John Mauldin's Outside the Box

The U.S.-Russian Summit Turns Routine

John Mauldin — Thu, 09 Jul 2009 16:46:44 GMT

This week saw a 2-day summit between the United States and Russia that looks to be the first in a trend of subtle push and pull that will shape economic agendas for both states. Just as at the height of the Cold War, these two superpowers are jockeying for global attention and prospective untapped markets. But while the communication between the two is at the same volume and frequency as it was back in the days of Kennedy and Khrushchev, the tone has taken on a different level - as Obama flexes his newly appointed muscle and plants a possible seed of discontent between Medvedev and Putin concerning the future of the former USSR.

Hands-down the most important thing in Russia is energy. It's not the headline on CNN these days, but come less than 6 months from now the cold European winters will make natural gas supply lines and shipping an unavoidable talking point. Today's U.S./Russia relationship lays the groundwork for the future of global energy markets.

I'm sending you an article by my friend George Friedman at STRATFOR, a global intelligence firm, discussing what's really going on between the U.S. and Russia - at the summit and in the coming months. If energy markets matter to you - and they do, regardless of how you're invested - then you need to understand this pivotal global relationship. Also, STRATFOR is offering special rates to Outside the Box readers. Click here to read more and be sure to take advantage of these low rates for priceless intelligence to help you in your future financial planning.

John Mauldin
Editor, Outside the Box

The U.S.-Russian Summit Turns Routine

July 7, 2009

By George Friedman

The Fundamental Issues

There are dozens of contentious issues between the United States and Russia, but in our mind three issues are fundamental.

First, there is the question of whether Poland will become a base from which the United States can contain Russian power, or from the Russian point of view, threaten the former Soviet Union. The ballistic missile defense (BMD) system that the United States has slated for Poland does not directly affect that issue, though it symbolizes it. It represents the U.S. use of Polish territory for strategic purposes, and it is something the Russians oppose not so much for the system's direct or specific threat — which is minimal — but for what it symbolizes about the Americans' status in Poland. The Russians hoped to get Obama to follow the policy at the summit that he alluded to during his campaign for the U.S. presidency: namely, removing the BMD program from Poland to reduce tensions with Russia.

Second, there is the question of Iran. This is a strategic matter for the United States, perhaps even more pressing since the recent Iranian election. The United States badly needs to isolate Iran effectively, something impossible without Russian cooperation. Moscow has refused to join Washington on this issue, in part because it is so important to the United States. Given its importance to the Americans, the Russians see Iran as a lever with which they can try to control U.S. actions elsewhere. The Americans do not want to see Russian support, and particularly arms sales, to Iran. Given that, the Russians don't want to close off the possibility of supporting Iran. The United States wanted to see some Russian commitments on Iran at the summit.

And third, there is the question of U.S. relations with former Soviet countries other than Russia, and the expressed U.S. desire to see NATO expand to include Ukraine and Georgia. The Russians insist that any such expansion threatens Russian national security and understandings with previous U.S. administrations. The United States insists that no such understandings exist, that NATO expansion doesn't threaten Russia, and that the expansion will continue. The Russians were hoping the Americans would back off on this issue at the summit.

Of some importance, but not as fundamental as the previous issues, was the question of whether Russia will allow U.S. arms shipments to Afghanistan through Russian territory. This issue became important last winter when Taliban attacks on U.S. supply routes through Pakistan intensified, putting the viability of those routes in question. In recent months the Russians have accepted the transit of nonlethal materiel through Russia, but not arms.

Even before the summit, the Russians made a concession on this point, giving the United States the right to transit military equipment via Russian airspace. This was a significant policy change designed to demonstrate Russia's flexibility. At the same time, the step is not as significant as it appeared. The move cost the Russians little under the circumstances, and is easily revoked. And while the United States might use the route, the route is always subject to Russian pressure, meaning the United States is not going to allow a strategic dependence to develop. Moreover, the U.S. need is not as apparent now as it was a few months ago. And finally, a Talibanized Afghanistan is not in the Russian interest. That Russia did not grant the U.S. request last February merely reveals how bad U.S.-Russian relations were at the time. Conversely, the Russian concession on the issue signals that U.S.-Russian relations have improved. The concession was all the more significant in that it came after Obama praised Medvedev for his openness and criticized Putin as having one foot in the Cold War, clearly an attempt to play the two Russian leaders off each other.

What the Summit Produced

Much more significantly, the United States did not agree to withdraw the BMD system from Poland at the summit. Washington did not say that removal is impossible, but instead delayed that discussion until at least September, when U.S. Secretary of State Hillary Clinton will visit Moscow. A joint review of all of the world's missile capabilities was established at the summit, and this joint review will consider Iranian — and North Korean — missiles. The Polish BMD system will be addressed in that context. In other words, Washington did not concede on the point, but it did not close off discussions. The Russians accordingly did not get what they wanted on the missiles at the summit; they got even less of what they wanted in the broader strategic sense of a neutralized Poland.

The Russians in turn made no visible concessions on Iran. Apart from studying the Iranians' missile systems, the Russians made no pledge to join in sanctions on Iran, nor did they join in any criticism of the current crackdown in Iran. The United States had once offered to trade Polish BMDs for Russian cooperation on Iran, an idea rejected by the Russians since the BMD system in Poland wasn't worth the leverage Moscow has with Iran. Certainly without the Polish BMD withdrawal, there was going to be no movement on Iran.

NATO expansion is where some U.S. concession might have emerged. In his speech on Tuesday, Obama said, "State sovereignty must be a cornerstone of international order. Just as all states should have the right to choose their leaders, states must have the right to borders that are secure, and to their own foreign policies. That is why this principle must apply to all nations – including Georgia and Ukraine. America will never impose a security arrangement on another country. For either country to become a member of NATO, a majority of its people must choose to; they must undertake reforms; and they must be able to contribute to the alliance's mission. And let me be clear: NATO seeks collaboration with Russia, not confrontation."

On the surface, this reiterated the old U.S. position, which was that NATO expansion was between NATO and individual nations of the former Soviet Union, and did not — and should not — concern Moscow. The terms of expanding, reforming and contributing to NATO remained the same. But immediately after the Obama-Putin meeting, Russian sources began claiming that an understanding on NATO expansion was reached, and that the Americans conceded the point. We see some evidence for this in the speech — the U.S. public position almost never has included mention of public support or reforms.

In many ways, however, this is splitting hairs. The French and Germans have long insisted that any NATO expansion should be limited to countries with strong public support for expansion, and which meet certain military thresholds that Georgia and Ukraine clearly do not meet (and could not meet even with a decade of hard work). Since NATO expansion requires unanimous support from all members, Russia was more interested in having the United States freeze its relations with other former Soviet states at their current level. Russian sources indicate that they did indeed get reassurances of such a freeze, but it takes an eager imagination to glean that from Obama's public statement.

Therefore, we come away with the sense that the summit changed little, but that it certainly didn't cause any deterioration, which could have happened. Having a summit that causes no damage is an achievement in itself.

The Kennedy Trap

Perhaps the most important part of the summit was that Obama does not seem to have fallen into the Kennedy trap. Part of the lack of serious resolutions at the summit undoubtedly resulted from Obama's unwillingness to be excessively accommodating to the Russians. With all of the comparisons to the 1961 Kennedy-Khrushchev summit being bruited about, Obama clearly had at least one overriding goal in Moscow: to not be weak. Obama tried to show his skills even before the summit, playing Medvedev and Putin against each other. No matter how obvious and clumsy that might have been, it served a public purpose by making it clear that Obama was not in awe of either of them. Creating processes rather than solutions also was part of that strategy.

It appears, however, that the Russians did fall into the Kennedy trap a bit. The eagerness of Putin's advisers to tout U.S. concession on Ukraine and Georgia after their meeting in spite of scant public evidence of such concessions gives us the sense that Putin wanted to show that he achieved something Medvedev couldn't. There may well be a growing rivalry between Medvedev and Putin, and Obama might well have played off it.

But that is for the gossip columns. The important news from the summit was as follows: First, no one screwed up, and second, U.S.-Russian relations did not get worse — and might actually have improved.

No far-reaching strategic agreements were attained, but strategic improvements in the future were not excluded. Obama played his role without faltering, and there may be some smidgen of tension between the two personalities running Russia. As far as summits go, we have seen far worse and much better. But given the vitriol of past U.S.-Soviet/Russian relations, routine is hardly a negative outcome.

In the meantime, BMD remains under development in Poland, there is no U.S.-Russian agreement on Iran and, as far as we can confirm at present, no major shift in U.S. policy on Ukraine and Georgia has occurred. This summit will not be long remembered, but then Obama did not want the word "disastrous" attached to this summit as it had been to Kennedy's first Soviet summit.

We wish there were more exciting things to report about the summit, but sometimes there simply aren't. And sometimes the routine might turn out significant, but we doubt that in this case. The geopolitical divide between the United States and Russia is as deep as ever, even if some of the sharper edges have been rounded. Ultimately, little progress was made in finding ways to bridge the two countries' divergent interests. And the burning issues — particularly Poland and Iran — continue to burn.

Make Sure You Get This One Right

John Mauldin — Mon, 06 Jul 2009 16:14:15 GMT

There are those who sweat over every decision, worrying about how it will affect their lives and investments. Then there is the school of thought that we should focus on the big decisions. I am of the latter school.

85% of investment returns are a result of asset class allocations and only 15% come from actually picking investment within the asset class. Getting the big picture right is critical. In this week's Outside the Box we look at a very well written essay about the biggest of all question in front of us today. Do we face deflation or inflation?

This OTB is by my good friends and business partners in London, Niels Jensen and his team at Absolute Return Partners. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box

Make Sure You Get This One Right

By Niels C. Jensen

"You can't beat deflation in a credit-based system."

Robert Prechter

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won't have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those 'make or break' decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or 'quantitative easing' as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don't understand the world of finance or you don't want to understand. Shame on those who fall for cheap tactics.

Let's begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that 'less bad' doesn't necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn't suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a 'buy and hold' market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people's problems than your own. A little bit like raising children, I suppose.

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won't rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?

Good question - counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn't go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest 'must have' amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry's leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. 'Get long and get loud' it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government's point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

A 20-Year Bear Market?

John Mauldin — Tue, 30 Jun 2009 02:31:31 GMT

Long time readers know that I am a huge fan of the work of Neil Howe. His book, The Fourth Turning, was one of the seminal pieces of my reading over the last 30 years. And it has turned out to be stunningly prophetic. Uncomfortably so. A roughly 80 year cycle has been repeating itself for centuries in the Anglophile world, broken up into four generations or turnings. We have begun what Howe called many years ago The Fourth Turning.

Neil Howe is the co-author, with the late William Strauss, of a number of seminal works on the impact of generations on cycles of history. Howe is a founding partner of LifeCourse Associates (lifecourse.com) which provides research to institutions looking to capitalize on generational research.

The June 2009 edition of The Casey Report, the flagship publication of Casey Research, featured a comprehensive 23 page interview with Neil Howe as well as suggestions on how to position your portfolio to profit during a Fourth Turning crisis. I persuaded my friend David Galland to at least summarize it for my Outside the Box this week, and he graciously did so. David is the managing editor of The Casey Report and has had a long career in the financial services industry; as a founding partner of the successful Blanchard Group of Mutual Funds and, before joining Casey Research, as a founding partner of EverBank, one of the big success stories in independent online banking.

Casey Research is offering readers of Out of the Box the opportunity to read the full edition of The Casey Report featuring the Howe Interview, and receive the publication for the next three months with a 100% satisfaction guarantee. For details click here... http://www.caseyresearch.com/crpmkt/crpSolo.php?id=144&ppref=CSN144ED0609B

I trust you will find this week's Outside the Box to be helpful. The more things change.....

John Mauldin, Editor
Outside the Box

A 20-Year Bear Market?

By David Galland, Casey Research

In November of 1997, my partner and co-editor of The Casey Report, Doug Casey, wrote an article titled "Foundations of Crisis," which leaned heavily on the research of Neil Howe and the late William Strauss.

Howe and Strauss have written many books on how generations determine the course of history and how they will shape America's future. Their forecasts on a wide variety of indicators have turned out to be amazingly accurate. They were among the first to predict (back in the late 1980s) the rise of Boomer-driven culture wars and the simultaneous rise of Gen-X-driven free agency and distrust of government. And they were completely alone back then in predicting, for the post-X "Millennial Generation" (a label they coined), a decline in youth crime and risk taking and an increase in youth civic engagement that would first become apparent around the year 2000. Guess what? For the last ten years, everyone has been noticing exactly these trends among teens and 20somethings.

Howe and Strauss also made extensive predictions, based on generational aging, on how America's entire social mood would likely change, in dramatic fashion, during our current 2000-2010 decade. To quote Doug's prescient 1997 article, which was reprinted in Outside the Box late last year...

"... an excellent case can be made the U.S. is approaching another time of secular crisis, a Fourth Turning, with an expected due date of 2005 – seven years from now – plus or minus a few years in either direction.

The Stamp Acts catalyzed the American Revolution, the election of Lincoln catalyzed the Civil War, the Crash of '29 catalyzed the Depression/WW II era. What might precipitate the elements now floating in solution? The answer is practically any random event that's sufficiently traumatic. Any of the theses of current disaster/action novels and movies will do nicely. Perhaps the accidental or intentional release of a super plague vector. The crashing of an airliner into the Capitol during a joint session. An all-out assault on the IRS computers by an armed group – or perhaps the computers just melting down due to the Year 2000 Problem. Perhaps a financial disaster that cascades into the Greater Depression. In any of these, or a hundred other scenarios, the federal government would almost certainly act precipitously and with a heavy hand, which would bring on a whole other set of consequences.

There's no way of telling where the Crisis will lead, or how it will end. That's going to depend not only on exactly who's in control, but what they do, who they're up against, and a hundred other variables we can't even anticipate.

One thing that seems certain is that real crisis brings out strong leadership. Because of its age and size, it will come from the Boomer generation, and it will be in the mold of Roosevelt or Lincoln – both very dangerous precedents. The boomers in elderhood will be dogmatic, harsh, puritanical, and quite willing to burn down the barn in order to destroy whatever rats they see. Admix that attitude to a time resembling the Revolution, the Civil War, or WW II, overlain with today's ethnic strife, urbanization, financial overextension, and powerful, compact new weaponry in the hands of foreign fanatics out to teach the Great Satan a lesson and it's a real witch's brew.

As eye-opening as Doug's predictions were, they brought us only to the onset of the current crisis. Consequently, we thought it both timely and important to check back with the source of much of the research he relied on. And so it was that I spent several hours talking with Neil Howe, co-author of the seminal work on generational cycles, The Fourth Turning, and, just recently, the subject of the DVD "The Winter of History." Howe is not just an historian, but also a Washington DC-based economist and demographer. While our conversation covered a great many topics, the overriding focus was on how things are likely to unfold from here.

Many bullish readers won't be thrilled to hear Howe's latest findings about the future, but given his predictive track record, dismissing them out of hand could be a costly mistake.

The summary outlook, according to Howe, is that we are in the very early stages of a 20-year period of economic and institutional upheaval – an era denominated by a crisis during which we'll likely witness the tearing down and reconstruction of many aspects of society as we know it.

As individuals, understanding Howe's views and taking some reasonable precautions makes a lot of sense. As investors, those views also have the potential to make us a lot of money.

Following is my high-level recap of my long conversation with Neil Howe, along with some general thoughts on the investment implications of a 20-year bear market.

Remember the Sixties?

If you're old enough -- or possess even a rudimentary sense of history -- think back to the 1950s, with roller-skating waitresses, crew cuts, and nuclear families of the sort represented by the iconic Leave it to Beaver. Fathers worked, while many mothers stayed home. Life had a certain predictable quality and, as far as anyone knew, would continue along the same lines for time immemorial.

But then something happened... the 1960s. Literally no one saw it coming. It was as if someone had flipped a switch that electrified America and, quickly, the world. Most everything changed, and a society accustomed to conformity was blown away with a fierce individualism expressed with long hair, sex, drugs, and rock and roll, topped off with civil disobedience and bloody riots in the streets.

What happened?

According to Neil Howe, in the mid-1960s, generational change pushed society around a dramatic corner as idealistic, individualistic young Baby Boomers (born 1943 to 1960) rebelled against the midlife leadership of their G.I. Generation parents (born 1901 to 1924).

These periods of transitions are part of a larger cyclical pattern made up of four distinct eras, or "Turnings," each lasting approximately 20 years. It can be helpful to think of the four turnings as you might think of the four seasons, repeating predictably in their own natural rhythm. A full cycle of turnings takes place over a period of about 80 to 90 years -- roughly the span of a long human life. A new turning begins as a new youth generation comes of age, bringing a new social ethic that compensates for the excesses of the midlife generation then in power.

While we don't have the space here to go into the full details of Howe's research, it's important to the topic at hand that we quickly recap the Four Turnings.

The First Turning is referred to by Howe as a High. As this follows a period of crisis, one of the hallmarks of a First Turning is a heightened sense of community and collective optimism, driven in part by the fact that the society has just come through a difficult and challenging time. Consequently, during First Turnings, societal institutions tend to be strong while individualism is weak. The post-World War II "High" of the mid-1940s through early '60s is the most recent example of a First Turning.

The Second Turning, called an Awakening, typically starts out feeling like the high tide of a High, with signs of progress and prosperity everywhere. But just as everything seems to be going along swimmingly, large swaths of society begin to chaff under the social conformity of the High, beginning to gravitate to more individualistic pursuits and demanding that their personal interests come first. You may recognize the "Consciousness Revolution" of the mid-1960s through early 1980s, correctly, as the Second Turning.

Next up, the Third Turning, which Howe calls an Unraveling, is much the opposite of a High. To wit, individualism dominates, while institutions are increasingly weak and discredited. Quoting Howe on the Unraveling...

"This is a time when social authority feels inconsequential, the culture feels exhausted, and people feel bewildered by the number of options available to them. It is a time of celebrity circuses and a tremendous amount of freedom and creativity in our personal lives, but very little sense of public purpose.

The most recent Third Turning began in the mid-'80s with Morning in America, and continued through the '90s. Previous periods of Unraveling in American history were also decades of cynicism and bad manners. Think of the 1920s, the 1850s, the 1760s. And history teaches us that the Third Turnings inevitably end in Fourth Turnings.

Finally, there is the Fourth Turning, called a Crisis. The recent Third Turning appears to be winding down, and we are currently on the cusp of a Fourth Turning. This is a time of great turmoil, when society's basic institutions are torn down and rebuilt, and seemingly insurmountable problems are addressed. During Fourth Turnings, America engages in a struggle for its very survival and redefines its identity as a nation. Large wars are often a part of this process. The American Revolution, Civil War, Great Depression, and World War II were all features of past Fourth Turnings.

In sum, Howe's research has shown that, with remarkable predictability, history is not a straight line extending toward a better and brighter (or increasingly awful) future, but rather a repeating cycle of the four distinct social eras. These four turnings have recurred with remarkable consistency throughout Anglo-American history, as Neil Howe outlines at length in Generations and The Fourth Turning. It is therefore no accident that America has experienced great cataclysms or "Crises" about every 80 years. Travel back eighty years from Pearl Harbor Day, and you land in the middle of the Civil War. Eighty years before that takes you to the Revolutionary War. If the rhythms of history hold, America is now poised to enter another Fourth Turning.

Bad News, Potentially Good News

You don't need me to tell you that the United States and in fact the world are now facing a plethora of intractable problems. The world's former powerhouse economy, the U.S., is now the world's largest debtor nation – and by a wide margin. The nation has trillions in unpayable liabilities coming due on Social Security and Medicare, to name just two of many broken government programs weighing on the country. And our much vaunted democracy is increasingly dysfunctional – rotten to the core, truth be known – thanks largely to entrenched special interests and a voting public clamoring for their own piece of the pie, while trying to hand the bill off to somebody else.

Meanwhile, the economy – despite rigorous jawboning by the government and its many friends in the large banking institutions -- is in serious trouble, with the housing market buffeted by tsunami-like waves of defaults, foreclosures, overvaluations, historic levels of personal debt, and tight credit that has left the U.S. government as the sole lender in many markets.

Bernanke and his ilk may see green shoots, but what they're really seeing is the deep, green sea rising up once again to bury the economy.

That's the bad news.

The potentially good news, if you credit Howe's research, is that the Crisis we're now entering will change pretty much everything. While this change will entail a great deal of pain and a reduced standard of living for a large number of people, by the time the Crisis subsides, society will have pretty much remade itself in ways that no one can predict at this point.

Put another way, today's intractable problems will be solved... one way or another.

What's Next

When discussing what's likely to follow next, Neil Howe turns to his generational profiles and points out that the rising societal power today belongs to the generation he calls the Millennials, individuals born between 1982 and 2004. They are a "Hero" generation, just like the G.I. Generation that coped so well with the turmoil of the Great Depression and World War II -- the last Fourth Turning. Coddled as children, the G.I.s were ultimately called upon to help society through a dark and dangerous period and rose to the occasion. Again, quoting Howe on the Millennials...

"These are today's young people, who are just beginning to be well known to most Americans. They fill K-12 schools, colleges, graduate schools, and have recently begun entering the workplace. We associate them with dramatic improvements in youth behaviors, which are often underreported by the media. Since Millennials have come along, we've seen huge declines in violent crime, teen pregnancy, and the most damaging forms of drug abuse, as well as higher rates of community service and volunteering. This is a generation that reminds us in many respects of the young G.I.s nearly a century ago, back when they were the first boy scouts and girl scouts between 1910 and 1920.

Unlike the Baby Boomers, who are largely individualistic and anti-establishment, the Millennials are good team players. We hear a lot these days about working together for a common cause, volunteerism, and the need for stronger government institutions, largely because these are the new priorities of the Millennial Generation.

As you may recall, out of the devastation of World War II, a spate of transnational political and economic institutions were born, including the United Nations, the World Bank, the World Health Organization, and the International Monetary Fund. By the time the current Fourth Turning is over, expect more of the same -- but probably even bigger and more ambitious.

What Does This Mean to You?

Most importantly, if Howe is right, this crisis is far from over. In fact, when I asked him where we are today on a scale from 1 to 10 -- with 10 representing as bad as the crisis will get -- he replied that we are at either 2 or 3. In other words, the worst is very much yet to come. And, per above, he expects this period of turmoil to take 20 years to play out. Thus, if nothing else, you may want to continue approaching matters of personal finance cautiously.

Secondly, if you're the type of individual that tends to get steamed up by larger and more intrusive government programs, you may want to take a few deep breaths and resolve yourself to the fact that this phenomenon is likely to get far worse before we see a return to celebration of individual rights. (And the cycle shows that we will see such a return -- about 40 to 50 years from now, when the next Second Turning comes around.)

If it is any consolation, the Millennial Generation places a great deal of weight on teamwork and the notion of doing things "smart." That doesn't mean, of course, that the various programs that are kicked off in an attempt to fix the many problems now confronting society will in fact turn out to be technically smart. But they will almost certainly be better thought out than some of the numbskull initiatives we've seen over the last 20 years.

You can also take some comfort in the fact that Millennials are builders, not destroyers. By contrast, the individualistic Boomers that dominate today's aging political class are world-class dissenters, radio talk show aficionados always ready to scrap it out for their beliefs. Millennials want to skip the philosophical debate and get straight to fixing things.

Other insights about Fourth Turning periods gained from my conversation with Neil Howe...

Government grows powerful, and sweeping new legislation is enacted. The old 1990s rule was: just compete and stay off the state's radar screen. The new 2010s rule will be: better have a presence in Washington so you're not dealt out of the "new" new deal. One political party tends to dominate. The Democrats under FDR during the last Fourth Turning offer a good example. While Neil Howe doesn't think it will necessarily be the Democrats this time around, they are certainly in the pole position at this point.
While public history speeds up, personal life slows down. Families will spend more time together, like in the old Frank Capra movies. Ever more households will be multi-generational, a trend now spurred by Boomers with large, empty McMansions and Millennials without jobs. There will be a blanding of the pop culture, with the entertainment of the young (put Miley Cyrus or "High School Musical" on fast forward) increasingly regarded as tamer than the entertainment of the old.
Innovation tends to stagnate, while a few new technologies will be chosen to be adopted on a large scale. We will see the equivalent of canals or railroads or interstates being built across America. To borrow from Carlotta Perez' four-stage description of technological revolutions, we are moving from the "innovation" to the "implementation" stage.
New laws and regulations will do less to referee a free market and more to pursue one or another national priority. They will increasingly favor the large producer over the retail buyer, investment over consumption, planning over risk, debt over equity. Businesses will hustle to reposition themselves. Anti-trust legislation will weaken.
The authority and obligations of community will strengthen at all levels, from local to national and possibly beyond (if our alliances prove durable). Personal reputation and membership will matter more. A "new localism" will reshape town and urban planning. A global slide toward national or regional protectionism will loom as a real danger.
It is too early to tell whether the crisis will ultimately be inflationary or deflationary, though we at Casey Research come down on the side of inflation for the simple reason that the government possesses the means to inflate. Due to the gold standard, that was not the case early in the Great Depression.
In the past, Fourth Turning periods have always resulted in the nation redefining who we are in some essential way. That was certainly the case during the American Revolution, when we transitioned from a British colony into a collection of independent states -- and the Civil War, when those states were hammered into a single nation. And, again, after World War II, when the U.S. went from being a relatively isolated nation to a global empire. A wild card, for instance a terrorist nuke going off in a city anywhere on the planet, could similarly take the country, and the world, into unforeseeable new directions.

li>Baby Boomers will continue to be respected for their cultural achievements (it's not a fluke of history that Boomer music and other entertainments are still wildly popular among the young), but will be increasingly ignored in the political debate. The term "senior citizen," already in decline, will disappear entirely. And if push comes to shove, Boomer's financial interests – including Social Security – will be subjugated "for the greater good."
There will be a growing push to rebuild the middle class. The wealthy and the impoverished alike will both come under pressure thanks to new pro-middle class initiatives. If you are a high-income earner, it's a certainty your taxes are going up, and likely by a lot. If you want to make a fortune, don't pursue the niche or the "long tail." Invent the next big brand that will appeal to Everyman.

Don't Worry, Be Happy

That is, at best, a sketch of my long conversation with Neil Howe and doesn't do justice to his research. If nothing else, however, I hope I've succeeded in giving you at least some sense of the man and his unique research and encouraged you to think outside the box about the nature of today's crisis.

A couple of final observations.

First, Neil Howe is not a negative person, nor a professional doomsayer. Rather, he is a social scientist and historian with decades of experience in the social sciences. As you speak to him, you get the sense that he doesn't view the world through any particular philosophical bias, but rather is simply reporting what his research is telling him about the current players on the global stage, and which act we are currently in.

Secondly, speaking as a Baby Boomer and someone with a lifelong distrust of government and its meddling institutions, talking to Neil left me feeling oddly relaxed -- letting go, if you will, of some of the frustration that has been building within me as I watch the nanny state grow more and more bloated.

That is not to say we won't continue to speak out against government waste and prolificacy. We will. But it seems increasingly clear that we're now caught up in a powerful trend toward bigger, not smaller, societal institutions -- and that these institutions will, over the period ahead, change the world as we know it.

Of course, being active investors, at the same time we raise our voices in protest, we'll deal with the reality of the situation by strategically positioning our portfolios to profit from the coming changes.

And so, like the Rockefellers and J.P. Morgan during the Great Depression, we'll make the trend -- to matter how negative -- our friend. You may want to consider doing so yourself.

Making the trend your friend is more important than ever, if your assets are to make it through the Fourth Turning intact. The Casey Report discovers and analyzes budding economic trends and turns them into hands-on, actionable recommendations for its subscribers. Read the latest report from Casey Chief Economist Bud Conrad about our favorite investment of 2009... a play on an all but inevitable economic development. Click here to read more.

A Tale of Two Depressions

John Mauldin — Mon, 22 Jun 2009 18:49:15 GMT

This week's Outside the box looks at some very interesting research done by two economic historians, Barry Eichengreen of the University of California at Berkeley and Kevin O'Rourke of Trinity College, Dublin They give us comparisons between the Great Depression and today's downturn. They continue to update their data from time to time, the link to their work is at http://www.voxeu.org/index.php?q=node/3421. I have not previously heard of www.voxeu.org, but it is a collection of the work of well regarded international economists that seems quite interesting for those who enjoy readings in the dismal science.

This week's OTB will print long, but it is primarily charts. Please note that I have re-arranged some of the new charts to cut down on space because of some duplications. Word count is not all that much and it reads well. I will be referring to their work in future letters as well. Have a great week!

John Mauldin, Editor
Outside the Box

A Tale of Two Depressions

New findings:

World industrial production continues to track closely the 1930s fall, with no clear signs of ‘green shoots'.
World stock markets have rebounded a bit since March, and world trade has stabilized, but these are still following paths far below the ones they followed in the Great Depression.
There are new charts for individual nations' industrial output. The big-4 EU nations divide north-south; today's German and British industrial output are closely tracking their rate of fall in the 1930s, while Italy and France are doing much worse.
The North Americans (US & Canada) continue to see their industrial output fall approximately in line with what happened in the 1929 crisis, with no clear signs of a turn around.
Japan's industrial output in February was 25 percentage points lower than at the equivalent stage in the Great Depression. There was however a sharp rebound in March.

The parallels between the Great Depression of the 1930s and our current Great Recession have been widely remarked upon. Paul Krugman has compared the fall in US industrial production from its mid-1929 and late-2007 peaks, showing that it has been milder this time. On this basis he refers to the current situation, with characteristic black humour, as only "half a Great Depression." The "Four Bad Bears" graph comparing the Dow in 1929-30 and S&P 500 in 2008-9 has similarly had wide circulation (Short 2009). It shows the US stock market since late 2007 falling just about as fast as in 1929-30.

Comparing the Great Depression to now for the world, not just the US

This and most other commentary contrasting the two episodes compares America then and now. This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices.

In fact, when we look globally, as in Figure 1, the decline in industrial production in the last nine months has been at least as severe as in the nine months following the 1929 peak. (All graphs in this column track behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.) Here, then, is a first illustration of how the global picture provides a very different and, indeed, more disturbing perspective than the US case considered by Krugman, which as noted earlier shows a smaller decline in manufacturing production now than then.

Updated Figure 1. World Industrial Output, Now vs Then (updated)

Source: Eichengreen and O'Rourke (2009) and IMF.

Similarly, while the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure 2). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.

Updated Figure 2. World Stock Markets, Now vs Then (updated)

Another area where we are "surpassing" our forbearers is in destroying trade. World trade is falling much faster now than in 1929-30 (Figure 3). This is highly alarming given the prominence attached in the historical literature to trade destruction as a factor compounding the Great Depression.

Updated Figure 3. The Volume of World Trade, Now vs Then (updated)

Sources: League of Nations Monthly Bulletin of Statistics, http://www.cpb.nl/eng/research/sector2/data/trademonitor.html

It's a Depression alright

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The "Great Recession" label may turn out to be too optimistic. This is a Depression-sized event.

That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline. We therefore turn to the policy response.

Policy responses: Then and now

Figure 4 shows a GDP-weighted average of central bank discount rates for 7 countries. As can be seen, in both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level. There is more at work here than simply the difference between George Harrison and Ben Bernanke. The central bank response has differed globally.

Updated Figure 4. Central Bank Discount Rates, Now vs Then (7 country average)

Source: Bernanke and Mihov (2000); Bank of England, ECB, Bank of Japan, St. Louis Fed, National Bank of Poland, Sveriges Riksbank.

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Figure 5. Money Supplies, 19 Countries, Now vs Then

Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators.

Figure 6 is the analogous picture for fiscal policy, in this case for 24 countries. The interwar measure is the fiscal surplus as a percentage of GDP. The current data include the IMF's World Economic Outlook Update forecasts for 2009 and 2010. As can be seen, fiscal deficits expanded after 1929 but only modestly. Clearly, willingness to run deficits today is considerably greater.

Figure 6. Government Budget Surpluses, Now vs Then

Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009.

[They added some country data in their revision that I put here, hence the two figure 5's, but they are labeled as such on the website and I did not change their labellling – JFM]

New Figure 5. Industrial output, four big Europeans, then and now

New Figure 6. Industrial output, four Non-Europeans, then and now.

The facts for Chile, Belgium, Czechoslovakia, Poland and Sweden are displayed below;

New Figure 7: Industrial output, four small Europeans, then and now.

Conclusion

To summarise: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.

The good news, of course, is that the policy response is very different. The question now is whether that policy response will work. For the answer, stay tuned for our next column.

Iranian Elections, Israel and the United States

John Mauldin — Thu, 18 Jun 2009 15:13:19 GMT

Dear Friends,

In the midst of an economic crisis, we are inundated with data - information that often, a few years down the line, turns out to be wrong. Forecasts are made based on a single month's set of data or previous trends, and the public often doesn't know how to read the fine print about margins of error.

The problem is faulty methodology. Most media and even government intelligence agencies assume the information they get from leadership figures is 100% correct, no questions asked - leading to defective analyses. Instead, underlying assumptions should be constantly vetted in the face of new facts. I'd encourage you to consider the intelligence produced by my friend George Friedman at STRATFOR - a trusted source in forecasting future geopolitical trends.

Click here to watch this video by George and his intelligence team. It looks beyond the current protests in Iran and delves into what policy changes could be on the horizon in this pivotal Middle Eastern state. George extrapolates what these recent events mean for President Obama's and Israel's options in terms of Iran and the peace process.

Anyone looking to gain a leg up in the world of finance needs to understand geopolitics and foreign investments. Take a look at STRATFOR, which offers a special deal for my readers. Barron's referred to them in a cover-story profile as the "Shadow CIA," but I would say that their methodology gives them much greater accuracy than their government counterpart.

To Intelligence,
John Mauldin

Fear for a Lost Decade

John Mauldin — Mon, 15 Jun 2009 19:02:56 GMT

Before we get into this week's Outside the Box, let me give you a few pieces of data that came across my desk this morning, which will help set the stage for the OTB offering.

Fitch (the ratings agency), in a downgrade of yet another 543 mortgage-backed securities of 2005-07 vintage, gives us the following side notes: "The home price declines to date have resulted in negative equity for approximately 50% of the remaining performing borrowers in the 2005-2007 vintages. In addition to continued home price deterioration, unemployment has risen significantly since the third quarter of last year, particularly in California where the unemployment rate has jumped from 7.8% to 11%... The projected losses also reflect an assumption that from the first quarter of 2009, home prices will fall an additional 12.5% nationally and 36% in California, with home prices not exhibiting stability until the second half of 2010. To date, national home prices have declined by 27%. Fitch Rating's revised peak-to-trough expectation is for prices to decline by 36% from the peak price achieved in mid-2006. The additional 9% decline represents a 12.5% decline from today's levels."

So, what does an aging population do that has seen its retirement nest egg in the form of housing and stocks go literally nowhere for 12 years? You go back to work! David Rosenberg, now with Gluskin Sheff, offers us this insight:

"What really struck us in the employment report of a few weeks ago was the fact that the only segment of the population that is gaining jobs is the 55+ age category. This group gained 224,000 net new jobs in May while the rest of the population lost 661,000. In fact, over the last year, those folks 55 and up garnered 630,000 jobs whereas the other age categories collectively lost over six million positions. This is epic." [See chart below.]

"Moreover, the number of 55 year olds and up who have two jobs or more has risen 1.1% in the last year, the only age cohort to have managed to gain any multiple jobs at all. Remarkable. These folks have seen their wealth get destroyed by two bubble-busts less than seven years apart — the Nasdaq nest egg back in 2001 and the 5,000 square foot McMansion in 2007. Both bubbles ended in tears ... and so close together."

With that as backdrop, what are we to make of the prospects for recovery over the next decade? Not much, if we listen to Professor Paul Krugman of Princeton. He suggests that the developed world could be entering a lost decade, just like Japan after their crash. Let me quickly point out that I routinely disagree with Krugman on a large number of issues. And I usually know why I disagree and believe his policy suggestions are wrong.

That being said, one purpose of Outside the Box is to look at ideas and thinkers that we may not always agree with. Krugman certainly qualifies on that front for me. However, it must be admitted that he is a very smart man. Further, his thinking is important, because it somewhat reflects the thinking of that part of the establishment that is in charge of the Fed and the Treasury. And while we are not getting gloomy long-term forecasts from either the Fed or the Treasury, I find it remarkable that Krugman is less sanguine than his peers. And there is much (certainly not all!) within this interview that I find myself in surprising agreement with. This one made me think as I read and reread it.

If he is correct, the rosy recovery assumptions built into the already bloated budget projections are going to be far too optimistic, not just for the US, but throughout Europe as well. Krugman is interviewed very capably by Will Hutton, a veteran writer and economist for the UK Guardian (a bastion of liberal politics). The direct link is http://www.guardian.co.uk/business/2009/jun/14/economics-globalrecession.

Green shoots? Really? I invite you to read and think about what this interview means for the road to recovery. I will take this up more in next Friday's missive. (Note, I did not write a letter last week. There was a new Mauldin grandchild on Friday, and I decided that some things just take precedence.) Have a great week.

John Mauldin, Editor
Outside the Box

Fear for a Lost Decade

As analysts and media hailed the tentative emergence of green shoots last week, Nobel Prize-winning economist Paul Krugman caused international shock with a prediction that the world economy would stagnate just as badly, and for just as long, as Japan's did in the 1990s. In an exclusive interview, he talks to Will Hutton about his anxiety for the future.

Will Hutton: You are warning that what happened to Japan could happen to the whole world. Japan's GDP at the end of this year will be no higher than it was in 1992 -- 17 lost years. You are saying that this is an ongoing risk, certainly for the North Atlantic economy – – maybe the world economy.

Paul Krugman: Yes. It's not that the risk of the Japan syndrome has receded very much. The risk of a full, all-out Great Depression – – utter collapse of everything – – has receded a lot in the past few months. But this first year of crisis has been far worse than anything that happened in Japan during the last decade, so in some sense we already have much worse than anything the Japanese went through. The risk for long stagnation is really high.

WH: So what is the heart of your pessimism? The bust banking system? A critic would say: "Hold on, Paul Krugman. Japan is a special case. It had an overblown export sector that had become too large for an American market it had saturated. The yen was very, very overvalued. And this interacted with a credit crunch and bust banking system. Its policy response was consistently behind the curve. That's not the story of the United States or the United Kingdom."

PK: The thing about Japan, as with all of these cases, is how much people claim to know what happened, without having any evidence. What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn't enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn't enough. We've hit that lower bound the same as they did. Now, everything after that is more or less speculation.

For example, were the problems with the Japanese banks the core problem? There are some stories about credit rationing, but they are not overwhelming. Certainly, when we look at the Japanese recovery, there was not a great surge of business investment. There was primarily a surge of exports. But was fixing the banks central to export growth?

In their case, the problems had a lot to do with demography. That made them a natural capital exporter, from older savers, and also made it harder for them to have enough demand. They also had one hell of a bubble in the 1980s and the wreckage left behind by that bubble – – in their case a highly leveraged corporate sector – – was and is a drag on the economy.

The size of the shock to our systems is going to be much bigger than what happened to Japan in the 1990s. They never had a freefall in their economy – – a period when GDP declined by 3%, 4%. It is by no means clear that the underlying differences in the structure of the situation are significant. What we do know is that the zero bound is real. We know that there are situations in which ordinary monetary policy loses all traction. And we know that we're in one now.

WH: So your point is that the crisis in Japan was about excess debt, excess leverage and lack of demand – – reinforced by the fallout from the asset bubble collapsing. They didn't have credit contraction on anything like our scale, but even so, zero interest rates were just unable to turn the economy around.

PK: That's right, that's right.

WH: But an optimist would say that there are signs all around of the traction that you say doesn't exist is working. The stockmarkets in London and Wall Street – – along with most world markets – – are up a solid 20% to 25%. You've got all these improving business confidence indicators. You've got the first signs of the housing market bottoming in both the UK and the United States. This is what the optimists would tell you.

PK: But all of that points to levelling off, rather than an actual recovery. Britain's looking the best among the major European economies because it's got a PMI [purchasing managers' index, a key measure of economic sentiment] that's just above 50. In other words, Britain actually may have stopped contracting – – that's the most positive thing one can say.

Who knows if the stockmarket makes sense or not? It was pricing in the possibility of an apocalypse a few months ago. That possibility seems to have receded, so it makes sense for the markets to come up, but that's not saying that the economy is going to be great. If you do the comparison not with where they were three months ago, but where they were two years ago, then the markets still seem awfully depressed.

I hope I'm wrong but the question you always have to ask is: where do we think that this recovery's going to come from? It's not an easy story to tell.

WH: In your lectures, you drew attention to the importance of stressed balance sheets holding back consumers and business alike in their likely spending ambitions – – and thus dragging back economic activity. Is this going to be a balance-sheet-constrained recovery?

PK: It's probably true that households have been impoverished a lot by the fall of the housing and stock prices. And that it's likely that households, with all of this debt, are going to have trouble spending. And yes, the North Atlantic economy was supported quite a lot by gigantic housing booms. Here in the UK you have had the house price surge without very much construction. Economists have a well-developed theory about how balance-sheet problems can cause financial and economic crises, but we thought of it in terms of third world countries with foreign-currency debt. We didn't realise that there were lots of other ways in which that can happen.

WH: So, one way to think about it is that self-reinforcing financial crises rooted in overstretched, overborrowed companies and governments in less developed countries – – like those in Argentina and Indonesia, which were amazingly destructive in the 1990s and 2000s, but localised – – are now playing out in the developed world?

PK: There are really two stories. One is the Japan-type story where you run out of room to cut interest rates. And the other is the Indonesia- and Argentina-type story where everything falls apart because of balance-sheet problems.

WH: So in a nutshell your story is ...

PK: The "Nipponisation" of the world economy with a bunch of "Argentinafications" playing a role in the acute crisis. But even after those are over, we have the Nipponisation of the world economy. And that's really something.

WH: What was the heart of the Japanese problem? What was at the heart of their 17 years of going nowhere?

PK: Well, my guess is that it was that the balance-sheet problems took a very long time to resolve. And it is difficult to get enough demand in an economy where you have really very adverse demography ...

WH: So, which countries look closest to being Nipponised – – combining balance-sheet problems and ageing populations?

PK: Well, the US doesn't have the same combination. But in Europe, Germany and Italy look comparable. France is better and Europe as a whole is considerably better.

WH: Germany matches Japan to an uncanny degree. You talk about the Nipponisation of the world economy: I'm not so sure. But I would talk about the Nipponisation of Europe via a German economy at its centre in the grip of the same problem – – and that starts to be a global problem.

PK: Germany has huge inadequacy of domestic demand. Their economic recovery in the first seven years of this decade rested on the emergence of gigantic current account surplus.

How is it possible that Germany, which did not have a house price bubble, is having a steeper GDP fall than anyone else in the major economies?

The answer is that they depended upon exporting to the bubble regions of Europe, so they actually got side-swiped by the loss of those exports worse than the bubble regions themselves got hit.

It's Germany on a global scale that is the concern. We worry about the drag on world demand from the global savings coming out of east Asia and the Middle East, but within Europe there's a European savings glut which is coming out of Germany. And it's much bigger relative to the size of the economy.

WH: And on top there is an unique and unaddressed huge potential banking crisis. The Germans pride themselves on their three-legged banking system, but it is incredibly interlinked. The IMF warns that Germany could have to take at least $500bn of writedowns, which its banks have not begun to recognise. German banks hold a trillion dollars – – maybe more – – of maturing collateralised debt obligations that can only be refinanced by crystallising the losses. We've had RBS and you've had Citigroup. Germany's GDP will fall 6% this year – – before the banking crisis has hit it.

PK: Yeah, that's the financial view. Its important to keep track of the financial state of the banks. But one always has to keep track of the real side of the economy, too. It is a hypothesis that the problem is essentially financial. But it is by no means a hypothesis that we know is true.

WH: So even after what we've gone through, you say it's just a hypothesis that the cause of the crisis is financial?

PK: That the cause is primarily financial. Certainly, Lehman and all of that alerted us all. And it did trigger an immediate drop in demand. But the housing bust was going to happen regardless.

The fall in business investment is at least to a large degree a response to excess capacity, which is the result of falling consumer demand and the housing bust. So we don't know.

WH: I think we know more than that. The links between bank capital, loan losses, credit availability and economic activity and asset prices have never been clearer. That was why there was a threat of Depression.

PK: Clearly, re-establishing stability in the financial markets is a necessary condition for recovery. But we're not sure it's sufficient.

WH: That's very scary.

PK: Well, that is part of the reason why I am so depressed.

WH: In one of your lecture charts you seemed to be suggesting that we're 12 months into what you think could be a 36-month period of downturn, albeit at a slower rate.

PK: Easily.

WH: It's quite shocking that you think it will be that severe.

PK: If we measure the 2001 US recession by when the labour market finally started to turn around, it was a 30-month recession. It was really 30 months in before you started to see the unemployment rate come down.

WH: In Britain, there is now a new consensus forming that the government's economic forecasts, which were roundly mocked at the time of the April budget for being wildly optimistic, could be right – – that is, growth will start to resume in 2010, albeit at a very low rate.

PK: Well, the UK has achieved a lot of monetary traction in the way that no one else has through the depreciation of the pound. In effect, you've carried out a successful beggar-my-neighbour devaluation.

WH: So, the United Kingdom might actually get through this in reasonably good shape?

PK: Yeah. That's why I've been watching with an outsider's slight puzzlement, your bizarre political circus.

WH: Darling and Brown deserve more credit than they're given?

PK: If the government can hold off having an election until next year, Labour might well be able to run as "we're the people who brought Britain out of the slump".

WH: So your advice to the Labour Party is: hold steady.

PK: Probably.

WH: Probably?

PK: I don't know enough about the other aspects of politics, but I would guess that the option value is quite high that the economy might actually have turned a corner. That's unique. That's a uniquely British thing. None of the other G7 countries has anything like that.

WH: And that's a combination of our big beggar-our-neighbour devaluation, aggressive monetary policy, successfully recapitalising our banks and our fiscal policy.

PK: There hasn't been very much discretionary fiscal expansion when all's said and done.

WH: Well, there was a £20bn temporary cut in VAT.

PK: Yeah.

WH: Which is non-trivial.

PK: Non-trivial. But not much [other spending], as I understand.

WH: Well, there was bringing forward £3-4bn of capital spending. Perhaps together in a full year the stimulus was 1.5% GDP. Maybe 2% at the outside.

PK: Monetary policy has been more aggressive – – though maybe less than the Fed – – and the depreciation of the pound is a nice thing from a UK point of view.

WH: So you remain committed to the key role of fiscal policy?

PK: Yeah. Fiscal policies are best; certainly something to do to mitigate recession. People say that the Japanese fiscal policy on all that infrastructure was wasted. But it did help sustain the economy and avoid a collapse. Fiscal policy can certainly do that: it gives the credit sector time to rebuild its balance sheets. There's every reason to be expansive around the fiscal side now because even if you're not sure that it provides a long-term solution, avoiding catastrophe is a big thing to do.

WH: If you believe that, is Obama doing enough on fiscal policy?

PK: Well we have a stimulus which is a little over 5% of one year's GDP but some of it is not real – something that was going to happen anyway and not very stimulative. So it's really about 4% of GDP of genuine stimulus, but spread over two and a half years. So, it's actually quite a lot less than what I was arguing for.

WH: So, will it be sufficient?

PK: Well, sufficient to actually restore full employment would probably have to be 5% or more. More than we have would certainly be a good thing. It actually might happen. You know, the buzz I'm getting is that a second-round stimulus might well come on the agenda.

WH: Really? When you say "the buzz you're getting", have you been asked?

PK: Well, it's what you hear from people who talk to people who talk to people.

WH: Who would argue for that? Would it be Larry Summers [director of the US National Economic Council]?

PK: I think Larry. I'm not sure Tim Geithner [US treasury secretary] would be opposed to it. Nor would Chrissie [Christine Romer, director of the Council of Economic Advisers] I'm sure they would be making similar judgements. It is actually a little spooky.

WH: They're all people you know pretty well, who look at the world the same way, use the same tools and framework ...

PK: Yeah. They may be sitting where they are, having some differences. Larry's always more conventional than I am. Sometimes rightly. Sometimes wrongly. But they do operate in the same framework.

WH: How seriously do you take the argument that the growth of public debt on this scale will crowd out the spontaneous amount of growth of corporate and private debt? Is this already happening with the rise in long-term interest rates in the US?

PK: The thing about long-term interest rates is that they are a weighted average of future expected short-term interest rates. Movements in long-term rates are mostly about what people think the short rates are going to be. Look, real rates are barely up at all. What seems to have moved up is the expected rate of inflation, which is still below the Fed target. So it's more like what the markets are doing is reducing their discounting of deflationary catastrophe. WH: how do you see the politics working out in the States and in the UK now? Your praise of Gordon Brown after the banks in October were recapitalised was front-page news. Are you still as well disposed?

PK: I still think his economic policies have been pretty good. They really kind of lost their nerve on fiscal policy, but I do understand it's harder to do it here. I think the UK economy looks the best in Europe at the moment. I have no position on all of the crazy stuff. But I think the policies are intelligent. The fact of the matter is that Britain did manage to stabilise the banking situation. I'm not ecstatic, but I'm not sure I know what I could have done better.

WH: So where are you on the debate about various shape recoveries? V-shaped? L-shaped ? A W-shaped recovery?

PK: There is a possibility that we get some perk-up as the stimulus dollars start to flow and an almost mechanical bounceback in industrial production as inventories are built up. But then we slide down again. The idea that we sort of bounce along the bottom is all too easy to imagine.

WH: Is it just a story about the right dose of fiscal policy? What structural change would you advocate in the economy, to support recovery?

PK: Financial regulation. Rein in that monster. The huge increase in general private-sector leverage is at the core of how we got so vulnerable. We went for 50 years after the Great Depression without any major financial crises, and that, I think, was because we had a financial sector that didn't let people get as deeply into debt as they have now.

WH: So rein in the financial monster and give a fiscal stimulus. So you would leave the American way of doing capitalism untouched?

PK: I'm not that cosmic in this stuff. But it is true that Gordon Gekko [the anti-hero of Oliver Stone's film Wall Street, motto: Greed is Good] went hand in hand with the wave of financialisation. Corporations got more brutal and fiercer.

WH: But it is all connected. Without the leverage, there would have been no Gordon Gekkos. And leverage meant that predator companies had the firepower to launch contested hostile takeovers. The only way to fend off attack, or to make the sums work after an attack, was for companies to be more brutal and fierce – often breaking the promises to staff and suppliers that kept commitment and trust.

PK: All of that is true. I have a more mundane view about what we do. I just want a stronger welfare state and a little bit more social democracy. And some restoration of the labour movement as a counterweight.

I'm not sure – maybe I'm just not thinking about it deeply enough. I guess I've got the same attitude Keynes had, which was he was looking for almost technical fixes. You're looking for ways to fix the parts that have gone wrong rather than replace the whole thing.

You know the human cost of this crisis is vastly worse in America than it is on this side of the Atlantic. So this is a good time to push for a better US social safety net too.

WH: And lastly – you've been critical about Obama. Your view now?

PK: I'm increasingly happy with him. I was unhappy; I think they could have gotten a bigger stimulus coming out the gate. But they've become more forceful. I would have been more aggressive on the banks; we'll see if we need to re-fight that battle later on.

Healthcare is looking really good. I'm getting increasingly optimistic on healthcare reform. Climate change looks like it's going to happen. So my odds that this will in fact be the kind of New Deal I was hoping for are rising. I had my scepticism, but he is smart. He's impressive. And it is such a relief to have somebody whom you can respect in the White House.

History lesson for economists in thrall to Keynes

John Mauldin — Tue, 09 Jun 2009 02:36:45 GMT

There is a debate in academic circles on the lessons of the current economic crisis. While most ivory tower debates are of little concern to our daily affairs, this debate should concern you, as it will inform those who hold central bank and political power. Remember, there is no playbook of rules for what to do in deflationary, deleveraging recessions. They are making it up as they go along.

Today we have a short essay by Niall Ferguson published last week in the Financial Times. It speaks for itself, and you should take a few minutes to read it.

John Mauldin, Editor
Outside the Box

History lesson for economists in thrall to Keynes

By Niall Ferguson

On Wednesday last week, yields on 10-year US Treasuries -- generally seen as the benchmark for long-term interest rates -- rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that "the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds" was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a "painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year".

De haut en bas came the patronising response: I belonged to a "Dark Age" of economics. It was "really sad" that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes's General Theory was published), much less its zenith in 2005 (the year Mr Krugman's macro-economics textbook appeared). Did I not grasp that the key to the crisis was "a vast excess of desired savings over willing investment"? "We have a global savings glut," explained Mr Krugman, "which is why there is, in fact, no upward pressure on interest rates."

Now, I do not need lessons about the General Theory. But I think perhaps Mr Krugman would benefit from a refresher course about that work's historical context. Having reissued his book The Return of Depression Economics, he clearly has an interest in representing the current crisis as a repeat of the 1930s. But it is not. US real GDP is forecast by the International Monetary Fund to fall by 2.8 per cent this year and to stagnate next year. This is a far cry from the early 1930s, when real output collapsed by 30 per cent. So far this is a big recession, comparable in scale with 1973-1975. Nor has globalisation collapsed the way it did in the 1930s.

Credit for averting a second Great Depression should principally go to Fed chairman Ben Bernanke, whose knowledge of the early 1930s banking crisis is second to none, and whose double dose of near-zero short-term rates and quantitative easing -- a doubling of the Fed's balance sheet since September -- has averted a pandemic of bank failures. No doubt, too, the $787bn stimulus package is also boosting US GDP this quarter.

But the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn -- equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House's over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems.

It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert "no upward pressure on interest rates".

Of course, Mr Krugman knew what I meant. "The only thing that might drive up interest rates," he acknowledged during our debate, "is that people may grow dubious about the financial solvency of governments." Might? May? The fact is that people -- not least the Chinese government -- are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

No doubt there are powerful deflationary headwinds blowing in the other direction today. There is surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank's latest quarterly report: "A policy mistake ... may bring inflation risks to the whole world."

The policy mistake has already been made -- to adopt the fiscal policy of a world war to fight a recession. In the absence of credible commitments to end the chronic US structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings. It was Keynes who noted that "even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist". Today the long-dead economist is Keynes, and it is professors of economics, not practical men, who are in thrall to his ideas.

The writer is Laurence A. Tisch professor of history at Harvard University and author of The Ascent of Money (Penguin)

The Geography of Recession

John Mauldin — Thu, 04 Jun 2009 21:16:46 GMT

Dear Friends:

One of the first things you learn about analyzing a company is how to dissect a balance sheet. What assets and liabilities can be deployed by a company to create equity over time? I've enclosed a fascinating variant on this process. Take a look at how STRATFOR has analyzed the "geographic balance sheets" of the US, Russia, China, and Europe to understand why different countries' economies have suffered to varying degrees from the current economic crisis.

As investors, it's precisely this type of outside-the-box thinking that can provide us profitable opportunities, and it's precisely this type of outside-the-box thinking that makes STRATFOR such an important part of my investment decision making. The key to investment profits is thinking differently and thinking earlier than the next guy. STRATFOR's work exemplifies both these traits.

I've arranged for a special deal on a STRATFOR Membership for my readers, which you can click here to take advantage of. Many of you are invested in alternative strategies, but I want to make sure that you also employ alternative thinking strategies. So take a look at these different "country balance sheets" as you formulate your plans.

Your Mapping It Out Analyst,

John Mauldin

The Geography of Recession

By Peter Zeihan

The United States and the Free Market

The most important aspect of the United States is not simply its sheer size, but the size of its usable land. Russia and China may both be similar-sized in absolute terms, but the vast majority of Russian and Chinese land is useless for agriculture, habitation or development. In contrast, courtesy of the Midwest, the United States boasts the world's largest contiguous mass of arable land — and that mass does not include the hardly inconsequential chunks of usable territory on both the West and East coasts.

Second is the American maritime transport system. The Mississippi River, linked as it is to the Red, Missouri, Ohio and Tennessee rivers, comprises the largest interconnected network of navigable rivers in the world. In the San Francisco Bay, Chesapeake Bay and Long Island Sound/New York Bay, the United States has three of the world's largest and best natural harbors. The series of barrier islands a few miles off the shores of Texas and the East Coast form a water-based highway — an Intercoastal Waterway — that shields American coastal shipping from all but the worst that the elements can throw at ships and ports.

The real beauty is that the two overlap with near perfect symmetry. The Intercoastal Waterway and most of the bays link up with agricultural regions and their own local river systems (such as the series of rivers that descend from the Appalachians to the East Coast), while the Greater Mississippi river network is the circulatory system of the Midwest. Even without the addition of canals, it is possible for ships to reach nearly any part of the Midwest from nearly any part of the Gulf or East coasts. The result is not just a massive ability to grow a massive amount of crops — and not just the ability to easily and cheaply move the crops to local, regional and global markets — but also the ability to use that same transport network for any other economic purpose without having to worry about food supplies.

The implications of such a confluence are deep and sustained. Where most countries need to scrape together capital to build roads and rail to establish the very foundation of an economy, transport capability, geography granted the United States a near-perfect system at no cost. That frees up U.S. capital for other pursuits and almost condemns the United States to be capital-rich. Any additional infrastructure the United States constructs is icing on the cake. (The cake itself is free — and, incidentally, the United States had so much free capital that it was able to go on to build one of the best road-and-rail networks anyway, resulting in even greater economic advantages over competitors.)

Third, geography has also ensured that the United States has very little local competition. To the north, Canada is both much colder and much more mountainous than the United States. Canada's only navigable maritime network — the Great Lakes-St. Lawrence Seaway —is shared with the United States, and most of its usable land is hard by the American border. Often this makes it more economically advantageous for Canadian provinces to integrate with their neighbor to the south than with their co-nationals to the east and west.

Similarly, Mexico has only small chunks of land, separated by deserts and mountains, that are useful for much more than subsistence agriculture; most of Mexican territory is either too dry, too tropical or too mountainous. And Mexico completely lacks any meaningful river system for maritime transport. Add in a largely desert border, and Mexico as a country is not a meaningful threat to American security (which hardly means that there are not serious and ongoing concerns in the American-Mexican relationship).

With geography empowering the United States and hindering Canada and Mexico, the United States does not need to maintain a large standing military force to counter either. The Canadian border is almost completely unguarded, and the Mexican border is no more than a fence in most locations — a far cry from the sort of military standoffs that have marked more adversarial borders in human history. Not only are Canada and Mexico not major threats, but the U.S. transport network allows the United States the luxury of being able to quickly move a smaller force to deal with occasional problems rather than requiring it to station large static forces on its borders.

Like the transport network, this also helps the U.S. focus its resources on other things.

Taken together, the integrated transport network, large tracts of usable land and lack of a need for a standing military have one critical implication: The U.S. government tends to take a hands-off approach to economic management, because geography has not cursed the United States with any endemic problems. This may mean that the United States — and especially its government — comes across as disorganized, but it shifts massive amounts of labor and capital to the private sector, which for the most part allows resources to flow to wherever they will achieve the most efficient and productive results.

Laissez-faire capitalism has its flaws. Inequality and social stress are just two of many less-than-desirable side effects. The side effects most relevant to the current situation are, of course, the speculative bubbles that cause recessions when they pop. But in terms of long-term economic efficiency and growth, a free capital system is unrivaled. For the United States, the end result has proved clear: The United States has exited each decade since post-Civil War Reconstruction more powerful than it was when it entered it. While there are many forces in the modern world that threaten various aspects of U.S. economic standing, there is not one that actually threatens the U.S. base geographic advantages.

Is the United States in recession? Of course. Will it be forever? Of course not. So long as U.S. geographic advantages remain intact, it takes no small amount of paranoia and pessimism to envision anything but long-term economic expansion for such a chunk of territory. In fact, there are a number of factors hinting that the United States may even be on the cusp of recovery.

Russia and the State

If in economic terms the United States has everything going for it geographically, then Russia is just the opposite. The Russian steppe lies deep in the interior of the Eurasian landmass, and as such is subject to climatic conditions much more hostile to human habitation and agriculture than is the American Midwest. Even in those blessed good years when crops are abundant in Russia, it has no river network to allow for easy transport of products.

Russia has no good warm-water ports to facilitate international trade (and has spent much of its history seeking access to one). Russia does have long rivers, but they are not interconnected as the Mississippi is with its tributaries, instead flowing north to the Arctic Ocean, which can support no more than a token population. The one exception is the Volga, which is critical to Western Russian commerce but flows to the Caspian, a storm-wracked and landlocked sea whose delta freezes in the winter (along with the entire Volga itself). Developing such unforgiving lands requires a massive outlay of funds simply to build the road and rail networks necessary to achieve the most basic of economic development. The cost is so extreme that Russia's first ever intercontinental road was not completed until the 21st century, and it is little more than a two-lane path for much of its length. Between the lack of ports and the relatively low population densities, little of Russia's transport system beyond the St. Petersburg/Moscow corridor approaches anything that hints of economic rationality.

Russia also has no meaningful external borders. It sits on the eastern end of the North European Plain, which stretches all the way to Normandy, France, and Russia's connections to the Asian steppe flow deep into China. Because Russia lacks a decent internal transport network that can rapidly move armies from place to place, geography forces Russia to defend itself following two strategies. First, it requires massive standing armies on all of its borders. Second, it dictates that Russia continually push its boundaries outward to buffer its core against external threats.

Both strategies compromise Russian economic development even further. The large standing armies are a continual drain on state coffers and the country's labor pool; their cost was a critical economic factor in the Soviet fall. The expansionist strategy not only absorbs large populations that do not wish to be part of the Russian state and so must constantly be policed — the core rationale for Russia's robust security services — but also inflates Russia's infrastructure development costs by increasing the amount of relatively useless territory Moscow is responsible for.

Russia's labor and capital resources are woefully inadequate to overcome the state's needs and vulnerabilities, which are legion. These endemic problems force Russia toward central planning; the full harnessing of all economic resources available is required if Russia is to achieve even a modicum of security and stability. One of the many results of this is severe economic inefficiency and a general dearth of an internal consumer market. Because capital and other resources can be flung forcefully at problems, however, active management can achieve specific national goals more readily than a hands-off, American-style model. This often gives the impression of significant progress in areas the Kremlin chooses to highlight.

But such achievements are largely limited to wherever the state happens to be directing its attention. In all other sectors, the lack of attention results in atrophy or criminalization. This is particularly true in modern Russia, where the ruling elite comprises just a handful of people, starkly limiting the amount of planning and oversight possible. And unless management is perfect in perception and execution, any mistakes are quickly magnified into national catastrophes. It is therefore no surprise to STRATFOR that the Russian economy has now fallen the furthest of any major economy during the current recession.

China and Separatism

China also faces significant hurdles, albeit none as daunting as Russia's challenges. China's core is the farmland of the Yellow River basin in the north of the country, a river that is not readily navigable and is remarkably flood prone. Simply avoiding periodic starvation requires a high level of state planning and coordination. (Wrestling a large river is not the easiest thing one can do.) Additionally, the southern half of the country has a subtropical climate, riddling it with diseases that the southerners are resistant to but the northerners are not. This compromises the north's political control of the south.

Central control is also threatened by China's maritime geography. China boasts two other rivers, but they do not link to each other or the Yellow naturally. And China's best ports are at the mouths of these two rivers: Shanghai at the mouth of the Yangtze and Hong Kong/Macau/Guangzhou at the mouth of the Pearl. The Yellow boasts no significant ocean port. The end result is that other regional centers can and do develop economic means independent of Beijing.

With geography complicating northern rule and supporting southern economic independence, Beijing's age-old problem has been trying to keep China in one piece. Beijing has to underwrite massive (and expensive) development programs to stitch the country together with a common infrastructure, the most visible of which is the Grand Canal that links the Yellow and Yangtze rivers. The cost of such linkages instantly guarantees that while China may have a shot at being unified, it will always be capital-poor.

Beijing also has to provide its autonomy-minded regions with an economic incentive to remain part of Greater China, and "simple" infrastructure will not cut it. Modern China has turned to a state-centered finance model for this. Under the model, all of the scarce capital that is available is funneled to the state, which divvies it out via a handful of large state banks. These state banks then grant loans to various firms and local governments at below the cost of raising the capital. This provides a powerful economic stimulus that achieves maximum employment and growth — think of what you could do with a near-endless supply of loans at below 0 percent interest — but comes at the cost of encouraging projects that are loss-making, as no one is ever called to account for failures. (They can just get a new loan.) The resultant growth is rapid, but it is also unsustainable. It is no wonder, then, that the central government has chosen to keep its $2 trillion of currency reserves in dollar-based assets; the rate of return is greater, the value holds over a long period, and Beijing doesn't have to worry about the United States seceding.

Because the domestic market is considerably limited by the poor-capital nature of the country, most producers choose to tap export markets to generate income. In times of plenty this works fairly well, but when Chinese goods are not needed, the entire Chinese system can seize up. Lack of exports reduces capital availability, which constrains loan availability. This in turn not only damages the ability of firms to employ China's legions of citizens, but it also removes the primary reason the disparate Chinese regions pay homage to Beijing. China's geography hardwires in a series of economic challenges that weaken the coherence of the state and make China dependent upon uninterrupted access to foreign markets to maintain state unity. As a result, China has not been a unified entity for the vast majority of its history, but instead a cauldron of competing regions that cleave along many different fault lines: coastal versus interior, Han versus minority, north versus south.

China's survival technique for the current recession is simple. Because exports, which account for roughly half of China's economic activity, have sunk by half, Beijing is throwing the equivalent of the financial kitchen sink at the problem. China has force-fed more loans through the banks in the first four months of 2009 than it did in the entirety of 2008. The long-term result could well bury China beneath a mountain of bad loans — a similar strategy resulted in Japan's 1991 crash, from which Tokyo has yet to recover. But for now it is holding the country together. The bottom line remains, however: China's recovery is completely dependent upon external demand for its production, and the most it can do on its own is tread water.

Discordant Europe

Europe faces an imbroglio somewhat similar to China's.

Europe has a number of rivers that are easily navigable, providing a wealth of trade and development opportunities. But none of them interlinks with the others, retarding political unification. Europe has even more good harbors than the United States, but they are not evenly spread throughout the Continent, making some states capital-rich and others capital-poor. Europe boasts one huge piece of arable land on the North European Plain, but it is long and thin, and so occupied by no fewer than seven distinct ethnic groups.

These groups have constantly struggled — as have the various groups up and down Europe's seemingly endless list of river valleys — but none has been able to emerge dominant, due to the webwork of mountains and peninsulas that make it nigh impossible to fully root out any particular group. And Europe's wealth of islands close to the Continent, with Great Britain being only the most obvious, guarantee constant intervention to ensure that mainland Europe never unifies under a single power.

Every part of Europe has a radically different geography than the other parts, and thus the economic models the Europeans have adopted have little in common. The United Kingdom, with few immediate security threats and decent rivers and ports, has an almost American-style laissez-faire system. France, with three unconnected rivers lying wholly in its own territory, is a somewhat self-contained world, making economic nationalism its credo. Not only do the rivers in Germany not connect, but Berlin has to share them with other states. The Jutland Peninsula interrupts the coastline of Germany, which finds its sea access limited by the Danes, the Swedes and the British. Germany must plan in great detail to maximize its resource use to build an infrastructure that can compensate for its geographic deficiencies and link together its good — but disparate — geographic blessings. The result is a state that somewhat favors free enterprise, but within the limits framed by national needs.

And the list of differences goes on: Spain has long coasts and is arid; Austria is landlocked and quite wet; most of Greece is almost too mountainous to build on; it doesn't get flatter than the Netherlands; tiny Estonia faces frozen seas in the winter; mammoth Italy has never even seen an icebreaker. Even if there were a supranational authority in Europe that could tax or regulate the banking sector or plan transnational responses, the propriety of any singular policy would be questionable at best.

Such stark regional differences give rise to such variant policies that many European states have a severe (and understandable) trust deficit when it comes to any hint of anything supranational. We are not simply taking about the European Union here, but rather a general distrust of anything cross-border in nature. One of the many outcomes of this is a preference for using local banks rather than stock exchanges for raising capital. After all, local banks tend to use local capital and are subject to local regulations, while stock exchanges tend to be internationalized in all respects. Spain, Italy, Sweden, Greece and Austria get more than 90 percent of their financing from banks, the United Kingdom 84 percent and Germany 76 percent — while for the United States it is only 40 percent.

And this has proved unfortunate in the extreme for today's Europe. The current recession has its roots in a financial crisis that has most dramatically impacted banks, and European banks have proved far from immune. Until Europe's banks recover, Europe will remain mired in recession. And since there cannot be a Pan-European solution, Europe's recession could well prove to be the worst of all this time around.

Credit Crisis Watch

John Mauldin — Tue, 26 May 2009 16:49:31 GMT

This week we look at a number of charts of various parts of the credit markets to see what kind of progress is being made on getting back to "normal" or to a "new normal." And my friend Prieur du Plessis shows us there is reason to believe that we have seen the worst.

"This too shall pass" are words we should all take to heart. Things will neither stay on permanently high or low plateaus. Those doom and gloomers who expect the world to keep devolving back to some pastoral age of scarcity where we will all need those guns and freeze dried food will be disappointed. We are simply hitting the re-set button on many of our institutions and businesses, and while the adjustment is painful, we will eventually get through it. Today's Outside the Box is a kind of map that tells us where we are in the process.

Dr Prieur du Plessis is chairman of Plexus Asset Management and writes the Investment Postcards from Cape Town blog (www.investmentpostcards.com). Click here to subscribe to e-mail updates to the blog.

John Mauldin, Editor
Outside the Box

Credit Crisis Watch: Thawing – noteworthy progress

Are the various central bank liquidity facilities and capital injections having the desired effect of unclogging credit markets and restoring confidence in the world's financial system? This is precisely what the "Credit Crisis Watch" is all about – a review of a number of measures in order to ascertain to what extent the thawing of credit markets is taking place.

First up is the LIBOR rate. This is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for "London InterBank Offered Rate" and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world. The higher the LIBOR rate, the greater the stress on credit markets.

Interbank lending rates – the three-month dollar, euro and sterling LIBOR rates – declined to record lows last week, indicating the easing of strain in the financial system. After having peaked at 4.82% on October 10, the three-month dollar LIBOR rate declined to 0.66% on Friday. LIBOR is therefore trading at 41 basis points above the upper band of the Fed's target range – a substantial improvement, but still high compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Importantly, US three-month Treasury Bills have edged up after momentarily trading in negative territory in December as nervous investors "warehoused" their money while receiving no return. The fact that some safe-haven money has started coming out of the Treasury market is a good sign.

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the peak of the TED spread at 4.65% on October 10, the measure has eased to an 11-month low of 0.48%. This is a vast improvement, although still somewhat above the 38-point spread it averaged in the 12 months prior to the start of the crisis.

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk. The opposite applies to a narrowing LIBOR-OIS spread.

Similar to the TED spread, the narrowing in the LIBOR-OIS spread since October is also a move in the right direction.

Further evidence that the convalescence process is on track comes in the form of data showing a sharp decline in borrowing by primary institutions at the discount window – down by almost 65% since the "panic peak" recorded during the week of October 29, 2008.

The Fed's Senior Loan Officer Opinion Survey of early May serves as an important barometer of confidence levels in credit markets. Asha Bangalore (Northern Trust) said: "The number of loan officers reporting a tightening of underwriting standards for commercial and industrial loans in the April survey was significantly smaller for large firms (39.6% versus peak of 83.6% in the fourth quarter) and small firms (42.3% versus peak of 74.5% in the fourth quarter) compared with the February survey and the peak readings of the fourth quarter of 2008."

"In the household sector, the demand for prime mortgage loans posted a jump, while that of non-traditional mortgages was less weak in the latest survey compared with the February survey. At the same time, mortgage underwriting standards were tighter for both prime and non-traditional mortgages in the April survey compared with the February survey," said Bangalore. In other words, more needs to be done by the lending institutions to revive mortgage lending.

The spreads between 10-year Fannie Mae and other Government-sponsored Enterprise (GSE) bonds and 10-year US Treasury Notes have compressed significantly since the highs in November. In the case of Fannie Mae, the spread plunged from 175 to 26 basis points at the beginning of May, but have since kicked up to 37 basis points on the back of the rise in Treasury yields.

After hitting a peak of 6.51% in July last year, there was a marked decline in the average rate for a US 30-year mortgage. However, the rise in the yields of longer-dated government bonds over the past nine weeks – 92 basis points in the case of US 10-year Treasury Notes – resulted in mortgage rates creeping higher since the April lows. Also, the lower interest rates are not being passed on to consumers, as seen from the 434 basis-point spread of the 30-year mortgage rate compared with the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis.

Fed Chairman Ben Bernanke said earlier in May that "mortgage credit is still relatively tight", as reported by Bloomberg. This raises the possibility that the Fed will boost its purchases of Treasuries to keep the cost of consumer borrowing from rising further. [The Fed has so far bought $95.7 billion of Treasury securities from $300 billion earmarked for this purpose. Similarly, purchases of agency debt of $71.5 (out of $200 billion) and mortgage-backed securities of $365.8 billion (out of $1.25 trillion) have taken place.]

As far as commercial paper is concerned, the A2/P2 spread measures the difference between A2/P2 (low-quality) and AA (high-quality) 30-day non-financial commercial paper. The spread has plunged to 48 basis points from almost 5% at the end of December.

Similarly, junk bond yields have also declined, as shown by the Merrill Lynch US High Yield Index. The Index dropped by 44.4% to 1,213 from its record high of 2,182 on December 15. This means the spread between high-yield debt and comparable US Treasuries was 1,213 basis points by the close of business on Friday. With the US 10-year Treasury Note yield at 3.45%, high-yield borrowers have to pay 15.58% per year to borrow money for a 10-year period. At these rates it remains practically impossible for companies with a less-than-perfect credit status to conduct business profitably.

Another indicator worth monitoring is the Barron's Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been a solid improvement in the ratio since its all-time low in December, showing that bond investors are growing more confident and have started opting for more speculative bonds over high-grade bonds.

According to Markit, the cost of buying credit insurance for American, European, Japanese and other Asian companies has improved strongly since the peaks in November. This is illustrated by a significant narrowing of the spreads for the five-year credit derivative indices. By way of example, the graphs of the North American investment-grade and high-yield CDX Indices are shown below (the red line indicates the spread).

In summary, the past few months have seen impressive progress on the credit front, with a number of spreads having declined substantially since their "panic peaks". The TED spread (down to 0.48% from 4.65% on October 10), LIBOR-OIS spread (down to 0.45%% from 3.64% on October 10) and GSE mortgage spreads have all narrowed considerably since the record highs.

In addition, corporate bonds have seen a strong improvement, although high-yield spreads remain at elevated levels. Credit derivative indices for companies in all the major geographical regions have also shown a marked tightening since the November highs.

Most indications are that the credit market tide has turned on the back of the massive reflation efforts orchestrated by central banks worldwide and that the credit system has started thawing. However, although the convalescence process seems to be well on track, it still has a way to go before confidence in the world's financial system returns to more "normal" levels, liquidity starts to flow freely again, and the economic recovery can commence.

* Dr Prieur du Plessis is chairman of Plexus Asset Management and writes the Investment Postcards from Cape Town blog (www.investmentpostcards.com). Click here to subscribe to e-mail updates to the blog.

An Israeli Prime Minister Comes to Washington Again

John Mauldin — Thu, 21 May 2009 13:37:00 GMT

Dear Friends –

Occasionally I need a fast answer. So I'll run a Google search, and 2.54 MILLION responses later I've learned how to handle a Thanksgiving turkey-roasting crisis but nothing useful about Turkey's financial crisis.

There's certainly no shortage of data these days. But what's in all-too-short supply is understanding. As investors, what creates opportunities isn't access to data but to ways of thinking about the world. I created Outside the Box precisely for this reason, to share with you some of the best thinkers in the world and some of the best ways to think about investments.

To understand how geopolitical events impact your investments, there's simply no one better than my friend George Friedman and his team at STRATFOR. They couple objective facts with unbiased context and analysis so you know what it all means for you. This understanding is a critical piece of my investment formula, and I strongly encourage you to click here to take advantage of a special offer that George is offering my readers.

In the meantime, take a look at this article about Israel, the U.S., and the chance for peace in the Middle East. If you've ever wondered why this conflict doesn't have a simple, Hollywood resolution, you'll be blown away by the clarity George provides.

To Understanding,
John Mauldin

An Israeli Prime Minister Comes to Washington Again

By George Friedman

Obstacles to the Two-State Solution

The foundation of the Israeli-Palestinian peace process for years has been the assumption that there would be a two-state solution. Such a solution has not materialized for a host of reasons. First, at present there are two Palestinian entities, Gaza and the West Bank, which are hostile to each other. Second, the geography and economy of any Palestinian state would be so reliant on Israel that independence would be meaningless; geography simply makes the two-state proposal almost impossible to implement. Third, no Palestinian government would have the power to guarantee that rogue elements would not launch rockets at Israel, potentially striking at the Tel Aviv-Jerusalem corridor, Israel's heartland. And fourth, neither the Palestinians nor the Israelis have the domestic political coherence to allow any negotiator to operate from a position of confidence. Whatever the two sides negotiated would be revised and destroyed by their political opponents, and even their friends.

For this reason, the entire peace process — including the two-state solution — is a chimera. Neither side can live with what the other can offer. But if it is a fiction, it is a fiction that serves U.S. purposes. The United States has interests that go well beyond Israeli interests and sometimes go in a different direction altogether. Like Israel, the United States understands that one of the major obstacles to any serious evolution toward a two-state solution is Arab hostility to such an outcome.

The Jordanians have feared and loathed Fatah in the West Bank ever since the Black September uprisings of 1970. The ruling Hashemites are ethnically different from the Palestinians (who constitute an overwhelming majority of the Jordanian population), and they fear that a Palestinian state under Fatah would threaten the Jordanian monarchy. For their part, the Egyptians see Hamas as a descendent of the Muslim Brotherhood, which seeks the Mubarak government's ouster — meaning Cairo would hate to see a Hamas-led state. Meanwhile, the Saudis and the other Arab states do not wish to see a radical altering of the status quo, which would likely come about with the rise of a Palestinian polity.

At the same time, whatever the basic strategic interests of the Arab regimes, all pay lip service to the principle of Palestinian statehood. This is hardly a unique situation. States frequently claim to favor various things they actually are either indifferent to or have no intention of doing anything about. Complicating matters for the Arab states is the fact that they have substantial populations that do care about the fate of the Palestinians. These states thus are caught between public passion on behalf of Palestinians and the regimes' interests that are threatened by the Palestinian cause. The states' challenge, accordingly, is to appear to be doing something on behalf of the Palestinians while in fact doing nothing.

The United States has a vested interest in the preservation of these states. The futures of Egypt, Saudi Arabia and the Gulf states are of vital importance to Washington. The United States must therefore simultaneously publicly demonstrate its sensitivity to pressures from these nations over the Palestinian question while being careful to achieve nothing — an easy enough goal to achieve.

The various Israeli-Palestinian peace processes have thus served U.S. and Arab interests quite well. They provide the illusion of activity, with high-level visits breathlessly reported in the media, succeeded by talks and concessions — all followed by stalemate and new rounds of violence, thus beginning the cycle all over again.

The Palestinian Peace Process as Political Theater

One of the most important proposals Netanyahu is bringing to Obama calls for reshaping the peace process. If Israeli President Shimon Peres is to be believed, Netanyahu will not back away from the two-state formula. Instead, the Israeli prime minister is asking that the various Arab state stakeholders become directly involved in the negotiations. In other words, Netanyahu is proposing that Arab states with very different public and private positions on Palestinian statehood be asked to participate — thereby forcing them to reveal publicly their true positions, ultimately creating internal political crises in the Arab states.

The clever thing about this position is that Netanyahu not only knows his request will not become a reality, but he also does not want it to become a reality. The political stability of Jordan, Saudi Arabia and Egypt is as much an Israeli interest as an American one. Indeed, Israel even wants a stable Syria, since whatever would come after the Alawite regime in Damascus would be much more dangerous to Israeli security than the current Syrian regime.

Overall, Israel is a conservative power. In terms of nation-states, it does not want upheaval; it is quite content with the current regimes in the Arab world. But Netanyahu would love to see an international conference with the Arab states roundly condemning Israel publicly. This would shore up the justification for Netanyahu's policies domestically while simultaneously creating a framework for reshaping world opinion by showing an Israel isolated among hostile states.

Obama is likely hearing through diplomatic channels from the Arab countries that they do not want to participate directly in the Palestinian peace process. And the United States really does not want them there, either. The peace process normally ends in a train wreck anyway, and Obama is in no hurry to see the wreckage. He will want to insulate other allies from the fallout, putting off the denouement of the peace process as long as possible. Obama has sent George Mitchell as his Middle East special envoy to deal with the issue, and from the U.S. president's point of view, that is quite enough attention to the problem.

Netanyahu, of course, knows all this. Part of his mission is simply convincing his ruling coalition — and particularly Lieberman, whom Netanyahu needs to survive, and who is by far Israel's most aggressive foreign minister ever — that he is committed to redefining the entire Israeli-Palestinian relationship. But in a broader context, Netanyahu is looking for greater freedom of action. By posing a demand the United States will not grant, Israel is positioning itself to ask for something that appears smaller.

Israel and the Appearance of Freedom of Action

What Israel actually would do with greater freedom of action is far less important than simply creating the appearance that the United States has endorsed Israel's ability to act in a new and unpredictable manner. From Israel's point of view, the problem with Israeli-Palestinian relations is that Israel is under severe constraints from the United States, and the Palestinians know it. This means that the Palestinians can even anticipate the application of force by Israel, meaning they can prepare for it and endure it. From Netanyahu's point of view, Israel's primary problem is that the Palestinians are confident they know what the Israelis will do. If Netanyahu can get Obama to introduce a degree of ambiguity into the situation, Israel could regain the advantage of uncertainty.

The problem for Netanyahu is that Washington is not interested in having anything unpredictable happen in Israeli-Palestinian relations. The United States is quite content with the current situation, particularly while Iraq becomes more stable and the Afghan situation remains unstable. Obama does not want a crisis from the Mediterranean to the Hindu Kush. The fact that Netanyahu has a political coalition to satisfy will not interest the United States, and while Washington at some unspecified point might endorse a peace conference, it will not be until Israel and its foreign minister endorse the two-state formula.

Netanyahu will then shift to another area where freedom of action is relevant — namely, Iran. The Israelis have leaked to the Israeli media that the Obama administration has told them that Israel may not attack Iran without U.S. permission, and that Israel agreed to this requirement. (U.S. President George W. Bush and Israeli Prime Minister Ehud Olmert went through the same routine not too long ago, using a good cop/bad cop act in a bid to kick-start negotiations with Iran.)

In reality, Israel would have a great deal of difficulty attacking Iranian facilities with non-nuclear forces. A multitarget campaign 1,000 miles away against an enemy with some air defenses could be a long and complex operation. Such a raid would require a long trip through U.S.-controlled airspace for the fairly small Israeli air force. Israel could use cruise missiles, but the tonnage of high explosive delivered by a cruise missile cannot penetrate even moderately hardened structures; the same is true for ICBMs carrying conventional warheads. Israel would have to notify the United States of its intentions because it would be passing through Iraqi airspace — and because U.S. technical intelligence would know what it was up to before Israeli aircraft even took off. The idea that Israel might consider attacking Iran without informing Washington is therefore absurd on the surface. Even so, the story has surfaced yet again in an Israeli newspaper in a virtual carbon copy of stories published more than a year ago.

Netanyahu has promised that the endless stalemate with the Palestinians will not be allowed to continue. He also knows that whatever happens, Israel cannot threaten the stability of Arab states that are by and large uninterested in the Palestinians. He also understands that in the long run, Israel's freedom of action is defined by the United States, not by Israel. His electoral platform and his strategic realities have never aligned. Arguably, it might be in the Israeli interest that the status quo be disrupted, but it is not in the American interest. Netanyahu therefore will get to redefine neither the Palestinian situation nor the Iranian situation. Israel simply lacks the power to impose the reality it wants, the current constellation of Arab regimes it needs, and the strategic relationship with the United States on which Israeli national security rests.

In the end, this is a classic study in the limits of power. Israel can have its freedom of action anytime it is willing to pay the price for it. But Israel can't pay the price. Netanyahu is coming to Washington to see if he can get what he wants without paying the price, and we suspect strongly he knows he won't get it. His problem is the same as that of the Arab states. There are many in Israel, particularly among Netanyahu's supporters, who believe Israel is a great power. It isn't. It is a nation that is strong partly because it lives in a pretty weak neighborhood, and partly because it has very strong friends. Many Israelis don't want to be told that, and Netanyahu came to office playing on the sense of Israeli national power.

So the peace process will continue, no one will expect anything from it, the Palestinians will remain isolated and wars regularly will break out. The only advantage of this situation from the U.S. point of view it is that it is preferable to all other available realities.

The End Game Draws Nigh - The Future Evolution of the Debt-to-GDP Ratio

John Mauldin — Mon, 18 May 2009 21:38:20 GMT

Nearly everyone I talk with has the sense that we are at some critical point in our economic and national paths, not just in the US but in the world. One path will lead us back to relative growth and another set of choices leads us down a path which will put a very real drag on economic growth and recovery. For most of us, there is very little we can do (besides vote and lobby) about the actual choices. What we can do is adjust our personal portfolios to be synchronized with the direction of the economy. The question is "What will that direction be?"

Today we are going to look at what I think is a very clear roadmap given to us by Dr. Woody Brock, the head of Strategic Economic Decisions and one of the smartest analysts I have come in contact with over the years. This week's Outside the Box is his recent essay, "The End Games Draws Nigh." For those who have the contacts in government, I urge you to put this piece into the correct hands so that Woody's very distinct message gets out. I think this is one of the most important Outside the Box letters I have sent out.

Woody normally does not allow his work to go beyond the circles of his clients, but I suggested to him that this piece was quite macro in cope and important for both individuals and policy makers everywhere to understand. In my own simple terms, trees cannot grow in some unlimited manner to the sky. Families cannot grow debt without limit beyond the growth of their incomes. And countries have the same constraints. While growth of debt in the short term is viable, growth of debt faster than the growth of GDP is not viable over the long run. This is not debatable. It is a simple fact. Therefore, as Woody says, it is important that you get the growth side of the equation right as you increase the debt side. Without the proper balance, you are heading for disaster.

From his intro:

"We weave these three concepts together so as to make possible an extension and generalization of "macroeconomic policy" as normally understood. Central to this extension is the need for policies that drive down the nation's Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time. Doing so not only points to a new set of policies for exiting today's quagmire, but also permits an appraisal of the Obama administration's current policy proposals. Regrettably these proposals do not fare well with respect to growth. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere."

This is longer than the usual Outside the Box, and will require you to put on your thinking cap. But you need to digest this, and especially the conclusions. But it is very important that you understand the principles and concepts Woody discusses. We are at a very critical juncture, and the paths we choose will have profound impacts on our lives and fortunes. I cannot overemphasize the point. If we choose a path of growing debt faster than we can grow GDP, the negative implications for many traditional asset classes are enormous.

Let me again thank Woody for allowing me to send this on to you. And for those who post this letter on various sites, just be sure to include a link to Woody's website, www.sedinc.com. For those interested in his subscription service you can contact Woody at woody@sedinc.com or visit his website.

Thanks,

John Mauldin, Editor
Outside the Box

The End Game Draws Nigh – The Future Evolution of the Debt-to-GDP Ratio

By Horace "Woody" Brock, Ph.D.

Preface: In this new report, we link together three quite different concepts that have been discussed in these publications during recent years. First, the problems posed for classical fiscal and monetary policy when extremely large deficits must be financed; second, the critical importance of the rate of economic growth as primus inter pares of all economic variables; and third, the all-important concept of "incentive-structure-compatibility" introduced by Leonid Hurwicz in the 1960s, and recognized in the award to him in 2007 of the Nobel Memorial Prize.

We weave these three concepts together so as to make possible an extension and generalization of "macroeconomic policy" as normally understood. Central to this extension is the need for policies that drive down the nation's Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time.

Doing so not only points to a new set of policies for exiting today's quagmire, but also permits an appraisal of the Obama administration's current policy proposals. Regrettably these proposals do not fare well. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere.

A. Introduction and Overview

In our 2008 research programme, we focused on three issues. First, what exactly caused the worst credit crunch the nation has arguably experienced since the depression of the 1930s? Second, how did the downturn in the US morph into a collapse in Planet Earth's GDP rate from nearly 5% in June 2008 to -0.5% in winter 2009? Third, can traditional macroeconomic policy suffice to turn around the economy? More specifically, will a killer application of classical fiscal and monetary policy truly restore the economy to a stable growth trajectory? Or is there an internal contradiction within macroeconomic policy that could prevent it from succeeding this time around?

To explain the "perfect storm" in the credit market, we drew extensively on the new Stanford theory of endogenous risk to demonstrate that there are three jointly necessary and sufficient conditions to predict and explain the perfect storm we have experienced: (i) A mistaken market forecast of some exogenous event that impacts security prices (in this case, a vastly higher than expected default rate on mortgages); (ii) A high level of Pricing Model Uncertainty bedeviling bank assets (the true cause of the "toxicity" of those complex securities that have clogged the

arteries of the banking sector); and (iii) An unprecedentedly high degree of leverage in the financial sector (money center banks had off-and-on balance sheet leverage of about 40:1 in contrast to the socially optimal leverage of 10:1). The reader can tack "greed" and "incompetence" onto this triad, although doing so diverts attention from the real causes of today's crisis.

To explain the collapse of economic growth worldwide in an astonishingly short period, we utilized a game theory model that explained how the cessation of inter-bank lending amongst the principal money center banks of the world precipitated the first known case of global credit market emphysema: The availability of credit dried up almost everywhere in the course of six months, from Auckland to Iceland. We stressed that this credit contraction had little to do with "globalization" as properly understood, and had no counter-part in history.

To explain the potential failure of fiscal and monetary policy in restoring growth, we demonstrated how the financing of exceptionally large government deficits usually causes a sharp rise in longer-term real interest rates—a rise that bites back and offsets the GDP impact of the fiscal stimulus being applied. The logic leading to this conclusion is reviewed just below in the context of Figure 2.

B. The Good News — A World of Greatly Reduced Uncertainty

A year ago, even six months ago, the great debate centered on whether the credit market crisis would precipitate either a US or global recession. A majority predicted a manageable recession in the US, but nowhere else with the possible exception of the UK. Uncertainty was great, and kept increasing until recently—but no longer. The good news today is that this uncertainty has disappeared. For we now know with probability 1 that everything sucks everywhere. Welcome to a risk free world!

To wit, the G-7 economies are all in recession, and more astonishingly the economy of the planet earth is growing at about -1% or even less. Earnings are crumbling, global trade has decreased by nearly 10%, rising global unemployment foretokens social unrest in many quarters, industrial production has dropped more than ever before, and excess capacity is rising in almost all manufacturing sectors globally. Stephen Roach of Morgan Stanley believes that the "world output gap" could reach a mind boggling 8%–10% by year end. All in all, we have witnessed problems that originated within the US give rise to global scenarios that were virtually unthinkable as recently as the summer of 2008, and do so with blinding speed.

Within the US, there are two parallel problems. First, the nation faces a hitherto unprecedented growth of Federal debt, over both the short and long run. Second, there is the severity of the recession itself. Figure 1 offers a simple way of understanding what killed growth in the US economy. The variables shown remind us of the old adage that "History rhymes, but does not repeat."

History Rhymes: More specifically, the contents of the figure will disturb those seeking to identify today's US recession with earlier ones in 2001 or 1991 or 1981 or 1973 or even 1931. No such identification is possible since the three developments highlighted in the chart and their improbable synergies are different from anything we have seen before. This sui generic nature of today's crisis explains why traditional theories of recessions and "debt super-cycles" possess little explanatory and predictive power.

For example, according to standard business cycle theory, "pent-up demand" on the part of consumers is a principal driver of recovery—but it will not be this time around. The shift towards less consumption and more savings due to the implosion of household balance sheets and to demographics is most probably permanent. If so, this bodes poorly for hopes of a pent-updemand-driven recovery.

History Repeats: While the context of today's crisis differs from those in the past, history repeats itself in that the common denominator of this and all other debt crises has been excess leverage—our mantra in these pages for three years. Our greatest fear was that the all-important role of leverage would be sidestepped in the rush to assign blame and reform the financial system. In this regard, it is dismaying that, whereas we have now vented our anger at bankers and capped bonuses, we have not capped leverage. To be sure, there are calls for "improved bank capitalization" and related reforms, but the crucial role of excess leverage in bringing down the global financial system has not been properly recognized. Instead, excess "greed" has been the principal focus.

Then again, from a game theoretic viewpoint, it may not be surprising that the role of leverage has been underplayed. For leverage is precisely what is required for financiers to reap those huge incomes needed to fund both political parties in Washington, not to mention those "blockbuster" exhibitions we all love so much at the Metropolitan Museum of Art in New York. Stay tuned for Loophole Analysis 101.

C. The Bad News — Two New Uncertainties

Two new uncertainties are now rising to the fore. First, will traditional fiscal and monetary policy suffice to restore economic growth—and in the process restore the viability of the financial sector? Without the latter, there is little hope of revived growth. Our concerns about the inadequacy of traditional macroeconomic policy were discussed at length in our February 2009 PROFILE, and are summarized in Figure 2 taken from that analysis. The flattening out of the stimulus curve in the figure reflects that, when fiscal stimulus exceeds a certain level (e.g., 7% on the horizontal axis), the financing of deficits is likely to cause a sharp increase in real longer-term interest rates. Importantly, this holds true regardless of whether the huge deficits are monetized for reasons we carefully articulated. Higher real yields in turn neutralize the original fiscal stimulus, thus causing the curve to flatten out.¹

We concluded that the risks of policy failure in today's context are disturbing. Moreover, even if traditional policies do prove successful in the shorter run, there is a genuine risk that the huge amount of debt that accrues and must be serviced in the future could transform the US into a "banana republic" in the much longer run. This risk is heightened by the need to fund soaring Social Security and Medicare "entitlements," as record numbers of baby-boomers retire during the next two decades. Moreover, as time goes on, it is precisely these longer-term risks that will matter most to the market, and will increasingly be discounted. Investors of every stripe will be impacted.

The second new uncertainty focuses on whether new and different fiscal and monetary policies can help salvage matters, and guarantee a happier ending.

If the effectiveness of traditional macroeconomic remedies is in doubt, can its arsenal of policies be expanded so as to restore strong longer-term equilibrium growth? The answer is yes, and it is the purpose of this new essay to sketch such an extension of classical macroeconomics.

D. The Critical Dynamics of the Debt-to-GDP Ratio

There is nothing new about a nation running into trouble and running up large amounts of debt in bailing itself out. There is also nothing new about attempting to monetize (via "quantitative easing") the resulting accumulation of debt. The good news for the US is that its total federal debt of some $10T at the outset of the crisis in 2008 was a manageable 70% of current GDP of $14T.² Suppose debt rises $3T by the end of 2011 as the Congressional Budget Office now predicts, and then rises $7T more by 2020. The result will have been a doubling of federal debt between 2008 and 2020, rising from $10T to $20T.³ While this increase is shocking, some forecasts are much worse.

Suppose, moreover, that GDP rises conservatively to $17 trillion in 2020 from today's $14T as a result of a modest 2% GDP growth recovery between 2011 and 2020. Then the federal Debt-to-GDP ratio would rise from today's 0.7 to 1.18. Interestingly, this does not represent the disaster many observers assume. To begin with, there are nations where a disturbingly high Debt-to-GDP ratio proceeded to fall way back down over time. Thus, the US Debt-to-GDP ratio was 1.25 at the end of World War II, yet it fell to 0.25 by 1980. Britain's Debt ratio upon defeating Napoleon in 1815 was over 2.7, and it fell back to 0.2 by the end of the 19^th century.

In other cases, the Debt-to-GDP ratio has stayed persistently high, neither increasing nor decreasing dramatically over time. Thus Japan has had a very high ratio of 1.5 to 1.8 for the past decade. Italy and Belgium, too, have sustained high ratios in the range of 1 to 1.25. Finally, there are the countries where the Debt ratio continues to rise after some initial shock with either hyperinflation or outright default being the end result. Such has been the fate of myriad banana republics including some large players such as Brazil, Argentina and Russia. What exactly determines which nations dig their way out, or else go under? This will be our primary focus in the pages ahead.

Rebounders versus "Banana Republics": To begin with, note that what matters is not a onetime rise in the Debt-to-GDP ratio due to a particular shock (e.g., today's US housing and credit crises), but rather the dynamic trajectory of the ratio in the years subsequent to the initial rise. It is the direction of this trajectory that is all-important. If the Debt ratio continues to rise, then it tends to accelerate due to the ever-rising cost of servicing this ever-rising "primary" deficit. Not only does the increasing debt-load itself cause ever-higher servicing costs, but the rising real rates that typically result from ever-greater debt make the spiral ever worse. The result can be economic and social collapse.

If, on the other hand, the Debt-to-GDP ratio stagnates, it tends to be associated with very low real growth, political paralysis, and a degree of social disenchantment. If the ratio falls, it is usually because of a combination of two developments: higher real growth and vigorous fiscal discipline. Rising living standards, dreams of a better future, and a sustained belief in democracy are associated with this happiest of trajectories.

Three Sets of Scenarios: Figures 3.A – 3.C illustrate the stunning range of outcomes that can result from sustained differences in the growth rates of debt versus of GDP. We have adapted the analysis here to the case of the US. We assume an initial federal debt burden of $12T for 2011, and an initial GDP value of $14T. We then grow these forward at the stipulated growth rates.

At the one extreme of very low economic growth and very high debt growth, the Debt ratio rises to an arresting 18—a half-way house to Zimbabwe. At the opposite extreme, the ratio falls to a paltry 0.4, half of today's level. These two extreme outcomes are circled in the table.

The data in the tables represent real growth rates of both debt and GDP.

E. The Case for Driving Down the Debt-to-GDP Ratio – "It's the Growth Rate, Stupid!"

We can deduce from the foregoing analysis that sustainable long run economic recovery from a debt overload requires two sets of policies: One set must be dedicated to curtailing the growth of government spending and hence, the growth of the deficit. The other set must be dedicated to maximizing real economic growth. In this way, both the numerator and the denominator of the killer Debt-to-GDP ratio will be managed so as to maximize future social welfare.

Policies aimed at augmenting real growth are arguably the more important here. This is because more rapid growth not only reduces the Debt ratio, but also causes swelling tax revenues which can help to reduce the deficit each year. That is, stronger growth drives both the numerator and the denominator in the right directions.

This reality underscores why "It's the real growth rate" must become the mantra of recoveries not only in the US, but almost everywhere else as well. Note that this "strong growth" mantra is a far cry from the Obama administration's counsel to the world at the recent G-7 conference: "Stimulate everywhere by running higher deficits!"

The True Payoffs from Strong Growth: Looking at matters from a game theoretical "Who wins?" standpoint, strong economic growth is the rising tide that lifts all ships. Within a given nation, it alone offers win-win strategies whereby most all interest groups can come out ahead. Externally across nations, strong growth generates expanding trade. Happily, the game of trade between nations is that all-important positive-sum game that encourages peace and discourages war. It creates "the ties that bind." For example, the recent globalization of the supply chain is a principal reason why the business community has been so strangely silent in demanding protectionist policies during the present crisis. When a significant portion of your own manufacturing inputs come from "abroad," do you really want trade barriers?

Finally, and perhaps most importantly, productivity-driven strong growth alone increases living standards that boost the hopes and dreams of people everywhere for a better tomorrow for their children. When citizens have realistic hopes of a better tomorrow, social unrest is minimized. Conversely, when prospects for the long run are grim, voters are easily swayed by demagogues to vote for the Hitler of their day.

Three Important Books: Are these points obvious? They should be, but they frankly are not. Moreover, they are never sufficiently emphasized, and virtually no orientation towards rapid future growth is evident in the policies and "reforms" proposed by the Obama administration, as we see in Section G below. The arguments set forth in three books support the view we are taking as regards the critical role of growth.

First, a widespread lack of understanding and appreciation of growth led Professor Ben Friedman of Harvard University to write his superb book, The Moral Consequences of Economic Growth (A. Knopf, 2005). This is the best work we know of that makes the case for growth and (more implicitly) for globalization at an appropriate economic and moral level of analysis.

Second, and at a more practical level, Alan Beattie's brand new book False Economy: A Surprising Economic History of the World (Riverhead Press, 2009) provides myriad case studies of how nations chose between success or survival or ruin by the specific policies they adopt. His case studies make very clear indeed how policies that depress the Debt-to-GDP ratio of Figure 3 correlate strongly with success, whereas policies that inflate the ratio correlate with ruin.

Third, at an even deeper and more theoretical level, there is the late Mancur Olson's magisterial The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities (Yale University Press, 1982). Olson explains from first principles how special interest groups become entrenched and, in defending their turf, usually cause nations to go bust. [Our "entitlements lobby" anybody?]

Olson's logic is game theoretical: He shows that special interest groups become the principal players in a generalized Prisoner's Dilemma game whereby individually group-rational strategies lead to the collectively irrational outcomes of declining growth, diminishing dreams, increasing social unrest, and ultimately ruin.

This book should be required reading by anyone serving in government. It is one of the best books the present author has ever read in the field of political economy.

F. Four Debt-Minimizing Strategies

Before turning to those all-important strategies for maximizing the growth in the denominator of the Debt-to-GDP ratio, consider several different strategies for minimizing the growth of the numerator.

First, counter-cyclical policies should consist of temporary increases in spending—spending that automatically expires with no Congressional vote when good times return. The Obama administration policies largely amount to permanent spending increases, and have been widely criticized as such.

Second, a new set of government accounts must be introduced that clearly distinguish government investment expenditures from non-investment expenditures. The former should not be included as part of "the deficit." Only an appropriately amortized portion should be included. Moreover, for reasons stressed below, infrastructure investments should take priority when discretionary government spending decisions are made. The current administration has not proposed the required accounting changes. This is, of course, consistent with its failure to propose serious investment spending in the first place (see below).

Third, true leadership—not to be confused with fine rhetoric—is needed to alert citizens to the true disaster we face if the growth of long-term federal debt is not curtailed. This is particularly true given the demographic realities that now lie around the corner. Nobody has made this point better than Stephen Roach in a recent commentary in Morgan Stanley's "Debating the Future of Capitalism" series, March 26, 2009:

I believe that Congress and the White House should collectively declare a formal "fiscal emergency" and empower a bi-partisan task force to develop new guidelines for federal budgetary control.

Washington did this once before in an effort to contain the runaway budget deficits of the Reagan era—deficits that now look like child's play when compared with what lies ahead. The automatic spending caps and sequestration mechanisms prescribed by the GrammRudman-Hollings Balanced Budget and Emergency Deficit Control Acts of 1985 succeeded in taking some of the optionality out of the fiscal debate.

This problem is too big—and the long-term stakes are too high—for fiscal sustainability to be entrusted to the oft-politicized whims of the year-by-year discretionary budgeting process.

Slam Dunk! Given the reality that today's deficit crisis far exceeds that of the Reagan era, it is all the more irresponsible that the President has not already proposed the "fiscal emergency task force" that Roach correctly calls for. Paul Volcker: Where are you when we need you the most? The reforms that such a task force would propose are all pretty obvious, including "sunset provisions" for all manner of government mandates, entitlement reforms, an end of ear-marking, etc.

Fourth, as noted in Section E above, policies must be adopted that maximize economic growth since faster growth is the best way to generate those higher revenues needed to reduce a given deficit. We identify specific growth policies just below.

Lingering Doubts: Even longstanding Democratic Party liberals are now expressing shock at the staggering growth of long-term government debt the US now confronts. Nonetheless, the President's cheerful rhetoric suggests little concern with the growth of the numerator. To be sure, his administration's OMB budget projections blithely assume that very high growth rates will magically return after the next three years, and nothing solves fiscal problems as well as rapid growth. Yet everyone acknowledges that these projections are smoke-and-mirrors, constituting a leadership default of the first magnitude.

Yet could all of this be deliberate? Could the administration's choice to tax and spend ad infinitum have been politically strategic in nature? After all, haven't both President Obama and his chief of staff Rahm Emanuel openly admitted that "the new budget is a means to altering the very architecture of American life, with government playing a much larger role than before"? The likelihood that their new architecture would drive the growth of numerator of the Debt-to-GDP ratio ever-higher and the growth of the denominator lower was never mentioned.

Do financial commentators even understand this risk? While the press has expressed appropriate "concern" about the sea of red ink to come, there is little sense of the true End Game at stake: Which of our Figure 3 scenarios will occur, and what will it imply?

The answer may well determine whether we face a future of peace and prosperity, or of war and privation. As a personal aside, this author has never been more concerned than he is now about the economic state of the nation.

G. Growth-Maximizing Strategies

We now identify a plethora of growth-maximizing policies. Before doing so, however, we must recall the true origins of economic growth itself. Only by understanding these origins can we identify meaningful pro-growth policies.

G. 1. The Two Principal Sources of Real Economic Growth

At the most basic level, trend growth is the sum of workforce growth plus productivity growth. Intuitively, this rate of growth equals the rate of growth of the number of workers producing the pie, plus the rate of increase of pie production per person hour. In the latter case, we distinguish between productivity increases that result solely from "working smarter" versus increases that result from increased investment per worker, or "factor stuffing" in economics jargon. The former is called pure labor productivity growth (e.g., take a weekend off and invent the differential calculus), whereas the latter is referred to as total factor productivity growth.

The very rapid growth of emerging economies is usually due to a very high rate of increase in total factor productivity growth as workers gain access to roads, computers, medicines, and other productivity-improving (but not free!) endowments for the first time. Developed economies cannot replicate this strategy, so their growth rate is much lower than the "catch-up" rates in newer economies.

Thus, policies that augment growth must operate through two channels: Increasing productivity growth (via enhanced skills and investment), and/or increasing workforce growth.

Incentive-Structure-Compatibility: In proposing pro-growth policies of both kinds, we shall keep in mind the requirement that such policies be "incentive-structure-compatible" with growth, a concept first articulated by the economist and philosopher Leonid Hurwicz in the late 1950s. Everyone acknowledges the importance of incentives in a given situation, e.g., the appropriate carrots and sticks needed to raise children, to motivate workers, etc.

What Hurwicz first articulated was the way in which the totality of incentives throughout society—its "incentive structure"—could be conducive to achieving a particular societal goal, such as maximal growth. The great importance of Hurwicz's concept is that it provides the correct analytical bridge between the micro and macro domains of social life. This was a stunning achievement, and earned him the 2007 Nobel Memorial Prize.⁴

Most "policies" and "goals" promulgated by politicians turn out not to be incentivestructure-compatible with growth, or with any other defensible objective. That is to say, most policy proposals are hot air.

Figure 3 summarizes the structure of our argument up to this point.

G.2. Productivity-Enhancing Growth Strategies

During the past three decades, a great deal of research has been done to understand the true sources of productivity growth. In particular, Paul Romer of Stanford University developed his theory of "endogenous growth" in which the rate of productivity growth is determined within the economic system, as opposed to being modeled as an external "residual" as it previously had been. In what follows, we draw on this and related research in an informal manner.

1. Infrastructure-Orientated Fiscal Stimulus: Economists increasingly believe that consumption will fall by 7% from its 72% share of US GDP in 2007 to around 65% over the next three years. Moreover, they believe it will remain at a significantly lower level. Pessimists conclude that "without a recovery of household spending to previous levels, the economy will suffer for a long time." Yet this is not the case.

Should investment spending (both in the corporate sector and in government infrastructure spending) rise by an offsetting 7% of GDP, the growth rate of GDP will not only match, but in fact exceed its old rate of growth. This is due to the role of classical macroeconomic "accelerator/multiplier" theory: A dollar invested will generate much greater future output than a dollar of transfer payments or consumption-stimulating tax cuts.

As regards today's humongous fiscal deficits, this reality implies that, the more the deficit is dedicated to infrastructure investment each year, then (i) the greater productivity will be (recall that investment raises productivity), and (ii) the greater both job growth and output will be over time via the Keynesian multiplier theory. Since virtually everyone recognizes that US infrastructure spending has been woefully inadequate for decades, and that consumption has been excessive, the current recession has, in fact, presented the government with a golden opportunity to "rebalance" the composition of GDP in a highly desirable manner.

Yet there are two additional reasons why the increased deficit should be infrastructure-investment-orientated. First, government expenditure on productivity-raising investment is not, in fact, "an expenditure" that raises the deficit and frightens bond market vigilantes. For as explained above, government investment spending of this ilk should be amortized over time. Thus, the larger the investment share of a given stimulus package, the smaller the resulting deficit. Second, to the extent that today's deficit explosion burdens the young with much more debt to be serviced, then it is our moral obligation to dedicate the extra spending to investments that raise the productivity growth and thus the size the future GDP. Doing so clearly reduces the real burden on future tax payers of servicing the debt being accumulated today.

Given this rare opportunity—and moral obligation—to tilt the economy towards long overdue investment spending, how can the Obama stimulus package have fallen so short of the mark? It is frankly embarrassing to witness Chinese policy advisors like Professor Yu Qiao of Tsinghua University scolding the US about something as basic as this:

Most of Mr. Obama's stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America's over-consumption problem and delay sustainable recovery.

Financial Times, Editorial page, April 1, 2009

Qiao's point parallels a principal point we are making in this essay. Why are we not reading this from Christina Romer or Larry Summers in Washington? Have the Best and the Brightest once again lost their moral integrity as they did during the Vietnam War era? Can they seriously believe that more transfer payments to Democratic Party special interest groups is what the nation needs in this hour of its distress? The author considers the composition of the proposed $3 trillion of discretionary stimulus over the next five years a moral travesty.

Case Study of Energy: As a case study in how poor the administration's policies are in this regard, consider its energy policies. Is anyone in the new administration reading about the disastrous 9% annual decrease in the output of "old" oil (yes, "peak oil" turned out to be true), in conjunction with a collapse of previously scheduled investments in exploration and development, and in refining capacity? Are they blind to the supply-crisis that is unfolding, one that calls not only for "renewable energy," but also for a major expansion of traditional oil and gas production?

By now, has it not become crystal clear that the increased production of traditional fuels should come from within the US, given the devolution of both the political leadership and the infrastructure of those thugocracies upon whom the US increasingly depends for 40% of its consumption? Is no thought being given to the rising probability of $500 oil prices—or perhaps outright rationing—when global energy demand recovers? [Recall how jointly price-inelastic demand and supply curves cause huge changes in price both upward and downward, as we demonstrated mathematically five years ago.]

Elementary arithmetic is all that is needed to ascertain that the administration's BTU gains from increased renewable energy production and conservation from increased "weather-stripping" will not yield even 10% of the BTU shortfall that the nation will confront. The reality, therefore, is that the country needs a vast expenditure of funds on novel and traditional sources of energy, as well as on our deteriorating energy infrastructure. Expenditures of this kind would create several million jobs of precisely the kind that are needed during the next decade. And they would leave the next generation with an improved infrastructure, in addition to lessening our extraordinary dependence on imports from rogue states.

But what do we get from the Obama team? A present value tax hike of up to $400 billion on "big oil" in one form or another, along with weather-stripping tax credits and expenditures on renewable energy alone. And who is the newly appointed spokesman for national energy policy? A highly credentialed academic who strikes virtually everyone as indecisive and ineffectual. Does even one reader of this essay know his name? [Steven Chu] Of course, his Nobel Prize supposedly substitutes for his lack of political skills. By extension, are we about to witness the "quant" financial theorist Myron Scholes appointed as Treasury Secretary after Tim Geithner steps down? After all, Scholes too, is a Nobel laureate, even if his notorious "pricing models" helped to bring down Long Term Capital Management and then the world economy a decade later. The Lord save us from "The best and the brightest!"

2. Stimulation of Innovation and Venture Capital: While increased infrastructure investment is one channel to higher productivity growth (and hence higher GDP growth), innovation is another. As someone who lived in Menlo Park, California for two decades between 1980 and 2000, the author was privileged to witness first hand the stunning comeback of the US from its "rust bowl" status of the 1970s.

The comeback was almost entirely due to a broad array of venture capital sponsored innovations, starting with the micro-processor. In a Memo he wrote for Mssrs. Clinton and Rubin in 1996, the author demonstrated that the US had an "Innovation Quotient" 17 times higher than that of our next competitor. [Finland. Think Nokia!] As a result, US productivity growth doubled from its depressed level of 1.4% in the 1970s to 3% by the late 1990s and early 2000s. No other nation came close to this achievement.

Yet now, when we need renewed innovation and enhanced productivity growth as much as we did in the 1970s, we read that the Obama Treasury Secretary Geithner has proposed to regulate the venture capital industry. Specifically, he has called for mandatory SEC registration of large firms, lest the sector become a "systemic risk" like hedge funds and proprietary trading desks. As Jack Biddle of the VC firm Novak Biddle Venture Partners has pointed out in a Wall Street Journal interview (April 9, 2009):

I cannot imagine any venture capital firm being of a size to pose 'systemic risk,' so they (the administration) either do not understand the nature of the business, or...What Washington needs to understand is that bank-style regulation could destroy the culture that created the micro-processor.

3. Education and Elitism: In contemplating the sources of productivity growth, we would all do well to recall Isaac Newton's celebrated confession that, in developing his theory of mechanics and the differential calculus, "I stood on the shoulders of giants." Politically incorrect as it is to admit, we need policies that identify and reward elite young people and entrepreneurs from a very early age, and do so regardless of where they come from. Indeed, we should be seeking young scientific talent worldwide and paying for immigrants to come to the US and study.

Instead, the stimulus package dedicates significant funds to lowest common denominator educational expenditures. In particular, virtually nothing is being proposed to end the monopoly of teachers' unions that discourages qualified teachers from attempting to teach. The consequences for productivity growth of the longstanding decline of our public schools is by now well known, and has been articulated by public figures ranging from Bill Clinton to Bill Gates and Steve Jobs.

4. Taxation that Rewards Innovation and Success: Both the president and his chief of staff Rahm Emanuel have been completely candid about their redistributionist agenda—an agenda that has even alarmed European liberals. Were they at all concerned with innovation, productivity, and growth, the administration would not publicly espouse taxation policies that punish success and reward failure. In particular, they would not have declared war on small business, since small businesses typically generate the bulk of new jobs and innovations that determine the rate of economic growth.

To be sure, disparities in the current tax code do permit Warren Buffet to incur a much lower tax rate than his receptionist, as he quipped. Such inequities must be remedied. But the fact remains that the top decile and quartile of income earners in the US pay a larger share of government tax revenues than in any other G-7 nation. If so, why does the president assume it is "fair" to hike the tax rates on top income earners, and only on this group? From an employment standpoint, the new tax rates may well send talented young Americans to live elsewhere. Starting in 2011, a New York City wage earner will pay a marginal tax rate (federal, state, and local) of over 60% on "high" incomes of $200,000. This rate is higher than comparable rates in Germany and France where taxes paid secure decent schooling and medical care, which they do not in the US. Yet even so, France has witnessed a veritable diaspora of young talent to London, the US, and Switzerland during the past two decades.

5. Incentives for Investment in the Private Sector: Productivity growth comes not only from government-sponsored infrastructure of the kind discussed above, but also from investment by private businesses of all sizes in new capital stock. It is not clear what the new tax policy will be towards investment tax credits, but such credits have not yet been identified as important. They are important, especially at a time when the search for higher productivity and hence higher economic growth must become the nation's number one priority.

6. Less Regulation, Not More: "Re-regulation" is back in vogue. But increased regulation where it's not needed chokes off innovation and growth. While the financial sector clearly needs re-regulation, it is not clear that other sectors do. Should the new administration become growth-oriented, then it must be very careful not to choke off the all-important forces of "creative destruction."

Even in the financial sector, overkill is likely. In our own view, two general forms of regulation are needed. First, incentives must be properly aligned (e.g., banks issuing securitized products must hold a certain proportion of such products in-house.) Second, leverage must be radically curtailed, a point we have stressed for three years. As for "excess pay," the limitation of leverage and proper alignment of incentives will automatically remedy most excesses of recent years. In brief, the less regulation the better.

G.3. Workforce-Enhancing Growth Strategies

1. Strong GDP Growth: The six growth-maximizing strategies above will do more to boost workforce growth than anything else. The strong correlation of workforce growth and GDP growth is well understood at both an empirical and theoretical level. Most important, perhaps, is the need to stimulate innovation so that new industries can rise and replace old industries via the unfettered forces of creative destruction. Indeed, new industries have contributed over 75% of job growth in the US during recent decades. Numerous studies have shown how policies preventing creative destruction within most of Europe depressed private sector job creation during recent decades. Most job creation occurred in the public sector. Regrettably, none of these employment realities have been discussed by the new administration.

2. Deficit Composition: Utilization of today's huge deficits for boosting investment expenditures triggers those accelerator/multiplier effects cited above that boost employment far more than transfer payments or tax cuts do. Yet the administration's stimulus package is very infrastructure-lite, as was discussed above.

3. Deregulation of the Labor Market: Labor unions have long wanted to return to the practices of card-check balloting (or majority sign-up) without secret balloting. Yet such practices are definitionally anticompetitive, and retard employment growth. The administration initially supported card-check legislation or the so-called Employee Free Choice Act, but does not have enough votes to impose it. As to the tricky issue of immigration, the Obama team is doing a good job to date supporting rights for undocumented workers who have played such an important role in the nation's economic history, and must continue to do so in the future.

4. Managing Demographic Change within the Labor Market: There will be new and important tensions within the US labor market, given the likely influx of millions of post-65 year old boomers. It is becoming clear that the retirement planning of this generation was woeful, with up to half of boomers expecting they could afford a retirement financed by the ever-rising values of stocks and houses. Such expectations have been shattered, and many boomers will have to work until age 75 to afford the lives they expect.

In many ways, this is a good development. However, it presupposes that the requisite jobs exist. Yet they will not exist unless labor markets are deregulated, not re-regulated. In particular, minimum wages and guaranteed hours of work must go by the boards. Maximum flexibility will be needed to equate supply and demand in the labor market, thereby reducing tensions between older and younger job-seekers. Such tensions have already begun to appear in today's scramble for jobs.

A welcome dividend of elderly workers joining the workforce will be the reduction of the Social Security Trust Fund deficit. If the average retirement age de facto (not de jure) rises from 64 to 70, trillions of dollars of unfunded liabilities will evaporate as people draw upon their Social Security entitlements later, and contribute longer. The present value of the resulting fiscal savings is truly huge, making it all the more important that the US labor market become as flexible and efficient as possible. The administration has never touched upon this issue.

5. Tax Policy: Any student of public finance will recall that the best kind of tax is the tax that least distorts the efficiency of the economy. The Value Added Tax (VAT) is well known to be optimal in this regard. Conversely, taxes on labor (e.g., income taxes) distort workforce growth and thus, economic efficiency the most. But the administration is wedded to higher taxes on labor, and has never proposed a VAT.

This concludes our identification of over a dozen policies that can drive the Debt-to GDP ratio down. Please note that each of the pro-growth strategies is incentive-structure-compatible with growth, as desired and as promised up front.

H. Conclusion: When Being "Smart" Is Not Enough

This essay began with a demonstration of the all-important role of the evolution of a nation's Debt-to-GDP ratio. The direction of this evolution is a good proxy for the future success or failure of the nation. We argued that a one-time shock (like today's US recession) that drives the initial Debt ratio way up does not pose the problem most people assume. Long run recovery is possible, but only if policies are adopted that drive the growth rate of the numerator down, that of the denominator up, and thus that of the ratio down.

We then identified over a dozen policies that can achieve the goal of driving down the Debt-to-GDP ratio in the longer term. The End Game that is now being played is whether policies of this kind are adopted, or whether they are not. In our view, the Obama administration has adopted both a philosophical perspective and a set of policies that will drive the ratio up. If this is indeed the price of a "new American social architecture," then it is a price that is too high.

We also proposed that these "ratio management policies" should be viewed as a refinement, and indeed an extension of classical monetary and fiscal policy. They add a new dimension to the concept of "macroeconomic policy," and to its objectives.

Why do so few administration spokesmen or economic commentators seem to share our views? Is "politics" the problem? We do not think so, at least to the extent that growth-maximizing policies are win-win policies that any good politician should be able to sell. No, the problem is rather one of the mind-set of a generation that has never before needed to confront the problems lying ahead, and that is tone deaf to philosophical issues, as opposed to "policy wonk" issues.

Today's True Challenge — Governance: In this vein, we proposed at the end of our February 2009 PROFILE that the root problems of today are not macroeconomic as much as they are political philosophical: How can democracy save itself from itself? How can people be made to realize that a reform of governance is what is now most needed—more so even than a reform of Wall Street? And even in the financial sector, it is increasingly clear that regulatory lapses in Washington were more responsible than "greed" for what has happened. Messrs. Rubin, Summers, and Greenspan actively encouraged the most pernicious of the deregulatory policies that brought down the system.

By now, it is clear that we need bold new constitutional amendments that mandate (i) sterilization of excess money creation during cyclical recoveries, (ii) fiscal surpluses during recoveries to pay down past fiscal deficits, and (iii) deficits during recessions tilted towards growth-enhancing infrastructure spending, not towards goodies for special interest groups.

In this regard, economists Martin Wolf and Stephen Roach have both correctly identified financial market "credibility" as the key to future growth, inflation, and interest rates. Can today's administration end up with any credibility when it blithely ignores the very existence of the End Game we have identified, much less those policies needed to solve it correctly? Will there be any credibility if the three proposed amendments just cited are not adopted?

In his magisterial The Rise and Decline of Nations, Mancur Olson understands that these are the topics that matter—not greed management 101. Yet barely a word is being said about these issues by the Best and the Brightest now staffing the Obama White House. Why? The explanation partly lies in a crisis of intellectual competence. Scholars trained in "macroeconomics" are as poor in discussing Olson's dilemmas of collective action as oncologists are in discussing dentistry. The fact that the macroeconomists in question are "brilliant" is irrelevant. Being smart is not enough.

The abject moral failure of the new team to identify much less to propose a solution to the End Game is extremely disturbing to the present author. Despite his initial support of President Obama, he increasingly wonders whether we have the right team in place. And he is alarmed that time to rebuild credibility is running out.

Footnotes:

¹We stressed that this hike in real rates does not occur in the case of normal-sized fiscal deficits caused by normal G-7 recessions. It only occurs when the deficits are exceptionally large, as they are turning out to be this time around. Accordingly, our analysis cannot be supported by the data of G-7 recessions during the past half century for the simple reason that we have rarely before experienced deficits of the magnitude confronting the US today. Nonetheless, our analysis can be supported by the experience of many emerging market economies that became overly indebted.

² US federal debt is often stated to be $5.5T. This is because some $4.5T of debt is held by the Social Security Administration trust funds and other entities. But what matters for the purposes of our analysis is the total debt of some $10T.

³ This forecast growth of debt excludes the growth of liabilities of the balance sheet of the Federal Reserve Bank, as well as some off-balance sheet operations by the Treasury. But much of the costs of bailing out the financial system should properly be viewed as asset exchanges, and not as increases in the fiscal deficit per se. The story is highly complicated, and mistaken interpretations are commonplace.

⁴ In one of the grandest achievements in the history of social thought, Hurwicz demonstrated mathematically that the incentive structure of "true capitalism" alone is compatible with the societal goals of efficiency, privacy, freedom, equity, and stability. In our view, this result gave a more compelling and concrete interpretation of Aristotle's concept of "The Good Life" than any theory before or since has done.

The $33,000,000,000,000 Question

John Mauldin — Mon, 11 May 2009 17:48:03 GMT

It has long been my contention that we are entering an extraordinary period of time in which using historical analogies to plot market behavior is going to become increasingly problematical. In short, the analogies, the past performance if you will, all break down because the underlying economic backdrop is unlike anything we have ever seen. It makes managing money and portfolio planning particularly challenging. Traditional asset management techniques just simply may not work. Buy and hope strategies may be particularly difficult to navigate.

Part of the reason we are co challenged in our outlook is that we are experiencing a deleveraging on a scale in the world that is absolutely breath-taking in its scope. And to balance that, governments are going to have to issue massive amounts of sovereign debt to deal with their deficits. But who will buy it, and at what price? And in which currency? This week's Outside the Box gives us some very basic data points that illustrate the challenge very well. But the problem is that even though we can see the challenge, it is not clear what the final outcome will be, other than stressful volatility as the market reacts.

This week's OTB is by my good friends and business partners in London, Niels Jensen and his team at Absolute Return Partners. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box

The $33,000,000,000,000 Question

The Absolute Return Letter
May 2009

"Never in the history of the world has there been a situation so bad that the government can't make it worse."

-Unknown

Is the crisis really over?

Commercial paper spreads have come down dramatically. Libor rates are (hmm - almost) back to normal. Even high yield spreads are narrowing. It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

No wonder equities are currently enjoying one of their best spells ever. And while equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as 'just' another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away. How is that possible?

The great bank illusion

The current bull market began in earnest in the second week of March, but what really got everyone going were the surprisingly good Q1 US bank earnings which were reported during the first half of April. Most commentators interpreted the numbers as the clearest piece of evidence yet that we are now firmly on the road to recovery.

Of course US banks made good money in Q1. The environment created for them is the equivalent of the US government reducing the cost of goods to zero for its embattled car manufacturers and then going on to buy - courtesy of the US tax payer - a couple of million cars that nobody really needs. Even Detroit would make money given those conditions!

Liquidity is trapped

The problem for the rest of us is that the banks are not sharing the candy they have been handed. Much of the liquidity created by the central banks remains trapped in the financial sector (see chart 1). Quite simply, the multiplier is not doing its job, as many banks prefer to hoard cash rather than increase lending at this juncture.

This is both good and bad news at the same time. Good because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place; bad because it means that the economy is not going to kick back to life as quickly as everyone would like – and expect.

Meanwhile investors are growing cautiously optimistic about the GDP outlook for the second half of the year with many now forecasting modest growth – at least in the United States. Only a fool would suggest that GDP would shrink by 5-10% per quarter in perpetuity, as has been the case over the past two quarters. The economic slowdown is now decelerating and, as I pointed out last month, there are good reasons why we may see a temporary lift in economic activity later this year, but it will almost certainly prove transitory.

We are still in a bear market

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally but, as one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932 (see chart 2). Bear market rallies can be extremely powerful and hence deceiving.

The problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks which between them have shrunk their balance sheets by about $3,600 billion so far in this crisis, will shed another $2,000 billion in 2009¹. If you do not share my pessimism, please take a quick look at chart 3 below. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off with total household debt now at 96% of GDP vs. 47% in 1982.

Further write-offs to come

The IMF reckons that both European and US banks - but in particular the European ones - are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1,500 billion to come. So when the US banks reported surprisingly good numbers for Q1 it was certainly not because the economy had suddenly and miraculously revived itself, but because some of the oldest tricks in the book were used to gloss over much bigger problems².

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. As you can see from chart 4, sub-prime is indeed a small fraction of the total loan book for the US banking sector.

Delinquencies are on the rise

And that is precisely what is beginning to happen as illustrated in chart 5. Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A and adjustable rate mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These are all temporary problems, though, however bad they may appear. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year³ which I would like to re-visit (see chart 6).

Banking crises run and run

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. It has to do with the subsequent rise in government debt which, according to Reinhart and Rogoff, has been "... a defining characteristic of the aftermath of banking crises for over a century". According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion⁴. And Reinhart and Rogoff's historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The IMF is too optimistic

I have a lot of respect for all the good work being produced by the people at the IMF; however, they are sometimes too politically correct for my taste; maybe too afraid of stepping on someone's toes. So when they go public, as they did recently, with an estimate of how much the current crisis would ultimately cost, their projection will more than likely prove hopelessly inadequate.

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world's bond markets. As you can see from chart 7, using the official IMF estimates, the twelve most industrialised of the world's G20 countries (in my book known as the Dirty Dozen) will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

The final cost will be enormous

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn't even bother to produce a worst case scenario - it all got too depressing!

I need to put the $33 trillion into perspective, because it is so big that it is almost incomprehensible. According to Wikipedia (see chart 9), total private wealth across the world today is about $37 trillion less the losses incurred in 2007-09, so the real number is probably closer to $30 trillion now. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings. No wonder Gordon Brown looks tired!

Where do we find the money?

Obviously, governments may buy a portion of these bonds themselves, but they cannot afford more than a fraction of the total unless they want to challenge Mugabe as the ultimate master of illusion. Neither should investors hold out for sovereign wealth funds to do the dirty work. As is clear from chart 9, the total amount of wealth accumulated in these funds is pocket money when compared to the projected bond issuance over the next few years.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term. Take your profits!

Niels C. Jensen

¹ "Doomsday is on hold but banks will still feel further pain", The Financial Times, 30^th April, 2009.

² In particular one US accounting rule change (FASB rule 160) explains a large part of Q1 profits.

³ "The Aftermath of Financial Crisis", Carmen Reinhart & Kenneth Rogoff, December 2009.

⁴ http://zerohedge.blogspot.com/2009/04/bail-out-for-dummies-part-1.html

The Geopolitics of Pandemics

John Mauldin — Fri, 08 May 2009 16:55:12 GMT

Dear Friends -

If you ever look at the footnotes, you know that "Past performance is no guarantee of future results." That said, by the time you've gotten a bit of gray hair, you realize that there are few teachers as good as history. "But this time it's different!" is the cry of people that are usually just about to lose a bunch of money.

Read the analysis below from my good friend George Friedman at STRATFOR on the latest new thing, the swine flu outbreak. A few points you ought to take away with you:

while the situation is serious, it's not cause to become hysterical or irrational
the way to evaluate the current threat is by benchmarking it against similar historical events
and as investors, if we don't look outside the worlds of finance and economics, we can get painfully blindsided

These three points are precisely why I incorporate STRATFOR insights into my investment planning. STRATFOR provides the narrative of the future by studying the past. Those of you that got to visit with George in La Jolla know what I'm talking about. If you're looking for context and understanding of tomorrow's global events - and if you're not, you're really in trouble! - I heartily suggest you click here to take advantage of the special offer that George makes available to my readers for a STRATFOR Membership.

There aren't any guarantees in life. But there are good, solid principles that you ignore at your peril. That "there's nothing new under the sun" is a lesson to take to heart.

Your Gray(ing) Eminence Analyst,
John Mauldin

The Geopolitics of Pandemics

By George Friedman

May 4, 2009

Related Special Topic Page - Swine Flu Outbreak 2009

Word began to flow out of Mexico the weekend before last of well over 150 deaths suspected to have been caused by a new strain of influenza commonly referred to as swine flu. Scientists who examined the flu announced that this was a new strain of Influenza A (H1N1) derived partly from swine flu, partly from human flu and partly from avian flu strains (although there is some question as to whether this remains true). The two bits of information released in succession created a global panic.

This panic had three elements. The first related to the global nature of this disease, given that flus spread easily and modern transportation flows mean containment is impossible. Second, there were concerns (including our own) that this flu would have a high mortality rate. And third, the panic centered on the mere fact that this disease was the flu.

News of this new strain triggered memories of the 1918-1919 flu pandemic, sparking fears that the "Spanish flu" that struck at the end of World War I would be repeated. In addition, the scare over avian flu created a sense of foreboding about influenza — a sense that a catastrophic outbreak was imminent.

By midweek, the disease was being reported around the world. It became clear that the disease was spreading, and the World Health Organization (WHO) declared a Phase 5 pandemic alert. A Phase 5 alert (the last step before a pandemic is actually, officially declared, a step that may be taken within the next couple of days) means that a global pandemic is imminent, and that the virus has proved capable of sustained human-to-human transmission and infecting geographically disparate populations. But this is not a measure of lethality, only communicability, and pandemics are not limited to the deadliest diseases.

'Pandemic,' not 'Duck and Cover'

To the medical mind, the word "pandemic" denotes a disease occurring over a wide geographic area and affecting an exceptionally high proportion of the population. The term in no way addresses the underlying seriousness of the disease in the sense of its wider impact on society. The problem is that most people are not physicians. When the WHO convenes a press conference carried by every network in the world, the declaration of a level 5 pandemic connotes global calamity, even as statements from experts — and governments around the world — attempt to walk the line between calming public fears and preparing for the worst.

The reason to prepare for the worst was because this was a pandemic with an extremely unclear prognosis, and about which reliable information was in short supply. Indeed, the new strain could mutate into a more lethal form and re-emerge in the fall for the 2009-2010 flu season. There are also concerns about how its victims disproportionately are healthy young adults under 45 years of age — which was reported in the initial information out of Mexico, and has been reported as an observed factor in the cases that have popped up in the United States. This was part of the 1918 flu pandemic pattern as well. (In contrast, seasonal influenza is most deadly among the elderly and young children with weaker immune systems.)

But as the days wore on last week, the swine flu began to look like little more than ordinary flu. Toward the end of the week, a startling fact began to emerge: While there were more than a hundred deaths in Mexico suspected of being caused by the new strain, only about 20 (a number that has increased slightly after being revised downward earlier last week) have been confirmed as being linked to the new virus. And there has not been a single death from the disease reported anywhere else in the world, save that of a Mexican child transported to the United States for better care. Indeed, even in Mexico, the country's health minister declared the disease to be past its peak May 3. STRATFOR sources involved in examining the strain have also suggested that the initial analysis of the swine flu was in fact in error, and that the swine flu may have originated during a 1998 outbreak in a pig farm in North Carolina. This information reopens the question of what killed the individuals whose deaths were attributed to swine flu.

While little is understood about the specifics of this new strain, influenza in general has a definitive pattern. It is a virus that affects the respiratory system, and particularly the lungs. At its deadliest it can cause secondary infections — typically bacterial rather than viral — leading to pneumonia. In the most virulent forms of influenza, it is the speed with which complications strike that drives death rates higher. Additionally, substantively new strains (as swine flu is suspected of being) can be distinct enough from other strains of flu that pre-existing immunity gained from flus of years past does not help fend off the latest variation.

Influenza is not a disease that lingers and then kills people — save the sick, old and very young, whose immune systems are more easily compromised. Roughly half a million people (largely from these groups) die annually worldwide from more common strains of influenza, with the Centers for Disease Control and Prevention (CDC) pegging average American deaths at roughly 36,000 per year.

Swine flu deaths have not risen as would be expected at this point for a highly contagious and lethal new strain of influenza. In most cases, victims have experienced little more than a bad cold, from which they are recovering. And infections outside Mexico so far have not been severe. This distinction of clear cases of death in Mexico and none elsewhere (again, save the one U.S. case) is stark.

Much of what has occurred in the last week regarding the new virus reminds us of the bird flu scare of 2005. Then as now, the commonly held belief was that a deadly strain was about to be let loose on humanity. Then as now, many governments were heightening concerns rather than quelling them. Then as now, STRATFOR saw only a very small chance of the situation becoming problematic.

Ultimately, by the end of last week it had become clear to the global public that "pandemic" could refer to bad colds as well as to plagues wiping out millions.

A Real Crisis

The recent swine flu experience raises the question of how one would attempt to grapple with a genuine high-mortality pandemic with major consequences. The answer divides into two parts: how to control the spread, and how to deploy treatments.

Communicability

The flu virus is widely present in two species other than humans, namely, birds and pigs. The history of the disease is the history of its transmission within and across these three species. It is comparatively easy for the disease to transmit from swine to birds and from swine to humans; the bird-to-human barrier is the most difficult to cross.

Cross-species influenza is of particular concern. In the simplest terms, viruses are able to recombine (e.g., human flu and avian flu can merge into a hybrid flu strain). What comes out can be a flu transmissible to humans, but with a physical form that is distinctly avian — meaning it fails to alert human immune systems to the intrusion. This can rob the human immune system of the ability to quickly recognize the disease and put up a fight.

New humanly transmissible influenza strains often have been found to originate in places where humans, pigs and/or fowl live in close proximity to each other — particularly in agricultural areas where animal and human habitation is shared or in which constant, close physical contact takes place.

Agricultural areas of Asia with dense populations, relatively small farms and therefore frequent and prolonged contact between species traditionally have been the areas in which influenza strains have transferred from animals to humans and then mutated into diseases transmissible by casual human contact. Indeed, these areas have been the focus of concern over a potential outbreak of bird flu. This time around, the outbreak began in Mexico (though it is not yet clear where the virus itself originated).

And this is key to understanding this flu. Because it appears relatively mild, it might well have been around for quite awhile — giving people mild influenza, but not standing out as a new variety until it hit Mexico. The simultaneous discovery of the strain amid a series of deaths (and what may now be in hindsight inflated concerns about its lethality) led to the recent crisis footing.

Any time such threats are recognized, they already are beyond containment. Given travel patterns in the world today, viruses move easily to new locations well before they are identified in the first place they strike. The current virus is a case in point. It appears, although it is far from certain, that it originated in the Veracruz area of Mexico. Within two days of the Mexican government having issued a health alert, it already had spread as far afield as New Zealand. One week on, cases completely unrelated to Mexico have already been confirmed on five continents.

In all probability, this "spread" was less the discovery of new areas of infection than the random discovery of areas that might have been infected for weeks or even months (though the obvious first people to test were those who had recently returned from Mexico with flu symptoms). Given the apparent mildness of the infection, most people would not go to the doctor. And if they did, the doctor would call it generic flu and not even concern himself with its type. What happened last week appears to have been less the spread of a new influenza virus than the "discovery" of places to which it had spread awhile ago.

The problem with the new variety was not that it was so deadly; had it actually been as uniquely deadly as it first appeared to be, there would have been no mistaking its arrival, because hospitals would be overflowing. It was precisely its mildness that sparked the search. But because of expectations established in the wake of the Mexico deaths, the discovery of new cases was disassociated from its impact. Its presence alone caused panic, with schools closing and border closings discussed.

The virus traveled faster than news of the virus. When the news of the virus finally caught up with the virus, the global perception was shaped by a series of deaths suddenly recognized in Mexico (as mentioned, deaths so far not seen elsewhere). But even as the Mexican Health Ministry begins to consider the virus beyond its peak, the potential for mutation and a more virulent strain in the next flu season looms.

Mortality

As mentioned, viruses that spread through casual human contact can be globally established before anyone knows of it. The first sign of a really significant influenza pandemic will not come from the medical community or the WHO; it will come from the fact that people are catching influenza and dying, and are doing so all over the world at the same time. The system established for detecting spreading diseases is hardwired to be behind the curve. This is not because it is inefficient, but because no matter how efficient, it cannot block casual contact — which, given modern air transportation, spreads diseases globally in a matter of days or even hours.

Therefore, the problem is not the detection of deadly pandemics, simply because they cannot be missed. Rather, the problem is reacting medically to deadly pandemics. One danger is overreacting to every pandemic and thereby breaking the system. (As of this writing, the CDC remained deeply concerned about swine flu, though calm seems to be returning.)

The other danger is not reacting rapidly enough. In the case of influenza, medical steps can be taken. First, there are anti-viral medicines found to be effective against the new strain, and if sufficient stockpiles exist — which is hardly universally the case, especially in the developing world — and those stockpiles can be administered early enough, the course of the disease can be mitigated. Second, since most people die from secondary infection in the lungs, antibiotics can be administered. Unlike with the 1918 pandemic, the mortality rate can be dramatically reduced.

The problem here is logistical: The distribution and effective administration of medications is a challenge. Producing enough of the medication is one problem; it takes months to craft, grow and produce a new vaccine, and the flu vaccine is tailored every year to deal with the three most dangerous strains of flu. Another problem is moving the medication to areas where it is needed in an environment that maintains its effectiveness. Equally important is the existence of infrastructure and medical staff capable of diagnosing, administering and supporting patients — and doing so on a scale never before attempted.

These things will not be done effectively on a global basis. That is inevitable. But influenza, even at the highest death rates ever recorded for the disease, does not threaten human existence as we know it. At its worst, flu will kill a lot of people, but the human race and the international order will survive.

The true threat to humanity, if it ever comes, will not come from influenza. Rather, it will come from a disease spread through casual human contact, but with a higher mortality rate than flu and no clear treatment. While HIV/AIDS boasts an extraordinarily high mortality rate and no cure exists, it at least does not spread through casual contact as influenza does, and so the pace at which it can spread is limited.

Humanity will survive the worst that influenza can throw at it even without intervention. With modern intervention, its effect declines dramatically. But the key problem of pandemics was revealed in this case: The virus spread well before information on it spread. Detection and communication lagged. That did not matter in this case, and it did not matter in the case of HIV/AIDS, because the latter was a disease that did not spread through casual contact. However, should a disease arise that is as deadly as HIV, that spreads through casual contact, about which there is little knowledge and for which there is no cure, the medical capabilities of humanity would be virtually useless.

There are problems to which there are no solutions. Fortunately, these problems may not arise. But if they do, no amount of helpful public service announcements from the CDC and the WHO will make the slightest bit of difference.

The Financial Commentator on the Economy

John Mauldin — Mon, 04 May 2009 20:04:47 GMT

Late last week a letter from Jim Welsh crossed my desk. I started reading and found myself being pulled through his very thoughtful letter. I have not met Jim, but think this letter is worthy of an Outside the Box.

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, "The Financial Commentator", since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

The Financial Commentator on the Economy

Perspective – A way of regarding facts and judging their relative importance.

There are a number of data series that evaluate economic conditions using a diffusion index. A diffusion index will have a value above 50, when a plurality of respondents are positive, and below 50 when a majority are negative. If a diffusion index increases from 35 to 38, it represents a gain of 8.6%, while a rise to 46 from 45 is only a gain of 2.2%. It is natural to think of the larger percentage gain to be more noteworthy. However, the smaller gain is actually more significant, since it will only require a small further improvement, before actual economic growth is achieved. In recent weeks, many economists and market strategists have heralded the end of the recession and the arrival of spring, after spotting a few 'green shoots' of improvement. In most cases, the 'green shoot' was a modest up tick, from a multi-decade low! For instance, the Conference Board's Consumer Confidence Index edged up to 26.0 in March, from 25.3 in February, the lowest reading since records began in 1967.

In February, new home sales were up 4.7% to 337,000, and after that robust increase, were only down 75.7% from their July 2005 peak. In the last three years, housing starts have plunged from 1,823,000 to 358,000, or 80.4%. At the February sales rate, it will take 12.2 months to clear the inventory of new homes for sale, versus 5 months in a healthy market. In the past year, the median price of a new home has fallen from $251,000 to $200,900, a drop of 20%. After retail sales collapsed in the fourth quarter, the inventory-to-sales ratio soared from 1.25 to 1.45, or 16%. Companies were forced to cut production drastically in the first quarter, so bloated inventories could be whittled down. Although the ratio dipped to 1.43 in February, production levels will remain low, until the ratio falls further. The large decline in production will contribute to a fairly weak first quarter, and depress second quarter GDP too.

As noted last month, there is a good chance that GDP will post a positive print in the fourth quarter of this year, and maybe in the third quarter. Most of the 'gain' will be statistical nonsense, but that won't deter most economists from getting excited. In the last 2 years, the 80% plunge in housing starts has subtracted about .9% from GDP each quarter. If housing starts stabilize near February's level in coming months, the .9% hit to GDP will become 0%. If inventories are brought down by the fourth quarter and are in line with sales, the decline of 1% to 2% to GDP from production cuts in the first and second quarter could also improve to 0%. In the fourth quarter last year, personal consumption fell an extraordinary -2.99%, as consumers turned into Grinches.

But consumer spending improved in the first quarter, as government income transfers of $127 billion offset the decline in wages and salaries of $89 billion. In the second quarter, social security recipients will receive a onetime $250 payment in May. Tax refunds are up 11% from last year, and the decline in gasoline prices is also providing a boost to incomes. Consumers will use the extra disposable income to pay down debt, and increase savings and spending. All of these factors should help swing personal consumption to a positive for GDP in coming quarters.

In the second quarter of 2008, GDP grew 2.8%, which is a respectable number. Despite this growth, job losses continued each month, and a self sustaining economic expansion failed to take hold. The most important issue in the next 12 to 15 months is whether the rebound in the second half of 2009 and first half of 2010 will gain enough traction to launch a self sustaining economic recovery. There are many reasons why I remain skeptical.

In the first three months of 2009, more than 2 million jobs were lost, causing the unemployment rate to jump from 7.6% to 8.5%, the highest since November 1983. The unemployment rate increased in March in 46 states, with California, the world's eighth largest economy, hitting 11.2%, the highest since January 1941.

Underemployment, which combines the unemployed, with involuntary part time workers and discouraged workers, reached 15.6%. As noted in recent months, post World War II recessions have on average caused personal income to fall between 4% and 7%, and this one has further to go. Wages and salaries shrank at a 4% annual rate in the first quarter, and according to Deutsche Bank, payroll-tax withholding receipts collected by the Treasury Department are down 8.2% from a year ago. This suggests that personal income growth will remain weak in coming months, and shave more than $250 billion from total income and future demand. Changes in temporary jobs lead reversals in the overall labor market by 6 to 10 months. In 2007, a continuous decline in temporary jobs and hours worked led me to forecast a decline in jobs in 2008. When non-farm jobs fell in January 2008, most economists were shocked, and the stock market sold off sharply. In March, employers cut 71,700 temporary workers, so any real improvement in job growth is many months away.

Most economists are quick to note that unemployment is a lagging indicator, and they're right. But the magnitude of the job losses shouldn't be dismissed so glibly, given the impact they are having on the banking system. The American Bankers Association reported that 3.22% of consumer loans were delinquent at the end of 2008. That is the highest level since the ABA began tracking overall loan delinquency rates in the mid 1970's. And that was before 2 million jobs were lost in the first quarter.

An average of 5,945 bankruptcy petitions were filed each day in March, up 9% from February and 38% from a year ago. The soaring job losses since last September are certainly behind the increase in bankruptcies.

The surge in job losses are working their way up the income ladder, with an increasing number of middle income and upper middle income workers being affected. This is pushing many of those who previously were considered prime credit risks over the edge. Two-thirds of mortgages in the U.S. are held by the best credit risk, prime borrowers. According to the American Bankers Association, 5.06% of prime borrowers have missed at least one mortgage payment. Since prime borrowers are such a large group, this represents 1.8 million mortgages. Although the delinquency rate for sub prime mortgages is up to 21.9%, it only accounts for 1.2 million mortgages.

In the fourth quarter, a number of states mandated a freeze on foreclosures, and a number of banks, not wanting to be a modern day Mr. Potter during the holidays, voluntarily suspended foreclosures. According to RealtyTrac, foreclosure filings increased to 341,180 in March, up 17% from February, and up 46% from a year ago. After the foreclosure moratorium expired in California, notices of trustee sales, which precede foreclosure sales, climbed more than 80% to 33,178 in March from February. Moody's Economy.com estimates more than 2.1 million homes will be lost this year, up from 1.7 in 2008.

Existing home sales have declined 33.3% since peaking in September 2005. The median price has dropped 28.7%, after peaking in July 2006 at $230,900. In February, existing homes sales increased 4.4%, and the median home price advanced 2.4%. The ratio of monthly sales to the inventory of homes for sale was 9.5 months, versus 5 months in a healthy market. However, 45% of the sales in February were foreclosures, and that proportion will remain high in coming months. Since foreclosed sales represent forced selling, the persistently high level of foreclosures will continue to push home prices lower. As home prices fall another 5% to 10% or more, more home owners will realize that their mortgage exceeds the value of their home. An increasing number are simply choosing to walk away, since they have nothing to lose.

According to RealtyTrac, job losses result in a home foreclosure 10% to 15% of the time. If job losses narrow from the monthly average of 670,000 in the first quarter to 325,000, almost 3 million more jobs will be lost before year end. That will translate into another 300,000-450,000 foreclosures, and an unemployment rate of almost 11%. But what if that estimate of job losses is too optimistic?

New research by the Federal Reserve and Boston University of credit spreads of 900 non-financial companies from 1990-2008 predicted changes in the economy 'phenomenally' well. Based on their initial research on low to medium risk corporate bonds with more than 15 years to maturity, the researchers went back to 1973 and found the analysis still worked well. With the massive widening of corporate bond spreads last fall, the researcher's model predicts the economy will lose another 7.8 million jobs by the end of 2009, and industrial production will fall another 17%. In the spirit of optimism, let's assume this 'phenomenal' model is off by 35%, due to the extreme nature of this credit crisis. That still results in another 5.1 million lost jobs, and an 11% drop in industrial production. In that scenario, the unemployment rate climbs to near 12.5%, the underemployment rate breaches 20%, and another 500,000-750,000 foreclosures result.

The International Monetary Fund (IMF) now estimates the U.S., European, and Japanese financial sectors face losses of $4.1 trillion. Banks are confronting losses of $2.5 trillion, insurers $300 billion, and other financial institutions $1.3 trillion. To date, the banking sector has written down $1 trillion of expected losses. The IMF estimates that U.S. and European banks need to raise $875 billion in equity by next year to return to pre-crisis levels.

Over the last week a number of banks have reported first quarter earnings, which was a pleasant surprise. Citigroup said it made $1.6 billion. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi's own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn't actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of 'earnings'. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in 'profit' on impaired assets. Without theses one-time adjustments, Citi's $1.6 billion in first quarter profit becomes a $2.8 billion loss.

According to a Wall Street Journal analysis of Treasury Department data, the 19 banks that received tax payer funds made or refinanced 23% less in new loans in February versus last October. Why lend money when all you've got to do is make a few adjustments and make even more money.

Between 2000 and 2008, the major credit card companies increased the number of credit cards issued to small businesses from 5 million to 29 million. During that period, many small business owners increasingly relied on their cards to provide short term financing for their business. Spending on small business credit cards increased from $70.4 billion in 2000, to $296.3 billion, according to the Nilson Report. Over the last 15 months, business bankruptcy filings have risen faster than consumer bankruptcies, with the average charge-off rising to $11,000 from $7,000, according to Equifax, Inc. In response, the card issuers have been aggressively scaling back, and have reduced available credit lines by almost $500 billion. Just another example of how the availability of credit to the economy is evaporating, despite all the Fed's efforts.

Industrial production fell 1.5% in March, and is down 12.8% from a year ago. Capacity utilization fell to 69.3%, the lowest since records began in 1967. As I discussed in detail in January, excess capacity is a powerful dynamic. Companies are forced to reduce or eliminate budgeted investments in new equipment, compete for every dollar of revenue, even if it means accepting thinner profit margins, and reduce costs through job cuts. The amount of excess capacity that has been created by the depth of this economic contraction is unprecedented. What most inflation bugs and investors fail to understand is how long it will take to work off the current over hang of excess capacity. If the output gap grows from the current 7% to 10% next year, Goldman Sachs estimates it could be 2015 before all the excess capacity is used up, and that's if GDP grows 4.75% per year! Ironically, one of the reasons the economy is not likely to grow that fast is that business investment will be weaker than in prior business cycles. With so much excess capacity, businesses won't need to materially increase business investment for the next 2 or 3 years.

The economy needs to create 125,000 jobs each month, just to absorb the number of new entrants into the labor market. If job growth were to average 325,000 per month in coming years, it would still take four years to replace all the jobs lost in this recession. With so much excess labor capacity, wage growth will be weak for the next few years, which will make it harder for consumers to increase savings and spending. The combination of less credit availability, weaker business investment and consumer spending will be headwinds whenever the economy emerges from this recession.

The Untied States is mired in the deepest cyclical contraction since at least World War II, and arguably the depression. Falling home prices led us into this crisis, and home prices are still falling. The financial crisis in 2008 has become the economic crisis in 2009, as more than 2 million jobs were lost in just the first quarter, with another 3 to 5 million likely before year end. With the unemployment rate headed over 10%, and maybe up to 12% next year, the default rate on every type of consumer credit – (prime mortgages, Alt-A mortgages, Option Arm mortgages, sub-prime mortgages, home equity lines, credit cards, auto loans, student loans) – is headed much higher. Commercial real estate values are plunging, and corporate default rates are set to soar. Although every bank will 'pass' the government's stress test, some banks will fail the real world stress test, and need billions more in capital. Sooner or later, the Treasury Department will likely have to go hat in hand asking for more money from Congress for some of the banks. For the first time since World War II, the global economy will contract in 2009, so there aren't many places to hide. Although it is welcome to see a few 'green shoots', in this case, those green shoots are unlikely to yield a bountiful harvest in 2010.

In addition to the daunting cyclical problems challenging the economy, there are a number of significant secular issues I've discussed before that will make it even more difficult for a self sustaining recovery to develop in 2010. Between 1982 and 2007, the amount of Total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the generational lows of the last few years. As interest rates fell, consumers were able to take on more debt, without their monthly payments increasing very much.

Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007. However, there is no more relief coming from lower rates, so consumers are going to have to pay for their debt from income. From the mid 1990's until 2007, most consumers had the luxury of believing that their homes and 401Ks would provide most of what they would need for their retirement. The saving rate fell from over 8% 15 years ago to near 0% in 2007. The last 18 months has convinced them they need to increase their savings. The saving rate has rebounded to near 4% in the last six months, which is one reason why the economy has been so weak. As debt levels increased over the last 25 years, GDP was boosted as consumer's bought cars, bigger homes, second homes, went on nice vacations, and basically lived the good life. However, since 1966, each dollar of additional debt has given the economy less of a boost. In 1966, $1 dollar of debt boosted GDP by $.93. But by 2007, $1 dollar of debt lifted GDP by less than $.20.

The message from these facts is fairly clear. Debt levels are high, and any increase in interest rates will impose a bigger burden on the economy and quickly stunt growth. Consumer debt is already so high and interest rates are so low that it will be difficult for consumers to add debt. This means economic growth will be far weaker than the debt induced growth of the last 25 years. As consumers increase their savings, GDP will be lowered by .70% for each 1% consumers increase their saving, since consumer spending represents almost 70% of GDP. In addition, the banking system remains crippled. Lending standards are high and are not coming down with the economy remaining weak. The need for additional capital will lower future lending by several trillion dollars, as banks work to repair their balance sheets and lower their leverage ratios from 30 to the low teens. The securitization markets provide more credit than the banking system, but they remain on life support. Credit availability will remain constrained well into 2010, which represents a headwind than will mute some of the lift from fiscal stimulus.

The diminishing boost given to GDP from each additional $1.00 of debt since 1966 strongly suggests that adding more debt will not return the economy to prosperity. I am reminded of a movie from the 1950's, 'The High and the Mighty'. It starred John Wayne and Robert Stack and was about an airline flight from Honolulu to San Francisco. During the flight, one of the engines fails, but they are past the point of no return, so they must try to make it to San Francisco. Over the last 60 years, the United States has used a combination of fiscal stimulus and monetary policy to soften each recession and spur the subsequent recovery, with a fair amount of apparent success. From 1982 until 2007, the U.S. only experienced two shallow recessions that each lasted just 8 months. This stretch of 25 years may be the best 25 years in our economic history. But much of this prosperity was bought with debt, as the ratio of debt to GDP rose from $1.60 to $3.50 for each $1.00 of GDP. Sometime in the last 25 years, we passed the point of no return. Unfortunately, Hollywood won't get to write the script on how this ends.

E. James Welsh

On Energy Production and US Intelligence Failures

John Mauldin — Mon, 27 Apr 2009 17:36:46 GMT

I send you Outside the Box each week not to make you comfortable but to make you think. Usually it is on some financial topic, but life is more than investments. Economics is not an isolated discipline (more like an art form I think) so we have to have a real understanding of the world around us. This week I offer two essays which made me both think and reflect. We live in a world which wants easy solutions to complex problems, and wish as we may, will not get easy solutions which will work.

The first essay is by Pewter Huber on the reality of energy production. We all want to be able to "go green." How realistic is that? The second is by my friend George Friedman on torture and US intelligence failures.

Peter Huber is a Manhattan Institute senior fellow and the coauthor, most recently, of The Bottomless Well. His article develops arguments that he made in an Intelligence Squared U.S. debate in January. George is well known to OTB readers. He is president of Stratfor and was with the CIA (as was his wife Meredith) before they founded Stratfor, what I think of as the premier private intelligence agency in the world.

I suggest you put on your thinking caps and take some time to read both of these very important essays, and enjoy your week. I am off to Orlando and the CFA conference.

John Mauldin, Editor
Outside the Box

Bound to Burn

Humanity will keep spewing carbon into the atmosphere, but good policy can help sink it back into the earth.

By Peter W. Huber

Like medieval priests, today's carbon brokers will sell you an indulgence that forgives your carbon sins. It will run you about $500 for 5 tons of forgiveness -- about how much the typical American needs every year. Or about $2,000 a year for a typical four-person household. Your broker will spend the money on such things as reducing methane emissions from hog farms in Brazil.

But if you really want to make a difference, you must send a check large enough to forgive the carbon emitted by four poor Brazilian households, too -- because they're not going to do it themselves. To cover all five households, then, send $4,000. And you probably forgot to send in a check last year, and you might forget again in the future, so you'd best make it an even $40,000, to take care of a decade right now. If you decline to write your own check while insisting that to save the world we must ditch the carbon, you are just burdening your already sooty soul with another ton of self-righteous hypocrisy. And you can't possibly afford what it will cost to forgive that.

If making carbon this personal seems rude, then think globally instead. During the presidential race, Barack Obama was heard to remark that he would bankrupt the coal industry. No one can doubt Washington's power to bankrupt almost anything -- in the United States. But China is adding 100 gigawatts of coal-fired electrical capacity a year. That's another whole United States' worth of coal consumption added every three years, with no stopping point in sight. Much of the rest of the developing world is on a similar path.

Cut to the chase. We rich people can't stop the world's 5 billion poor people from burning the couple of trillion tons of cheap carbon that they have within easy reach. We can't even make any durable dent in global emissions -- because emissions from the developing world are growing too fast, because the other 80 percent of humanity desperately needs cheap energy, and because we and they are now part of the same global economy. What we can do, if we're foolish enough, is let carbon worries send our jobs and industries to their shores, making them grow even faster, and their carbon emissions faster still.

We don't control the global supply of carbon.

Ten countries ruled by nasty people control 80 percent of the planet's oil reserves -- about 1 trillion barrels, currently worth about $40 trillion. If $40 trillion worth of gold were located where most of the oil is, one could only scoff at any suggestion that we might somehow persuade the nasty people to leave the wealth buried. They can lift most of their oil at a cost well under $10 a barrel. They will drill. They will pump. And they will find buyers. Oil is all they've got.

Poor countries all around the planet are sitting on a second, even bigger source of carbon -- almost a trillion tons of cheap, easily accessible coal. They also control most of the planet's third great carbon reservoir -- the rain forests and soil. They will keep squeezing the carbon out of cheap coal, and cheap forest, and cheap soil, because that's all they've got. Unless they can find something even cheaper. But they won't -- not any time in the foreseeable future.

We no longer control the demand for carbon, either. The 5 billion poor -- the other 80 percent -- are already the main problem, not us. Collectively, they emit 20 percent more greenhouse gas than we do. We burn a lot more carbon individually, but they have a lot more children. Their fecundity has eclipsed our gluttony, and the gap is now widening fast. China, not the United States, is now the planet's largest emitter. Brazil, India, Indonesia, South Africa, and others are in hot pursuit. And these countries have all made it clear that they aren't interested in spending what money they have on low-carb diets. It is idle to argue, as some have done, that global warming can be solved -- decades hence -- at a cost of 1 to 2 percent of the global economy. Eighty percent of the global population hasn't signed on to pay more than 0 percent.

Accepting this last, self-evident fact, the Kyoto Protocol divides the world into two groups. The roughly 1.2 billion citizens of industrialized countries are expected to reduce their emissions. The other 5 billion -- including both China and India, each of which is about as populous as the entire Organisation for Economic Co-operation and Development -- aren't. These numbers alone guarantee that humanity isn't going to reduce global emissions at any point in the foreseeable future -- unless it does it the old-fashioned way, by getting poorer. But the current recession won't last forever, and the long-term trend is clear. Their populations and per-capita emissions are rising far faster than ours could fall under any remotely plausible carbon-reduction scheme.

Might we simply buy their cooperation? Various plans have circulated for having the rich pay the poor to stop burning down rain forests and to lower greenhouse-gas emissions from primitive agricultural practices. But taking control of what belongs to someone else ultimately means buying it. Over the long term, we would in effect have to buy up a large fraction of all the world's forests, soil, coal, and oil -- and then post guards to make sure that poor people didn't sneak in and grab all the carbon anyway. Buying off people just doesn't fly when they outnumber you four to one.

Might we instead manage to give the world something cheaper than carbon? The moon-shot law of economics says yes, of course we can. If we just put our minds to it, it will happen. Atom bomb, moon landing, ultracheap energy -- all it takes is a triumph of political will.

Really? For the very poorest, this would mean beating the price of the free rain forest that they burn down to clear land to plant a subsistence crop. For the slightly less poor, it would mean beating the price of coal used to generate electricity at under 3 cents per kilowatt-hour.

And with one important exception, which we will return to shortly, no carbon-free fuel or technology comes remotely close to being able to do that. Fossil fuels are extremely cheap because geological forces happen to have created large deposits of these dense forms of energy in accessible places. Find a mountain of coal, and you can just shovel gargantuan amounts of energy into the boxcars.

Shoveling wind and sun is much, much harder. Windmills are now 50-story skyscrapers. Yet one windmill generates a piddling 2 to 3 megawatts. A jumbo jet needs 100 megawatts to get off the ground; Google is building 100-megawatt server farms. Meeting New York City's total energy demand would require 13,000 of those skyscrapers spinning at top speed, which would require scattering about 50,000 of them across the state, to make sure that you always hit enough windy spots. To answer the howls of green protest that inevitably greet realistic engineering estimates like these, note that real-world systems must be able to meet peak, not average, demand; that reserve margins are essential; and that converting electric power into liquid or gaseous fuels to power the existing transportation and heating systems would entail substantial losses. What was Mayor Bloomberg thinking when he suggested that he might just tuck windmills into Manhattan? Such thoughts betray a deep ignorance about how difficult it is to get a lot of energy out of sources as thin and dilute as wind and sun.

It's often suggested that technology improvements and mass production will sharply lower the cost of wind and solar. But engineers have pursued these technologies for decades, and while costs of some components have fallen, there is no serious prospect of costs plummeting and performance soaring as they have in our laptops and cell phones. When you replace conventional with renewable energy, everything gets bigger, not smaller -- and bigger costs more, not less. Even if solar cells themselves were free, solar power would remain very expensive because of the huge structures and support systems required to extract large amounts of electricity from a source so weak that it takes hours to deliver a tan.

This is why the (few) greens ready to accept engineering and economic reality have suddenly emerged as avid proponents of nuclear power. In the aftermath of the Three Mile Island accident -- which didn't harm anyone, and wouldn't even have damaged the reactor core if the operators had simply kept their hands off the switches and let the automatic safety systems do their job -- ostensibly green antinuclear activists unwittingly boosted U.S. coal consumption by about 400 million tons per year. The United States would be in compliance with the Kyoto Protocol today if we could simply undo their handiwork and conjure back into existence the nuclear plants that were in the pipeline in nuclear power's heyday. Nuclear power is fantastically compact, and -- as America's nuclear navy, several commercial U.S. operators, France, Japan, and a handful of other countries have convincingly established -- it's both safe and cheap wherever engineers are allowed to get on with it.

But getting on with it briskly is essential, because costs hinge on the huge, up-front capital investment in the power plant. Years of delay between the capital investment and when it starts earning a return are ruinous. Most of the developed world has made nuclear power unaffordable by surrounding it with a regulatory process so sluggish and unpredictable that no one will pour a couple of billion dollars into a new plant, for the good reason that no one knows when (or even if) the investment will be allowed to start making money.

And countries that don't trust nuclear power on their own soil must hesitate to share the technology with countries where you never know who will be in charge next year, or what he might decide to do with his nuclear toys. So much for the possibility that cheap nuclear power might replace carbon-spewing sources of energy in the developing world. Moreover, even India and China, which have mastered nuclear technologies, are deploying far more new coal capacity.

Remember, finally, that most of the cost of carbon-based energy resides not in the fuels but in the gigantic infrastructure of furnaces, turbines, and engines. Those costs are sunk, which means that carbon-free alternatives -- with their own huge, attendant, front-end capital costs -- must be cheap enough to beat carbon fuels that already have their infrastructure in place. That won't happen in our lifetimes.

Another argument commonly advanced is that getting over carbon will, nevertheless, be comparatively cheap, because it will get us over oil, too -- which will impoverish our enemies and save us a bundle at the Pentagon and the Department of Homeland Security. But uranium aside, the most economical substitute for oil is, in fact, electricity generated with coal. Cheap coal-fired electricity has been, is, and will continue to be a substitute for oil, or a substitute for natural gas, which can in turn substitute for oil. By sharply boosting the cost of coal electricity, the war on carbon will make us more dependent on oil, not less.

The first place where coal displaces oil is in the electric power plant itself. When oil prices spiked in the early 1980s, U.S. utilities quickly switched to other fuels, with coal leading the pack; the coal-fired plants now being built in China, India, and other developing countries are displacing diesel generators. More power plants burning coal to produce cheap electricity can also mean less natural gas used to generate electricity. And less used for industrial, commercial, and residential heating, welding, and chemical processing, as these users switch to electrically powered alternatives. The gas that's freed up this way can then substitute for diesel fuel in heavy trucks, delivery vehicles, and buses. And coal-fired electricity will eventually begin displacing gasoline, too, as soon as plug-in hybrid cars start recharging their batteries directly from the grid.

To top it all, using electricity generated in large part by coal to power our passenger cars would lower carbon emissions -- even in Indiana, which generates 75 percent of its electricity with coal. Big power plants are so much more efficient than the gasoline engines in our cars that a plug-in hybrid car running on electricity supplied by Indiana's current grid still ends up more carbon-frugal than comparable cars burning gasoline in a conventional engine under the hood. Old-guard energy types have been saying this for decades. In a major report released last March, the World Wildlife Fund finally concluded that they were right all along.

But true carbon zealots won't settle for modest reductions in carbon emissions when fat targets beckon. They see coal-fired electricity as the dragon to slay first. Huge, stationary sources can't run or hide, and the cost of doing without them doesn't get rung up in plain view at the gas pump. California, Pennsylvania, and other greener-than-thou states have made flatlining electricity consumption the linchpin of their war on carbon. That is the one certain way to halt the displacement of foreign oil by cheap, domestic electricity.

The oil-coal economics come down to this. Per unit of energy delivered, coal costs about one-fifth as much as oil -- but contains one-third more carbon. High carbon taxes (or tradable permits, or any other economic equivalent) sharply narrow the price gap between oil and the one fuel that can displace it worldwide, here and now. The oil nasties will celebrate the green war on carbon as enthusiastically as the coal industry celebrated the green war on uranium 30 years ago.

The other 5 billion are too poor to deny these economic realities. For them, the price to beat is 3-cent coal-fired electricity. China and India won't trade 3-cent coal for 15-cent wind or 30-cent solar. As for us, if we embrace those economically frivolous alternatives on our own, we will certainly end up doing more harm than good.

By pouring money into anything-but-carbon fuels, we will lower demand for carbon, making it even cheaper for the rest of the world to buy and burn. The rest will use cheaper energy to accelerate their own economic growth. Jobs will go where energy is cheap, just as they go where labor is cheap. Manufacturing and heavy industry require a great deal of energy, and in a global economy, no competitor can survive while paying substantially more for an essential input. The carbon police acknowledge the problem and talk vaguely of using tariffs and such to address it. But carbon is far too deeply embedded in the global economy, and materials, goods, and services move and intermingle far too freely, for the customs agents to track.

Consider your next Google search. As noted in a recent article in Harper's, "Google . . . and its rivals now head abroad for cheaper, often dirtier power." Google itself (the "don't be evil" company) is looking to set up one of its electrically voracious server farms at a site in Lithuania, "disingenuously described as being near a hydroelectric dam." But Lithuania's grid is 0.5 percent hydroelectric and 78 percent nuclear. Perhaps the company's next huge farm will be "near" the Three Gorges Dam in China, built to generate over three times as much power as our own Grand Coulee Dam in Washington State. China will be happy to play along, while it quietly plugs another coal plant into its grid a few pylons down the line. All the while, of course, Google will maintain its low-energy headquarters in California, a state that often boasts of the wise regulatory policies -- centered, one is told, on efficiency and conservation -- that have made it such a frugal energy user. But in fact, sky-high prices have played the key role, curbing internal demand and propelling the flight from California of power plants, heavy industries, chip fabs, server farms, and much else (see "California's Potemkin Environmentalism," Spring 2008).

So the suggestion that we can lift ourselves out of the economic doldrums by spending lavishly on exceptionally expensive new sources of energy is absurd. "Green jobs" means Americans paying other Americans to chase carbon while the rest of the world builds new power plants and factories. And the environmental consequences of outsourcing jobs, industries, and carbon to developing countries are beyond dispute. They use energy far less efficiently than we do, and they remain almost completely oblivious to environmental impacts, just as we were in our own first century of industrialization. A massive transfer of carbon, industry, and jobs from us to them will raise carbon emissions, not lower them.

The grand theory for how the developed world can unilaterally save the planet seems to run like this. We buy time for the planet by rapidly slashing our own emissions. We do so by developing carbon-free alternatives even cheaper than carbon. The rest of the world will then quickly adopt these alternatives, leaving most of its trillion barrels of oil and trillion tons of coal safely buried, most of the rain forests standing, and most of the planet's carbon-rich soil undisturbed. From end to end, however, this vision strains credulity.

Perhaps it's the recognition of that inconvenient truth that has made the anti-carbon rhetoric increasingly apocalyptic. Coal trains have been analogized to boxcars headed for Auschwitz. There is talk of the extinction of all humanity. But then, we have heard such things before. It is indeed quite routine, in environmental discourse, to frame choices as involving potentially infinite costs on the green side of the ledger. If they really are infinite, no reasonable person can quibble about spending mere billions, or even trillions, on the dollar side, to dodge the apocalyptic bullet.

Thirty years ago, the case against nuclear power was framed as the "Zero-Infinity Dilemma." The risks of a meltdown might be vanishingly small, but if it happened, the costs would be infinitely large, so we should forget about uranium. Computer models demonstrated that meltdowns were highly unlikely and that the costs of a meltdown, should one occur, would be manageable -- but greens scoffed: huge computer models couldn't be trusted. So we ended up burning much more coal. The software shoe is on the other foot now; the machines that said nukes wouldn't melt now say that the ice caps will. Warming skeptics scoff in turn, and can quite plausibly argue that a planet is harder to model than a nuclear reactor. But that's a detail. From a rhetorical perspective, any claim that the infinite, the apocalypse, or the Almighty supports your side of the argument shuts down all further discussion.

To judge by actions rather than words, however, few people and almost no national governments actually believe in the infinite rewards of exorcising carbon from economic life. Kyoto has hurt the anti-carbon mission far more than carbon zealots seem to grasp. It has proved only that with carbon, governments will say and sign anything -- and then do less than nothing. The United States should steer well clear of such treaties because they are unenforceable, routinely ignored, and therefore worthless.

If we're truly worried about carbon, we must instead approach it as if the emissions originated in an annual eruption of Mount Krakatoa. Don't try to persuade the volcano to sign a treaty promising to stop. Focus instead on what might be done to protect and promote the planet's carbon sinks -- the systems that suck carbon back out of the air and bury it. Green plants currently pump 15 to 20 times as much carbon out of the atmosphere as humanity releases into it -- that's the pump that put all that carbon underground in the first place, millions of years ago. At present, almost all of that plant-captured carbon is released back into the atmosphere within a year or so by animal consumers. North America, however, is currently sinking almost two-thirds of its carbon emissions back into prairies and forests that were originally leveled in the 1800s but are now recovering. For the next 50 years or so, we should focus on promoting better land use and reforestation worldwide. Beyond that, weather and the oceans naturally sink about one-fifth of total fossil-fuel emissions. We should also investigate large-scale options for accelerating the process of ocean sequestration.

Carbon zealots despise carbon-sinking schemes because, they insist, nobody can be sure that the sunk carbon will stay sunk. Yet everything they propose hinges on the assumption that carbon already sunk by nature in what are now hugely valuable deposits of oil and coal can be kept sunk by treaty and imaginary cheaper-than-carbon alternatives. This, yet again, gets things backward. We certainly know how to improve agriculture to protect soil, and how to grow new trees, and how to maintain existing forests, and we can almost certainly learn how to mummify carbon and bury it back in the earth or the depths of the oceans, in ways that neither man nor nature will disturb. It's keeping nature's black gold sequestered from humanity that's impossible.

If we do need to do something serious about carbon, the sequestration of carbon after it's burned is the one approach that accepts the growth of carbon emissions as an inescapable fact of the twenty-first century. And it's the one approach that the rest of the world can embrace, too, here and now, because it begins with improving land use, which can lead directly and quickly to greater prosperity. If, on the other hand, we persist in building green bridges to nowhere, we will make things worse, not better. Good intentions aren't enough. Turned into ineffectual action, they can cost the earth and accelerate its ruin at the same time.

And now to George Friedman:

Torture and the U.S. Intelligence Failure

By George Friedman

The Obama administration published a series of memoranda on torture issued under the Bush administration. The memoranda, most of which dated from the period after 9/11, authorized measures including depriving prisoners of solid food, having them stand shackled and in uncomfortable positions, leaving them in cold cells with inadequate clothing, slapping their heads and/or abdomens, and telling them that their families might be harmed if they didn't cooperate with their interrogators.

On the scale of human cruelty, these actions do not rise anywhere near the top. At the same time, anyone who thinks that being placed without food in a freezing cell subject to random mild beatings -- all while being told that your family might be joining you -- isn't agonizing clearly lacks imagination. The treatment of detainees could have been worse. It was terrible nonetheless.

Torture and the Intelligence Gap

But torture is meant to be terrible, and we must judge the torturer in the context of his own desperation. In the wake of 9/11, anyone who wasn't terrified was not in touch with reality. We know several people who now are quite blasé about 9/11. Unfortunately for them, we knew them in the months after, and they were not nearly as composed then as they are now.

Sept. 11 was terrifying for one main reason: We had little idea about al Qaeda's capabilities. It was a very reasonable assumption that other al Qaeda cells were operating in the United States and that any day might bring follow-on attacks. (Especially given the group's reputation for one-two attacks.) We still remember our first flight after 9/11, looking at our fellow passengers, planning what we would do if one of them moved. Every time a passenger visited the lavatory, one could see the tensions soar.

And while Sept. 11 was frightening enough, there were ample fears that al Qaeda had secured a "suitcase bomb" and that a nuclear attack on a major U.S. city could come at any moment. For individuals, such an attack was simply another possibility. We remember staying at a hotel in Washington close to the White House and realizing that we were at ground zero -- and imagining what the next moment might be like. For the government, however, the problem was having scraps of intelligence indicating that al Qaeda might have a nuclear weapon, but not having any way of telling whether those scraps had any value. The president and vice president accordingly were continually kept at different locations, and not for any frivolous reason.

This lack of intelligence led directly to the most extreme fears, which in turn led to extreme measures. Washington simply did not know very much about al Qaeda and its capabilities and intentions in the United States. A lack of knowledge forces people to think of worst-case scenarios. In the absence of intelligence to the contrary after 9/11, the only reasonable assumption was that al Qaeda was planning more -- and perhaps worse -- attacks.

Collecting intelligence rapidly became the highest national priority. Given the genuine and reasonable fears, no action in pursuit of intelligence was out of the question, so long as it promised quick answers. This led to the authorization of torture, among other things. Torture offered a rapid means to accumulate intelligence, or at least -- given the time lag on other means -- it was something that had to be tried.

Torture and the Moral Question

And this raises the moral question. The United States is a moral project: its Declaration of Independence and Constitution state that. The president takes an oath to preserve, protect and defend the Constitution from all enemies foreign and domestic. The Constitution does not speak to the question of torture of non-citizens, but it implies an abhorrence of rights violations (at least for citizens). But the Declaration of Independence contains the phrase, "a decent respect for the opinions of mankind." This indicates that world opinion matters.

At the same time, the president is sworn to protect the Constitution. In practical terms, this means protecting the physical security of the United States "against all enemies, foreign and domestic." Protecting the principles of the declaration and the Constitution are meaningless without regime preservation and defending the nation.

While this all makes for an interesting seminar in political philosophy, presidents -- and others who have taken the same oath -- do not have the luxury of the contemplative life. They must act on their oaths, and inaction is an action. Former U.S. President George W. Bush knew that he did not know the threat, and that in order to carry out his oath, he needed very rapidly to find out the threat. He could not know that torture would work, but he clearly did not feel that he had the right to avoid it.

Consider this example. Assume you knew that a certain individual knew the location of a nuclear device planted in an American city. The device would kill hundreds of thousands of Americans, but he individual refused to divulge the information. Would anyone who had sworn the oath have the right not to torture the individual? Torture might or might not work, but either way, would it be moral to protect the individual's rights while allowing hundreds of thousands to die? It would seem that in this case, torture is a moral imperative; the rights of the one with the information cannot transcend the life of a city.

Torture in the Real World

But here is the problem: You would not find yourself in this situation. Knowing a bomb had been planted, knowing who knew that the bomb had been planted, and needing only to apply torture to extract this information is not how the real world works. Post-9/11, the United States knew much less about the extent of the threat from al Qaeda. This hypothetical sort of torture was not the issue.

Discrete information was not needed, but situational awareness. The United States did not know what it needed to know, it did not know who was of value and who wasn't, and it did not know how much time it had. Torture thus was not a precise solution to a specific problem: It became an intelligence-gathering technique. The nature of the problem the United States faced forced it into indiscriminate intelligence gathering. When you don't know what you need to know, you cast a wide net. And when torture is included in the mix, it is cast wide as well. In such a case, you know you will be following many false leads -- and when you carry torture with you, you will be torturing people with little to tell you. Moreover, torture applied by anyone other than well-trained, experienced personnel (who are in exceptionally short supply) will only compound these problems, and make the practice less productive.

Defenders of torture frequently seem to believe that the person in custody is known to have valuable information, and that this information must be forced out of him. His possession of the information is proof of his guilt. The problem is that unless you have excellent intelligence to begin with, you will become engaged in developing baseline intelligence, and the person you are torturing may well know nothing at all. Torture thus becomes not only a waste of time and a violation of decency, it actually undermines good intelligence. After a while, scooping up suspects in a dragnet and trying to extract intelligence becomes a substitute for competent intelligence techniques -- and can potentially blind the intelligence service. This is especially true as people will tell you what they think you want to hear to make torture stop.

Critics of torture, on the other hand, seem to assume the torture was brutality for the sake of brutality instead of a desperate attempt to get some clarity on what might well have been a catastrophic outcome. The critics also cannot know the extent to which the use of torture actually prevented follow-on attacks. They assume that to the extent that torture was useful, it was not essential; that there were other ways to find out what was needed. In the long run, they might have been correct. But neither they, nor anyone else, had the right to assume in late 2001 that there was a long run. One of the things that wasn't known was how much time there was.

The U.S. Intelligence Failure

The endless argument over torture, the posturing of both critics and defenders, misses the crucial point. The United States turned to torture because it has experienced a massive intelligence failure reaching back a decade. The U.S. intelligence community simply failed to gather sufficient information on al Qaeda's intentions, capability, organization and personnel. The use of torture was not part of a competent intelligence effort, but a response to a massive intelligence failure.

That failure was rooted in a range of miscalculations over time. There was the public belief that the end of the Cold War meant the United States didn't need a major intelligence effort, a point made by the late Sen. Daniel Moynihan. There were the intelligence people who regarded Afghanistan as old news. There was the Torricelli amendment that made recruiting people with ties to terrorist groups illegal without special approval. There were the Middle East experts who could not understand that al Qaeda was fundamentally different from anything seen before. The list of the guilty is endless, and ultimately includes the American people, who always seem to believe that the view of the world as a dangerous place is something made up by contractors and bureaucrats.

Bush was handed an impossible situation on Sept. 11, after just nine months in office. The country demanded protection, and given the intelligence shambles he inherited, he reacted about as well or badly as anyone else might have in the situation. He used the tools he had, and hoped they were good enough.

The problem with torture -- as with other exceptional measures -- is that it is useful, at best, in extraordinary situations. The problem with all such techniques in the hands of bureaucracies is that the extraordinary in due course becomes the routine, and torture as a desperate stopgap measure becomes a routine part of the intelligence interrogator's tool kit.

At a certain point, the emergency was over. U.S. intelligence had focused itself and had developed an increasingly coherent picture of al Qaeda, with the aid of allied Muslim intelligence agencies, and was able to start taking a toll on al Qaeda. The war had become routinized, and extraordinary measures were no longer essential. But the routinization of the extraordinary is the built-in danger of bureaucracy, and what began as a response to unprecedented dangers became part of the process. Bush had an opportunity to move beyond the emergency. He didn't.

If you know that an individual is loaded with information, torture can be a useful tool. But if you have so much intelligence that you already know enough to identify the individual is loaded with information, then you have come pretty close to winning the intelligence war. That's not when you use torture. That's when you simply point out to the prisoner that, "for you the war is over." You lay out all you already know and how much you know about him. That is as demoralizing as freezing in a cell -- and helps your interrogators keep their balance.

U.S. President Barack Obama has handled this issue in the style to which we have become accustomed, and which is as practical a solution as possible. He has published the memos authorizing torture to make this entirely a Bush administration problem while refusing to prosecute anyone associated with torture, keeping the issue from becoming overly divisive. Good politics perhaps, but not something that deals with the fundamental question.

The fundamental question remains unanswered, and may remain unanswered. When a president takes an oath to "preserve, protect and defend the Constitution of the United States," what are the limits on his obligation? We take the oath for granted. But it should be considered carefully by anyone entering this debate, particularly for presidents.