Sunday, January 31, 2010

This Time Is Different

This Time Is Different
Click here for a link to complete ORIGINAL article:

By John Mauldin | 29 January 2010

The Statistical Recovery has Arrived
This Time Is Different
A Crisis of Confidence
Greeks Bearing Gifts
Biotech, Conversations and Babies

"Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that 'this time is different.' That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy."
— This Time is Different (Carmen M. Reinhart and Kenneth Rogoff)
When does a potential crisis become an actual crisis, and how and why does it happen? Why did most everyone believe there were no problems in the US (or Japanese or European or British) economies in 2006? Yet now we are mired in a very difficult situation. "The subprime problem will be contained," said now controversially confirmed Fed Chairman Bernanke, just months before the implosion and significant Fed intervention.

I have just returned from Europe, and the discussion often turned to the potential of a crisis in the Eurozone if Greece defaults. Plus, we take a look at the very positive US GDP numbers released this morning. Are we finally back to the 'Old Normal'? There's just so much to talk about.

At the end of the letter I am going to comment on my latest Conversations with two of the leading lights in the biotech world and give you a link to my recent Outside the Box on biotech, which has had more response than almost any letter I have posted. If you missed it, you should read it, as I outline why I am actually buying stocks in the biotech space, even as I think we are headed for a double-dip recession and a rather sharp bear market. But now, let's jump into today's letter.

The Statistical Recovery Has Arrived

Before we get into the main discussion point, let me briefly comment on today's GDP numbers, which came in at an amazingly strong 5.7% growth rate. While that is stronger than I thought it would be (I said 4-5%), there are reasons to be cautious before we sound the "all clear" bell.

First, over 60% (3.7%) of the growth came from inventory rebuilding, as opposed to just 0.7% in the third quarter. If you examine the numbers, you find that inventories had dropped below sales, so a buildup was needed. Increasing inventories add to GDP, while, counterintuitively, sales from inventory decrease GDP. Businesses are just adjusting to the New Normal level of sales. I expect further inventory build-up in the next two quarters, although not at this level, and then we level off the latter half of the year.

While rebuilding inventories is a very good thing, that growth will only continue if sales grow. Otherwise inventories will find the level of the New Normal and stop growing. And if you look at consumer spending in the data, you find that it actually declined in the 4th quarter, both annually and from the previous quarter. "Domestic demand" declined from 2.3% in the third quarter to only 1.7% in the fourth quarter. Part of that is clearly the absence of "Cash for Clunkers," but even so that is not a sign of economic strength.

Second, as my friend David Rosenberg pointed out, imports fell over the 4th quarter. Usually in a heavy inventory-rebuilding cycle, imports rise because a portion of the materials businesses need to build their own products comes from foreign sources. Thus the drop in imports is most unusual. Falling imports, which is a sign of economic retrenching, also increases the statistical GDP number.

Third, I have seen no analysis (yet) on the impact of the stimulus spending, but it was 90% of the growth in the third quarter, or a little less than 2% [[of the overall GDP number: normxxx]].

Fourth (and quoting David):
"… if you believe the GDP data— remember, there are more revisions to come— then you de facto must be of the view that productivity growth is soaring at over a 6% annual rate. No doubt productivity is rising— just look at the never-ending slate of layoff announcements. But we came off a cycle with no technological advance and no capital deepening, so it is hard to believe that productivity at this time is growing at a pace that is four times the historical norm. Sorry, but we're not buyers of that view.

"In the fourth quarter, aggregate private hours worked contracted at a
0.5% annual rate and what we can tell you is that, scanning over 50 years of data, such a decline in labor input has never before coincided with a GDP headline this good. Normally, GDP growth is 1.7% when hours worked is this weak. And that is exactly the trend that was depicted this week in the release of the Chicago Fed's National Activity Index, which was widely ignored.

"On the flip side, when we have in the past seen GDP growth come in at or near a
5.7% annual rate, what is typical is that hours worked grows at a 3.7% rate. No matter how you slice it, the GDP number today represented not just a rare but an unprecedented event. As such, we are willing to treat the report with an entire saltshaker— a few grains won't do."

Finally, remember that third-quarter GDP was revised downward by over 30%, from 3.5% to just 2.2% only 60 days later. (This is the first release, to be followed by revisions over the next two months.) The first release is based on a lot of 'estimates', otherwise known as guesswork. The fourth-quarter number is likely to be revised down as well.

Unemployment rose by several hundred thousand jobs in the fourth quarter, and if you look at some surveys, it approached 500,000. That is hardly consistent with a 5.7% growth rate. Further, sales taxes and income-tax receipts are still falling.

As I said last year that it would be, this is a Statistical Recovery. When unemployment is rising, it is hard to talk of real recovery. Without the stimulus in the latter half of the year, growth would have been much slower.

So should we, as Paul Krugman suggests, spend another $trillion in stimulus if it helps growth? No, because, as I have written for a very long time, and will focus on in future weeks, increased deficits and rising debt-to-GDP is a long-term losing proposition. It simply puts off what will be a reckoning that will be even worse, with yet higher debt levels. You cannot borrow your way out of a debt crisis.

This Time Is Different

While I was in Europe, and flying back, I had the great pleasure of reading This Time is Different, by Carmen M. Reinhart and Kenneth Rogoff, on my new Kindle, courtesy of Fred Fern. I am going to be writing about and quoting from this book for several weeks. It is a very important work, as it gives us the first really comprehensive analysis of financial crises.

I highlighted more pages than in any book in recent memory (easy to do on the Kindle, and even easier to find the highlights). Rather than offering up theories on how to deal with the current financial crisis, the authors show us what happened in over 250 historical crises in 66 countries. And they offer some very clear ideas on how this current crisis might play out.

Sadly, the lesson is not a happy one. There are no good endings once you start down a deleveraging path. As I have been writing for several years, we now are faced with choosing from among several bad choices, some being worse than others. This Time is Different offers up some ideas as to which are the worst choices.

If you are a serious student of economics, you should read this book. If you want to get a sense of the problems we face, the authors conveniently summarize the situation in chapters 13-16, purposefully allowing people to get the main points without drilling into the mountain of details they provide. Get the book at a 45% discount at Buy it with the excellent book I am now reading, Wall Street Revalued, and get free shipping.

A Crisis Of Confidence

Let's lead off with a few quotes from This Time is Different, and then I'll add some comments. Today I'll focus on the theme of confidence, which runs throughout the entire book.

"But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

"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— this 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, that 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? I was writing that there would be a recession, a subprime crisis, and a credit crisis in our future. I was on Larry Kudlow's show with Nouriel Roubini, and Larry and John Rutledge were giving us a hard time about our so-called "doom and gloom". If there is going to be a recession you should get out of the stock market, was my call. I was a tad early, as the market proceeded to go up another 20% over the next 8 months.

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 out, that things can't really be that bad. 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 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.

Now, there are bullish voices telling us that things are headed back to normal. Mainstream forecasts for GDP growth this year are quite robust, north of 4% for the year, based on evidence from past recoveries. However, the underlying fundamentals of a banking crisis are far different from those of a typical business-cycle recession, as Reinhart and Rogoff's work so clearly reveals. It typically takes years to work off excess leverage in a banking crisis, with unemployment often rising for 4 years running. We will look at the evidence in coming weeks.

The point is that complacency almost always ends suddenly. You just don't slide gradually into a crisis, over years. It happens! All of a sudden there is a trigger event, and it is August of 2008.

The evidence in the book is that things go along fine until there is that crisis of confidence. There is no way to know when it will happen. There is no magic debt level, no magic drop in currencies, no percentage level of fiscal deficits, no single point where we can say "This is it". It is different in different crises.

One point I found fascinating, and we'll explore it in later weeks. When it comes to the various types of crises which the authors identify, there is very little difference between developed and emerging-market countries, especially as to the fallout. It seems that the developed world has no corner on special wisdom that would allow crises to be avoided, or allow them to be recovered from more quickly.

In fact, because of their overconfidence— because they actually feel they have superior systems— developed countries can dig deeper holes for themselves than emerging markets. Oh, and the Fed should have seen this crisis coming. The authors point to some very clear precursors to debt crises. This bears further review, and we will do so in coming weeks.

Greeks Bearing Gifts

On Monday, the government of Greece offered a "gift" to the markets of 8 billion euros worth of bonds at a rather high 6.25%. The demand was for 25 billion euros, so this offering was rather robust. Today, those same Greek bonds closed on 6.5%, more than offsetting the first year's coupon. Greek bond yields are up more than 150 basis points in the last month!

Why such a one-week turnaround? Ambrose Evans Pritchard offers up this thought: "Marc Ostwald, from Monument Securities, said the botched bond issue of €8bn (6.9bn pounds) of Greek debt earlier this week has made matters worse. Many of the investors were 'hot money' funds that bought on rumors that China was emerging as a buyer, offering them a chance for quick profit. When the China story was denied by Beijing and Athens, these funds rushed for the exit."

Greece is running a budget deficit of 12.5%. Under the Maastricht Treaty, they are supposed to keep it at 3%. Their GDP was $374 billion in 2008 (about €240 billion).

If they can cut their budget deficit to 10% this year, that means they will need to go into the bond market for another €25 billion or so. But they already have a problem with rising debt. Look at the following graph on the debt of various countries.

Click Here, or on the image, to see a larger, undistorted image.

When Russia defaulted on its debt and sent the world into crisis in 1998, they had total debt of only €51 billion. Greece now has €254 billion and added another €8 billion this week, and needs to add another €24 billion (or so) later this year. That's a debt-to-GDP ratio of over 100%, well above the limit of the treaty, which is 60%.

Greece benefitted from being in the Eurozone by getting very low interest rates, up until recently. Being in the Eurozone made investors confident. Now that confidence is eroding daily. And this week's market action says rates will go higher, without some fiscal discipline.

To help my US readers put this in perspective, let's assume that Greece was the size of the US. To get back to Maastricht Treaty levels, they would need to cut the deficit by 4% of GDP for the next few years. If the US did that, it would mean an equivalent budget cut of $500 billion. Per year. For three years running.

That would guarantee a very deep recession. Just a 10% suggested pay cut has Greek government unions already planning strikes. Nevertheless, the government of Greece recognizes that it simply cannot continue to run such huge deficits. They have developed a plan that aims to narrow the shortfall from 12.7% of output, more than four times the EU limit, to 8.7% this year.

That reduction will be achieved even though the economy will contract 0.3%, the plan says. The deficit will shrink to 5.6% next year and 2.8% in 2012. The market is saying they don't believe that will happen.

For one thing, if the Greek economy goes into recession, the amount collected in taxes will fall, meaning the shortfall will increase. Second, it is not clear that Greek voters will approve such a plan at their next elections. Riots and demonstrations are a popular pastime.

Both French and German ministers made it clear that there would be no bailout of Greece. But here's the problem. If they ignore the noncompliance, there is no meaning to the treaty. The euro will be called into question. And the other countries with serious fiscal problems [[especially Ireland, which has made some truly draconian cuts to date: normxxx]] will ask why they should cut back if Greece does not.

If Greece does not choose deep cutbacks and recession, the markets will keep demanding hikes in interest rates, and eventually Greece will have problems meeting just its interest payments. Can this go on for some time? The analysis of debt crises in history says yes, but there comes a time when confidence breaks. My friends from GaveKal had this thought:

"What is the next step? Having lived through the Mexican, Thai, Korean and Argentine crises, it is hard not to distinguish a common pattern. In our view, this means that investors need to confront the fact that we are at an important crossroads for Greece, best symbolized by a simple question: 'If you were a Greek saver with all of your income in a Greek bank, given what is happening to the debt of your sovereign, would you feel comfortable keeping all of your life savings in your savings institution?

"Or would you start thinking about opening an account in a foreign bank and/or redeeming your currency in cash?' The answer to this question will likely direct the next phase of the crisis. If we start to see bank runs in Greece, then investors will have to accept that the crisis has run out of control and that we are facing a far more bearish investment environment. However, if the Greek population does not panic and does not liquefy/transfer its savings, then European policy-makers may still have a chance to find a political solution to this growing problem.

"What could a political solution be? The answer here is simple: there is none. So if Europe wants to save Greece from hitting the wall towards which it is now heading, the European commission, the ECB and/or other institutions (IMF?) will have to bend the rules massively. In turn, this will likely lead to a further collapse in the euro.

"But for us, an important question is whether it could also lead to a serious political backlash. Indeed, at this stage, elected politicians are likely pondering how much appetite there is amongst their electorate for yet another bailout, and for further expansions in government debt levels. The fact that the intervention would occur on behalf of a foreign country probably makes it all the more unpalatable (it's one thing to save your domestic banking system … but why save Greece?)."

If Greece is bailed out, Portugal and Ireland will ask "Why not us"? And Spain? And Italy? If Greece is allowed to flaunt the rules, what does that say about the future of the euro? Will Germany and France insist on compliance or be willing to kick Greece out?

A few months ago, the markets assumed that not only Greece but Portugal, Italy, Spain, and Ireland would have a few years to get their houses in order. This week, the markets shortened their time horizon for Greece. Even so, we get this quote, which may end up ranking alongside Fisher's quote in 1929, that the stock market was at 'a permanently high plateau', or Bernanke's quote that "The subprime debt problem will be contained".

"There is no bailout problem," Monetary Affairs Commissioner Joaquin Almunia said today at the World Economic Forum's annual meeting in Davos, Switzerland. "Greece will not default. In the euro area, default does not exist."

The evidence in This Time is Different is that default risk does in fact exist. You cannot keep borrowing past your income, whether as a family or a government, and not eventually go bankrupt. Are we at an inflection point? Too early to say.

It all depends on the willingness of the Greek people to endure what will not be a fun next few years, for the privilege of staying in the Eurozone. And on whether the bond market believes that this time is different and the Greeks will actually get their fiscal house in order. Oh by the way, did I mention that the history of Greece is not exactly pristine in terms of default?

In fact, they have been in default in one way or another for 105 out of the past 200 years. Aristotle, can you spare a dime? And one last thought. The US is running massive deficits. If we do not get them under control, we will one day, and perhaps quite soon, face our own "Greek moment". Look at the graph below, and weep.

Click Here, or on the image, to see a larger, undistorted image.

Obama offering to freeze spending by 17% in US discretionary-spending programs, after he ran them up over 20% in just one year, is laughable. Greece is an object lesson for the world, as Japan soon will be. You cannot cure too much debt with more debt.

Biotech, Conversations, And More

Two quick commercial notes. I mentioned a few weeks ago that I was going to start a stock-buying program for the first time in 15 years (I normally invest in managers and funds rather than specific stocks). I published an Outside the Box last week that talked about why I think biotech stocks could be at the beginning of a decade-long run, and why I wanted to participate directly. You can read that Outside the Box by clicking on this link.

Second, I offer a subscription service called Conversations with John Mauldin, where I hold conversations with people who I think have something important for us to understand. It has been very well received. We provide both audio and a transcript. I just posted my latest Conversations, in which I interviewed two gentlemen who are CEOs of companies that I think are at the very bleeding edge of the biotech revolution.

Subscribers have already gotten that posting. Over the year, in addition to the usual economic Conversations we have, I will be interviewing other industry leaders who will be changing the world of medicine in the coming decade. You can subscribe here.

In addition, George Friedman and Niall Ferguson and I are exchanging emails on a time to get together for another of the series where George and I talk about geopolitics. I guarantee a lively and fascinating Conversation.

John Mauldin

Copyright 2010 John Mauldin. All Rights Reserved

  M O R E

Optimist? Or Pessimist? Test Your 2010 Strategy!

Optimist? Or Pessimist? Test Your 2010 Strategy!
12 'Dr. Dooms' Warn Wall Street's Optimism Misleads, Will Trigger New Crash

By Paul B. Farrell, MarketWatch | 31 January 2010

ARROYO GRANDE, Calif. (MarketWatch)— Test time: A neuroeconomic peek inside your brain's new strategy as we enter the "Doomsday Decade" and leave behind the "Lost Decade" ("lost" because the Dow dropped from 11,497 to 10,428 in 10 years, while Wall Street got rich wiping out almost 10% of your retirement funds). Test your 2010 strategy. Are you an:

Optimist? As the new decade starts, are you an optimist who trusts Wall Street's advice that 2010 will be a great time to buy stocks. Wall Street says the "Lost Decade" (what a great title) is now behind us. So you believe that the 60% market rally since the March 2009 bottom will continue, with at least 20% gains in 2010.

Pessimist? Or, you're distrustful, cynical and pessimistic about all predictions made by Wall Street's bosses and pundits. You're particularly skeptical of any and all forecasts by the "too-greedy-to-fail" bankers who stole trillions from taxpayers, the Fed and Treasury, then failed to stimulate the economy and now pocket mega-bailout bucks as record bonuses, just one year after we saved Wall Street from near bankruptcy.

This is a simple test of your mindset. Betting odds say most of you will pick answer "1". Why? America was founded by optimists. You believe that a "happy conspiracy" binds politicians, CEOs and Wall Street, making capitalism work and America a powerful nation: So you accept Wall Street's greed, lies and thievery as the price of "free-market capitalism," and part of America's DNA. You embrace "capitalism-without-morals".

What Year Will 2010 Look Like?

The bulls see the market mimicking 1983, the bears point to 1931. Those in the middle see many similarities with 2004. Barron's Michael Santoli reports.

Unfortunately, optimism also blinds us to our individual and national faults: Hidden saboteurs tell us we know more than we do, have amazing skills we don't, and are protected by divine forces against dark enemies and even our own irrational stupidity. Yes, optimism is our inner enemy that periodically triggers trillion-dollar meltdowns.

New Strategy: 'Getting Back To Even' Means New Risks, More Debt

True optimists are gung-ho about the future, expecting to recover losses and, as CNBC television host Jim Cramer preaches, "get back to even" in 2010. But the problem is no one has a clue if the market will ever "get back to even."

Quite the opposite, since Fed chief Ben Bernanke is pushing the same optimistic cheap-money fantasies that his predecessor Alan Greenspan used to create the dot-com and the subprime crashes. We can expect to see the next bubble fizzle and pop, pushing us deep into the dreaded Great Depression 2 that the Fed and Treasury are trying to avoid by downstreaming today's problems onto future generations.

But soon future generations will start screaming: "The buck stops here" and revolt when the buck isn't worth much, and they've lost faith in the dollar (just like China). Then the game of musical chairs will end, tragically, sadly, stupidly, unfortunately. Why? Because we failed to stop short of total disaster, failed to prepare, and it's too late.

So to all you optimists who plan to actively invest in 2010 because you accept that America's "capitalism-without-morals" is working in spite of Wall Street's quasi-criminal behavior: Here's some dark-side input to factor into your investment equation for 2010 and beyond.

Listen closely to the words of our 12 "Dr. Dooms". For a moment, take off your rose-colored glasses, step out of your denial, see the Great Depression 2 dead ahead, really look at the future our "Dr. Dooms" see in their "Doomsday Scenarios":

1. Faber: The 'American Empire' Has Peaked, Is On A Decline

Hong Kong economist Marc Faber says "the average life span of the world's greatest civilizations has been 200 years … Once a society becomes successful it becomes arrogant, righteous, overconfident, corrupt, and decadent … overspends … costly wars … wealth inequity and social tensions increase; and society enters a secular decline".

2. Grantham: Learned Nothing, Doomed To Repeat Past, Only Bigger

Money manager Jeremy Grantham warns that our irrational nightmare will repeat. A year ago we came dangerously close to the "Great Depression 2". Unfortunately, we've "learned nothing … condemning ourselves to another serious financial crisis in the not too-distant future."

We had our bear-market rally. Next, historical cycles plus our irrational behavior guarantees another, bigger global meltdown. We "learned nothing."

3. Stiglitz: Wall Street Creating Short Respite Before Next Crash

Nobel economist Joseph Stiglitz recently warned: Unless Wall Street's incentive system is drastically reformed, "the financial sector will only try to circumvent whatever new regulations we put in place. We will simply have a short respite before the next crisis". Warning, nothing's changed, it's worse: Lobbyists run Obama, Congress and the Fed.

4. Johnson: Running Out Of Time Before Great Depression 2

Yes, "we're running out of time … to prevent a true depression," warns former IMF chief economist Simon Johnson. The "financial industry has effectively captured our government" and is "blocking essential reform," and unless we break Wall Street's "stranglehold" we will be unable prevent the Great Depression 2.

5. Ferguson: Fed's Easy Money Fuels New Bubbles, Meltdowns

In the 400-year history of the stock market "there has been a long succession of financial bubbles," says financial historian Niall Ferguson. Who's the culprit? The Fed: "Without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks."

Another bubble (and crash) is virtually certain, thanks to Washington's $23.7 trillion explosion in debt, the Fed's support for the $670 trillion shadow banking system and Wall Street lobbyists getting superrich thanks to Wall Street's insatiable greed.

6. Taleb: Fed Haunted By Ghost Of Greenspan's Failed Reaganomics

When Obama reappointed Bernanke, Nassim Taleb, risk-management professor and author of "The Black Swan," warned of a new disaster: "The world has never, never been as fragile," yet Obama reappoints an economist who "doesn't even know he doesn't understand how things work". New proof? At last week's American Economic Association, Bernanke was still shifting the blame: "The best response to the housing bubble would have been regulatory, not monetary."

Wrong: He conveniently forgets he was advising Bush earlier, did nothing. Now Obama's stuck with a Greenspan clone and an insane ideology focused solely on saving a failed banking system by flooding the world with inflated dollars guaranteed to trigger another meltdown.

7. Soros: Dollar Dead As A Reserve Currency, Nest Eggs Dying

Billionaire investor George Soros' "New Paradigm:" America's 25-year "superboom … led to massive deregulation … blindly chasing free markets … unleashed excessive greed … created the dot-com and credit meltdowns" and a "shadow banking system" of derivatives.

"The system is broken. The current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency," warns Soros. "We're now in a period of wealth destruction. It is going to be very hard to preserve your wealth in these circumstances."

8. Hedgers: Make Billions Shorting Stupid Politicians, Bankers

Soros isn't alone. Lots of hedge fund buddies made hundreds of millions and billions betting on the stupidity of Washington with the Fed's cheap-money policies. Alpha magazine reports that four hedgers made more than $1 billion each in 2008. The top-25 "managers made $464 million each on average last year … a kingly sum, especially during a year of global recession, stock market wipeouts and vanishing wealth".

9. Shiller: Dot-Com, Subprime Meltdowns, 'Third Episode' Next

Economist Robert Shiller a "Dr. Doom?" Remember a decade ago with "Irrational Exuberance"? Now he's warning— "Bubbles are primarily social phenomena. Until we understand and address the psychology that fuels them, they're going to keep forming. We recently lived through two epidemics of excessive financial optimism, we are close to a third episode, only this one will spread irrational pessimism and distrust— not exuberance."

10. Kaufman: Irrationality Replaced Reason, Science, Technology

Henry Kaufman was Salomon's chief economist and "Dr. Doom" for 24 years: "Why are we so poor at managing our key economic institutions while at the same time so accomplished in medicine, engineering and telecommunications? Why can we land men on the moon with pinpoint accuracy, yet fail to steer our economy away from the rocks? Why do our computers work so well, except when we use them to manage derivatives and hedge funds?"

Kaufman warns: "The computations were correct, but far too often the conclusions drawn from them were not". Why? Selfish, myopic politicians and bankers.

11. Biggs: Sell Everything, Buy Guns, Food, Head For The Hills

In his 2008 bestseller "Wealth, War and Wisdom" former Morgan Stanley research guru Barton Biggs warns us to prepare for a "breakdown of civilization … Your safe haven must be self-sufficient and capable of growing some kind of food … It should be well-stocked with seed, fertilizer, canned food, wine, medicine, clothes, etc … A few rounds over the approaching brigands' heads would probably be a compelling persuader that there are easier farms to pillage." Biggs sounds like an anarchist militiaman.

12. Diamond: Nations Ignore Obvious Till It's Too Late, Then Collapse

The end will be swift. In our age of short-term consumerism and instant gratification, few hear the warnings of our favorite evolutionary biologist, Jared Diamond. Societies fail because they're unprepared, will be in denial till it's too late: "Civilizations share a sharp curve of decline. Indeed, a society's demise may begin only a decade or two after it reaches its peak population, wealth and power."

The warnings were everywhere in 2008, but Greenspan, Bernanke and former Treasury Secretary Henry Paulson were in denial: It will happen again with Obama. Downstreaming problems will fail. Future bubbles get too big, crashes more deadly.

Saturday, January 30, 2010

Stock Market Forecast S&P500 1400 By End 2010, And 400 By 2014

[ Normxxx Here:  Looks like we could easily be well on the way to achieving this Forecast by end of this year— more probably by Fall of 2011— and then…  ]

Stock Market Forecast S&P500 1400 By End 2010, And 400 By 2014
Stock-Markets / Forecasts & Technical Analysis

By Lorimer_Wilson | 1 September 2009

Merrill Lynch Asia (Bank of America) strategists Sadiq Currimbhoy, Arik Reiss, and Jacky Tang suggest that the S&P 500 could soar another 40% by December 2010 before it collapses completely based on a unique comparison with the Nikkei 225. (Before you reject this possibility out of hand please read the entire article.) Were the S&P 500 to indeed rise by 40% then, by extension, precious metals stocks (as represented by the HUI and GDM indices) and their associated warrants (as represented by our proprietary PreciousMetalsWarrants Index) would top out at record highs as would gold and silver.

Uncanny Relationship Exists (With A Twist) Between The Nikkei And The S&P 500

The strategists have identified a pattern that supports the likelihood of major additional gains in the US stock market even without a strong economic recovery which suggests that the rally should continue until the end of the year. Below is an edited version of what the Merrill Lynch strategists had to say:

Some investors like to compare the US to Japan. From a market perspective, plotting the Nikkei and the S&P 500 shows no similarity. However, a peculiar variation shows an uncanny relationship. The chart below shows the Nikkei in U.S. dollars compared to the S&P 500. The S&P 500 in DXY terms has been rebased to the same peak as in Japan, except 117 months (9.75 years) later. If this pattern repeats, there is potential for 40% upside over the next 3-4 months.

Click Here, or on the image, to see a larger, undistorted image.

Assuming a relationship similar to that which Japan went through, the S&P 500 in DXY terms could well rise another 40% pretty much from now until mid-December 2010. Importantly, this is in DXY terms, so if the U.S. dollar were to rally 20% and the S&P 500 17% (as it's multiplied), that would do it. If the market were only to rally to the lower trend line in the chart, then the total upside would be 33%, split between the U.S. dollar and the equity market.

The Merrill strategists went further, constructing an equally-weighted index of all markets that have crashed more than 45% since 1970 plus the U.S. stock market crash in 1930 and then averaged the recoveries from these crashes (referred to as 'Historical Peak-Trough Index'). They found that strong "relief rallies" are common and that, should this pattern hold for the S&P 500, then it should experience a further 40% appreciation by the end of 2010.

Specifically, they looked at all the markets since 1970 that had had crashes of more than 45% in the previous 12 months in U.S. dollar terms (or 50% in local currency terms) and added in the U.S. stock market crash of 1930 to create their equally-weighted index. This is shown in the chart below with 25% and 75% bands.

Click Here, or on the image, to see a larger, undistorted image.

Relationship Suggests S&P 500 Will Rise To 1400-1500 Before Falling Back To 400

When the Historical Peak-Trough Index was compared to markets that have recently experienced similar deterioration (referred to as 'Current Peak-Trough Index') they concluded that the current S&P 500 index looks like it's following a similar pattern and is set to peak in 3-4 months some 40% higher than the current level. That would have the S&P 500 topping out at somewhere around 1400-1500 (i.e. 5-10% less than the S&P 500's record high of 1565 in October 2007) before crashing back to it's 1994 low of 400 (when the stock market bubble first began) by the end of 2013 or early 2014.

Peculiar Variation Confirms Projections Of Dent, Napier And Others

It is interesting to note that Merrill Lynch's projections, based on this approach, mirror those of Russell Napier and Harry S. Dent Jr. whom I highlighted in a March, 2009 article entitled "Dent, Prechter and Others Warn that the Worst is yet to Come (Engulf Us)." Both men, independent of each other and based on their own unique approaches to market research, maintained a year ago that the S&P 500 would rally dramatically in 2009 to mid 2010. (Dent saying the Dow would go to a high of 13,200 which, incidentally, would represent a 38% increase from last Friday's close of 9544) only to slowly decline to a bottom of 400 or so by either 2012 (Dent) or 2014 (Napier).

Napier, who wrote "Anatomy of the Bear" and teaches at Edinburgh Business School in addition to being a strategist with CLSA Ltd., based his projections on Tobin's "q" ratio which compares the market value of companies to their constituent parts. His projected low of 400 was conditional on deflation setting in, which it has, because "with deflation the value of assets falls and the value of debt stays up crushing equities". No one was expecting deflation a year ago but we currently are in the midst of it which should cause us to reflect on the merits of Napier's assertions. Below are the inflation (deflation) rates year-to-date compliments of

2009 0.03% 0.24% -0.38% -0.74% -1.28% -1.43% -2.10% NA NA NA NA NA NA

Relationship Suggests The HUI And GDM Could Rise To Record Highs

Year-to-date the HUI and GDM are up 20.6% and 18.6% respectively (see table below) or, on average, 41% greater than the S&P 500 increase YTD of 13.9%. If the S&P 500 were to appreciate 40% and the trend ratio between the broad stock market and the narrow large/medium cap precious metals mining sector were to continue one could expect the HUI and GDM to increase in the neighborhood of 56% by year's end. That would put the HUI at around 570 (10.6% above it's all-time high of 515 in March 2007) and the GDM at about 1666 (7.2% above it's all-time high of 1553 in March 2008.) The results of the comparative analysis seem plausible.

***CDNX is the symbol for the S&P/TSX Venture Composite Index consisting of 558 micro/nano cap companies of which 44% are engaged in the mining, exploration and/or development of gold and/or silver and other mineral resources and 18% in oil or natural gas pursuits.
****HUI is the symbol of the AMEX Gold BUGS (Basket of Un-hedged Gold Stocks) Index and is a modified equal dollar-weighted index of 15 large/mid cap gold mining companies that do not hedge their gold beyond 1.5 years.
*****GDM is the symbol for the NYSE Arca Gold Miners Index and is a modified market capitalization weighted index of 31 large/mid/small cap gold and silver mining companies.
******SPTGD is the symbol for the S&P/TSX Global Gold Index and is a modified market capitalization index of 19 large/mid cap precious metals mining companies.

Relationship Suggests Gold Could Go To $1175 And Silver To $27.67

Were we to apply the same approach to the analysis of the short-term price for gold and silver a record price would result for gold and a dramatic increase would be realized in the price of silver. Gold has gone up only 8% YTD vis-à-vis the S&P 500's 13.9% or 57.5% as much. Therefore, should the S&P 500 go up 40% one could expect, under this scenario, that gold would go up a further 23% (57.5% of 40%) which would put gold well above that 'precious barrier' of $1000 to a record $1175 by end of 2010. Again, the results of the comparative analysis seem achievable.

Silver is up 30.3% YTD or 2.2 times that of the S&P 500. That would translate into an 87% price increase in the current price of silver from $14.72 as of last Friday to $27.50 by the end of 2010. The resulting number seems a bit far-fetched but that is what the analysis reveals for what it is worth.

Relationship Suggests The Micro/Nano-Cap Category Could Set Record High

The CDNX is the proxy for the micro/nano-cap category of stocks and it is up 67% YTD in U.S. dollars. As such, if the micro/nano category were to continue to outperform the S&P 500 by the same ratio for the balance of the year the 40% increase in the S&P 500 would equate to a value of 3472 for the CDNX or 3% beyond the record high of 3370 reached in May 2007. The results of this comparative analysis seem possible on the surface but given the continuing tight credit situation such an advance in such a short period of time and at this particular point in time seems somewhat unlikely.

Relationship Suggests 33% of Warrants Would become Exercisable?

The above analyses suggests that, as the relationships currently stand between the S&P 500, the HUI and GDM indices, gold, silver and the micro/nano-cap category of stocks, were the S&P 500 to go up 40%, gold bullion might well go up 23%, large/medium cap gold and silver mining/royalty companies might go up by 60%, silver might go up as much as 87% and micro/nano-cap companies might go up by almost 200%. Since the 24-month plus duration warrants of commodity-related companies are up 75% more than their associated stocks, i.e. 112.3% vs. 64.2% YTD, according to information gleamed from's free database, one would expect such warrants to appreciate in excess of 300% if the relationship holds true. If that were to happen, a third of the 100 or so commodity-related warrants trading in the market would become exercisable enabling owners of same to reap major over-and-above returns.

The Hong Kong-based Merrill Lynch Asia strategists concluded their August 26 analysis by explaining that a 40% melt-up rally in the U.S. may be triggered by central bankers keeping interest rates low (and there is no evidence to the contrary at this point in time), an economic recovery (which there seems to be if we are to believe even a fraction of the "green shoots" hype we have been hearing the past few weeks) or an undervalued dollar (which is debatable with many a convincing argument that the dollar is just the opposite and going to get much weaker).

Their analysis bears scrutiny and an ongoing review for us to successfully navigate these troubled investment waters we all find ourselves currently in. It certainly would be nice to see the S&P 500 go up a further 40% in the next few months; gold and silver a further 23% and 87% respectively to set a base for even greater heights as the stock market crumbles; commodity-related large and medium-cap stocks a further 60%; micro and nano (penny) stocks go up 200% and a warrants with the right leverage/time values to go up in excess of 300%. Very nice indeed!

To my readers: I receive many emails with questions and comments regarding my articles and I make a point of replying to each and every one. Please feel free to drop me a line or two. If you are interested in writing an article we would be delighted in considering you as one of our periodic Guest Contributors.

Lorimer Wilson ( is Director of Marketing and Contributing Editor of: which provides an online subscription database for all warrants trading on mining and other natural resource companies in the United States and Canada and offers a free weekly email and which alerts subscribers when corporate insiders of a limited number of junior mining and natural resource companies are buying and selling.

Wednesday, January 27, 2010

A Big Game Of Chicken

Greece, EU And Markets In Big Game Of Chicken, 29 January 2010

Never mind the denials and semantics: the European Union will help Greece cope with its financial problems because it has no choice. That is the political reality. Whether aid comes in the form of bilateral loans from euro zone member countries, or via 'special facilities' that are possible under the existing treaties, it has become clear that Athens will not be left out in the cold.

Yet jittery markets do not seem to be convinced, and have sent Greek sovereign spreads to record highs in the last two days. Investors seem to be taking at face value the official protestations that Greece must— and indeed will— deal with its problems by itself. A feverish poker game is likely to intensify in the coming days— and perhaps until mid-February, when EU leaders will scrutinise the Greek government's plan to drastically cut down its deficits.

Around the smoky table sit Greece and the rest of the European leaders who want to make sure that maximum— but not fatal— pressure is applied to Greece so that both its government and its people understand how radical its turnaround plan must be. Then there are the markets, not sure who is bluffing, and frantically biting their nails the as stakes rise. Investors are testing the limits of euro zone solidarity, and are challenging EU member countries to tackle the problem of their ballooning deficits.

Greece, in this respect, is mostly seen as the first and weakest link that could be followed by, say, Spain or Portugal. But the EU, Greece included, is keen to send the message that the fort will hold— and that it doesn't mind some weakening of the euro, which would help boost exports. Greek sovereign debt is likely to be prone to wild swings in the weeks leading to the EU finance ministers meeting next month. With its fraudulent statistics, corruption and massive tax evasion, Greece surely has serious local problems.

But markets want credible reassurance that European governments will do what it takes to deal with their deficits and long-term debt challenges. In that respect, the intensifying Greek drama is about more than Greece.


Funds Flee Greece As Germany Warns Of "Fatal" Eurozone Crisis

By Ambrose Evans-Pritchard | 28 January 2010

Germany has triggered a near-panic flight from southern European debt markets by warning that there will be no EU bail-outs, even though it fears the region's economic crisis has turned dangerous and could prove "fatal" for the entire eurozone. The yield on 10-year Greek bonds blasted upwards by over 40 basis points to 7.15% in a day of wild trading. Spreads over German Bunds reached almost four percentage points, by far the highest since Greece joined the euro, and close to levels that risk a self-feeding spiral. Contagion hit Portuguese, Spanish, Irish, and Italian bonds.

George Papandreou, the Greek premier, said in Davos that his country had been singled out as the weak link in a "attack on the eurozone" by speculators and political foes. "We are being targeted, particularly by those with an ulterior motive". Marc Ostwald, from Monument Securities, said the botched bond issue of €8bn (£6.9bn) of Greek debt earlier this week has made matters worse.

Many of the investors were "hot money" funds that bought on rumours that China was emerging as a buyer, offering them a chance for quick profit. When the China story was denied by Beijing and Athens, these funds rushed for the exit. However, a key trigger yesterday was testimony in Germany's parliament by economy minister Rainer Brüderle, who said there would be "no bail-outs" for struggling debtors and no move to a "European economic government".

"A few European nations are exhibiting dangerous weaknesses. That could have fatal consequences for all countries in the eurozone," he said. Despite the warning, he said each country must solve its own problems. "Germany is not in a mood to be the deep pocket for what they consider profligate, southern neighbours," said hedge fund doyen George Soros.

Mr Brüderle's hard line contradicts a report in Le Monde that Franco-German officials are discussing a rescue for Greece in order to keep the International Monetary Fund at bay. The paper cited a source saying that EMU partners were ready to "help" Greece. "It is a question of credibility for the eurozone. The IMF might want to impose monetary conditions."

Le Monde's story was shot down by Berlin and Paris, but there is little doubt that certain officials have been trying to build momentum for a rescue. It is clear that the EU family is split on the issue. Jean-Claude Juncker, head of the Eurogroup of finance ministers, backs "assistance", with support of EU integrationists hoping to nudge the EU towards full fiscal union.

This is fiercely opposed by Berlin, and the German-led bloc at the European Central Bank. There are reports that Berlin is deliberately bringing the crisis to a head, hoping to lance the boil early and force the Club Med states to reform before it is too late. If so, this is a risky strategy. German banks have huge exposure to Greek, Spanish, and Portuguese debt.

Hans Redeker, currency chief at BNP Paribas, said Greece will face "great trouble" if it has to pay 7% rates for long. Athens must raise €53bn this year, mostly in the first half. It has a been relying on cheap short-term debt to fund the budget deficit of 13% of GDP, but this raises "roll-over risk". Tim Congdon, from International Monetary Research, said the danger is that wealthy Greeks may shift money to bank accounts abroad if they lose confidence (akin to Mexico's Tequila Crisis in 1994-1995). This would set off a banking crisis and become self-fulfilling.

Greece has been financing current account deficits— 15% of GDP in 2008— through its banks, which have built up €110bn in foreign liabilities. "If foreign creditors want their money back, defaults and/or a macroeconomic catastrophe appear inevitable," Mr Congdon said. Adding to worries, Moody's has issued an alert on Portugal's "adverse debt dynamics", saying Lisbon needs a "credible plan" to reduce a structural deficit stuck at 7% of GDP rather than "one-off measures".

The deeper concern is Spain, where youth unemployment has reached 44% and the housing bust has a long way to run. Nouriel Roubini— the economist known as 'Dr Doom'— said Spain is too big to contain. "If Greece goes under that's a problem for the eurozone. If Spain goes under it's a disaster," he said.

Jose Luis Zapatero, Spain's premier, replied wearily: "Spanish public debt (52% of GDP) is 20% lower than Europe's average; our treasury spends 5% of revenues on debt costs, less than France and Germany. Nobody is going to leave the euro," he said.

How Expensive Is Housing?

How Expensive Is Housing?

By Cassander In Debtwatch | 12 January 2010

This is often treated as a "how long is a piece of string"? question, but The Economist has performed a great public service by allowing an easy comparison of the length of this piece of string across many countries and over time.

Check it out yourself. For Australian readers, house prices today are almost 2.5 times what they were in real terms in 1986; and our [aussie] price bubble (in CPI-deflated terms) turns out to be smaller than some countries (notably Belgium's) but larger than the USA's and UK's. Like all such exercises, it is limited by the time series from which the data is taken: the earliest data shown here is for 1975, which is after the second major financial crisis of the post-WWII era (the first was in 1966) but at the end of what was, for its time, a very large property bubble. So the reference point of 1975 could itself represent a "highish" point for house prices, rather than "fair value".

The data is also short for some countries, and with a difference reference date (say 1987 rather than 1976) the relative ranking of countries changes substantially. A quick look at the Herengracht Index–which shows the CPI-deflated value of housing along a wealthy canal in Amsterdam between 1628 and 1972–shows how important the starting date can be in working out whether housing is "expensive" or "cheap" at any point in time:

The important macroeconomic issue which this data alone doesn't address is the level of debt that house price inflation has led to. It is probable that a higher real house price reflects a bigger ratio of mortgage and other private debt to GDP, but this isn't necessarily the case. That ratio is the key indicator of whether a country is going to experience a debt-induced recession.

Thoughts On The End Game

Thoughts On The End Game

By John Mauldin | 27 January 2010

When I was at Rice University, so many decades ago, I played a lot of bridge. I was only mediocre, but enjoyed it. We had a professor, Dr. Culbertson, who was a bridge Life Master at an early age. He was single and lived in our college, playing bridge with us almost every night. He was a master of the "end game". He had an uncanny ability to seemingly force his opponents into no-win situations, understanding where the cards had to lie and taking advantage.

Traveling to London and on into Europe, I have some time to think away from the tyranny of the computer. Over the last year, and especially the last few months, I have written in depth about the problems we face all across the developed world. We have no good choices left, so making the correct unpleasant choice is now our most hopeful option.

As I wrote in my 2010 forecast, this year is a waiting game. There are so many choices we must make, and the paths we will take from those choices vary wildly. But make no mistake, we are coming close to the end game. Some countries and economies are closer to that point than others, but the entire developed world is lurching, in almost drunken fashion, towards our economic denouement.

Over the next several months, we are going to start to explore various aspects of the end game. Whither Japan? Are they actually, as I think, a bug in search of a windshield? What does that mean for the world? How safe is the euro? Everyone over here seems to think Germany will bail out Greece. A breakup seems unthinkable to the people I've been talking to (so far). But what about Spain? Italy? Can you spell moral hazard?

The Fed has said it will 'exit' quantitative easing (QE) at the end of March. But what if mortgage rates rise? Where do we find $1 trillion (plus!!!) in US savings to fund the deficit, assuming foreigners buy about $400 billion? By definition, savings and foreign investment and the federal deficit must add up to zero. (We will go into that later— just take it as gospel for now.)

How can we run 10% of GDP deficits if the Fed does not print money (as they did by buying Fannie and Freddie paper, which became treasuries, as I outlined last week)? That would require almost a 10% savings rate— with it all ending up in treasuries. How can that happen? Really?

This Time Is Different

"But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked."— Carmen M. Reinhart and Kenneth Rogoff from their new book, This Time is Different.

I am reading (on my new Kindle as I travel through Europe) a very important book, which I will be referring to a lot in the future. Reinhart and Rogoff have catalogued over 250 financial crises in 66 countries over 800 years and then analyzed them for differences and similarities. This is a VERY sobering book. It does not augur well for the developed world to blithely exit from our woes.

The book gives evidence to my adamant statement that we have a lot of pain to experience because of the bad choices we have made. This is the entire developed world, and the emerging world will suffer, too, as we go through it. It is not a matter of pain or no pain. There is no way to avoid it. It is simply a matter of when and over how long a period.

In fact, Reinhart and Rogoff's research suggests that the longer we try to put off the pain, the worse the total pain will be. We have simply overleveraged ourselves, and the deleveraging process is not fun, whether on a personal or a country basis. Let's look at part of their conclusion, which I think eloquently sums up the problems we face:

"The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be. Technology has changed, the height of humans has changed, and fashions have changed.

"Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis.

"As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

"This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk— if only they do not become too drunk with their credit bubble— fueled success and say, as their predecessors have for centuries,
"This time is different."

A small confession. I am in a London hotel, it is late on a Friday, and my mind is slowing down. So rather than ramble, I am going to hand you off to Van Hoisington and Dr. Lacy Hunt, two of the brightest economists I know (Lacy will be at my conference). The following is their latest quarterly letter. I have already read it five times. It is THAT important, and chock full of intriguing concepts.

They also reference Reinhart and Rogoff, and offer up a very contrarian view about deflation. Open your minds, and let's jump in.

John Mauldin


Quarterly Review And Outlook— Fourth Quarter 2009

By Van R. Hoisington and Dr. Lacy Hunt | 27 January 2010

Hard Road Ahead

The U.S. is facing a long and difficult road as it attempts to correct the over-indebtedness and wasteful expenditures of the past two decades. Both current and historical research help us to understand where we are in the continuing economic crisis, and to put it in perspective.

The brilliant U.S. economist Irving Fisher first highlighted the fact that an economy's debt level could have a deleterious impact on economic growth if it is, in fact, excessive. At $3.70 of debt for every dollar of GDP, U.S. debt is excessive (Chart 1). Fisher pointed out that the unwinding of debt levels results in prolonged economic distress, and we certainly agree.

In 2009, the book This Time is Different— Eight Centuries of Financial Folly, by Reinhart and Rogoff, shed new light on the role of debt by compiling a database that looked at financial crises in 66 countries over a period of 800 years. The main standard in explaining more than 250 crises studied is whether debt is excessive relative to national income, even though idiosyncrasies apply in each case. They reiterate that this old rule (excessive debt) continues to apply, and this time is not different.

Research And The Deflation Risk

We glean five important factors from this work that pertain to our present situation. First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.

Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt. Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, "Infusions of cash can make a government look like it is providing greater growth to its economy than it really is."

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices. Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

The real question for financial participants is whether all these influences result in inflation or deflation, and the authors' research details both outcomes. As is widely feared here in the U.S., they outline that many countries have had the right circumstances and mechanisms to inflate away their debt overhang, and, in fact, have done so by debasing their currency. Those particular circumstances are not currently present in the United States.

According to Reinhart and Rogoff the norm is that major economic contractions lead to deflation. Importantly, they call our present economic circumstances the "second great contraction". Thus, not only has the historical "qualitative" research on the subject of deflation chronicled the deflationary impulses emanating from overindebtedness (Fisher's 1933 "Debt-Deflation Theory of Great Depressions", see in paperback, "Essays on the Great Depression" by Ben Bernanke), but also modern "quantitative" methods have now essentially confirmed this conclusion. Over-indebtedness and major contractions lead to deflation.

Debt Overwhelms Monetary Policy

It has been more than a year since the Federal Reserve began a massive expansion of Federal Reserve Bank credit, from $1 trillion to $2.2 trillion, flooding the banking system with reserves. This unprecedented action naturally raised inflationary fears since it was assumed that this was the beginning of a monetary creation process which would eventually lead to job and income growth, excessive expenditures, and finally massive price increases. If the economy were not in the throes of writing down bad debts that were caused by a massive decline in asset prices, it is possible that the money supply (M2) in response to this increase in reserves could have [[already: normxxx]] expanded by $4 trillion, or 96%.

According to the late Nobel prize winning economist Milton Friedman, an increase in M2 of that magnitude would have been highly inflationary. However, M2 did not explode. Instead, in the past twelve months this aggregate has risen only 3%. This is less than half of the average growth rate over the past fifty years (Chart 2).

If, as Friedman assumed, the velocity of money is stable (MV=GDP) [[probably a bad assumption, since we already know that in a severe recession/depression, Velocity takes a nose dive: normxxx]] then nominal GDP expansion in the ensuing quarters can be expected to grow about 3%. If prices rise about 1.5%, then real GDP growth would also rise about 1.5%, which is far below the level of growth needed to employ new labor force entrants and existing unemployed or to more fully utilize our present unused capacity in our factories.

In the last six months the growth rate of M2 has slowed to near zero [[largely because of the drop in Velocity: normxxx]]. If this pattern continues, it would be rational to expect GDP to grind to zero with no change in the price level. The very first step toward an inflationary cycle has to be to get the monetary aggregates expanding vigorously.

That cannot be accomplished [by] the Fed "printing money", i.e., adding more reserves into banks that cannot or will not make loans. The reason this process has not begun (and will not for a time) is the overhang of excessive indebtedness and asset price depreciations. No one needs to borrow, or has the resources or balance sheet to borrow, and banks are busily writing off bad debt. Irving Fisher warned of that process (note our Third Quarter 2009 quarterly letter).

Over-Indebtedness Creates Excess Supply

Despite the concurrent developments of little money growth and declining loan growth (Chart 3), the fear nevertheless remains that an inflation surprise might be just around the corner. The reason to discount this notion is that excessive debt has contributed greatly to a flat, or perfectly elastic aggregate supply curve. A country's inflation is determined by the interaction of aggregate supply and demand.

Friedman wrote that a large increase in money in the hands of the non-bank public would be inflationary because he assumed a normal upward sloping aggregate supply curve (Chart 4). In this case the aggregate demand for goods (depicted as the demand curve Line A) would shift outward to Line A1, and thus prices would naturally rise. You will note what happens to prices if a demand curve B is intersecting the supply curve in the so-called Keynesian range where it is flat. If aggregate demand increases to B1, prices do not change.

Whether the supply curve is in a flat, normal, or upward sloping position depends on the extent of excess resources in the economy. Today it is obvious that the U.S. economy has plentiful excess resources, so any increase in demand will result in little price change. This will be the case until our unemployment rate of over 17% (the U6 measure) drops by a considerable amount and we begin to use our factories well above our current 68% utilization rate.

Thus, our current economic circumstances guarantee there will be no surprise inflation. Employing those who are out of work and fully utilizing our resources will be a slow process. More importantly, it will take time to get the monetary engine reignited. Banks will have to begin lending and people and companies will have to determine that prospects are good enough to take the risk for expansion and investment. It will take years for these processes to get started because of our over-indebtedness and falling asset prices.

The consequences of excessive debt are already painful at the household level. The civilian employment to population ratio, a highly important barometer of the average household's standard of living, fell to 58.2% in December, the lowest reading in 26 years and down from a peak of 64.7% in April of 2000 (Chart 5). Thus, the standard of living has worsened as the debt to GDP ratio has marched steadily higher. With debt to GDP still rising, a further deterioration of the standard of living is inescapable.

Debt And Fiscal Policy

Deficit spending only provides a transitory boost to the economy. It initially raises GDP, as it did in the second half of 2009, but then the effect dissipates and later is reversed, as financial resources available to the private sector are reduced. In a separate research study Rogoff and Reinhart write, "At the height of Japan's banking crisis in the 1990s, repaving the streets in Tokyo became a routine exercise. As a result, Japan's gross (government) debt-to-GDP ratio is now nearly 200% and a drag on what once was a vibrant economy."

Our present high deficit situation suggests that taxes will rise (including those of state and local governments), depressing economic activity further. In addition to the expiration of the 2001 and 2003 tax cuts, the Obama administration is proposing substantial taxes on financial institutions to pay for the cost of the financial bailout. Since the tax multiplier is high, this will reinforce the drag on economic activity from the lagged effects of deficit spending.

Treasury Bonds

Since 1990 Treasury bond yields have steadily moved downward in line with a more benign inflationary environment (Chart 6). Those yearly declines in yields continued last year with an average interest rate of 4.07% versus 4.28% in 2008. Obvious sharp reversals have occurred in their downward trend due to shifts in psychology reacting to generally transitory factors, as we saw in 2009. To remain fully invested in long Treasuries in this high volatility environment requires a simple discipline based on the academic literature which demonstrates that over time bond yields move in the same direction as inflation (Fisher equation).

Presently, we view the inflationary environment as benign because: 1) the U.S. economic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; 3) the federal government's spending spree will necessarily cause taxes and borrowings to rise, further stunting any economic growth. These factors ensure that inflation will be quiescent. Interest rates easily can and do rise for short periods, but remaining elevated in a disinflationary environment is contrary to the historical experience. We are owners and buyers of long U.S. Treasury debt.

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