddaughter Lively to go see Yo Gabba Gabba "live." This is a new kid's show for very young toddlers that captures their attention like nothing I have ever seen. Below is a photo from last spring, when we were on a plane to somewhere (Lively is now a seasoned traveler!) and she was watching Yo Gabba Gabba on an iPad with her special baby earphones. Look how rapt she is. "Papa John" gets to sit in on this and even go back stage to meet with the cast. Wild horses could not drag me to endure this with your kid, but with my granddaughter? Try and keep me away! How we change with the advent of the next generation.

I am looking forward to the holidays. All the kids will be here, and we will go out to look at the lights, take in movies, and munch lots of great food! And it now looks like professional basketball will launch on Christmas Day, with the Mavericks playing the Miami Heat in a reprise of the NBA Finals last year. I do have rather good seats (front row behind the chairs), and my phone has been blowing up! The #1 most rabid Mavericks fan in the whole world, my daughter Abbi, has begged me to take her, and Dad can't say no. (Are you listening, Mark?)

All Dad wants for Christmas is to meet his deadlines for the irrational amount of writing I have committed to do before I leave for Hong Kong. That and to have my kids around.

It is time to hit the send button so the translator in Hong Kong can get started. In theory, no more really late nights on Friday for me. But this letter has been more than long enough. Have a great week.

Your wondering how we Muddle Through analyst,

John Mauldin
John@FrontlineThoughts.com

2011-12-01T16:46:00.001-08:00

A Special John Mauldin Outside the Box: Taking Control of Your World

John Mauldin | December 1, 2011

Today I offer something a little different from normal economic fare. As I keep saying, I think it is important that as business people and entrepreneurs we look for ways to increase our business while others are pulling back. While innovation can mean new technologies (and their costs!), in my experience it is often even better to figure out a new way to offer your products and services to the market, leveraging (in a good way!) your existing work.

Today, simply because you are one of my 1 million closest friends, I have arranged for you to receive absolutely free and with no strings attached some of the best (if not THE best) marketing and innovation materials I have ever read, from a long-time friend of mine who has sold this information for tens of thousands of dollars (and more!). It is my way of saying thanks for allowing me to come into your life each week. (The link is near the end of the letter.)

And for those who just want economic ideas from me, delete this now and move on. Seriously. No problem at all. I get it. This is not everyone's cup of tea. I offer you this material because it has made a real difference in my business life and the lives of so many others. Though I should point out that it's because of how I handle my business that I can write my weekly letter to you for free. Every week for 11 years. So before you put me in a "box" of your construction, you might want me to take a look and see what I see. And remember, when I say free, I mean free. If that is not a good price for you, then…

Now, with that out of the way, if you can't directly benefit from what I am going to share with you, I bet you know someone who can (young people starting out?)! Read on…

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com

A Different "Take" on Improving Business Performance

I want to introduce a little personal note into the difficult times we are facing as business people, entrepreneurs, and investors. While my economic forecasts are decidedly not positive for the next 4-6 years, I really do not advocate digging a hole and crawling into it and pulling a cover over yourself.

Wrong, wrong, wrong! As business people we need to focus on how to improve our own situations. It is the collective acts of multiple millions of businesses, new, small and large, that will ultimately pull us out of this malaise. To let the dysfunctional actions of government prevent you from taking charge of your own world is precisely the wrong thing to do.

I believe you have far more control over the performance of your business than you might realize.

Years ago (in another bad economy) I remember reading an interesting perspective on business growth. The economist writing it acknowledged that it was tough times for any business. It was easy for entrepreneurs to think that this was not a time to grow, but rather a time to "bunker in" and focus on how to quickly cut operating costs.

But he went on to point out that that was reaction, not action. In looking at history (he pointed out) and the patterns and cycles of the economy, you see a bigger picture: one that tells us difficult times are the perfect time for explosive growth: when the giant trees fall in a forest, it's the new shoots that fill the gaps.

Did you know that the Great Depression created the largest number of new business millionaires in America? One key strategy these "positive deviants" (who defied reactive wisdom) used was developing innovative, breakthrough market strategies and business tactics that maximized their success. This let them gain the upper hand on larger, established brands that were focused on cutting costs or services. In short, they took positive strategic action while others simply reacted.

More recently, I was struck by these paragraphs sent to me by Daniel Stelter of the Boston Consulting Group:

"What Businesses Need to Do Now

"Nearly a year ago, we interviewed executives at companies that had dealt successfully with the downturn of 2009. They shared their approaches to managing through the recession – and, more important, to permanently improving their competitive position. All these winners in the crisis had set similar priorities.

"Innovation. Without exception, the manager we interviewed emphasized how innovation would play a decisive role in enabling them to exploit the opportunities arising over the next few years, particularly with less savvy competitors cutting back. As one of them observed, 'The crisis is a catalyst for change in the technological environment. Things that we only gave half a thought to in the past are suddenly being addressed very quickly.' Many innovations are geared to optimizing processes and reducing non-personnel costs. Fundamental issues are also being broached: 'Without innovating,' said one manager 'it won't be possible to prosper over the next few years.' One characteristic shared by all the companies surveyed is that none reduced spending on research and development. On the contrary, some even increased it sharply because, as another executive emphasized, 'The capital market is looking longer term – at least for now.' The winners are making the most of the opportunities arising from modified investor perspectives."

I am a big believer in innovation. We try and use the latest technology we can to enhance service, increase productivity, and cut costs. But innovation is not just about using some fancy piece of new tech or software. I think the most important innovations are in marketing. The right marketing innovation can make all the difference in the world between mere survival and prosperity. I have learned that lesson time and time again and have seen it done hundreds of times. And there is almost no limit to the possibilities of marketing innovation that you can access. Many actually reduce your costs, especially in cost per sale (while you sell more people more things, more often). And that funnels right into your bottom line.

I'm equally reminded of two staggering quotes from legendary business guru Peter Drucker. I'll paraphrase both, for brevity.

Peter said: Marketing and innovation are the only two factors that generate business. Everything else is an expense. He also said innovation refers to anything (technology or otherwise) that brings greater advantage, access, impact, interest, connection, trust, and buying motivation to the customer.

In a past life, some 30 years ago, I was considered something of a marketing wunderkind. I traveled around giving seminars, speaking at industry conferences, writing papers, and pioneering a few cutting-edge techniques in the direct marketing world. Then along came the financial world, in 1981 (for me personally, that is, as I got involved in the financial publishing industry). I began my economic studies in earnest and ended up today where I always wanted to be up until I left college in 1972 – as a writer. Who knew? I certainly did not see the path, but simply "took the fork in the road" when I came to it.

Along the way I met one person who I consider to be maybe the best marketing mind in the world.

I spent a lot of time with Jay Abraham, absorbing the perceptive, always useful information he dispensed in his own rapid-fire, almost maniacal, but truly brilliant way. Some of the best ideas I ever used I learned from Jay (the same was true of dozens of other companies I dealt with that Jay was also advising). We became good friends and are to this day. I am privileged that I can call Jay up and talk and don't have to pay the $50,000 a day he sometimes gets (if you're asking "What could a person know, do, or see in a given business situation that's worth $50,000 a day, the answer is "A lot!").

Jay has been laser-focused on how to maximize explosive business success for over 25 years. He's helped companies of all types and sizes find what I call "the difference that IS the difference" and add enormous profit and value to their brands, products, and companies in any and all economic climates. He has developed a vast breadth and depth of understanding on how true exponential business growth and profit increases happen – oftentimes doubling and even redoubling companies' current profit levels through the shifts in marketing, strategy, or their business model that Jay innovates.

Jay has had numberless accolades from serious partners and publications.Forbescalled him "the real thing." Investor's Business Daily said, "He knows how to get maximum results from minimum effort." The list of clients he has worked with (and engineered breakthroughs for) is huge, a "Who's Who."

Jay started out (about when I met him) only doing business with companies that would pay him a piece of the profits from new ideas he generated for them. He's almost unreal when it comes to finding hidden assets, overlooked profits, untapped opportunities, and underperforming activities a company isn't mining.

Over time he drifted into doing expensive seminars (we're talking up to $40,000 per attendee) and reports (priced up to $10,000 each) and sold tens of millions (lots of tens of millions) of proprietary "information" pieces. I have sent Tiffani to his seminars, and she always comes back charged up! But not merely motivated with optimism. Rather, she'd return armed with highly actionable, specific strategies and techniques we could apply right away.

And of course, eventually all of Jay's information got ripped off and repackaged by others. And the cost of the information dropped, even as the actual information remained the best out there. Jay correctly decided he did not wish to do battle with a bunch of internet information knock-off artists. He preferred competing on the front lines of capitalism, by personally helping real-world businesses grow and prosper.

So, Jay is coming full circle, back to private, performance-based advisory work and looking for a small handful of suitable, high-quality companies that he can work with on a contingency basis. He simply wants a piece of the money he makes them. He'll focus on improving their strategy, marketing, selling approach, business model, and competitive position).

He asked me if I could help him find a few such companies, betting that they are in my list of 1 million closest friends.

As I thought about it, I told him, "Yes, but there's a catch: I want you to make ALL of the best material you have done over the last 30 years available – for free – to ALL of my readers. Because 99.99% of my readers aren't the companies you can help, but any business can use your ideas if they spend the time and effort to read and study. And, you'll generate a huge sea of goodwill and referrals if you give freely to my friends."

Jay "got it" instantly, nd enthusiastically offered to give each of my business owner/CEO subscribers highly desirable resources – completely gratis – with his and my compliments and best wishes. He agrees that benefiting from all he'll freely share is the best possible way to get some of you excited about working with him, and build goodwill with all of you. (You can jump right in at http://www.abraham.com/gifts)

If you are a business owner or manager, you can take these ideas and apply them directly, meaningfully, and profitably to your particular situation; and my bet is you will improve your offering or unique selling proposition. Many of you will thank me and find this helps your situation more than my macroeconomic forecasts. At the very least, your mindset and methods of doing business will go through one of the most stimulating "reality checks" you ever experienced.

Below is a short list of what you will get. It doesn't begin to do justice to these resources. You access the full list by clicking the link above or below, along with information on how you can set up a personal interview to see whether you and Jay want to work together.

And let me just note that I have known Jay for more than 30 years. He does what he says, and delivers.

It's Like an Early Christmas for Business Owners and CEOs:

You'll receive ( when you click on this link):

* Both of Jay's top-rated business books, containing 336 examples, 21 ways to outperform the competition, and 9 ways to turn stagnant performance into accelerated growth.

* Two full-length, two-hour-long, famous interviews of Jay. One by Anthony (Tony) Robbins, the other by Fran Tarkenton. Both will come in audio and text format.

* Two separate assessment test/questionnaires. One is an 87-question self assessment, the other is a 200-question giant Jay uses when evaluating profit-partner deals with companies.

* Two hours of watching Jay in action, performing 35 rapid business interventions/makeovers, which will show you how to think differently.

* The Strategy of Preeminence– A three-part collection (transcript, audio, reference notes) that teaches you now to hurtle your company from commodity status to preeminence in all you do –culture-changing, relationship-changing, impact-changing.

* 35 separate, short, 2-4 minute videos, each designed to instantly teach a different "Point of Power" or "Ex Factor" (for exponential growth) or strategic distinction.

* The transcript of a two-hour interview Jay conducted with Stephen M.R. Covey, teaching how to build greater trust between you and your marketplace.

* "Nine Drivers of Geometric Growth," which identifies the nine biggest upside leverage forces within any business/company that you can most effectively implement.

* Jay interviews Fran Tarkenton on how he's built over $250 million worth of entrepreneurial businesses.

* League of Extraordinary Minds – Jay and colleagues interview 57 of the business world's foremost icons on ways to make your business perform better right now!

* "The Abraham Mind Shift Challenge" – A 53-page dossier that teaches paradigm-shifting nonlinear thinking and a multitude of higher and better ways to think about your business possibilities, options, and opportunities – with 45 case studies.

* "How To Win Friends and Influence the Right People" (the right way) using social media. This provocative, four-segment compendium explains how to authentically connect, impact, and engage strategically in social media for your business.

You can get started changing your business life by clicking here.

Also, because each one of these resources is truly valuable – and there is a lot he is offering you– Jay and I don't want you to get overwhelmed. So he has carefully described each resource and recommended a program of orderly progress to follow to maximize your grasp of all he has to share. Also, when you opt in you'll get automatic access to Jay's periodic eclectic business perspectives and insights.

OK, the price is right. I truly believe you will learn a great deal and earn a great deal for your business. Now, go out and innovate and help get this economy moving! The link again is http://www.abraham.com/gifts.

One final thought. And it's important. In times like this, you must take forceful, innovative action to capitalize on economic opportunities in order to achieve real business growth. Jay Abraham is an excellent person to help you make this happen – whether you merely use his ideas, strategies, advice, and expert guidance on your own,– or collaborate with him directly and personally.

Your hoping to help analyst,

John Mauldin

P.S. Steve Jobs and Steve Wozniak started Apple in 1976. America was then at a low point, following the 1973-74 recession, the Arab oil embargo, the Watergate scandal, and the fall of Saigon. Other US companies that were started in bad times include General Electric, IBM, Hewlett-Packard, and Microsoft.

Question: Do tough times beget a disproportionate number of great companies? If so, why? Something to ponder.

So, you've got nothing to lose. There are no costs or hidden sign-up fees. No BS. Just solid, transformative information.

Warning: If your idea of marketing is to placidly cast something out there and hope people find you, then you will not like this work. This is not for business wimps. Will every idea make your business better? Obviously not, but what would 3-4 transformative ideas be worth? Yes, to get them you might have to do some reading and head scratching. I can't read your mind and tell you the five pages in Jay's work that will really light up your situation. And maybe getting outside your comfort zone will spur you to new vistas. Soclick and get started!And then write and tell me how you did!

Share Your Thoughts on This Article

Send to a Friend | Print Article | View as PDF | Permissions/Reprints | Previous Article

Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.JohnMauldin.com.

Please write to johnmauldin@2000wave.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.JohnMauldin.com.

To subscribe to John Mauldin's e-letter, please click here:
http://www.frontlinethoughts.com/subscribe

To change your email address, please click here:
http://www.frontlinethoughts.com/change-address

If you would ALSO like changes applied to the Mauldin Circle e-letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request towave@frontlinethoughts.com.

To unsubscribe, please refer to the bottom of the email.

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

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

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

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

EASY UNSUBSCRIBE click here:
http://www.frontlinethoughts.com/unsubscribe
Or send an email to wave@frontlinethoughts.com
This email was sent to jmiller2000@gmail.com
You subscribed at www.johnmauldin.com

Thoughts From The Frontline | 3204 Beverly Drive | Dallas, Texas 75205

barr

2011-12-01T09:54:00.001-08:00

The Choice Ahead

By JIM MCTAGUE

Should the U.S. continue on its path to becoming more like Europe? Or should we play to entrepreneurial strengths?

If the presidential election had been held early this month, Barack Obama would have been voted out by a populace both angry and disheartened by his serial inability to spur economic growth and bring down record-high levels of unemployment. Some red states that Obama snatched from the GOP in the 2008 election -- Florida, Indiana, Virginia, North Carolina and Ohio -- would be back in the Republican camp. The nation's youth, which staged a remarkable "children's crusade" for Obama in 2008, showing up at the polls in historic numbers, would have stayed home, unemployed and, consequently, disenchanted.

The victor would be Republican Mitt Romney, who, while by no means a perfect candidate, offers positions that are encouraging enough to convince a public desperate for a strong recovery that he is the right man for the job -- a competent manager with a workmanlike understanding of a free-market economy, not a novice like Obama, who constantly favored costly, super-size government programs in a vain search for a magic elixir.

The election, however, is not until November 2012, and it would be naïve to write off a skilled campaigner like President Obama -- and we haven't. Independent voters will determine the outcome of the election. This electorate's current gloomy mood could swing to cheer if our trial-and-error president's luck changes and the languid economy's pulse strengthens.

"The elections will be 90% about the economy," says Larry Sabato of the University of Virginia, a storied prognosticator whose Crystal Ball Web site is bookmarked by political junkies everywhere. "The economy is all anybody talks about. Obama had his shot. He got his stimulus, and he had his health-care bill. He said these would make things better -- and it's not better. Maybe things will be better in a year, or at least people will have hope that things will get better."

This is the key to Obama's re-election prospects, asserts Sabato. If people feel better about the future in 11 months than they do today, Obama wins. If they feel worse, he loses.

Enlarge Image

Left: Chris Ratcliffe/Bloomberg News, Right: Ethan Miller/Getty Images

President Obama and Mitt Romney

The European economic crisis, too, could be a factor, though it's a stretch, perhaps, to expect voters to connect the rapid ramp-up in entitlement spending under Obama with the policies that laid Greece low. The costly consequences of Obama's expansion of government into the health-care and financial sectors won't begin to hit until 2014, assuming the GOP can't roll them back before then.

That being said, Obama's ratings have actually improved slightly since late October. Pollster Scott Rasmussen of Asbury Park, N.J., says Romney's two-point polling lead over Obama as of the last week of October evaporated by mid-November. Polls now show the two men in a dead heat. This bump for Obama is as much the result of memorable gaffes and pratfalls by the GOP's unimpressive cast of presidential wannabees as it is to any improvement in the electorate's state of mind. In the age of the Internet and social media, a blunder is amplified farther and wider than ever before -- with devastating consequences. Witness the rapid rise and fall in the polls of Herman Cain, the former pizza-chain CEO now dogged by accusations of sexual harassment.

As long as Romney doesn't commit a memorable gaffe, it's a safe bet he will be the Republican standard bearer. Most polls predict this outcome. Sabato says political scientists and campaign analysts assume this will be so. Romney also has built the only credible campaign organization and is the sole candidate attracting support from the party's wealthy establishment, excepting members of the Texas chapter, who remain loyal to Rick Perry.

Nevertheless, Romney must fight like a junkyard dog to win the nomination, despite his impressive résumé. He's a Mormon -- a religion viewed suspiciously by the GOP's large, influential contingent of evangelical Christians. And because of his record as governor of Massachusetts, where he sometimes compromised with the state's Democratic legislature, he's considered an untrustworthy moderate by the party's influential tea-party conservatives.

Enlarge Image

Democrats predict that the Republican Party's nomination machinery is so badly bent to the right that it can't possibly nominate someone like Romney, who has broad voter appeal. They point out that tea-party-endorsed candidates in the midterms were so far out of the mainstream that they were unable to win contests, including the one for Harry Reid's Senate seat in Nevada, that should have been easy pickings.

Another negative: Polls indicate the party faithful are looking for anybody but Romney. The acerbic Newt Gingrich appears to be the latest flavor of the month. He's topping polls now after bouncing along the bottom like a lead sinker for most of the year. Gingrich should make the most of his popularity while it lasts. Republicans have proved to be more fickle than a child in a toy aisle, falling in love first with Donald Trump, and then, briefly, with Ron Paul and next with Cain and his 9-9-9 elixir.

ROMNEY SUPPORTER Jim Talent, a former Missouri senator, says he views the volatile polling swings as a healthy part of the traditional GOP mating ritual. "I think Romney is the candidate with a solid core of support throughout the party and in every region of the country," says Talent, who has known the former governor for six years."Having said that, I do think that it is typical for the Republican electorate to accept new leaders slowly. That's why typically you have to run several times to get the party nomination."

Talent also asserts that the Republican electorate is naturally skeptical of political leaders and that it takes time for them to warm up to them, unlike Democrats, who latch on quickly to someone new, as they did to both Bill Clinton and Barack Obama. "But if you look at the underlying numbers in the polls, the more people see Romney and listen to what he says, the more they like him," says Talent.

Romney's résumé suggests that he's far better equipped to deal with economic problems than Obama, despite the president's three years of on-the-job training. Romney has managed private companies. He's run a large state. He's run the Olympics. Besides being a proven problem solver, he sees the economic forest where Obama finds lots of trees. Romney believes a macro-economic overhaul is the way to fix the sluggish economy and to make the U.S. competitive with China and other emerging economies. He'd cut discretionary spending.

He'd keep tax rates at the current level until Congress could overhaul the system to one that encourages savings and investment as opposed to consumption. He'd ask Congress to repeal Obama-era regulations that stymie job creation, including the entire Affordable Health Care Act and most of the Dodd-Frank Wall Street Reform Act, which he'd replace with streamlined rules that curb reckless behavior without hobbling growth and innovation. And he'd embrace the refrain popularized by John McCain and Sarah Palin in 2008: "Drill, Baby, Drill!"

"ONE THING ROMNEY believes is that the next recovery can be an energy-led recovery," says Talent. "We have all of this capacity we are not [exploiting] solely because of the government. We don't even know how many oil or natural-gas reserves exist because the government won't do a survey."

Romney would lift all drilling and exploration moratoriums, streamline the permitting process and order the Environmental Protection Agency to stop trying to regulate carbon emissions, a practice he says is killing jobs. Production of these new supplies would create millions of jobs and generate billions in royalty revenue for the Treasury, he predicts. The U.S. might even become a net exporter of energy, which would improve its balance of trade with the rest of the world.

That said, Romney's strong support for drilling will hurt him with some of the independent voters he needs to win next fall's election.

Romney economic advisor R. Glenn Hubbard says Obama's policies have been pronouncedly anti-free-market. This view is shared by entrepreneurs in the private sector. Hubbard is the dean of Columbia University's Graduate School of Business and a former advisor to President George W. Bush. "Obama's repeated goal is to raise marginal tax rates to enable expansion of the welfare state," he claims. Indeed, Romney and Hubbard believe in tax cuts as the most potent form of fiscal stimulus.

Romney also favors reducing the corporate tax rate to 25% after closing loopholes to make the U.S. a more attractive destination for manufacturing. "We'd have 4% growth if the Congress were to do everything he proposes," claims Hubbard.

That's a big if. Republicans will retain control of the House and pick up a few seats in the Senate, but Congress is likely to remain divided. If by some chance the GOP wins the Senate and Romney emerges victorious, expect a profusion conservative initiatives to aid the economy

Lawrence Summers of Harvard, who was chairman of Obama's National Economic Council until the end of 2010, counters that Obama would be far better than any Republican for the economy. The Obama campaign referred our questions to Summers, though officially he is not part of the re-election team.

"The president has a realistic plan for addressing the country's different deficits," Summers told us. "He has a realistic plan for addressing the current jobs and growth deficit in the short run by supporting middle-income families, by investing in large scale infrastructure and by preventing excessive cutbacks at the state and local level."

The president's proposed American Jobs Act offers a litany of government programs that he claims would create four million jobs. The centerpiece is an infrastructure bank to be funded with about $10 billion and sell bonds to private investors to finance projects. Local taxpayers would pay the interest on those bonds. The bill also contains targeted tax cuts to provide an incentive to employers to hire more workers and programs to modernize school buildings as well as money to allow local communities to retain teachers and police. It's typical Obama: a huge grab bag of goodies targeting beloved constituencies as opposed to an approach that tries to address the systemic problems hindering growth.

Obama favors letting the Bush tax cuts on the wealthy expire in 2012, raising the marginal rates on the wealthiest taxpayers as high as 39.6%. And in 2013, a provision of Obama's health-care law raises Medicare taxes on higher tax brackets and levies a 3.8% Medicare surcharge on passive investment income, including dividends, capital gains, annuities, rents and royalties.

On the corporate front, Obama has said he is willing to engage in discussions about corporate tax reform that eliminates loopholes, lowers rates and raises revenues. But he seemed to rule out immediate action in an October news conference, claiming there were more pressing problems, especially the plight of working-class families. He does, however, propose targeted tax cuts to businesses that hire new workers, with the greatest relief going to small corporations.

But over all, Obama seems intent on raising revenues significantly in an attempt to pay down the deficit without overhauling wasteful programs, imposing the highest tax rates in over 25 years on the rich, the source of most investment capital. This is much like paying to pump air into a tire without plugging a huge nail hole.

Obama continues to push for a cradle-to-grave-style welfare state like the one that just brought down the economy of Greece and threatens to topple Italy, Spain and France, as well. Life under a President Romney certainly would not suddenly become better. The economy is at a dangerous tipping point. If Romney is true to his word, he'd have to tackle major problems and inflict some near-term pain on us all. But the future would certainly be brighter. Romney's right when he says that the fiscal system needs an overhaul to prepare us for life in the 21st century.

bar

2011-12-01T09:46:00.001-08:00

The most wonderful time of the year, is it?

Holiday greetings and gay happy meetings aside, this notion is a hard sell for most attentive investors who own just about anything but United States Treasury obligations.

What with the Standard & Poor's 500 index losing 4.7% last week in a mere three-and-a-half days of trading, and the comprehensive Wilshire 5000 Total Market index shedding 8%, or $1.3 trillion, in value in seven straight losing sessions, tying the seven days ended Aug. 2 for the longest skein since October 2008. Meantime, 10-year borrowing rates for the U.S. Treasury spent the entire week yielding less than 2%.

(Despite the typical superficialities voiced by soapboxers, there is no real irony in the fact that Treasuries retained their rock-solid bid in a week when the supercommittee in Congress opted to ignore a Congressional mandate to find $1.2 trillion in spending to forgo over a decade. Both sides were already incented to avoid compromise, and most indications pointed unequivocally to an underwhelming result from the supercommittee's work. Had markets reacted to the committee's failure to reach an agreement, they would have surrendered whatever remaining status they hold as efficient processors of new information.)

No, nothing on this side of the Atlantic, even where the Potomac River and Chesapeake Bay spill into it, can summon the bile into the mouths of investors more readily than what's occurring daily on the other side. The virtual boycott of European government debt continues. Overstressed Continential governments face ever-higher interest costs. The European Central Bank remains unmoved to respond and local banks are wheezing under the stress.

It's fair to say that markets here haven't so dreaded headlines from Europe since the days of coastal blackout orders and beachside patrols for Nazi submarines.

At the risk of over-explaining what's been unfolding for a while, U.S. markets are contending with an unwelcome process of tightening. This is not the textbook tightening of money growth orchestrated by the Federal Reserve in response to overheated economic growth or inflation, which gave rise to familiar Wall Street rules of thumb such as "Three jumps and a stumble," suggesting the third rate hike would stall stock prices. No, the Fed, of course, remains close to "maximum easy" with money production.

The tightening is occurring in Europe via several market mechanisms. Investors are extracting higher government-bond rates to compensate for dicey sovereign finances, with Italian and Spanish yields hitting euro-era records, and Germany suffering a spongy response to a bond offering last week. Banks then need to buy less and reserve more, reducing liquidity. They are also under regulatory pressure to shrink their balance sheets, and so some 500 million to 3 trillion euros worth of assets are being prepped for sale, by some estimates.

But who are the buyers? U.S. banks are similarly being ordered to keep leverage low and rebuild capital, and the Fed last week initiated another round of "stress tests." On top of it all, a seasonal ebb in market liquidity is upon us as year end nears.

Reuters recently quoted a London-based bond trader as saying, "Things have felt almost as bad as it was back during the Lehman days in terms of liquidity—it is increasingly hard to get any business done and, to be honest, we think it is going to get worse.''

Before the big New York investment banks became bank holding companies via shotgun marriages with the FDIC in the 2008 crisis, most closed their fiscal years Nov. 30, in part because their clients needed to utilize the banks' balance sheets as they themselves finished their years. Now we have everyone on a December year, in balance-sheet-shrinkage mode, and stiff regulatory mandates to curtail market risk. In other words, more sellers than buyers for risk, and therefore risk gets more expensive. The main index of credit-default swap prices on European governments hit an all-time high on Wednesday.

With all this playing out, the ECB remains both chief villain and the only potential savior, in the minds of many market participants. The bank's refusal to step in as lender of last resort to strapped governments is widely viewed as recalcitrant and doctrinaire, its gun sights on a nonexistent inflation threat while it disarms in the face of lethal financial contagion.

There's a line of interpretation that says the ECB, and its German play callers, are simply allowing the pain to build in peripheral Europe just enough to ensure that any eventual aid will be met with a sufficient degree of fiscal rectitude and political commitment by the beneficiary governments.

High-yield credit strategists at Bank of America Merrill Lynch last week put such a thought forward: "All in all, we expect EU crisis reaching a short-term boiling point again relatively soon—next few weeks to a couple of months—a moment that will likely push ECB into further action. That point will likely mark a near-term bottom in the markets, as uncertainty surrounding near-term funding needs is removed."

Maybe so. But doctors will also tell you that a high fever indicates the body is resolutely battling an infection, a reassuring prelude to recovery. The capital markets are clearly not sure the clinicians in Brussels know the point at which a fever implying effective immune response could turn fatal.

WRITING ABOUT THE STOCK MARKET these days feels like Mary Todd Lincoln might have felt if hired as a drama critic in 1865. The performance she last saw might have been quite respectable, but was rather overshadowed by the carnage that interrupted it.

What to make of the fact that long-term Treasuries, as measured by the iShares Barclays 20-Plus-Year Treasury exchange traded fund (ticker: TLT), has returned to within 2% of its Oct. 3 high, and that other signs of credit stress and risk aversion (bond swap spreads, the above-mentioned CDS index) are at their worst levels of the year—and yet the S&P 500 remains 5.4% above its Oct. 3 closing low for 2011?

If, as we've been conditioned to believe, stocks are always and everywhere the residual asset class, beholden to the more prescient bond markets, then equity investors are whistling past the graveyard (again). The fact that stocks failed to hold up in the typically strong Thanksgiving week lends this reading some weight.

Yet there's also a concept of "bullish divergences," instances where one instrument or asset class stubbornly refuses to go along with the prevailing story, often a sign that it's sniffing out a reversal in the recent trend. The Treasury/stock relationship in this light looks like an overstretched rubber band with a chance of snapping back.

Without suggesting that the prevailing mood among stock players is profoundly sour, this group is clearly flinching at the passing of most every shadow. It's no wonder, given that the Chicago Board Options Exchange has blanketed the platforms of Grand Central Terminal, entryway for Wall Streeters who live in New York's northern suburbs, with ads for its Volatility Index trading products as a means to profit from calamity.

Speaking of that index, known as the VIX, it has remained stubbornly high, above 34 at Friday's close, but is well above its early October lows and also below where it sat the last time the S&P 500 was at its current quote. Another thin reed for the bulls, perhaps. It probably doesn't hurt that corporate insiders largely quit selling shares, relatively speaking, in the past week, and the Economist magazine served up some juicy bait for optimistic contrarians with its new "Is This Really the End?" cover headline featuring the euro as flaming meteor.

These might be useful inputs for tactical traders sniping for a handful of basis points trading daily or weekly moves, but they don't address the larger structural investment predicament.

Dan Greenhaus, chief global strategist at institutional brokerage house BTIG, last week wrote, "We have been asking clients what the basis is for meaningfully and sustained higher equity prices, and quite frankly, the only notable response we get is that 'equities are cheap.' We counter by noting that multiple expansion is unlikely, margins are running out of steam and any hit to aggregate demand is likely to hurt profits more generally."

Fair enough, though at some level the relative cheapness of stocks can mitigate or at least foreshorten the episodes in which macro fears drive further equity selloffs. Given steady corporate results and a recent warming trend in domestic economic data, stocks arguably don't "need" to go back to or below the October lows in order to price in the ratcheting up of euro fears and assorted scary stuff on the cusp of what will be an exasperating political year.

Strategists at JPMorgan Asset Management last week produced an interesting paper on investing based on price/earnings multiples over long periods of time. It notes that while the average trailing P/E multiple for U.S. stocks since 1927 is 15, the market has rarely traded right at that average, and it has crossed this average level no more often than might be explained by random statistical movement.

Still, the impressively self-skeptical study shows that adjusting stock weightings according to a P/E-based rule works better than a buy-and-hold asset mix, and right now strongly favors stocks, if perhaps only because of artificially low interest rates.

up

2011-12-01T09:44:00.001-08:00

Between burps, and still evincing the glazed and dazed satisfaction that gurgles through your being after digesting a particularly succulent meal, we fervently hope you found a moment or two last Thursday to silently render thanks to Newt Gingrich for his spirited return to the political wars.

After 10 years devoted to the successful pursuit of riches, via the eminently respectable profession of influence-peddling in his old stomping grounds in Washington (it's hard and dirty work, but somebody's got to do it), Newt decided to give something back to the country like, oh, becoming its president.

Wonderful gesture, you have to admit.

In typical Newt style, the old warrior chose to enter the lists by boldly confronting our blessed nation's No. 1 woe—the listless economy, and, more specifically, its horrible fiscal imbalance. Carefully avoiding all the fancy-schmancy mathematical formulas that economists use to becloud the vacuity of their labors, Newt went to the heart of the problem—too many public-school janitors.

By his own description a deep thinker, gimlet-eyed Newt detected what had eluded the ken of conventional pundits—multiple benefits in getting rid of the janitors. It would obviously relieve the taxpayers of the enormous and recurring burden of having to pony up for their salaries. Ever notice how many janitors drive Bentleys?

But it would also entail getting the students to do the classroom cleaning, paying them some nominal amount. The kids, especially those in poor neighborhoods, he insisted, would be thrilled to have a few coins in their pockets and would experience a vast surge of pride in their schools.

Although we haven't had a chance to ask the kids, or for that matter, the janitors, we can't imagine anyone not agreeing it's a great idea. Is it any wonder that, in the warrens and cubbyholes of D.C. where the political elite huddle, they call Newt the thinking man's politician?

The thought did occur to us—and doubtless to Newt, as well—that, given both the huge monetary savings and the invaluable educational lessons it provides, it might be worth getting members of Congress to do the work, since, for the most part, idleness is their principal occupation. But, of course, as the past few years have sorrowfully demonstrated, our beloved solons are good at making messes, not cleaning them up.

And in any case, that would leave the janitors bereft of gainful employment, although they might consider running for Congress, if they didn't feel the job would be too demeaning.

In delivering this modest panegyric to Newt, we don't mean to diminish the intellectual qualifications of the other candidates vying for the GOP nomination.

Take Rick Perry, for example, who's attracted plenty of heat because of his manifest difficulty in thinking on his feet. If only the poor guy would insist on debating sitting down, he'd prove a dynamite fount of brilliant ideas.

We were wowed, by way of illustration, by his proposal that Congress, following the example of the Texas legislature, meet every other year, and be paid a proper pittance—instead of the ample paycheck and big benefits a federal lawmaker now enjoys. As the late Molly Ivins, to her immortal credit, once observed: Another significant plus of such a truncated schedule is that it makes it easy for the residents of the state to tell when the Texas legislature is in session—because every village in the Lone Star State is missing its idiot.

If Rick Perry had his way, the same awareness could be vouchsafed the rest of the nation's population.

The excuse proffered by admirers of contestants for the grand prize in American politics is that their favorites have no choice but to pander to their base. That's true of the aspirants of both parties, no matter how base their so-called base is. Pretty lame excuse, we say.

We're lucky, then, that one of the fortunate idiosyncrasies of our political system is that, while the far-out, noisy fringe of the electorate may occasionally decide who gets to run, it's the unprepossessing, mellower middle that usually decides who gets elected.

What's bothersome now is that rarely has the swollen tide of coincident crises, domestic and foreign, economic, social and political, reached such epic proportions that it may sweep away long-standing precedents and time-tested truisms, including the reassuringly hoary one cited in the preceding paragraph.

IN THE LATEST EDITION OF THEIR admirable Levy Forecast, David and Jay Levy cite the rarity of this spectacular confluence of serious crises as virtually unprecedented in the more than three generations their family has been chronicling the economy and the markets.

As they relate: "We have seen expansions undermine themselves by overshooting on inventory building, capital spending and home building. We have seen bubbles burst, taking down expansions…and seen the domestic and world economies collapse into a great depression."

But they confess to having never seen anything like this before, when "an enormous external crisis is unfolding with sufficiently severe consequences to take out the U.S. expansion." An expansion, they're careful to remind us, that in itself is anything but robust.

The Levys are more than a little aware of the Street's scoffing at the notion that our economy might be stumbling toward recession in the face of solid growth in retail sales, brisk levels of capital investment and domestic indicators that mostly look stronger of late rather than weaker. They take it, in a sense, as confirmation that the crowd (including, alas, the so-called policy makers, who probably deserve to be called something more acerbic) doesn't really have much of a clue as to what's happening.

And they willingly concede this devilishly deceptive economy "will not necessarily show many of the typical signs of heading into recession until increased fiscal drag or the first major international shock wave hits, which might not occur until after the turn of the year."

But in support of their downbeat view, they finger problematic aspects of the domestic economy, including its dependence on a humongous federal deficit, the lag of such critical sectors as residential fixed income, commercial construction and inventory-building, and the likelihood that exports will decelerate sharply in this quarter.

All of which raises the specter, they maintain, that the great boom in corporate earnings will begin to lose its vigor before this year calls it quits. And we aren't disclosing any classified information when we venture that more than any other single factor, what has propelled this market these past three years has been the sterling performance of private-sector profits.

Even so, the Levys hold fast to their belief that if indeed recession rears its ugly head next year, it will do so only if there's a great jolt coming from abroad. As it happens, thanks to the ever-worsening European crisis, just such a great jolt is, they assert, "almost a sure thing." To the Levys, and they are hardly alone in making the analogy, watching Europe in the throes is like watching a horror movie.

"Something scary and destructive is going to emerge," they contend, and until it does, there is gathering anxiety over when it "will jump out" and precisely "from what dark corner." The never-ending shilly-shallying by the European big cheeses in search of a solution only adds to the suspense and hastens the day when the farce begets tears rather than chuckles.

ALMOST ANYONE WITH EVEN A CURSORY interest in the market (including us) had been expecting at least the semblance of a dead-cat bounce last week. Instead, of course, what we got for our eager anticipation was a growing feeling that this cat, unbeknownst to Wall Street, had been given an Osama bin Laden burial. That sound you may have heard was a swoosh, not a bounce.

Even in Friday's abbreviated session, stocks were unable to cling to early modest gains. Trading, as it inevitably is on a compressed day, was meager. Those lucky traders who could still afford it were long gone to some pleasant retreat, rather than standing around and watching their wealth melt. For their part, short sellers did their covering early, the better to have more time to congratulate themselves on their astuteness.

Meaningful news was as sparse as the shares changing hands, and what news there was, we're sorry to report, was heavily tilted to the downside. Having already wrested a 50% haircut on its borrowings from banks, Greece decided to go for a 25% haircut on any new bonds it issues. Do yourself a favor, and don't expect a rush to buy Greek paper.

Nor were the economic dispatches closer to home entirely comforting. In particular, consumer spending in October barely edged higher (the crowds apparently were husbanding their dough for Black Friday, which actually began late Thursday, and this year featured a Los Angeles woman using pepper spray to keep other shoppers from putting their greasy hands on stuff she coveted).

Durable-goods orders slackened, with aircraft demand taking a swan dive. More worrisome, though, if you happen to be the fretful type, was a decline in shipments of nondefense capital goods, stuff like computers and communications equipment, which serve as a proxy for business investment—just the kind of spending that has been one of the reliable pillars of the shaky recovery.

Who knows? Maybe this week's employment report will finally give us cause to cheer. But, then, maybe not.

gross

2011-11-29T07:55:00.001-08:00

December 2011

Family Feud

Investors should recognize that Euroland's problems are global and secular in nature; it will be years before Euroland and developed nations in total can constructively escape from their straitjacket of debt.
Global growth will likely remain stunted, interest rates artificially low and investors continually disenchanted with returns that fail to match expectations.
Investors should consider risk assets in emerging economies, such as Brazil and Asia, and bonds in the strongest developed economies, where the steep yield curve may offer opportunities for capital gains and potentially higher total returns.

A 12-year-old coffee mug has a permanent place on the right corner of my office desk. Given to me by an Allianz executive to commemorate PIMCO's marriage in 1999, it reads: "You can always tell a German but you can't tell him much."

It was hilarious then, but less so today given the events of the past several months, which have exposed a rather dysfunctional Euroland family. Still, my mug might now legitimately be joined by others that jointly bear the burden of dysfunctionality.

"Beware of Greeks bearing gifts" could be one; "Luck of the Irish" another; and how about a giant Italian five-letter "Scusi" to sum up the current predicament?

The fact is that Euroland's fingers are pointing in all directions, each member believing they have done more than their fair share to resolve a crisis that appears intractable and never-ending. The world is telling them to come together; they're telling each other the same; but as of now, it appears that you can't tell any of them very much.

The investment message to be taken from this policy foodfight is that sovereign credit is a legitimate risk spread from now until the "twelfth of never."

Standard & Poor's shocked the world in August with its downgrade of the U.S. – one of the world's cleanest dirty shirts – to double A plus. But what was once an emerging market phenomenon has long since infected developed economies as post-Lehman deleveraging and disappointing growth exposed balance sheet excesses of prior decades.

Portugal, Ireland, Iceland and Greece hit the headlines first, but "new normal" growth that was structurally as opposed to cyclically dominated exposed gaping holes in previously sacrosanct sovereign credits.
What has become obvious in the last few years is that debt-driven growth is a flawed business model when financial markets and society no longer have an appetite for it. In addition to initial conditions of debt to gross domestic product and related metrics, the ability of a sovereign to snatch more than its fair share of growth from an anorexic global economy has become the defining condition of creditworthiness – and very few nations are equal to the challenge.

It was in this "growth snatching" that the dysfunctional Euroland family was especially vulnerable. Work ethic and hourly working weeks aside, the Euroland clan has long been confined to the same monetary house. One rate, one policy fits all, whereas serial debt offenders such as the U.S., U.K. and numerous G-20 others have had the ability to print and "grow" their way out of it.

Beggar thy neighbor if necessary was the weapon of choice in the Depression, and it has conveniently kept highly indebted non-Euroland sovereigns with independent central banks afloat during the past few years as well. Depressed growth with more inflation, perhaps, but better than the alternative straitjacket in Euroland. As currently structured, Euroland's worst offenders now find themselves at the feet of a Germanic European Central Bank that cannot be told to go all-in and to print as much and as quickly as America and its lookalikes.

Proposals from the German/French axis in the last few days have heartened risk markets under the assumption that fiscal union anchored by a smaller number of less debt-laden core countries will finally allow the ECB to cap yields in Italy and Spain and encourage private investors to once again reengage Euroland bond markets. To do so, the ECB would have to affirm its intent via language or stepped up daily purchases of peripheral debt on the order of five billion Euros or more. The next few days or weeks will shed more light on the possibility, but bondholders have imposed a "no trust zone" on policymaker flyovers recently. Any plan that involves an "all-in" commitment from the ECB will require a strong hand indeed.

On the fiscal side the EU's solution has been to "clean up your act," throw out the scoundrels and scofflaws (eight governments have fallen) and balance your budgets. Such a process, however, almost necessarily involves several years of recessionary growth and deflationary wage pressures on labor markets in the offending countries. While the freshly proposed 20-30% insurance scheme of the European Financial Stability Facility (EFSF) offers hope for the refunding of maturing debt, it is the deflationary, growth-stifling, labor/wage destroying aspect of the EU's original currency construction that threatens a positive outcome over the long term. Without an ability to devalue their currency vs. global competitors or even – "Gott im Himmel" – Germany itself, peripheral countries may have survival to look forward to, but little else. Perhaps the Italians and Spaniards will put up with it, but maybe they won't. The ultimate vote of the working men and women in these countries will always hang over the markets like a Damocles sword or perhaps a French/German guillotine. If the axe falls, then bond defaults may follow no matter what current policies may promise in the short term.

Investors and investment markets will likely be supported or even heartened by recent days' policy proposals. The problem of Euroland is twofold however. First of all, they will remain a dysfunctional family no matter what the outcome. You can't tell a German much, and while they can issue what appear to be constructive orders and solutions to the southern peripherals, there is little doubt that none of them will "like it very much." Slow/negative growth and historically wide bond yield spreads will therefore likely continue. Globalized markets themselves will remain relatively dysfunctional, pointing towards high cash balances in presumably safe haven countries such as the United Kingdom, Canada and the United States. The U.S. dollar should stay relatively strong, ultimately affecting its own anemic growth rate in a downward direction.

Secondly, and perhaps more importantly however, investors should recognize that Euroland's problems are global and secular in nature, reflecting worldwide delevering and growth dynamics that began in 2008. It will be years before Euroland, the United States, Japan and developed nations in total can constructively escape from their straitjacket of high debt and low growth. If so, then global growth will remain stunted, interest rates artificially low and the investor class continually disenchanted with returns that fail to match expectations. If you can get long-term returns of 5% from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors.

To approach those numbers, risk assets in developing as opposed to developed economies should be emphasized. Consider Brazil with its agricultural breadbasket and its oil. Consider Asia with its underdeveloped consumer sector but be mindful of credit bubbles. In bond market space, the favorite strategy will be to locate the cleanest dirty shirts – the United States, Canada, United Kingdom and Australia at the moment – and focus on a consistent, "extended period of time" policy rate that allows two- to ten-year maturities to roll down a near perpetually steep yield curve to produce capital gains and total returns which exceed stingy, financially repressive coupons. A 1% five-year Treasury yield, for instance, produces a 2% return when held for 12 months under such conditions. Bond investors should also consider high as opposed to lower quality corporates as economic growth slows in 2012.

Because of Euroland's family feud, because of too much global debt, because of deflationary policy solutions that are in some cases too little, in some cases ill conceived, and in many cases too late, financial markets will remain low returning and frequently frightening for months/years to come. I can imagine the coffee mugs for 2020 now: "Gesundheit!" from the Germans, "C'est la vie," from the French and "Stiff Upper Lip," from the British. In the United States I suppose it'll still say, "Let's go shopping," although our wallets will be skinnier. You can always tell an American, you know, but you can't tell 'em to stop shopping. Likewise, investors should always be able to tell a delevering, growth constrictive global economy – but perhaps not. Dysfunction is not exclusive to politicians. Families, it seems, feud everywhere.

Note: Initial paragraphs were originally published in Financial Times Markets Insight on November 15, 2011
(http://www.ft.com/intl/cms/s/0/cc1ada48-0c4d-11e1-8ac6-00144feabdc0.html#axzz1f1q48ixJ)

malde

2011-11-29T04:44:00.001-08:00

It's All Very Taxing

John Mauldin | November 29, 2011

Today's Outside the Box is something a little different for me. Howard Marks of Oaktree Capital Management has produced a most excellent summary of the problems inherent in "all things taxing" in the US. He delves into not only the specifics but also some of the philosophy of taxation. This is a balanced piece in which he tries to present all sides and arguments, giving us a very real picture of the dilemma we face, and leaving us to draw our own conclusions. Whatever we do going forward, including nothing, the outcome with regard to taxes is going to be difficult if not painful for most of us. We talk about everyone paying their fair share, but what does that mean? The answer is that it means very different things to different people.

This goes hand in hand with my contention that we face very difficult choices, and none of them are pain-free. I have my preferred methods and choices, and you have yours, and your neighbors have yet more divergent views. But we must make the tough decisions, or the market is going to treat us as roughly as it is Italian debt. If we let it get to that point, the choices will be even more limited and painful.

This is a longer than usual OTB but it is very good, and I suggest you send it on to others, as it provides a framework for discussion and understanding the positions that others in our society might take – people of good will but with different understandings of how the world works and what is "fair." Often, their views will not be based on the same rationale as yours or mine, and thus they will come to different conclusions. But soon we will all make some very important decisions (at the polls) about who will make those decisions for us. Let's choose wisely.

Right now, I am going to choose to hit the send button and go along with my daughter Tiffani to dinner with Art Cashin, Rich Yamarone, and Barry Ritholtz, and see what wisdom they may impart. With Art, you can always count on learning something, and on hearing some wonderful stories. I am sure we will also debate the end of the euro, among other pleasant dinner topics. I live for such moments. I will report back.

Your enjoying a beautiful day in New York City analyst,

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com

It's All Very Taxing

By Howard Marks
November 16, 2011

The issue is simple: the U.S. government generally spends more than it brings in . . . and recently, a lot more. For years Congress was willing to serially raise the federal debt ceiling and monetize the deficit. But this past summer, some legislators balked. When the early August deadline for an increase in the ceiling arrived, our elected officials kicked the can down the road, but less far than usual. They created a Congressional supercommittee with unprecedented power to propose solutions, and they designed automatic spending cuts in case no proposal won approval.

With the committee working under a November 23 deadline to find ways to reduce the federal deficit by $1 trillion-plus over the next decade, and with a presidential election less than a year away, the subject of taxes is all over the headlines and likely to remain there. Thus I've decided to provide a background piece on the issues.

What form will the deficit-cutting action take? In fact, the possibilities fall into only four categories:

• cut discretionary spending,
• reduce expenditures on entitlements,
• cut waste and fraud, or
• increase tax revenues.

Given the magnitude of the problem, the limited number of potential solutions, and the differences between the parties on the subject, there's already debate regarding the fourth of those listed above. Democrats generally feel tax increases should be part of any solution, and Republicans often insist that while they're open to overhauling the tax code, total taxes must not rise.

What's Fair is Fair

This memo got its start as an excuse for me to write about one of my greatest pet peeves: the so-called "fair share."

Ask your typical Democrat or liberal about the idea of increasing taxes on upper-bracket earners, and what will they say? In my experience, the answer's always the same: "We're not out to soak the rich. We just want them to pay their fair share." We've seen it over and over for years. For example:

"Were [the politicians levying taxes on Americans] seeking to redistribute wealth, to recast society along more egalitarian lines? Or were they simply trying to ensure that rich people paid their "fair share"? The answer, predictably, is both. . . .

"If poor and middle class Americans were going to be asked [by President Roosevelt], of necessity, to shoulder much of the fiscal burden, then they needed assurance the rich were paying their share. . . .

"No one made the case more succinctly than Rep. Cordell Hull, legislative father of the 1913 income tax. 'I have no disposition to tax wealth unnecessarily or unjustly,' he explained in his memoirs. 'But I do believe that the wealth of the country should bear its just share of the burden of taxation and that it should not be permitted to shirk that duty.' "

("Soaking the Wealthy: An American Tradition" The Wall Street Journal, January 29-30, 2011)

The rhetoric remained unchanged in the late twentieth century:

" 'We will lower the tax burden on middle class Americans,' [Bill Clinton] pledged in 1992, 'by asking the very wealthy to pay their fair share.' " ("The Middle-Class Tax Trap" The New York Times, April 17, 2011)

More recently, President Obama carried on the tradition.

"I will veto any bill that changes benefits for those who rely on Medicare but does not raise serious revenues by asking the wealthiest Americans or biggest corporations to pay their fair share." (The New York Times, September 20, 2011)

And here's another reference from just a month ago:

"In proposing a 5 percent surtax on incomes of more than $1 million a year to pay for job-creation measures sought by President Obama, Senate Democratic leaders on Wednesday escalated efforts to strike a more populist tone and to draw Republicans into a confrontation over how much affluent Americans should pay to help others cope with a struggling economy. . . .

" 'It's interesting to note that independents, Democrats and Republicans and even the Tea Party agree it's time for millionaires and billionaires to pay their fair share of taxes,' [Senate Majority Leader] Reid said Wednesday."

(The New York Times, October 6, 2011)

But what is the fair share? How is it to be determined, and by whom? When Senator Reid says, "it's time for millionaires and billionaires to pay their fair share," he implies they haven't been doing so thus far. How does he know? What's the standard? If there's an objective standard for one's fair share, why does it only seem to be those from the left side of the political spectrum who say it's not being paid? And if there isn't an objective standard, how can the fair share be determined? The truth is, fairness is almost entirely in the eye of the beholder, and "get them to pay their fair share" seems like just another way to say "raise their taxes."

There's probably only one element of fairness that's beyond discussion: those with higher incomes should pay more in taxes. After that, everything is up for grabs.

• For example, we have a progressive system of taxation, meaning that higher earners don't merely pay more in terms of dollars; they generally pay a higher percentage of their incomes in taxes. Most people agree that this is fair. But is it? Why should success be penalized through greater taxation? And if the tax rate for those who earn more should be higher, how much higher? Should the top marginal tax rate be double that applicable to lower-income taxpayers? Triple? What's fair?

• Are some forms of income more desirable to society and thus deserving of taxation at lower rates?
• And should we encourage certain expenditures by making them deductible from taxable income?

The fairness of all of these things is subject to discussion and disagreement. They come under the heading of tax policy.

Is Taxation Progressive? Progressive Enough?

Under the U.S. system, people in higher income brackets pay tax at higher rates. (However, Mark Twain said, "All generalizations, including this one, are false." For an exception to the generalization above, see the discussion of the "Buffett Rule" on page 5.) In large part, the question of fairness primarily surrounds whether the higher rates are high enough.

Talk about "the eye of the beholder." There's evidence on both sides of this debate:

• The top 1% of U.S. taxpayers pay 38% of all individual federal taxes. The top 10% pay 70% of all taxes, the top 25% pay 86%, and the top 50% pay 97%.
• That leaves the bottom 50% of all taxpayers paying only 3% of the total.
• About half of Americans pay no federal income tax, and almost 25% pay no federal taxes at all.
• The average federal income tax rate for the top 1% of Americans is 23% (and for the top half it's 14%), while the average rate for the bottom half is 3%.

Notwithstanding the rhetoric, there's no doubt about the fact that America's top earners are taxed more heavily than the rest. On the other hand, they pay at lower rates than they used to (when I was a boy the top marginal rate was 94%), and it seems progressivity has declined.

". . . the effective federal tax rate, including payroll taxes, for the wealthiest 0.01 percent of earners fell to 31.5 percent in 2005, from 42.9 percent in 1979 [for a decline of 26.6%], according to data from the Congressional Budget Office. Over the same time, effective rates for taxpayers in the center of the range fell to 14.2 percent, a decrease of just 4 percentage points [or 22.0%]." (The New York Times, September 21, 2011)

Total revenues from income taxes have declined in the U.S. – they "are at a historical low of 15.3 per cent of the gross domestic product, compared with a postwar average of 18.5 per cent" (Financial Times, September 25) – and they've declined more for top earners than for the rest. This is because of both specific rate cuts that have been enacted and the fact that the rates applied to dividends and capital gains – which clearly flow more to people in the upper income brackets – have declined relative to the rates on salaries and wages.

On average, higher earners absolutely do pay a higher percentage than those who earn less. But the decision as to whether the differential is just right, too little or too great is highly subjective and certainly a valid topic for debate.

Righteous Income

In the U.S., different types of income are taxed at different rates, suggesting some are considered more virtuous than others. For example, profits on investment assets held for more than a year, so-called "long-term capital gains," are taxed less than "ordinary income" such as salaries and interest. This has been the case for so long that we consider it the norm, and what we're used to often becomes the baseline for "fairness."

Long-term capital gains are taxed at reduced rates because of a judgment that long-term investment in things like securities, companies and real estate is beneficial for the economy and should be encouraged. Right now, the top tax rate on long-term investment profit is less than half that on short-term gains and ordinary income. And in recent years, the taxes on dividends have been reduced to similar levels, in part to mitigate double taxation of corporate profits but also because of a judgment that the equity investments that give rise to dividends are good for our society.

Is it appropriate to tax profits on long-term investments at rates below those on other forms of income? Certainly we should encourage investment, but there's no consensus that the tax code is the place to do it. Some foreign jurisdictions don't tax capital gains at all, while others tax them at the same rate as all other income.

What about interest? Why are dividends taxed at preferential rates and interest at ordinary rates? The explanation may lie in the fact that interest is deductible for corporations, while dividends aren't. Interest is paid out of pretax income, while in theory dividends are paid out of after-tax income – although the existence of corporate deductions and credits means dividends may, in fact, be paid out of income that hasn't been taxed by the U.S. Alternatively, the difference in tax treatment may be the result of a desire to encourage investment in "risky" equities rather than "safe" debt. But some companies' dividends are no doubt safer than some other companies' interest payments, so this distinction is questionable. If the goal is to encourage risk bearing, is dividend versus interest the right criterion?

While on the subject of gains from investments, it's interesting to note that, not long ago, dividends were included with interest under the rubric "unearned income." This pejorative phrase implied that income on capital, not requiring labor, was less virtuous than that stemming from labor, so-called "earned income." Thus unearned income – primarily dividends and interest – was taxed more heavily than wages.

But now things have turned 180 degrees, and returns on capital are taxed at lower rates than wages. It's worth noting that the Democrats – commonly considered the party of labor – controlled the government for much of the period 1928 to 1980, when earned income was favored. On the other hand, the Republicans – the party of those with capital to invest – have been in control more of the time since 1980, and the taxation of returns on capital has declined in relative terms. The definition of virtuous income that should be encouraged through lower taxes clearly is subjective, impermanent and subject to change with the winds of politics.

One debate that has arisen recently surrounds the so-called "Buffett Rule." For the last few years, Warren Buffett has been speaking about the fact that he pays a smaller percentage of his income in taxes than does his secretary. Presumably this is because his income consists primarily of long-term capital gains and very little of salary, bonus and interest.

(As an aside, it should be noted that Buffett's lower tax rate, while not unique, is far from the norm. According to The New York Times of September 24, "The number of people who fall under the Buffett Rule is quite small, only 60,000" out of 450,000 taxpayers who make over $1 million. "And the amount of revenue that would be generated [by the Buffett Rule] over the next 10 years is equally small – just $13 billion. . . .")

Buffett's tax status is a function of policy choices made by the people who wrote our tax laws. According to The New York Times of September 21, "President Obama's proposal for a new tax on millionaires . . . would counteract decades of tax reductions for most Americans that have given the wealthy the most benefit. . . ." Do we consider these decisions appropriate in principle and Buffett's just an extreme case? Or do we want to change things so returns on capital are less favored and big earners can never pay overall taxes at lower rates than those who earn less? (And, as an aside, are all long-term profits truly beneficial to society? How, for instance, does society benefit when someone buys a bar of gold?)

Deductions, Loopholes and Tax Incentives

Speaking of gold, in "All That Glitters" on that subject, I quoted from a speech by Mississippi state legislator "Soggy" Sweat that showed his ability to simultaneously praise and condemn whiskey with equal conviction. Outdoing Soggy, depending on who's talking, Washington politicos use the three very different terms above to describe the same thing: offsets to taxable income.

The drafters called them deductions: provisions that reduce the net income on which taxes are levied. Critics call them loopholes, suggesting there's something underhanded about those provisions. And politicians use the laudatory-sounding term tax incentives to describe tax code provisions that reduce tax revenues in order to encourage certain behavior. It all depends on your point of view.

Let's take a look at one of the most popular deductions: interest on mortgages. For as long as I can remember, interest on home mortgages has been treated as a desirable expenditure that should be encouraged. Because home ownership is considered part of the American dream, the tax code subsidizes it by reducing the after-tax cost for those who borrow to buy homes (and are able to itemize rather than take the standard deduction). While everything else may be arguable, certainly this seems fair. But is it?

• Are homeowners more virtuous than renters? If mortgage interest is deductible but rent isn't, we're requiring renters to subsidize owners. Is that appropriate?
• On average, homeowners are from the middle and upper income brackets. Is it fair that poorer renters provide a benefit for richer owners?
• And is it desirable that those able to buy more expensive homes should get more of a subsidy than those consigned to cheaper ones?

As with the taxation of dividends, judgments on these matters change over time. Until 1987, there was no limit on the amount of mortgage interest that could be deducted. If you could afford to own ten homes with multiple million-dollar mortgages on each one, taxpayers would collectively share the cost by reducing your income taxes due. Today interest is deductible on only a maximum of $1.1 million of debt, and only on first and second mortgages, and only on a primary residence and a second home. So the tax treatment of owners of many homes and more expensive homes has become less generous. But it's still better than that of renters. Is that proper?

What about the tax deductibility of charitable donations? As I travel the world visiting with clients, I see that two things about the U.S. are quite uncommon: (a) Americans give a lot of money to charity and (b) donations to charity are deductible in calculating taxable income. Everyone tells me the latter is the main reason for the former. In particular, these things are part of the explanation for the existence of the many private, non-state-supported colleges and universities in the U.S., the best of which are so good at least in part because of their significant donor-provided endowments. For example, Harvard and Yale are only half as old as England's Oxford and Cambridge, but they benefit from endowments that are far larger.

Part of this is true because legislators decided at some point to subsidize non-profits by encouraging contributions through the tax code. That's certainly understandable. And yet, changes were made in recent years to limit upper-bracket taxpayers' use of deductions in order to ensure that they pay some minimum tax rate.

What about the unevenness of the subsidy? The cost of giving $1 to charity is reduced by the amount of taxes it saves the donor, which is equal to $1 times the person's tax rate. So today, speaking simplistically, it costs a top-bracket taxpayer 65 cents to give a dollar to charity, while it costs a bottom-bracket taxpayer 85 cents. Is that fair? Should the bigger earner receive a greater reward for a dollar of philanthropy than someone who can afford it less easily? And should those who aren't inclined to give to charity be required to subsidize those who are?

Finally, what about state and local taxes, the third of the significant deductions? Here tax deductibility isn't due to a decision to encourage people to pay non-federal taxes, but rather to cushion the effect of being taxed in multiple jurisdictions. Texas, Florida and five other states have no personal income tax, California has a heavy one, and someone living in Manhattan pays tax to both New York State and New York City. Deductibility on the federal tax return somewhat evens out the burden and ensures that (a) the states get first crack at taxing income and (b) the federal government can only tax what's left, in line with federalist principles.

This raises a number of questions. Is the deductibility of state and local taxes fair? As with other deductions, the key question is "fair to whom?" Some people pay more state and local taxes than others, meaning they get greater deductions than others. As a result, while a person with a given income who lives in a high-tax state pays higher total taxes, he or she pays less federal tax than someone in a low-tax state. Is that fair?

Further, what all of this means is that by providing more benefits to its residents (or at least spending more money, whether beneficially or not), a high-tax state creates a deduction for its residents and thus reduces the federal government's total tax take. Is this right? Should the federal government subsidize spending on the part of high-tax states? That is, should residents in low-tax states bear part of the expenses of high-tax states? There's nothing simple about these matters.

While the source of an exemption rather than a deduction, what about interest on "municipal bonds" issued by states, counties, cities and local agencies. This is exempt from federal taxation, under the legal doctrine that the federal government mustn't tax the operations of the states. ("The power to tax is the power to destroy," one of our great Supreme Court decisions held.) But here again, we're talking about a federal benefit (in the form of a lower cost of capital) for the biggest-spending local governments and their citizens, and a tax break for people who lend to them.

And what about property taxes? These are deductible without limitation. Thus the owner of a mansion – or ten mansions – receives more of a tax benefit than a low-income earner. And it's another subsidy for homeowners versus renters. Is this right, or should it be changed?

To date, it has been deemed fair for state and local income tax to be deductible on federal tax returns. But is this immutable? Sales tax used to be deductible, too (meaning the buyer of a Rolls Royce got assistance from the federal government). Now it's not. More fair?

What if the deduction for state and local taxes and the exemption for muni interest were ended? This would increase the cost of financing for state and local governments and most impact the highest-spending states, potentially requiring higher taxes causing people to move away. This would reduce those states' revenues and require them to raise taxes further (and drive away still more taxpayers) in a painful cycle. And are those states profligate or just burdened (like California by a substantial low-income population) or natural-resource-poor (lacking Texas's oil)?

So even in "small" matters like the tax deductibility of mortgage interest, charitable donations, and state and local taxes, there are lots of difficult questions. While on their face the deductions seem fair to homeowners, philanthropists and residents of high-tax states, they're simultaneously penalizing renters, non-donors and residents of low-tax states (as well as taxpayers in low tax brackets and those without enough deductions to itemize).

How about the biggest exclusions of all: employer-provided health care and the deferral of taxation of contributions to pension plans? In both cases, those receiving these employer-paid benefits enjoy a substantial benefit not shared by those not fortunate enough to participate. For instance, is it fair that many better-paid workers get thousands of dollars a year in untaxed health-care benefits, while other workers enjoy no such subsidy?

Fairness turns out to be quite an elusive concept.

Reasons for Increasing Taxes

As U.S. leaders wrestle to reduce the budget deficit in the coming months and years, spending cuts are a certainty. But the question of whether taxes should be increased is sure to be hotly debated. A number of justifications for doing so are advanced:

• Some people want wealth to be redistributed throughout society by taxing the rich and giving to the poor. They want the government to do more for those who are less fortunate (or less able), and that means having the rest pay for it.
• There's an argument that for the deficit solution to be equitable, all citizens should contribute to it. Though some government spending benefits all citizens alike, such as national defense, national parks and the administration of justice, much spending disproportionately benefits lower earners, in the form of public education and transportation (which are supported by the federal government), unemployment insurance, food stamps, Medicare and Medicaid, etc. Thus the effect of the coming spending cuts will fall more heavily on the poor. Some argue that since they receive less in benefits and are therefore less likely to experience their loss, the wealthy should share the burden of reducing the deficit through increased tax payments.
• As opposed to the ideological arguments reviewed above, tax increases are among the limited number of possible contributors to deficit reduction listed on page 1. Thus, in the simplest terms, we can cut more from the deficit if we tax more (all else being equal).
• The ultimate practical point is that spending cuts alone won't do much to eliminate the deficit.
• Viewed another way, promises of entitlements have been in place for decades, people have relied on them, and those promises have to be kept. This is clearly impossible without increased taxes and/or exploding deficits.

Is redistribution a valid goal? To some people, it is part of the process of helping every citizen in the "pursuit of happiness." To others, it's akin to socialism and contrary to the American ethic in which rewards follow ability and hard work.

Should everyone contribute to deficit reduction, including bigger earners through the biggest tax increases? Or should the savings come primarily through sacrifices on the part of those who to date have been the primary beneficiaries of excessive government spending? I have no doubt that we'll see fireworks on these topics.

Reasons for Not Increasing Taxes (or for Lowering Them)

Before concluding that the above points are persuasive, you should consider the equally numerous arguments to the contrary.

• Many believe our massive deficit stems from a government (and an entrenched army of government employees) willing and able to spend all available cash (and more). A bureaucracy will always find uses – many of them wasteful – for available revenues. Thus the only solution is to "starve the beast": only tax cuts and restraints on borrowing will force the government to limit spending.
• It is argued that by decreasing the after-tax proceeds from a dollar earned, tax increases reduce people's incentive to work, and thus cut into a nation's overall productivity. From 1974 to 1979, Britain's top marginal rate was 83% (although with a 15% surcharge on interest and dividends, it could rise to 98%). I remember reading about a banker who took time off without pay to paint his house. Society benefits when each of us does the things we're best at. But if a banker who earns $20,000 a month only gets to keep $3,400, he's better off forgoing a month's salary to avoid paying a painter who gets $5,000 a month.
• Research into the "elasticity of taxable income" (ETI) shows that "when marginal tax rates go up, the amount of reported incomes goes down," suggesting higher taxes do reduce productivity. (The Wall Street Journal, March 30, 2010). Of course, it's also possible that when rates go up, the incentives for failing to report income also go up. Thus part of the ETI effect could come from under-reporting, as opposed to reduced effort.
• Taking the above a step further, the "Laffer curve," named after economist and presidential adviser Arthur Laffer, posits that by discouraging work (and thus reducing incomes), raising income tax rates actually reduces income tax collections. Thus, by increasing taxable income, rate reductions bring revenue gains.
• Last but especially timely is the classic Keynesian argument that raising taxes and thus reducing after-tax incomes shouldn't be done at a time when the economy is weak and spending should be encouraged, not inhibited.

For me the bottom line – the real reason why many people don't want rates to go up – is that they don't want to pay more taxes. I think people tend to "vote their pocketbooks," meaning many people with incomes to tax will vote for the candidate who promises lower taxes. But the economic theories discussed above certainly lend validity and even nobility to the pursuit of higher after-tax income . . . and the fact that their supporters are self-interested doesn't make them wrong. Finally, for whichever reason, a good portion of the electorate buys these arguments. And The New York Times reported on November 2 that "Americans for Tax Reform, a taxpayer advocacy group . . . says that 41 senators and more than 235 House members have pledged in writing to oppose all tax increases."

Topics in the News – Income Inequality

One of the outstanding characteristics of the U.S. economy at this time is the rising dispersion between incomes. The percentage of total income going to higher earners has been increasing dramatically, whether because of (a) the rising importance of education and technological literacy or (b) the movement of work offshore, the declining availability of blue-collar jobs and the reduced power of private-sector unions to garner wage gains. And given the pattern of tax cuts and the special treatment given to income on capital, the tax system has magnified the divergence.

A recent report from the Congressional Budget Office provided dramatic evidence of the divergent trends in income. It outlined the percentage gain in average inflation-adjusted after-tax income of various income groups between 1979 and 2007:

• Top 1% of the population in terms of income: 275%
• Next 19%: 65%
• Middle 60%: 40%
• Bottom 20%: 18%

According to the CBO:

• The share of income going to higher-income households rose, while the share going to lower-income households fell.
• The top fifth of the population saw a 10-percentage-point increase in their share of after-tax income.
• Most of that growth went to the top 1 percent of the population.
• All other [quintile] groups saw their shares decline by 2 to 3 percentage points.

An October 26 article in The New York Times reported the following conclusions:

". . . the report said government policy has become less redistributive since the late 1970s, doing less to reduce the concentration of income.

" 'The equalizing effect of federal taxes was smaller' in 2007 than in 1979, as 'the composition of federal revenues shifted away from progressive income taxes to less-progressive payroll taxes,' the budget office said.

"Also, it said, federal benefit payments are doing less to even out the distribution of income, as a growing share of benefits, like Social Security, goes to older Americans, regardless of their income. . . .

"Also cited as factors contributing to the rapid growth of income at the top [in addition to federal tax and spending policies] were the structure of executive compensation; high salaries for some 'superstars' in sports and the arts; the increasing size of the financial services industry; and the growing role of capital gains, which go disproportionately to higher- income households."

The implications for tax discussions are obvious. Upper earners have moved further ahead relative to lower earners, and tax policies have contributed to this trend. For those who think progressivity should be bolstered, income should be redistributed, and those most able to pay should contribute more heavily to solving the deficit problem, upper-bracket earners make a most attractive target.

Topics in the News – The Sputtering Economy

In early 2011, there was a growing consensus that the U.S. economy was on an upward trajectory – that recovery had taken hold. Reported growth in GDP was accelerating. Orders, sales and profits were strong. Cash was piling up in corporate coffers. The Fed gave increased thought to increasing interest rates to cool off the economy and prevent the rekindling of inflation.

But in the summer it was reported that the economy had cooled, and earlier estimates of GDP were revised downward. A possible double-dip recession became the topic of the day. At the same time, an unseemly political confrontation regarding the U.S. federal debt ceiling exposed a flawed, unconstructive political system at work; produced a downgrade of long-term Treasury debt on the part of Standard & Poor's; seemed to take us to the brink of a default; and sapped confidence at all levels.

Despite the economy's weakness, further government aid for the economy has been rendered untenable by widespread negative feelings about the stimulus programs of 2007-08 and the popular view that the government took care of Wall Street but not Main Street, combined with the nearness of the next presidential election. Especially with stimulus unlikely, government actions that discourage growth should be viewed skeptically.

In the U.S. – just like in Greece and elsewhere in Europe – the answer to problems of excessive deficit and debt can be summed up in one word: austerity. Everyone's after debtor nations to practice austerity; that is, to spend less and tax more. The problem is that such behavior will reduce citizens' incomes, discourage consumer spending and slow or reverse economic growth. While on paper austerity will cut deficits, it may actually add to them by reducing government tax collections. In this way, it would necessitate further borrowing.

There's no doubt that, along with spending cuts, tax increases would have a detrimental impact on the prospects for economic recovery. Thus even people who are open to tax increases may not want them to be effective until the economy is out of danger. As the Financial Times put it on October 29, "Many households are so badly overleveraged that a balanced federal budget would ruin them."

But our economic problems aren't just cyclical. There are worrisome secular trends, many surrounding the scarcity of new jobs, the movement of manufacturing overseas, and the low level of business investment in the U.S. The best cure for our cyclical and secular difficulties would be growth based on industrial expansion. This would put people to work, support increases in spending, reinvigorate the housing sector, increase tax revenues and shrink the deficit. But for this to happen, we need (a) tax rates that allow successful entrepreneurs to retain a substantial percentage of the resulting profits and (b) confidence that the tax system won't be made more confiscatory after they've made their investments. At the present time, the latter, in particular, is very much lacking.

Topics in the News – Flat Tax

It's interesting to note that writers of tax law have two main routes to a given revenue total: low rates without deductions, exemptions and credits, or high rates with them. To date they have chosen the latter course. An article in The Wall Street Journal of January 29, 2011 marked down this choice to pure politics:

"Why did [Roosevelt's high tax rates] last so long . . . beginning their long steady decline only during the Kennedy administration? . . . In part to fund the Korean conflict and the Cold War, but also to grease the skids of modern politics. Lawmakers were able to blunt the effect of high statutory rates by handing out tax preferences to their friends, constituents and contributors. Steep rates preserved the appearance of progressivity (and, to be fair, some of the reality), while supplying politicians with their stock in trade: favors."

There are periodic calls for lower "flat" income tax rates and the elimination of deductions and other wrinkles, and we are hearing them today. The main goal is tax simplification. I commend this. (I have to admit that I, with my MBA in accounting, stopped being able to understand my own tax return decades ago.) But of course we cannot convert to a flat tax system without altering people's relative taxes. A change would require sweeping policy decisions.

Flat tax proposals are often accompanied by calls for a national sales, consumption or "value added" tax on spending, such as many other nations have. The problem here is that those with low incomes spend most or all of their earnings on life's necessities, and as incomes rise, people gain the possibility of spending less of their incomes and saving more. Thus sales taxes tend to take a higher percentage of income the lower one's income. That's why, in contrast with progressivity, sales taxes are described as "regressive."

Last month, Republican presidential candidate Herman Cain announced his "9-9-9 plan," which features a flat 9% income tax rate, 9% national sales tax and 9% business tax. Let's take a look at it. The Tax Policy Center is a non-partisan joint venture of the Urban Institute and Brookings Institution. The St. Petersburg Times's politifact.com summarized the results of the TPC's analysis as follows: "83.8 percent of tax filers would get a tax increase . . . compared with current tax policy. On the other hand, most of the tax filers who make more than $1 million would get a tax cut . . . about 95.4 percent of this high income group."

Would it be right to make poor people pay income tax at the same rate as rich people and pay a higher percentage of their incomes in a national sales tax? Anything's fair game, I guess, but if the TPC's analysis is correct, this plan would represent a step away from progressivity and further skew after-tax income toward the wealthy. Yet we're likely to hear a lot more about flat tax during the coming campaign. When confronted with complex problems, people often welcome simple solutions.

Topics in the News – Political Posturing

A Democratic politician I know decided not to run for president in 2008 because he expected a rising tide of populist rhetoric to be required. He was right: classist speech rose substantially. And the rise continues unabated.

Democrats tend to lean toward bigger entitlement programs, greater governmental involvement in the economy, deficit spending, progressive taxation and income redistribution. These things are in contrast to Republicans' averred traditions of small government, individual self-sufficiency, free markets, balanced budgets and tax reduction. At the present time, with the economy performing poorly, Democrats are glad to describe Republicans' laissez faire policies as having contributed to joblessness and economic hardship. With difficulty more prevalent than prosperity today, populism – appealing to disadvantaged economic classes based on claimed inequities – represents a compelling brand of politics.

Thus in recent months we've increasingly heard Democratic politicians sneer at "millionaires and billionaires" (see Senator Reid on page 2), an epithet aimed at a group that's supposedly been getting away with something. (In the past, I seem to recall, it was instead a group most people wanted to be part of.) To date, the preferred Republican label for people with money has been "job creators," although this line of defense may be tough to maintain in the current climate.

The Financial Times of October 29 carried an article headlined "Obama takes high-risk stance against the rich." It described a decision to emulate Roosevelt's Depression-era rhetoric and point an accusing finger at the Republicans as the party of wealth.

"Throwing out the standard presidential playbook dictating an aspirational approach to centrist voters, the White House is cementing a message that strikes at wealth and privilege.

" 'There is surging sentiment among voters that the economy is weighted towards the wealthy,' said a senior White House official.

"The White House strategy will make the 2012 election a generational test of the Republican push of the last three decades for cutting taxes, in ways their critics say have been constantly skewed towards the highest earners."

However, the article goes on to say Republicans may respond in kind to this tactic, joining in support of the common man rather than standing up for wealthier supporters:

". . . Republicans are tweaking their public message, with the hardline [H]ouse majority leader, Eric Cantor, recently acknowledging the need to address the rich-poor gap.

"Mitt Romney, the frontrunner in the race to challenge Barack Obama in 2012, has taken to saying that he is standing up for the 'middle class' because the rich 'can look after themselves.' "

With candidates in both parties competing to sound less pro-wealth, top earners and their supportive tax policies should expect to be rhetorical targets in the coming election. Whether this will extend to Republican candidates dropping their resistance to tax increases remains to be seen.

The Ultimate Worry: Tyranny of the Majority

The elements that contributed importantly to America's success included economic aspiration, upward mobility and a tax system that encouraged labor and risk-taking. In short, we all could get rich. As a result, both those with money and those hoping to make money were attracted to the idea of low taxes. This made tax reduction a very popular theme over the last few decades.

But when people without money start to believe they can't make money, there's little to keep them from taking it from those who have it. This represents a threat to our way of life.

As I've written before, I was very impressed when, as a young man, I heard an interesting explanation for America's economic progress relative to Great Britain: "When the worker in Britain sees the boss drive out of the factory in his Rolls Royce, he says 'I'd like to put a bomb under that car.' When the worker in America sees the boss drive out of the factory in his Cadillac, he says 'I'd like to have a car like that someday.' " This tale says a lot about how we achieved our success . . . and also about what we'd better retain if we want to keep it.

The truth is, in a democracy, the lower-earning majority is perfectly capable of voting to confiscate the wealth of the minority. A lot of people have written about this and associated threats to our system:

" 'If Sparta and Rome perished,' asked Rousseau in his Social Contract, 'how can any state hope to live forever? The Body Politick, like the body of a man, begins to die as soon as it is born; it contains the seeds of its own destruction.' " (Financial Times, October 29)

" 'When men get in the habit of helping themselves to the property of others,' warned the New York Times in 1909, 'they are not easily cured of it.' " (The Wall Street Journal, January 29, 2011)

"Some people regard private enterprise as a predatory tiger to be shot. Others look on it as a cow they can milk. Not enough people see it as a healthy horse, pulling a sturdy wagon." (Winston Churchill)

"As Margaret Thatcher famously said, the problem with socialism is that sooner or later 'you run out of other people's money.' " (New York Post, January 12, 2011)

The risk is exacerbated today by the fact (as noted earlier) that about half of all Americans pay no federal income tax. This makes me wonder whether our democracy can make good decisions about taxation when half the people are outside the system.

Obviously, it's tempting to many to increase taxes on the rich, seeing it as a harmless way to enhance the welfare of the many at a small cost to the few. But the damage to the U.S.'s success machinery could vastly outweigh the sums confiscated from those who are targeted. The "fair share" taken from upper bracket earners has to be kept as small as possible if the tax system is to benefit all of our society. The coming debate over tax increases will be very important in this regard.

There can be no easy solution. Social programs and tax policies have been put in place that will combine with demographic and income trends to create challenging conditions. "The Middle-Class Tax Trap" (The New York Times, April 17, 2011) outlined the consequences:

"[Consider] the 'current law baseline,' a Congressional Budget Office projection in which the Bush-era tax rates aren't renewed in 2012, the Alternative Minimum Tax (which is supposed to hit only the rich but increasingly bites into middle-class paychecks) isn't indexed for inflation, and Medicare payments to doctors are slashed 20%.

"With these changes, the deficit drops away in the next 10 years, and more important, it stays manageably low for the decades after that. . . .

"This is how the 'current law baseline' cuts the deficit: Thanks to inflation and bracket creep, its tax code generally subjects more and more Americans to rates that now fall only on the wealthy.

"Today, for instance, a family of four making the median income . . . pays 15% in federal taxes. By 2035, under the C.B.O. projection, payroll and income taxes would claim 25% of that family's income. The marginal tax rate on labor would rise from 29% to 38%. Federal tax revenue, which has averaged 18% of G.D.P. since World War II, would hit 23% by the 2030s and climb ever higher after that.

"Such unprecedented levels of taxation would throw up hurdles to entrepreneurship, family formation and upward mobility. . . .

"They could have ugly political consequences as well. Historically, the most successful welfare states (think Scandinavia) have depended on ethnic solidarity to sustain their tax-and-transfer programs. But the working-age America of the future will be far more diverse than the retired cohort it's laboring to support. Asking a population that's increasingly brown and beige to accept punishing tax rates while white seniors receive roughly $3 in benefits for every dollar they paid in (the projected ratio in the 2030s) promises to polarize the country along racial as well as generational lines.

"The Republican vision for entitlement reform, President Obama said last week, would lead to a "fundamentally different America" than the one we inhabit today. He's right: asking the elderly to pay more for their health care, as [Representative] Paul Ryan proposes to do, would transform the American social contract, and cause no small amount of pain.

"But what Obama doesn't acknowledge is that the alternative path could lead to a different country as well – a more stagnant and balkanized society, in which our promise to the elderly crowds out the fundamental promise of America itself." (Emphasis added)

Will we keep the promise of entitlement programs or cut them back? Given the prominence of entitlements in the U.S. budget, in large part it comes down to that.

Over the last 80 years, politicians in the U.S. created entitlement programs that we cannot afford. Likewise, to varying degrees citizens throughout the developed world have been given promises their governments can't keep. That a day of reckoning would arrive is not news – credible observers have warned of our current problems for decades – but few politicians have been willing to fall on the sword of unpopular solutions.

Whatever action is taken now, it will not be pain-free. The unpayable debts run up in the past will have to be dealt with. And as for the future, there are only three possibilities: the promises will have to be scaled back, the tax burden will have to grow, and/or the deficits will have to be permitted to increase. If nations are to limit deficits – and it seems they may be forced to – there is no alternative to the first two of these. This fundamental truth will constitute a major portion of the public debate in coming years.

Tax policy consists of deciding who to take from (and how much) and who to give it to. There are no easy answers. We should all throw our support behind the common good and not just our individual interests.

mald

2011-11-26T12:14:00.001-08:00

Changing the Rules in the Middle of the Game

By John Mauldin | November 25, 2011

Changing the Rules
When Even Germany Fails
European Inverted Yield Curves
Time to Review the Bang!Moment
The Risk of Contagion in the US
Time to Start Watching China
New York, China, and Some Links

Angela Merkel is leading the call for a rule change, a rewiring of the basic treaty that binds the EU. But is it both too much and too late? The market action suggests that time is indeed running out, and so we'll look at the likely consequences. Then I glance over the other way and take notice of news out of China that may be of import. Plus a few links for your weekend listening "pleasure." There is lots to cover, so let's get started.

Changing the Rules

I have been writing for a very long time about the changes needed to the EU treaty if Europe is to survive. Specifically, last week I noted that Angela Merkel has made it clear that the independence of the ECB must not be compromised. This week Sarkozy and the new prime minister of Italy, Mario Monti, agreed to stop their public calls for such changes (at least until their own crises get even worse, would be my guess). And Merkel has called for a new, stronger union with strict control of budgets as the price for further German aid for those countries in crisis. In seeming response:

"The European Commission on November 23 proposed a new package including budget previews at EU level, the establishment of independent fiscal councils and growth forecasts, closer surveillance of bailout recipients and a consultation paper on Eurobonds. There is also a growing consensus among EU policy makers on the need for the adoption of fiscal rules in national legislation. However, it is far from clear whether EU countries would accept the implicit loss of sovereignty this would involve and agree to treaty changes enshrining legally enforceable fiscal oversight at EU level. The German Chancellor, Angela Merkel, is willing to support a change in Germany's own constitution if the EU Treaty change to that effect is agreed first." ( www.roubini.com)

But this means a major treaty change that must be approved by all member countries. Note that Merkel wants the treaty change first, or at least the language, before she takes it to German voters, which will certainly be required, since what she is suggesting is not allowed by the present German constitution. Without the changes stated clearly and explicitly in advance, it is unlikely, as I read the polls, that German voters will go along. Merkel has made it clear that any proposed changes will be limited to fiscal issues and central control and not touch on the ECB's independence. She is adamant against eurozone bonds and putting the German balance sheet at risk (see more below).

But will the rest of Europe go along with what would be a major alterations of their own individual sovereignty and their ability to adjust their own budgets, no matter what? And agree to all this in time to deal with the current crisis? Such changes will be controversial, to say the least. And they would require, if I understand, the yes votes of all 27 European Union members, or at a minimum the 17 eurozone members.

That is problematical. Will even German voters give up their independence and listen to an EU commission tell them what they can and cannot do with their own budget? A budget that is in theory controlled by the rest of Europe? The answer depends on whom you listen to last, as the answers range all over the board.

When Even Germany Fails

Let's get back to the German balance sheet. This week the markets were greeted with a failed German bond offering. The German central bank had to step in and buy German bunds, at a recent-series-high rate. And while the "trade" has been to buy German bunds as a hedge, Germany is not precisely a model of balance and austerity, with high (above 4%) deficits and a rising debt-to-GDP ratio. And the market senses the contradictions here. When even German bond auctions fail, whither the rest of Europe?

As a quick aside, notice that German yields are not higher than those of UK debt at some points. The market is clearly signaling that the lack of a national central bank with a printing press is an issue. Go figure. But that is a story for another letter at another time.

Let's look at some recent headlines. Greek 2-year bonds are now at 116%. You read that right. "Bond yields on short-term Italian debt rose above 8 per cent on Friday as Rome was forced to pay euro-era-high interest rates in what analysts called an 'awful' auction. A peak of 8.13 per cent was reached on three-year bonds, according to Reuters data, as Italian debt traded deeper into territory associated with bail-outs of Greece, Portugal and Ireland in the past 18 months.

"Italy raised its targeted €10bn in an auction of two-year bonds and six-month bills but at sharply higher yields. 'Rates have skyrocketed. It's simply not sustainable in the long run,' said Marc Ostwald, strategist at Monument Securities in London.

"Investors demanded a yield of 7.81 per cent for the two-year bond, up from 4.63 per cent last month. The six-month bills saw yields of 6.50 per cent, up from 3.54 per cent. That was significantly higher than Greece paid for six-month money earlier this month when it issued bills at 4.89 per cent." (Reuters)

Spanish bond yields are slightly lower but not by much, with both countries paying more for short-term debt than Greece.

And no one is really talking about Belgium, which I have been pointing to for some time. Belgium debt yield on its ten-year bonds went to 5.85%. Notice the recent trend, in the chart below. It looks like Greece in the not-very-distant past. (Chart courtesy of Roubini.com and Reuters data)

European Inverted Yield Curves

Let's rewind the tape a little bit. Both the Spanish and Italian bond markets are close to or already in an "inverted" state. That is when lower-term bonds yield higher than longer-term bonds, which is not a natural occurrence. Typically, when that happens, the markets are sending a signal of something. (Charts below courtesy of my long-suffering Endgame co-author, Jonathan Tepper of Variant Perception, who lets me call him up late for data like this.)

Note that Greece (especially) and Portugal inverted when they began to enter a crisis. And shortly thereafter they went into freefall. Why did it happen so suddenly?

The short explanation is that once the market perceives there is risk, the debt in question has to collapse to the point where risk takers will step in. Do you remember two summers ago, when I related what I thought was a remarkable conversation with two French bond traders in a bistro in Paris after the markets had closed? Greece was all the news. It was all Greece, all the time. And I asked them what their favorite trade was (as I like to do with all traders). The surprising answer (to me) was they were buying short-term Greek bonds. They walked me through the logic. I forget the yields, but they were sky-high. They figured they had at least a year and maybe two before the bonds defaulted, plenty of time to get a lot of yield and exit. And there were hedges.

Italian and Spanish yields are approaching that "bang!" moment. The only thing stopping them is the threat of the ECB stepping in and buying in real size. Which Merkel is against. And the market is starting to believe her, hence the move in yields.

Time to Review the Bang! Moment

One of the most important sections of Endgame is in a chapter where I review (and compare with other research) the book This Time is Different by Ken Rogoff and Carmen Reinhart, and include part of an interview I did with them. This chapter was one of real economic epiphanies for me. Their data confirms other research about how things seemingly bounce along, and then the end comes seemingly all at once. Which we'll term the bang! moment. Let's review a few paragraphs from the book, starting with quotes from the interview I did:

"KENNETH ROGOFF: It's external debt that you owe to foreigners that is particularly an issue. Where the private debt so often, especially for emerging markets, but it could well happen in Europe today, where a lot of the private debt ends up getting assumed by the government and you say, but the government doesn't guarantee private debts, well no they don't. We didn't guarantee all the financial debt either before it happened, yet we do see that. I remember when I was first working on the 1980' Latin Debt Crisis and piecing together the data there on what was happening to public debt and what was happening to private debt, and I said, gosh the private debt is just shrinking and shrinking, isn't that interesting. Then I found out that it was being "guaranteed" by the public sector, who were in fact assuming the debts to make it easier to default on."

Now from Endgame:

"If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.

"Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short-term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget."

And the following is key. Read it twice (at least!):

"Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence—especially in cases in which large short-term debts need to be rolled over continuously—is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!—confidence collapses, lenders disappear, and a crisis hits.

"Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained —or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite."

"How confident was the world in October of 2006? John was writing that there would be a recession, a subprime crisis, and a credit crisis in our future. He was on Larry Kudlow's show with Nouriel Roubini, and Larry and John Rutledge were giving him a hard time about his so-called 'doom and gloom.' 'If there is going to be a recession you should get out of the stock market,' was John's call. He was a tad early, as the market proceeded to go up another 20% over the next 8 months. And then the crash came."

But that's the point. There is no way to determine when the crisis comes.

As Reinhart and Rogoff wrote:

"Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!—confidence collapses, lenders disappear, and a crisis hits."

Bang! is the right word. It is the nature of human beings to assume that the current trend will work itself out, that things can't really be that bad. The trend is your friend … until it ends. Look at the bond markets only a year and then just a few months before World War I. There was no sign of an impending war. Everyone "knew" that cooler heads would prevail.

We can look back now and see where we have made mistakes in the current crisis. We actually believed that this time was different, that we had better financial instruments, smarter regulators, and were so, well, modern. Times were different. We knew how to deal with leverage. Borrowing against your home was a good thing. Housing values would always go up. Etc.

Until they didn't, and then it was too late. What were we thinking? Of course, we were thinking in accordance with our oh-so-human natures. It is all so predictable, except for the exact moment when the crisis hits. (And during the run-up we get all those wonderful quotes from market actors, which then come back to haunt them.)

If it was just Europe and if the crisis could be contained there, then maybe we could focus on something else for a change. But Europe as a whole is critical to the world's economy. A huge percentage of global lending is from euro-area banks, and they are all contracting their balance sheets. In a banking balance-sheet crisis, you reduce the debt you can, not the debt that is the most needed or reliable. And some of the debt will be to foreign entities. As an example, Austria is now requiring its banks to cover their Eastern European loans with local deposits. Which is of course problematical, as the size of those loans relative to the bank balance sheets and the Austrian economy is huge. According to BIS statistics, Austrian banks' total exposure to the region equates to around 67% of the country's GDP, not including the Vienna-based Bank Austria, which is technically Italian.

We could find similar results for other European (mostly Spanish), as well as Latin American banks. And as I note below, this will reach into China and throughout Asia.

The Risk of Contagion in the US

And the US? I am constantly asked what my biggest worry is. What is the largest monster I think I hear in my closet of nightmares? And the answer has been the same for a long time: it is European banks.

Those who think this is all a non-event note (correctly) that US net exposure to European banks is not all that large, and that while it may not be a non-event, it's not system-threatening. The problem is that little three-letter word net.

Gross exposure is huge, and we are starting to read that regulators and other authorities are becoming concerned. As well they should. The problem is that as a bank sells risk insurance, it can buy protection from another bank in Europe to hedge it. But who is the counterparty? How solvent are they? It was only a month before Dexia collapsed that authorities and markets assured us that the bank was fine, and then bang! it was nationalized.

That is the part we do not know enough about. If European banks are as bad as they appear to be, then that counterparty risk is large. Will sovereign nations step up and bail out US banks on the credit default swaps their banks sold? Care to wager your national economy on that concept selling in today's political climate?

Contagion is the #1 risk on the minds of European leaders and regulatory authorities, and it should be in the US, too. This points to a massive failure in Dodd-Frank to regulate credit default swaps and put them on an exchange. This is the single largest error in the last few decades, as it was so predictable. At least with the repeal of Glass-Steagall it was the unintended consequences that got us. Dodd- Frank almost guarantees another credit and banking crisis. Don't get me started.

Since the ECB is for now off the table as a source of unlimited funds (remember I said "for now"), there are calls for funds from a variety of sources. Some new supranational fund, more EFSF "donations," etc. The only semi-realistic one is IMF participation. If that is seriously considered, then the US Congress should step in and protest. US funds should not be used for governments of the size of Italy and Spain. These are not third-world countries. This is a European issue of their own making and not the responsibility of US taxpayers, or for that matter taxpayers anywhere else. We should "just say no."

As I have been writing, there is no credible source other than the ECB for the amount of funds needed. Maybe something can be cobbled together under the pressure of a crisis, but for now there is no realistic option. Europe is at the end of the road unless Germany "blinks." The only thing we can do now is to see how it works out.

If the ECB can't print, then the rules have to be changed, if the eurozone is to survive. And while a recession is underway.

"Maersk Line, the world's largest container shipper by volume, plans to cut its capacity on Asia-to-Europe routes, a senior executive said Friday, as the euro-zone debt crisis weighs on international trade.

"Almost all carriers are losing money now ... and it looks like 2012 will going to be similarly challenging," Tim Smith, the company's North Asia chief, told reporters at a shipping conference."

Time is not on the Europeans' side. Let's hope they can figure it out, but prepare for what might happen if they don't.

Time to Start Watching China

I am going to begin devoting more time to analysis of Asia in general and China in particular. There are signs of problems developing, and they demand study. Here is just one note (of a dozen) that came across my desk in the last two days. This is from Andy Lees of UBS:

"We saw today that 80% of Chinese construction firms say developers are now behind on payments (late cash flow), and that consequently land purchases are already 42% down y/y (slowing local authority cash flow). We also heard that pricing controls means that utility companies no longer have the cash flow to afford vital imports. Q3 corporate cash flow was down 27%.

"China's trade surplus is annualizing this year at USD152bn, FDI [Foreign Direct Investing] @ USD114bn yet its FX reserve increase is USD472bn. The attached chart [below] shows Chinese external borrowings which unfortunately were last updated at the end of last year, but the data would infer these have continued to soar.

"I am being told that European banks are now starting to shrink their foreign loan books to meet domestic needs, with Mexico, Brazil and China all big losers. With China now saying they may run a full-year trade deficit next year, and with them unable to afford to import vital coal and other resources without either suffering domestic inflation or without selling its FX reserves, it may now well be time to consider some sort of puts on the yuan. In fact the only reason perhaps not to is that India may collapse first, reducing the competition for coal and giving China a little more breathing room.

China is not a problem in the short term. But there have to be adjustments to keep that status of "not a problem." The situation bears watching and becoming familiar with, as I am on the record that Japan is the next in line to suffer a real world-shaking crisis. And China, which does not adjust in advance, can suffer contagion effects from Japan. The world is so connected.

My plan now, in addition to reading more is to tap some very good sources who either live in or travel to China a lot. And I will visit China for at least two weeks next summer, depending on publishing schedules. Europe is getting so old hat, and the crisis there will resolve, one way or another. Let's focus on a different set of opportunities.

New York, China, and Some Links

Last week I had the privilege of meeting Ken Rogoff at the UBS Wealth Management Conference. He graciously allowed me to take a picture with him. I got to listen to a panel with him; Ottmar Issing, noted German former central banker); and Jim O'Neil, Chairman, Goldman Sachs Asset Management; along with Alan Greenspan. Your basic $400,000 panel, assuming O'Neil was free. Only Greenspan spoke separately (and gave a very short speech). I could have listened to all of them a lot longer.

There was remarkable convergence with the panel I was on, except that I am under no pressure to be politically correct, or simply do not recognize that I should be. Everyone was concerned about Europe. I was not seen as alarmist by any fair comparison.

It was also good to have lunch with Art Cashin and finally hear him speak. He got two standing ovations, both of which he deserved. Not many know his pivotal role at the NYSE or have his level of experience and trust. He is a true legend. And if luck and schedule hold, I get to be with him for dinner Monday night, along with Barry Ritholtz, Barry Habib, Michael Lewitt, Rich Yamarone (of Bloomberg), and maybe Dennis Gartman, as well as Tiffani. What a treat.

Then it's back home the next morning to be here until January 10, when I fly to Hong Kong and Singapore.

Let me commend to you an interview the BBC did with my friend Kyle Bass of Hayman Advisors, which is the opening story in the current best-selling book by Michael Lewis, Boomerang! You can listen to it at http://www.zerohedge.com/news/kyle-bass-un-edited-buying-gold-just-buying-put-against-idiocy-political-cycle-its-simple. It is 24 minutes, and the video does not seem exactly synced, so just listen to someone who is always thinking about what lies ahead and has done a good job of it so far. And think with him. And kudos to Kyle for handling a very hostile interview so well. He has more patience than I do.

I was at the Cleveland Clinic on Monday and saw eight doctors for a general check-up and some real focus on my arm. Turns out to be a torn rotator cuff and also tennis elbow. They are not related, and no surgery needed, but there is rehab.

And then I heard from Richard Russell. Let me belatedly wish Richard an even faster recovery than I enjoy. He broke his hip and is graciously sharing his rehab with readers, as he has shared his life over the years. He wrote yesterday, "I heard rehab for a broken hip was hard. That's a false statement. It's harder than hard. You have to build the strength in your good leg and both of your arms, to a point beyond your wildest fantasies. In other words, three of your limbs have to make up for the loss in strength in the leg that you can't use."

Makes me think "What arm pain?" I am embarrassed to even mention it. Richard, as in everything, continues to be my hero.

It is time to hit the send button. I fly to NYC Sunday morning to meet with Bill Dunkelberg, and we will spend a long afternoon detailing our book on jobs and employment. Then Tiffani comes in for dinner and we have meetings all day Monday for our business. So much is happening. Have a great week and enjoy the season. Figure out how to spend more time with family and friends. I know I need to.

Your just stopping here before it becomes another book analyst,

John Mauldin
John@FrontlineThoughts.com

mald

2011-11-22T05:13:00.001-08:00

Simon Hunt November/December Economic Report

John Mauldin | November 21, 2011

I have been reading and talking with Simon Hunt for a long time. He is a very thoughtful Brit who spends a lot of time in China and thinks about copper and commodities and cycles. He has enough seasoning to have seen a few cycles himself. This piece summarizes rather well the view that he has expressed for some time. And while I am generally skeptical of relying too much on cycles for specifics (they work until they don't), I think Simon has some very powerful conclusions. From his summary:

"The world is in a balance sheet depression which will make a second and perhaps more dangerous credit crisis almost inevitable. That should break out next year or in 2013.

"The three global pillars of the world economy, the USA, Europe and China, each have their own problems, but their impact is global because of the feedback loops from the financial sector to the economy.

"The USA has a debt and deficit profile which is unsustainable; the Euro Zone has to decide whether it can forge a fully fiscal union or whether the costs are too great, in which event membership will be restructured; and China is trying to put its economy on a more sustainable growth path at a time of leadership change.

"Debt and demographics will be the determining forces to global growth. Markets will no longer countenance indecision and pushing debt problems under the table by lending more funds to indebted governments. Politicians want to postpone what they know is inevitable: debts must be repaid."

This is a very interesting Outside the Box and one I suggest you put some thought into, as to how its conclusions may affect you.

I write this from Dr. Mike Roizen's office in Cleveland, where I will be at the Wellness Clinic tomorrow to do a general physical and to find out specifically what is wrong with my right arm. Nothing life-threatening here, as I told my daughters last night. Just life-annoying.

I get back to Dallas in time to go shopping for Thanksgiving dinner and start the cooking. Some things just have to be done overnight. I love this week! 40-plus people coming to dinner. And I hope you have a great holiday as well. And if you are not in the US and don't celebrate Thanksgiving, then make up an excuse and get your family and friends together and have a great meal, emphasis on together. We should do things like this more often!

Your enjoying life more and more (even with the damn arm) analyst,

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com

Simon Hunt Strategic Services

Simon Hunt November/December Economic Report

"Four years into the crisis it is surely time to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. Of course, the provision of additional liquidity support to countries and institutions in trouble can buy valuable time. But that time will prove valuable only if it is used to tackle the underlying problem.......But the underlying problems of excessive debt have not gone away. As a result, markets are now posing new questions about the solvency of banks and indeed governments themselves." Mervyn King, Governor of the Bank of England, 18th October 2011.

1. Summary

• The world is in a balance sheet depression which will make a second and perhaps more dangerous credit crisis almost inevitable. That should break out next year or in 2013.
• The three global pillars of the world economy, the USA, Europe and China each have their own problems, but their impact is global because of the feedback loops from the financial sector to the economy.
• The USA has a debt and deficit profile which is unsustainable; the Euro Zone has to decide whether it can forge a fully fiscal union or whether the costs are too great in which event membership will be restructured; and China is trying to put its economy on a more sustainable growth path at a time of leadership change.
• Debt and demographics will be the determining forces to global growth.
Markets will no longer countenance indecision and pushing debt problems under the table by lending more funds to indebted governments. Politicians want to postpone what they know is inevitable: debts must be repaid.
• European banks are under duress; government debt represents a large proportion of their asset base. They are also the largest lender to all the major regions of the world. To shore up their own balance sheets they will be cutting credits etc.
• The world will suffer from rolling recessions starting either next year or in 2013 lasting to about 2018. Global industrial production should fall by an average of 0.25% a year during this period.
• By then the process of deleveraging should have run its course. The world beyond 2018 will be a different place. World industrial production should average around 3% a year to 2030 compared with an average of 3.3% in the period 1990-2010. Monetary policy will also be quite different; global money supply will match global GDP, not the massive increase experienced since 2008.
• Asset inflation will be virtually non-existent as funds will experience solid long term growth in equities. CPI inflation will be contained at around 3% a year as a world average. This will be a golden period after the turmoil of the 2000 to 2018 years.

2. Introduction

Truth can be ugly and solutions often painful. The world is at the start of a balance sheet depression as Professor Rogoff stated in a German interview. But, policy makers will not own up to this simple description of the world economy, preferring to put band aids on gaping wounds. The truth, though both ugly and painful, is that the world is heading towards its second and, arguably, more serious global credit crisis within five years of the first.

Each of the three principal pillars of the world economy, the USA, Europe and China, has their own problems, but they boil down to two simple ingredients: debt and demographics. They may be special to their own countries/region but the impact is global because of the feedback loops from the financial sector, which is global in structure, into the world economy.

Few, if any, country will be spared from the rolling recessions and deflation which have started, will intensify and probably not end until around 2018. One example of this interrelationship is that European banks are and, have been, the principal providers of international lending. They account for more than 50% of international bank lending in all the major regions of the world, excepting Asia where it is just under 45%. These banks are under duress; they are probably already scaling back their international lending even to Asia. If this trend were to become significant, the contagion impact would be substantial.

This point was made by Mark Carney, the Bank of Canada governor and the first chairman of the Financial Stability Board. Market volatility is increasing and activity declining as global liquidity shrinks. He added, "The effect on the real economy will soon be felt." To meet tier 1 capital ratios by next June, European banks have to raise US$2.4 trillion with a good part being raised by asset sales. And this, of course, takes neither account of impaired sovereign, corporate or household loans nor the latest EMU guidelines "which ask banks to mark down distressed assets to better ascertain capital raising requirements", as GaveKal wrote yesterday.

The interdependency of governments and their banks is well and shrewdly described by Jim Millstein in today's FT.

"The financial fate of Europe's banks and its governments are inextricably linked: because the banks are the primary source of funding for government deficits, government debt represents a large proportion of the asset base of most eurozone banks. Insolvency of one therefore threatens the insolvency of the other...The truth, however, is that given the level of eurozone government indebtedness and the relative size of Europe's banks, Europe's largest banks are too big to save."

Such is the seriousness of the problems facing so many countries in Europe; their fate will have global repercussions. It is why a new, or, some would argue ongoing, global credit crisis is virtually inevitable.

Asia, so long thought of as the epicentre of global growth, will not be immune to the issues faced in the three pillars because exports to two of them will fall substantially and are likely to slow to the third, namely China. And, as the Euro Zone (EZ) becomes a more stressful region next year, European banks may well be forced to cut credit lines to corporates and governments in Asia even more.

3. Current Situation

As the global balance sheet depression takes hold, the world is moving from one crisis to another. It was only a few months ago that the market's focus was on the USA; then it was China and now it is the EZ.

Today's EZ's problems were caused by trying to cement together a ragbag of countries into the European Monetary Union which included Germany on the strong side and Greece, Ireland, Portugal, Spain and Italy on the weak side. The monetary assumption that was appropriate for Germany would be appropriate for all of the other members.

Herein lay the fault lines. The weak members were able to get a German credit rating which meant that they could borrow to consume goods and finance industry and infrastructure that otherwise would not have been possible. Banks, too, were happy to lend to the governments of these countries because they could take the loans to the ECB and use them as collateral for even more borrowing. A credit frenzy followed which has resulted in today's debt crisis.

Chart 1: Household, Corporate & Government Debt as % of Nominal GDP

Source: Bank for International Settlements

Now many of these countries are in a critical condition. This table produced by the BIS in their September report breaks down a country's total debt by household, corporate and government for some European countries plus the USA and Japan. There are three countries whose debt is above the BIS threshold level for all three categories – the UK, Canada and Portugal – and ten whose debt is above the threshold level for two of them.

Once again markets tend to focus on one culprit at a time starting with Greece, now to Italy and then perhaps to France, Spain and Belgium. The reality is that markets are going to have to focus on all of the weak countries because the numbers are just too large.

Chart 2: E1,500bn to be financed in peripheral euro area states between now and 2014

Source: Pictet, Decision Time for Monetary Union, November 2011

Sovereign refinancing by 2014 will be huge and this ignores the sums required to recapitalise the banks: in total we are talking of between E3trillion and E4trillion. As a percent of GDP, the refinancings are alarming for four of these five countries – Greece 30%, Italy 26%, Portugal 19% and Spain 16% for next year.

That is not the end of the story. Analysts conveniently forget the future liabilities such as pension funds. If these are added to the debt set out in the previous chart total government liabilities as a percent of GDP become quite extraordinary. As of last year they were:

Chart 3

Thanks to Niels Jensen of Absolute Return Partners in their November 2011 letter, our attention was drawn to the work of Egan-Jones, a credit rating company whose revenues originate from institutions and who have a powerful track record. They state that Greece cannot reasonably support more than E40bn in taxes, equivalent to only 10% of the amount outstanding. "That's why debt holders are likely to face a 90% haircut.....And unless trends reverse, Spain, Italy and Belgium will follow."

This brings us to an awful truth: will Germany allow the ECB and/or the EFSF to effectively print money to enable the weak members to repay their debts. The problem is that the Bundesbank and Germany's Constitutional Court will not allow Germany to participate in such a program for their own historic reasons and because, quite sensibly, printing money does not work. Future stability, together with fiscal and structural reforms, would disappear risking a substantial rise in the cost of living (CPI inflation) as well as asset inflation.

The choice before Germany is then simple but harsh. Either to throw caution to the winds and hope that by printing money the Euro Zone can be saved and stability created or to accept the painful truth that "the Euro is an incoherent nonsense which, in its current form, is doing far more harm than good", as Liam Halligan wrote on Sunday.

There are sign that German and other officials are quietly preparing for the possible departure of weak countries from the EZ. The heads of Germany and France have publically acknowledged that euro membership is not permanent. This could mean either that the weaker members leave or that the stronger leave and reconstitute the Euro around a smaller number of countries. Either way the cost would be considerable but arguably less than attempting to force the high spending countries into a German fiscal and monetary structure.

The prospect of a temporary return to sanity in Italian and Greek politics with the swearing in of Mario Monti as Italy's new Prime Minister and the appointment of lucas Papademus in Greece raises market expectations that both countries will begin the process of making their economies more competitive and in a position to repay debt etc. Both are well respected technocrats but both are unelected officials. Both countries will introduce some of the right measures but the question of implementation remains. For Greece, the arrival of the troika to help run the economy is likely to provoke anger in the country; and for Italy, whilst Berlusconi has lost office, his influence will still be felt in parliament via his party members who had supported him.

Implementation of the technocrats' policies will be the real problem. This is possibly the EU's last throw of the dice. If their policies are not fully implemented a change in the membership structure of the EZ will be unavoidable.

In summary, our best guess is that there will be a temporary honeymoon as markets react positively to the appointment of the two technocrats. Other problems will surface in some of the other weaker members of the EZ. Eventually, there will be a restructuring of the EZ centred on Germany, the northern members and France though the latter country might find the disciplined approach to fiscal and monetary policies of Germany too difficult for them to swallow.

Chart 4: Markit Eurozone PMI & GDP

Source: Markit, Eurostaat, GDP = gross domestic product

Meanwhile, business is falling sharply in Europe as has been clearly shown by the various PMIs and the IFO data. The latest OECD Composite Leading Indicators also show that business activity is falling in Europe. However, it is not only in Europe that business is weakening.

Chart 5: NBS China PMIs

Source: NBS

China's official GDP for the fourth quarter is likely to fall to around 8.5% in the fourth quarter and to remain at around that level in 2012. Its electricity production fell sharply in October (- 5.8%) versus September and by a massive 15% compared with August. Railway freight is growing by only 3.5% year-on-year and fell marginally month-on-month in October.

China is not immune to the twin global constraints of debt and demographics. We will expand on the latter later, but McKinsey estimated that China's total debt to GDP ratio was 159% at the end of 2008. It must now be considerably higher. A recent report, for instance, estimates that local government debt is as much as $473 billion or RMB 3 trillion when township government debt is included which was not the case under the nation's audit office.

Imbedded inflation is a growing problem due to rising cost inputs for foods, grains and soya for pigs and fertilizers for corn etc. Per capita meat consumption is rising; wages are increasing at a rate faster than productivity and soon the costs of water and electricity will have to be increased even faster.

Managing the transition from an export model to a domestically driven consumption one is proving difficult and will become even more so should the world economy slump into recession, a likely scenario. And managing the leadership transition is more fraught than usual. We suspect that once the new leadership takes full control in 2013 there will be a period of „clamp down' as government digests the hangovers from years of growth beyond sustainable rates.

Chart 6: IFO North American Economic Climate

Most forward-looking indicators are suggesting either that the US economy will slip into recession if not next year then in 2013. The just released OECD Composite Leading Indicators also signal a slowing economy. Rail freight data for October was up by only 1.7% on 2010 despite the fact that October is almost always the top month for intermodal traffic as it is the month when retailers do the bulk of their stocking for the holidays.

Debt, of course, is on an unsustainable path. Politicians seem incapable of devising a credible long-term deficit reduction program. Some foreign holders of Treasury paper are becoming frustrated by the antics of Washington. At some point over the coming six months a shock will be imposed which will bring down the US dollar; the index (DXY) could then fall below the 70 level so resulting in a full blown run on the currency. Markets will be sufficiently frozen that the politicians will be forced to devise a sensible long-term plan to reduce the deficit; the run on the US$ should also force the Federal Reserve to raise interest rates. The US dollar will then recover very sharply into 2013 at least, though we suspect that its recovery will be longer lasting.

In summary, current indicators suggest that at the very best global growth will be slow next year. There is a risk that the Federal Reserve will have another drive to pour liquidity into the system to be followed by the ECB having to act as lender of last resort. If this does occur asset prices will rise, but the impact of such monetary ease on the real economy will be anaemic. It is likely to be followed by a crash in 2013. We rate this scenario as a 40% chance.

The more likely outcome is that the ECB continues to operate under the Bundesbank mantra providing token relief to the weak members. Europe will remain in recession. The US economy, despite any action by the Federal Reserve (pushing on a string) will have very slow growth at best but will return to recession in 2013. Asia will be affected by banks in Europe having to raise capital together with much reduced exports outside the region. And in China growth will be slower so experiencing a reduction in exports. World industrial production will be very weak with a recession in 2013. We rate this outcome as a 60% chance.

4. The 2013 & Beyond

The period starting in 2013 – and it could be in 2012 – will be fraught as the world deleverages after a generation of governments promising more than they can pay for and in many countries households borrowing more than they can afford. This is a bad enough environment but it is made worse by society aging in so many countries: there will be far fewer workers to support retirees.

Professors Reinhardt and Rogoff have well documented what happens to economic activity in their book, "This Time is Different: Eight Centuries of Financial Folly." "The aftermath of systemic banking crises involves a protracted contraction in economic activity and puts significant strains on government resources." More recently they add that you can't get rid of debt quickly and you can't get rid of it nicely. The bullet has to be bitten meaning that debt must be repaid rather than one institution lending to another so that the latter can repay its debt.

Anyone who had listened to what the Bank for International Settlements was saying since 2005 would have been well prepared for the shocks that began towards the end of 2007 and then blew up in 2008. They are now issuing a new warning in their September 2011 report, The Real Effects of Debt. We should heed this warning. They conclude,

"Our examination of debt and economic activity in industrial countries leads us to conclude that there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth (in 1st qtr 2010 USA's debt: GDP ratio was 117%)....A clear implication of these results is that debt problems facing advanced economies are even worse than we thought. Given the benefits that governments have promised to their populations, ageing will sharply raise public debt to much higher levels in the next few decades. At the same time, ageing may reduce future growth and may raise interest rates, further undermining debt sustainability. So, as public debt rises and populations age, growth will fall. As growth falls, debt rises even more, reinforcing the downward impact on an already low growth rate."

They conclude, "In the end, the only way out is to increase saving." This is part of the process of deleveraging which is likely to take until around 2018 to run its course. These years will be characterised by rolling recessions and deflating asset prices interspaced by short periods of recovery.

The second dynamic which will help shape the world economy will be the demographic changes with so many countries' population age profiles changing for the worse and far outnumbering those that will continue to have positive demographic profiles, India, Indonesia and Brazil to name just three.

Chart 7: A Snapshot of Global Demographic Trends

Source: CIA, Long Term Global Demographics Trends: Reshaping the Geographical Landscape

Demographic change is not an abstract development; it will have serious consequences for future growth. The OECD, for instance, estimates that the impact of aging on GDP growth rates will be a decrease of growth in Europe to 0.5% a year, in Japan to 0.6% a year and in the USA to 1.5% a year in the period 2025-2050.

Chart 8: Aging Will Cause a Global Wealth Shortfall

Source: McKinsey & Company

Demographic changes will impact household wealth creation. In their report, The Coming Demographic Deficit: How Aging Populations will Reduce Global Savings, they wrote: "Aging will cause growth in household financial wealth to slow by more than two-thirds across countries we studied (USA, Japan, and W Europe), from 4.5% historically to 1.2% going forward. The slowing growth will cause the level of household financial wealth in 2024 to fall some 36% or by $31 trillion, below what it would have been had the higher historical growth rates persisted."

For Europe, the demographic profile is worrisome. According to data by Dr Clint Laurent and his team at Global Demographics, the number of 65+ aged group rises from around 19.6% of the population in 2011 to 29.1% in 2031 with the dependency ratio standing at just 2% by then.

Chart 9: Demographics of China & the USA

Source: Dr Clint Laurent, Global Demographics

A surprising development is that the demographic profile of the USA is so much better than that of China. Once the USA puts its financial house in better order, which it will if not willingly, its growth expectations will be better than China's. As we say in Yorkshire, "Think on".

For China, based on simple fundamentals, growth has peaked. The years of circa 10% growth are over because such growth is unsustainable and brings in its wake a package of problems. "One approach to forecasting total real GDP of a country is to combine the projected trend in the number of persons employed with the projected trend in the gross productivity per worker" writes Dr Laurent. He calculates that the trends in the education index of the country should give an expected productivity growth of 7.8% a year to 2016 and 5.8% a year to 2021. This equation gives a trend growth rate for real GDP growth of

• 7.5% a year to 2016
• 5.1% a year to 20121, and
• 3% a year to 2031

This slowdown will have a huge impact on China's future requirements of imported metals like copper. This trend is likely to be magnified also by US and other foreign companies vacating China and returning to their home bases – in the USA once the political system rolls back much of the red tape, health care costs and tax issues etc. There is a fundamental reason for companies to return home: it is that multinationals want their supplier chains adjacent to the market, not on the other side of the world.

Thus, demographics and debt will be huge constraints on world growth. In the 2020-30 period it will partially be made good by technology so enhancing productivity per worker. The chart below sets out our forecasts of world industrial production to 2035 with average annual growth rates shown for each decade.

Chart 10: World Industrial Production - % Growth Per Annum

mald

2011-11-15T13:29:00.001-08:00

Things That Make You Go Hmmm...

John Mauldin | November 15, 2011

What do the "Big Fitz," the largest ship ever to sail the Great Lakes, and the Eurozone have in common? Hint: the former sank without a trace. Or, as Grant Williams so eloquently puts it, in his Things That Make You Go Hmmm... for Nov. 13 (this week's Outside the Box), "One can't help but think ... that this week may well have brought us to the wall at the end of the road down which Europe has been kicking the can for quite some time now."

Grant inspects the SS Europe from bow to stern and concludes: "The smoke has pretty much cleared now and those in charge of the SS Europe are left with a stark choice – print money or allow the break-up of the Eurozone and the end of the common currency known as the Euro. At this point it really IS that simple."

So come on along as Grant takes us on an eye-opening and at times jaw-dropping ride – there are some real insights here. From his perch in Singapore he sees the same problems I do, just from the other side of the globe. And that perspective is worth your time.

As you read this, I am on my way to Capitol Hill to meet with a member of the Super-Committee. If there is anything I can report, you will get it this weekend. I hope I can bring good news at some point. Then it's back to the UBS Wealth Management Conference in time to hear Ken Rogoff (and Alan Greenspan) on a panel. I am looking forward to that. Tomorrow night in my own bed again. And be looking for a special note from me on Thursday.

Your trying to figure out how we get out of this mess analyst,

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com

Things That Make You Go Hmmm...

Grant Williams | Nov. 13, 2011

"Common responsibility for the European currency will also engender a common decision-making instance for the European economy. It is unthinkable to have a European central bank but not a common leadership for the European economy. If there is no counterweight to the ECB in European economy policy, then we will be left with the incomplete construction which we have today... However even if the building is not finished it is still true that monetary union is part of a supranational constitution... It is our task for the future to work with the appropriate means for the transfer of traditional elements of national sovereignty to the European level."
– Italian President Carlo Ciampi, Frankfurter Allgemeine Zeitung, February 8, 2000

"The euro is Europe's key to the 21^stcentury. The era of solo national fiscal and economic policy is over."
– German Chancellor Gerhard Schröder, December 31, 1998

"No amount of synthesized growth can evaporate global debt. Trying to sell creditors, debtors and taxpayers on the idea that it can be done is a futile and dangerious proposition. Time is not a variable. There is debt that is owed and only money or assets-in-kind can satisfy it."
– Paul Brodsky / Lee Quanitance

Big Fitz sounds like the name of a Heavyweight Champ - or the affectionate nickname given to the regular in a neighbourhood bar whom everybody knows. Big Fitz doesn't ordinarily sound like the name of a boat.

In the mid-1970s though, the only Big Fitz anybody spoke about in Duluth, Minnesota was the Great Lakes freighter that carried taconite from Duluth to the iron works in the then-thriving Detroit, Michigan and Toledo, Ohio.

When she was launched in 1958, the SS Edmund Fitzgerald was the largest boat on the Great Lakes. 729 feet long with a 75ft beam and a 25 foot draft, she could carry 26,000 DWT in her 33' 4"deep hold. Powered by a Coal fired Westinghouse Electric Corporation steam turbine 2 cylinder, she had a top speed of 14 knots and carried a crew of 29.

For 17 years, the floating workhorse ploughed back and forth across Lake Superior, setting seasonal haul records six times and became a firm favourite with boatwatchers (yes, they do exist) due to her size and her record-breaking exploits. Besides her affectionate soubriquet, the SS Edmund Fitzgerald was also known as The Titanic Of The Great Lakes.

On November 9, 1975, Big Fitz was loaded with 26,116 tons of taconite iron ore pellets in Superior, Wisconsin and embarked on what would tragically turn out to be her final voyage - a routine crossing of Lake Superior, bound for a steel mill in Detroit, Michigan.

The next day, November 10th, Big Fitz found herself caught in the midst of a massive winter storm, with 35 ft waves and hurricane force winds. Captain Ernest McSorely, a 44-year veteran, made contact with the Avafor, a nearby ship, and reported that he had encountered "one of the worst seas he had ever been in".

A couple of hours later, with Big Fitz roughly 17 miles from the relative safety of Whitefish Bay at the northeastern tip of Michigan's Upper Peninsula, another ship made contact and was told that the Titanic of The Great Lakes was holding her own.

Then something strange happened.

(History Channel): ...minutes afterward, the Fitzgerald disappeared from radar screens. A subsequent investigation showed that the sinking of the Fitzgerald occurred very suddenly; no distress signal was sent and the condition of the lifeboats suggested that little or no attempt was made to abandon the ship.

Subsequently, many theories on what caused the SS Edmund Fitzgerald to capsize and sink 530 feet to the lake bed almost instantly were put forward.

(History Channel): One possible reason for the wreck is that the Fitzgerald was carrying too much cargo. This made the ship sit low in the water and made it more vulnerable to being overwhelmed by a sudden large wave. The official report also cited the possibility that the hatches to the cargo area may have been faulty, leading to a sudden shift of the cargo that capsized the boat.

Either way, it didn't matter. Big Fitz sank - quickly. So quickly in fact that nobody was saved and all 29 crew members perished in the icy waters of Lake Superior. Big Fitz had been battling the odds for several hours and things had looked bleak but she was managing to stay above water until, suddenly, without warning, she didn't.

This week's anniversary of the tragic sinking of Big Fitz got me thinking about the Euro - another behemoth currently navigating some extremely choppy waters but managing to keep herself above water. Holding her own, if you will.

The odds have been stacked heavily against the common currency for some time now and yet, despite a clearly unsustainable level of debt, several countries who should never have been allowed through the doors of the Eurozone, rapidly slowing growth and a group of basket-case politicians who have redefined the meaning of ineptitude, if you had shorted the Euro on January 7th of this year, you would now be staring at a loss of roughly 6% on your investment (chart, below).

SOURCE: BLOOMBERG

To have sat and read the headlines these past 10 months and yet to be losing money on a short Euro position would have doubtless sent even the most stoic of investors in search of a stiff drink or some heavy counselling - but that's the way these things go sometimes. Things stay afloat against all the odds - until, suddenly, they don't.

One can't help but think, however, that this week may well have brought us to the wall at the end of the road down which Europe has been kicking the can for quite some time now.

With the long-expected demise last week of the Papandreou government and now the swift fall of Silvio Berlusconi's administration in Italy, events in Europe picked up speed as they move rapidly towards the kind of definitive end that we have needed for some time now, but that the prevaricating of the various bureaucrats in Brussels and beyond have denied us.

The smoke has pretty much cleared now and those in charge of the SS Europe are left with a stark choice - print money or allow the break-up of the Eurozone and the end of the common currency known as the Euro. At this point it really IS that simple.

The impediment to a EuroTARP or QEU program remains Germany. That's pretty much it. Sure, the Dutch and the Finns and even the Austrians all pay lip service to a hard line on monetary easing, but, as oneby- one the formerly 'strong' countries get dragged into the maelstrom of the peripherals leaving a new country exposed on the outer fringes of the 'core', it becomes more and more obvious that somehow, some way, Germany has to find a way of justifying an action that is anathema to the citizens of Europe's powerhouse economy. The blowout in the spread between Austrian and German 10yr bonds this week highlights that perfectly (chart, below).

SOURCE: BLOOMBERG

Weimar hyperinflation is still a very vivid memory for many Germans and, as Adam Fergusson explained in his seminal work ' When Money Dies, the reasons why Germany is so set against the idea of money-printing are clear:

Over most of Germany the lead was beginning to disappear overnight from roofs. Petrol was syphoned from the tanks of motor cars. Barter was already a usual form of exchange; but now commodities such as brass and fuel were becoming the currency of ordinary purchase and payment. A cinema seat cost a lump of coal. With a bottle of paraffin one might buy a shirt; with that shirt, the potatoes needed by one's family. Herr von der Osten kept a girl friend in the provincial Capital, for whose room in 1922 he had paid half a pound of butter a month: by the summer of 1923 it was costing him a whole pound. 'The Middle Ages came back,' Erna von Pustau said.

Communities printed their own money, based on goods, on a certain amount of potatoes, or rye, for instance. Shoe factories paid their workers in bonds for shoes which they could exchange at the bakery for bread or the meat market for meat.

Those with foreign currency, becoming easily the most acceptable paper medium, had the greatest scope for finding bargains. The power of the dollar, in particular, far exceeded its nominal rate of exchange. Finding himself with a single dollar bill early in 1923, von der Osten got hold of six friends and went to Berlin one evening determined to blow the lot; but early the next morning, long after dinner, and many nightclubs later, they still had change in their pockets. There were stories of Americans in the greatest difficulties in Berlin because no-one had enough marks to change a five-dollar bill: of others who ran up accounts (to be paid off later in depreciated currency) on the strength of even bigger foreign notes which, after meals or services had been obtained, could not be changed; and of foreign students who bought up whole rows of houses out of their allowances.

There were stories of shoppers who found that thieves had stolen the baskets and suitcases in which they carried their money, leaving the money itself behind on the ground; and of life supported by selling every day or so a single tiny link from a long gold crucifix chain. There were stories (many of them, as the summer wore on and as exchange rates altered several times a day) of restaurant meals which cost more when the bills came than when they were ordered. A 5,000-mark cup of coffee would cost 8,000 marks by the time it was drunk.

Stories like these still live and breathe in Germany so it is no surprise that the language of Mrs. Merkel and Messrs. Schauble, Wiedmann et al have been defiant whenever the subject of money-printing has arisen. But this week, as the Eurozone threatened to spiral out of control, it became abundantly clear that the Euro has reached the point of no-return.

The ECB now has to either become the lender of last resort that Europe so desperately needs (and trample over Germany's sensitivities in the process), or the Euro must fall. There is no other choice.

On Thursday, Italy's 10-year bond yield spiked to 7.5%. Presumably the only thing that stopped it shooting higher still was aggressive buying on the part of the SMP (we shall hopefully find out on Monday when the weekly totals are updated on the ECB website), but whatever the reason for the sudden and sharp retracement to 6.5% on Friday (surely it wasn't due to the news that Massimo Monti had been touted as Prime Minister in Berlusconi's stead? Surely?), you can be certain the bond market has not finished with Italy just yet.

SOURCE: BLOOMBERG

BUT..... Italy is running a primary surplus. The only thing sending her over the edge is the simple fact that the Italian government cannot borrow at low-enough rates. At 4% (where rates were a year ago), they can gradually begin to adjust their debt ratios and still finance their borrowing - it will not be easy, but they, unlike their spendthrift cousins in the Aegean, have one of the highest savings rates in the OECD (although, as you can see from the chart, below, that savings rate has been eaten into rapidly over the past five years).

SOURCE: BLOOMBERG

But what of that other 'Big Fitz', the Euro?

Any attempt to make a significant change to either the treaties that surround the common currency or the constituent members of the union would require a hellacious amount of maneuvering in order to pull them off and, like the notion of Greece (or any weakened EU member) ever being allowed to leave the Euro, the idea of either a fiscal union, the ECB becoming the lender of last resort or, God forbid, Germany exiting, stage left, was strictly verboten - at least until this week:

(UK Daily Telegraph): German and French officials have discussed plans for a radical overhaul of the European Union that would involve setting up a more integrated and potentially smaller eurozone, EU sources say.

"France and Germany have had intense consultations on this issue over the last months, at all levels," a senior EU official in Brussels told Reuters, speaking on condition of anonymity because of the sensitivity of the discussions.

"We need to move very cautiously, but the truth is that we need to establish exactly the list of those who don't want to be part of the club and those who simply cannot be part," the official said.

French President Nicolas Sarkozy gave some flavour of his thinking during an address to students in the eastern French city of Strasbourg on Tuesday, when he said a two-speed Europe - the eurozone moving ahead more rapidly than all 27 countries in the EU - was the only model for the future.

Pretty conclusive.

Naturally, any such plan was immediately denied by 'a spokesman':

A French finance ministry spokesman denied there was any project in the works to reduce the currency bloc's membership.

"There have been no conversations between French and German authorities at any level on decreasing the size of the eurozone," the spokesman said.

But this time it really WAS different as the Germans, too, were talking about the possibility of exits from the Eurozone:

One senior German government official said it was a case of pruning the eurozone to make it stronger.

"You'll still call it the euro, but it will be fewer countries," he said, without identifying those that would have to drop out.

"We won't be able to speak with one voice and make the tough decisions in the eurozone as it is today. You can't have one country, one vote," he said, referring to rules that have made decisionmaking complex and slow, exacerbating the crisis.

If you listen very carefully, you can hear the subtle changes that make it pretty clear that German officials are now trying to find a way to make 'temporary' money-printing palatable to the German electorate. The tabling of possible exits from the Eurozone was the first flare sent up, next was the discussion of a breakaway union featuring the'strong' countries, but immediately, Frau Merkel dropped the hammer with this stark warning to her constituents (delivered at just the right degree of arm's length, of course):

(Businessweek): Germany will resist any attempt to reduce the euro region to its strongest members to increase its stability, the parliamentary finance spokesman for Chancellor Angela Merkel's Christian Democratic Union said.

"Such a shrinking process would be deadly for Germany because we would end up in a mini-euro zone with all the effects you can see in Switzerland," Michael Meister, who is also a CDU deputy floor leader, said today in a phone interview in Berlin. "It would be a deadly development for an export country like Germany. It can't be in our interest at all and if it's not in our interest, we should do everything to keep it from happening."

Once more, with feeling:

It would be a deadly development for an export country like Germany. It can't be in our interest at all and if it's not in our interest, we should do everything to keep it from happening."

SOURCE: BLOOMBERG

There it is.

That is the first step in a move to persuade the German people that a EuroTARP or some form of QEU will be'manageable' and will not cause the runaway inflation of which Germans are terrified. It will probably be proposed as a program designed to alleviate the pressure facing the likes of Italy, Spain and Portugal and its architects will point to the (relatively) benign US CPI numbers in the wake of repeated Quantitative Easing as testament to the fact that money printing doesn't necessarily lead to hyperinflation - although, very quietly, US CPI has almost quadrupled since the beginning of QE2 and its trajectory remains solidly bottom-left to top-right.

SOURCE: ST LOUIS FED

They WON'T mention the US'adjusted monetary base (chart above), nor will they bring up UK CPI (chart, below) which is moving ever faster away from its target rate of 2% - currently standing at a breathtaking 5.2% - and will assure the citizens of Germany that there will be a cap on inflation past which the ECB WILL NOT go - either that or it will be a program that will be wound back after, say, two years by which time everything will be on the mend again.

SOURCE: BLOOMBERG

Mach dir keine Sorgen. Wir haben alles unter Kontrolle.

Don't worry. We've got it all under control.

Of course, this assumes that the vagaries of a vastly expanded money supply can be controlled once released into the wild and, as Weimar Germany, the Zimbabwe of Gideon Gono, Eduardo Duhalde's Argentina and, to a lesser extent, even the America of Paul Volcker in the 1980s bear witness, once this particular beast is unleashed it can take some pretty drastic tranquilizers to get it back in the cage again.

No matter for now though, as Europe's problems are both immediate and pressing. The Eurocrats will eschew the potential pitfalls of runaway inflation in favour of the short-term fix of money-printing. Lots and lots of money-printing.

In addition to Frau Merkel's Michael Meister's dire warning, other headlines this week have been very carefully laying the groundwork for a speech I dare say we'll be seeing soon about how, much as it is against the original concept of the Euro, a temporary bout of Quantitative Easing is necessary to save Europe and the Euro from destruction. We will be in 'desperate times', will require 'bold action' and can have'confidence' in the ability of Europe's leaders to ensure there is no inflationary impact from any monetization. The gang is definitely all here...:

(NY Times): Europe's economic outlook received a fresh dose of gloom Thursday, when the European Commission warned that the Continent's economies were stalled and faced the risk of a double-dip recession.

"The recovery in the European Union has now come to a standstill, and there is a risk of a new recession," Olli Rehn, the European commissioner for economic and monetary affairs, told reporters in Brussels.

"This forecast is in fact the last wake-up call," he added.

(UK Daily Telegraph): Barack Obama, the US President, tonight urged Europe to provide "strong" assurances that countries like Italy will be able to finance their debt.

"We are not going to see massive growth out of Europe until the problem is resolved and that will have a dampening effect on the overall global economy."

Speaking at the Asia Pacific Economic Cooperation (APEC) summit, Mr Obama said: "It's not going to be addressed over night. So it is important that Europe as a whole stands behind its Eurozone members."

(UK Daily Telegraph): Europe must "move quickly" to control its spreading debt crisis, because the volatility it is causing is the "central challenge" to global growth, US Treasury Secretary Timothy Geithner said.

"We are all directly affected by the crisis in Europe, but the economies gathered here are in a better position than most to take steps to strengthen growth in the face of these pressures from Europe."

Mr Geithner added that the basic framework for the European recovery was good.

"But we need to see it put in place with the speed that markets require and with the force that restores confidence," he said. "They're moving ahead. We just need to see them move a little more quickly and with a little more force behind it."

(Todayonline): The global economy could suffer a "lost decade" unless nations act together to counter threats to growth, International Monetary Fund managing director Christine Lagarde warned yesterday.

Speaking at a financial forum, Ms Lagarde said: "There are clearly clouds on the horizon ... particularly in the advanced economies and particularly so in the European Union and the United States." Said Ms Lagarde:"If we do not act, and act together, we could enter a downward spiral of uncertainty, financial instability and a collapse in global demand. Ultimately, we could face a lost decade of low growth and high unemployment."

Let's see.... is that everybody pulling in the same direction? US President? Check. US Treasury Secretary? Check. EU commissioner for monetary & economic affairs? Check. Head of the IMF? Check. German and French heads of state? Check. Anybody else?

(Reuters): "I refuse to even speculate about so-called two-speed Europe," Czech Finance Minister Miroslav Kalousek said in response to Reuters questions on the matter.

"That would go against the Czech Republic's interests."

Czechs? Check. Hell, they're not even IN the Eurozone yet.

I guess that just leaves the big dog, China:

(Brecorder): Chinese President Hu Jintao warned on Saturday that the global economy recovery was under threat and called for efforts to boost growth and liberalize trade.

"The global economic recovery is fraught with greater instability and uncertainty," Hu said during a speech in Honolulu ahead of a summit of Asia-Pacific leaders.

Referring to Europe's sovereign debt crisis, he said the world must remain committed to "ensuring strong growth in order to add momentum to the economic development of the Asia-Pacific and beyond."

So there we have it. A carefully crafted scenario which will give Germany the ability to stand astride the world stage by giving up its objections to money-printing (temporarily, you understand) in the interests of the global good; the all-new Committee To Save The World.

Judging by the Daily Telegraph story on page 20 of this week's Things That Make You Go Hmmm..... this cunning plan comes not a moment too soon (can you say 'Ponzi'?):

(UK Daily Telegraph): Europe's€1 trillion (£854bn) rescue fund has been forced to buy its own debt as outside investors become increasingly concerned about the worsening eurozone sovereign debt crisis.

The European Financial Stability Facility (EFSF) last week announced it had successfully sold a €3bn 10-year bond in support of Ireland.

However, The Sunday Telegraph can reveal that target was only met after the EFSF resorted to buying up several hundred million euros worth of the bonds.

Sources said the EFSF had spent more than €100m buying up its own bonds to help it achieve its funding target after the banks leading the deal were only able to find about €2.7bn of outside demand for the debt.

Speechless.

SOURCE: BLOOMBERG

But before we finish for today, we return to our own 'Big Fitz' of the currency markets - the Euro - as it struggles to stay afloat against all the odds. So far, it has been managing quite nicely, although the technical picture has been deteriorating rather dramatically (see chart, above). Once the now-inevitable European money-printing begins, it's hard to make a case for a strong Euro -particularly in light of weakening economic data across the core of the region- from the French trade balance (which showed a €6.303 billion deficit in September - the seventh largest single-month deficit in French history and a staggering 46% m-o-m decline), to a plunge in French exports that matched the lows seen in 2008-9, to Germany's Industrial output (which fell almost 3% in September) and Industrial Orders (which fell 3.6% m-o-m) and on to the rise in unemployment in Germany - the first such increase for 28 months.

Mario Draghi's rate cut is just the beginning. Interest rates in the EU are heading below 1% in a hurry if the recent data are anything to go by and, once QEU or the EuroTARP commence, Europe's Big Fitz , which has stayed afloat for so long against all the odds, will likely sink - suddenly and without warning.

You have been... oh, wait...

Place articles here

Accelerate your Growth

Urgent-Notification

m

Your Three Investing Opponents - John Mauldin's Weekly E-Letter Inbox x Mauldin x

Your Three Investing Opponents

"Tough Year!"

Three Opponents in Investing

We Have Met the Enemy and They Is Us

We Are Tool Makers

Individual Investors Have Certain Advantages Over Institutions

We All Need a Coach

Hong Kong, South Africa, Stockholm, and More

Verizon Wireless

Sign in to My Verizon

My Verizon Benefits

Prepaid

Sign in today

Your Three Investing Opponents - John Mauldin's Weekly E-Letter

Inbox
x

Mauldin
x