Thoughts From The Frontline

Skills, Education, and Employment

John Mauldin — Sun, 12 May 2013 06:16:00 GMT

David Rosenberg: A Bond Bull Turns Bearish
Wage Inflation?
Skills Versus Education
Kyle Bass and Japan
Tulsa, Atlanta, Nashville, and Brussels

"The large shortfall of employment relative to its maximum level has imposed huge burdens on all too many American households and represents a substantial social cost. In addition, prolonged economic weakness could harm the economy's productive potential for years to come. The long-term unemployed can see their skills erode, making these workers less attractive to employers. If these jobless workers were to become less employable, the natural rate of unemployment might rise or, to the extent that they leave the labor force, we could see a persistently lower rate of labor force participation."

- Janet L. Yellen, Vice-Chair, US Federal Reserve, March 4, 2013

It is graduation time, and this morning finds me swimming in a sea of fresh young faces as a young friend graduates, along with a thousand classmates. But to what? I concluded my final formal education efforts in late 1974, in the midst of a stagflationary recession, so it was not the best of times to be looking for work. It turned out that I had a far different future ahead of me than I envisioned then. But I would trade places with any of those kids who graduated today, as my vision of the next 40 years is actually very optimistic. With all the advances in healthcare, technology, and communications that have come and will come, they will get to embrace a world full of opportunity; and yet, this generation is starting out with more than just a minor economic handicap.

This week's letter will explore changes in the work marketplace, changes that generated quite a lot of discussion at last week's Strategic Investment Conference. At the end of the letter I will also provide a link for qualified investors to listen in on a webinar conversation between Kyle Bass and me on another of the main topics last week: Japan. This is one you'll want to tune in to. (Warning: this letter will read fast but print long, as there are more than the usual number of charts and graphs, though the word count is actually shorter than usual.)

And a quick note up front on Japan. As of the last two weeks, Japanese investors are now net buyers of foreign bonds, and the yen has broken through 100 to the dollar. I think what is happening in Japan is going to be the nexus of a global flow of cash that will be unlike any we have ever seen. Attention MUST be paid. It is windshield time.

David Rosenberg: A Bond Bull Turns Bearish

How do we get to full employment and improved national education from the launching point of David Rosenberg's very recent call (at the conference and elsewhere) that we will soon see inflation and the onset of a bond bear market? I must say that he surprised a few of us with his conversion from bond bull to bond bear. But the reason why he converted surprised us even more. I am not going to be able to do justice to his impeccably reasoned, highly detailed presentation in this short space, but let me hit some highlights.

Specifically, Rosie thinks that the Fed is going to be surprised by wage-push inflation. How could we see inflation in wages in such a soft labor market? That was the first question in my mind, and the following charts give me some reasons for my question.

The present unemployment rate is still higher than at any time in the last 60 years, except after recessions. The Great Recession ended four years ago, and unemployment is still stubbornly high. Indeed, this is the slowest "jobs recovery" we have ever experienced. The current level of unemployment has never been seen four years after the end of a recession.

And those who lose their jobs are staying unemployed longer. The fact is that the mean duration of unemployment is still almost double what it has ever been. Average length of unemployment is 37 weeks. When the recession ended, it stood at 23 weeks. This is structural, not frictional, unemployment. Ninety million American adults now subsist outside the official labor force –It could be there's an underground economy that we need to capture. The pool of available labor for the business sector is shrinking 2% per year.

Worse yet, the unemployment rate is still stubbornly high in spite of an unprecedented rise in the number of people who are no longer counted as being in the labor force. These are people who are no longer looking for jobs.We are back to workforce participation levels not seen since the 1970s. A good 5% of US citizens who are able to work are no longer are looking for work. Part of this trend is due to alternatives to employment becoming easier to pursue. Millions have been added to the disability rolls – some 4 million since the beginning of this century and almost 2 million since the beginning of the Great Recession (and still rising at an alarming rate!). Others have gone back to school, borrowing money in the form of student loans, which have topped over $1 trillion and are the only form of consumer credit that has been on the increase.

As a quick aside, we are also seeing skyrocketing rates of late payments as student loans overwhelm the ability of borrowers to pay. This is a true crisis brewing, as student loans are the only type of debt that cannot be discharged in bankruptcy. Student loans can make you an indentured servant for a very long time.

Some would-be workers find that in some states they can collect more on government assistance than they can earn by working lower-wage jobs, and thus they have no economic incentive to look for jobs that would actually lower their income. As I wrote in a recent letter, this is why we are seeing a large rise in non-reported incomes and jobs. And finally, there are those who are just discouraged. Jobs seemingly do not exist for their skill sets and in places where they can access them.

With so many people not participating in the labor market, isn't it reasonable to assume that if jobs again ever become available, these people will rejoin the official workforce? And wouldn't that create a shadow supply of workers that would keep wages suppressed for a long time?

Wage Inflation?

Maybe yes and maybe no. Rosie makes the case that there are numerous jobs available and that the numbers are rising, and there is data that supports his argument. I will reproduce here a few of his charts (out of the 59 he showed!). Job openings are on the rise and are back to levels last seen in the middle of the previous decade.

And what about all the businesses that have jobs on offer but can't find people to fill them? The following chart is from Rosie's and my mutual friend William Dunkelberg, chief economist for the National Federation of Independent Businesses. While job openings are not at all-time highs, the trend is encouraging.

The next chart shows the ratio of job openings to new hires. It is at a six-year high. As Rosie stated (inexact quotes, from my notes):

Looking for labor? Labor demand is not weak – JOLTS survey shows job openings up 10%, employers can't find qualified applicants. Firings plunge, layoffs 10% lower than in 2007. Number of job quitters rises – people leaving jobs to go to new ones, the 'take this job and shove it index.' 7.5% unemployment is actually the new 4.4%.

What are companies doing? More overtime, longer work week. Combination of rising wages, productivity growth heading lower. We've taken a lot of inventory out of the labor market. Keep your eye on unit labor costs. Correlation with inflation – unit labor costs are on the rise.

Employees are increasingly willing to leave a job and go to another one, yet productivity has recently begun to fall.

Yet young people are having increasing difficulty landing jobs. People aged 20-24 are still unemployed at levels not seen unless a recession is involved (see chart below). And research keeps coming in that more than 50% of college graduates are stuck in jobs for which a degree is not needed.

Even though the headline unemployment rate is falling, a large part of that drop is due to the precipitous plunge in the participation rate, as well as a rise in low-paying jobs. Curiously, it now seems a disproportionately high level of temporary jobs is no longer a precursor to economic recovery but is a new structural fixture.

Part of the responsibility for that increase in temporary employment can readily be laid at the feet of the Affordable Healthcare Act (Obamacare). Employers do not have to pay health insurance for temporary employees; that burden falls on the employee.

Healthcare for lower-wage employees can be a huge percentage of overall labor costs. While you may argue that employers should cover workers at all levels, the data coming in says that is not happening – thus the rise in temporary workers. Even an established employer like UPS is hiring new temporary employees in low-skill jobs at low wages without health insurance for their first year and cutting back on employees with major seniority (who cost more than double what new employees do), not giving them enough hours to survive and forcing them into the temporary market to meet their basic living needs.

We see evidence of this happening system-wide in the data showing lower hourly wages and a reduced number of hours in the work week. And those trends seem to be stabilizing. We are seeing the creation of a two-tier market, an upper tier for those with skills in demand and a lower one for those whose skills just do not command a premium in today's marketplace.

Rosie makes the argument that there is a shortage of skilled labor and that the price for those workers is going to rise, surprising the Federal Reserve, which still looks at historical data from a world that no longer exists. And he says this segment of the labor market is going to be large enough to create wage-push inflation.

It is an interesting argument, and contradicting David Rosenberg is generally not a good idea, although he did not convince Lacy Hunt or Gary Shilling, at least not at the conference. But at any turn there is always someone who has to lead the way. His arguments are something we must pay attention to.

In the panel discussion later in the day, I agreed that there are two labor markets, but the divide is between workers with skills that are in demand and workers whose jobs require no special experience or education.

Skills Versus Education

I am writing part of this week's letter in the rafters of a huge auditorium as I watch 1100 liberal art graduates at a major university receive their degrees. (I long ago made a promise to be here.) This was an expensive education, and the graduates are smart; yet when you ask them what their plans are, all too often you hear that they have not been able to find jobs or are opting to continue with school, often borrowing yet more money to do so, as they see no other viable options.

Recent research suggests that the cost/benefit ratio for education is not as good as it once was. See for example this article by Jeff Selingo.

Education – at least in the conventional sense – is not always necessary for job success. All too often it is the enemy of success. Yet the fallacy persists among the unemployed that "going back to school" will somehow solve their problems.

In most cases, it will not. The unemployed do not need more school; what they need are more skills. Why? Because what employers need are abilities. Workers are essentially a delivery mechanism for the ability to do whatever the employer happens to need done. This is not to say that formal education is unimportant; it is critically important – but not for the reason most people expect.

Degrees and diplomas are credentials. They do not, in and of themselves, guarantee that the holder possesses the skill an employer wants. They serve as screening tools, used to reduce a long list of applicants to a smaller number for closer review.

Employers want workers with the necessary skills. Workers want an employer who values their particular skills. When a match is made, everyone wins. Skills are the key to every match.

Skills can be acquired in school, of course. Indeed, it is impossible to spend thousands of hours in classrooms during one's formative years, while the brain is in peak learning mode, without acquiring at least some kind of skill. Children and adolescents are highly tuned skill-acquisition machines.

If schools produced the right number of students with the right sets of skills, the economy would be much closer to full employment. Something is wrong somewhere.

Yet those with college degrees are clearly able to find jobs of some kind. The unemployment level for college graduates is about half that of high school grads and almost three times better than for those with no high school degree. Education does matter.

Michael Ellsberg gives us one reason for that seeming advantage a degree delivers:

True, people with college degrees tend to earn more. But that could be because most ambitious people tend to go to college; there is little evidence to suggest that the same ambitious people would earn less without college degrees (particularly if they mastered true business and networking grit).

And while most people who end up starting businesses likely have college degrees, those degree-bearers should be well aware (as they learned in their freshman statistics classes) that correlation does not equal causation. Assuming that college was responsible for their success gives higher education more credit than it deserves. (New York Times: Will Dropouts Save America?)

America, as Ellsberg describes it, has yet another way to divide today's job market into two pieces: formal and informal. The "formal" job market is the old-fashioned one in which employers advertise and workers send resumes. It was never as effective as people thought. Successful professionals and business owners have long preferred the second, informal market.

When you need someone who can do X, you ask trusted friends and colleagues who they know. You will usually find a well-qualified candidate in short order. (And now you use LinkedIn and other social media.)

What role does your wall-decorating degree play in this process? A little – and a lot. If you can do what needs to be done, employers usually won't care where (or if) you went to college. But, since they turn to people they know when they search for candidates, and since our lifelong friendships are so often formed in college, being "in the circle" increases your odds of being known to the right people at the right time.

The old saying is then somewhat true: it isn't just what you know; it's who you know.

Further, if you advertise for a new employee today on one of the online job boards, you can get hundreds of resumes. Most are just people sending you a resume in hopes of attracting attention, but you can still get an overwhelming number of potential employees. How do you sort? One way is by education. That degree helps you sort, even when the job really does not require a degree.

But the skills advantage shows up in the next graph. Notice that the older you get, the lower your likelihood of being unemployed. As I have shown in previous letters, Boomers are not only working more than any other age cohort, they are taking market share from the 20-somethings. In fact, as of less than a year ago, 100% of the overall increase in jobs was going to those age 55 and up. Young people were actually losing ground in what was already a slow jobs recovery.

The reasons are trite but obvious. We Boomers have not saved enough to retire and must keep working. Given our fewer remaining work years, we'll work where we can and for what we can get. And then there are those of us who simply have no interest in anything that looks like traditional retirement. We are living longer and healthier lives than previous generations enjoyed, and there are simply more of us.

Even the youngest Boomer probably has 35-40 years of work experience and a lot of acquired skills. Young people may have more energy, but many jobs are not a function of simple energy and enthusiasm. Go into a Barnes and Noble or any number of other stores and notice the ages of those working. There are young people, sure, but I see my age peers as well. I didn't see that 20 years ago. And those "starter" jobs are where workers gain experience.

We have policies in place that encourage young people to load up on debt to get that degree. We need to create programs that match skills and jobs and that give employers incentives to hire and train those younger workers.

As Paul McCulley said at the conference last week,

Ages 22-27 are the years that really matter for your lifetime of financial security. We now have a job market that is the antithesis of what you and I graduated into.

That is a structural phenomenon, not cyclical. It will not heal itself with platitudes about more and better education. New businesses are being formed at the lowest rate in generations. Over the long term, the growth in the job market comes from new businesses. Want to create jobs? Stop increasing costs and regulations and making it harder for entrepreneurs to get started.

And get the SEC to issue the rules that Congress mandated they write over a year ago (the much-ballyhooed JOBS Act), which will make it possible for new ventures to publicly announce their need for capital on the internet without running afoul of the current regulations. The SEC is way behind the 90-day deadline specified in the act. The law as written by Congress is clear. Those groups lobbying for the status quo and standing in the way need to step aside. You are costing young people future jobs. Those are MY kids. And everyone else's.

(Just for the record, I am an equal opportunity employer. I have younger and older employees, all genders and races. Talent and a solid work ethic are the currency I look for.)

Kyle Bass and Japan

As you know, I am a firm believer that the state of the global economy is such that we as investors need to be diversified, flexible, and opportunistic. Consequently, I spend a great deal of time and effort looking into alternative investment strategies and managers. The Mauldin Circle program was created specifically to provide access to "best of breed" alternatives managers that I believe in. That's why I am particularly pleased to announce an upcoming Mauldin Circle webinar event featuring Kyle Bass of Hayman Capital Management, LP.

Many readers will recognize Kyle as one of the few investors who successfully predicted and profited from the subprime mortgage crisis in 2008, making significant gains for his investors. He has since continued to make well-defined predictions on the European sovereign-debt crisis and is a leading provocateur on the unsustainability of Japan's debt.

Please join my partners at Altegris Investments for this special webinar on May 29^th and learn more about how Kyle is globally positioned to leverage his investment thesis. This may be the most compelling discussion that you hear all year. I will be in Brussels talking with thought leaders and EU politicians, and Kyle will just be back from Asia and a deep dive into Japan, so we will be giving you the view from both sides.

If you are a qualified purchaser or a licensed investment adviser, qualified to make private placement recommendations, please join us for this exclusive Mauldin Circle webinar on Wednesday, May 29, at 12:00 EDT/9 PDT. Be sure to register here for this event – it will be one of the most interesting discussions of the year.

Upon qualification by my partners at Altegris, you will receive an email invitation. I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. I look forward to having you at this exclusive Mauldin Circle event. (In this regard, I am president and a registered representative of Millenium Wave Securities, LLC, member FINRA.)

Tulsa, Atlanta, Nashville, and Brussels

The conference last week was powerful and inspiring. But before we got started, I took time to visit with some of the team at International Stem Cell. We spent a good deal of time going over the exciting research they are doing on stem cells and Parkinson's disease. Even though I have not written about biotech in a long time, I still follow the industry closely. There is just so much promise of real breakthroughs everywhere I look.

Yes, ISCO is the company that launched the Lifeline Skin Care product that I have written about. Almost a dozen people at the conference came up and thanked me for recommending they try it. The skin crème is a follow-on of research they were doing on growing skin for burn victims. It is not a miracle, but it has made a difference to many, and the product helps support their far more important research on diseases such as Parkinson's. You can learn about Lifeline at http://bit.ly/0504md.

I believe we will see cures for many of the conditions that afflict us and have so far eluded treatment. I will be writing on my latest biotech findings in future letters.

I leave for Tulsa next weekend to "give away" my daughter Abbi to her fiancé, Stephen. Just Abbi, Stephen, and 200 of their closest friends. "Dad, we just can't cut the list any more!"

The following Wednesday I head for Atlanta for a board meeting of Galectin Therapeutics (another biotech I follow) and then move on the next day to Nashville for a presentation for my partners at Altegris Investments. Then it's back home for a day or so before I fly for Brussels for a speech. I might stop over in London before heading back, but one way or another I'll be spending extensive time with Jonathan Tepper, my Endgame co-author.

It is time to hit the send button and race to the airport. Dallas has a newly built terminal to replace the old one at Love Field. It is very nice and a true upgrade, but there the same old TSA drill and long lines await me. I know there is better technology available than what we are forced to endure. We pay for all this, and those workers are not cheap. Where is the new technology to make airport security faster and more efficient? But kudos to the head of the FCC telling the FAA to allow us to use our iPads as we take off. The FAA is so behind in so many small ways that add up to a bad overall customer experience.

Have a great week. And figure out how to hire an able young person!

Your started to work at the tender age of 10 analyst,

John Mauldin

subscribers@mauldineconomics.com

The QE Sandpile

John Mauldin — Sun, 05 May 2013 05:49:00 GMT

Ubiquity, Complexity Theory, and Sandpiles
The Critical State
We Are Managing Uncertainty
Fingers of Instability
A Stable Disequilibrium
Tulsa, Brussels, NYC, and Monaco

Sell in May and go away? What about "risk off?" And ever more QE? Today's letter is a quick note and a reprise of a popular letter from yesteryear (with a bit of new slant), as I am at my conference in Carlsbad.

But first, I thought I would shoot you a few quick, interesting notes that crossed my desk in the last week. It is almost a ritual for me to mention at this time of year the old investment saw, "Sell in May and go away." It has been surprisingly good advice in most years. My good friend Art Cashin is a curator (and prodigious progenitor) of investment wisdom. He offers these two insights from his research:

Tomorrow is the beginning of May, so a "Sell in May" review is in order. To avoid reinventing the wheel, let me plagiarize the veteran Jim Brown's synopsis yesterday.

Sell in May? We are at that time of year when investors have to decide if they want to take profits and move to cash for the summer or risk losing those profits in the next correction. The Stock Trader's Almanac has made the "Sell in May and go away" trade one of the most visible trends in the market. Because the markets normally decline in the summer, they came up with the best six-month trading system. If you had invested $10,000 in the Dow in 1950 and only kept the money in stocks from November through April, you would have had $684,073 as of the end of 2011. If you reversed the strategy and invested for the May-October period, you would have lost $1,024 over the same 61-year period. That is a pretty telling statistic, and the cycle rarely fails to produce.

And Art followed up the next day with:

Mark Hulbert suggests it may be a much older multi-national phenomenon. The "sell in May" pattern also exists in other countries besides the US. Ben Jacobsen, a finance professor at Massey University in New Zealand, reached that conclusion after studying all available historical evidence from each of 108 separate stock markets around the world. For example, his statistical tests detected the seasonal pattern in the United Kingdom stock market as far back as 1694.

Jacobsen, in an interview, emphasized that the Halloween Indicator isn't merely the product of a shameless, after-the-fact data-mining exercise. He said that he found an article as long ago as 1935 – in the Financial Times – in which the "sell in May" pattern is referred to as something that was already well-known and followed.

Even though the pattern nearly 80 years ago already had a solid historical foundation, Jacobsen notes, since then the difference between the average returns in winter and summer has become even bigger.

This is a crucial point, he argues, since the all-too-usual tendency is for patterns to begin to evaporate once investors become aware of them and try to exploit them."

China's PMI came in this week at barely above 50 and has been clearly falling for the last year. Despite what you read, China's economic growth is slowing, which is NOT good for commodity metals and products (different from the "softs" like grains, cattle, etc.). GaveKal argues that the commodity price fall that we have been seeing of late is possibly structural in nature. Yet the bond market rises, gold is rising, stocks are rising. (Clearly, the market did not listen to my friend Nouriel Roubini this morning – Dr. Doom indeed! After his speech, no one at this conference can call me pessimistic. Although he prefers the term realistic.) Seemingly everything is levitating.

"Where is risk off?" I ask aloud back in the green room as I write this.

Paul McCulley quips to me, "Never get in a …… contest with a man who buys ink by the barrel." The clear implication is that this levitation is all central bank-induced. The Fed, Japan, and the ECB are all in full gear, and England is only waiting for Mark Carney to arrive from Canada with the North American printing technology employed so well by his friend Ben Bernanke.

The question I am asking at the conference is, "What will happen when quantitative easing has to end? What does that look like?" I will report next week on what I am learning here, but right now let's return to what has proven to be the most popular piece I have written over the last 13 years. And as you read it, think not just of sand piles but of the analogous pile of electrons of quantitative easing as it mounts up toward criticality.

Friedrich Nietzsche knew just how the troubling unknown grips our imaginations and compels us to look for answers:

"To trace something unknown back to something known is alleviating, soothing, gratifying, and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown – the first instinct is to eliminate these distressing states. First principle: any explanation is better than none…. The cause-creating drive is thus conditioned and excited by the feeling of fear…." –Friedrich Nietzsche

"Any explanation is better than none." And the simpler, it seems in the investment game, the better. "The markets went up because oil went down," we are told. Then the next day the opposite relationship occurs. Then there is another reason for the movement of the markets. But we all intuitively know that things are far more complicated than that. As Nietzsche notes, dealing with the unknown can be disturbing, so we look for the simple explanation.

"Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain that make us feel good. We literally become addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important to the chemical release. And so we look for reasons.

That is why some people get so angry when you challenge their beliefs. You are literally taking away the source of their good feeling, like drugs from a junkie or a boyfriend from a teenage girl.

Thus we may reason that the NASDAQ bubble happened because of Greenspan. Or was a collective mania. Or was due to any number of things – pick your favorite belief. My favorite: just as the proverbial butterfly flapping its wings in the Amazon triggers a storm in Europe, maybe a borrower in Las Vegas triggered the subprime crash.

Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, disasters, and the movements of markets. Then we'll look at how New Zealand, Fed policy, gold, oil, and an investor in St. Louis can all be tied together in a critical state. Of course, how critical and what state are the questions here.

Ubiquity, Complexity Theory, and Sandpiles

We are going to start our explorations with excerpts from a very important book by Mark Buchanan, called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory and critical states. It is written in a manner any layman can understand. There are no equations, just easy to grasp, well-written stories and analogies.

As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic buckets and making sand piles? Slowly pouring the sand into an ever bigger pile, until one side of the pile started an avalanche?

Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds on itself and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

The piles were indeed completely chaotic in their unpredictability. Now, let's read this next paragraph from Buchanan slowly. It is important, as it creates a mental image that may help us understand the organization of the financial markets and the world economy. (emphasis mine)

"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

The Critical State

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]… In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."

Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth's crust triggering earthquakes, or as wholesale changes in an ecosystem – or as a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third rate paper in Denmark could cause world-wide riots?

Buchanan concludes in his opening chapter: "There are many subtleties and twists in the story … but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before."

Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the probability of an avalanche becomes 2.14 times more likely. We find something similar in earthquakes. In terms of energy, the data indicate that earthquakes become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law," a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game? "…after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."

Now, let's couple this idea with a few other concepts. First, Hyman Minsky (who should have been a Nobel laureate) points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction. The problem with long term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."

We Are Managing Uncertainty

Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, giving a paradoxical rise to even more apparent stability. As the late Hunt Taylor wrote:

"Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters….

"I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it. This is something old.

"I think shocks will come, but they will be shallower, shorter. They will be harder to predict, because we are not really managing risk anymore. We are managing uncertainty – too many new variables, plus leverage on a scale we have never encountered (something borrowed). And, when the inevitable occurs, the buying opportunities that result will be won by the technologically enabled swift."

Another way to think about it is the way Didier Sornette, a French geophysicist, has described financial crashes in his wonderful book Why Stock Markets Crash (the math, though, was far beyond me!). He wrote, "[T]he specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. Think of a ruler held up vertically on your finger: this very unstable position will lead eventually to its collapse, as a result of a small (or an absence of adequate) motion of your hand or due to any tiny whiff of air. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary."

When things are unstable, it isn't the last grain of sand that causes the pile to collapse or the slight breeze that causes the ruler on your fingertip to fall. Those are the "proximate" causes. They're the closest reasons at hand for the collapse. The real reason, though, is the "remote" cause, the farthest reason. The farthest reason is the underlying instability of the system itself.

A fundamentally unstable system is exactly what we saw in the recent credit crisis. Consumers all through the world's largest economies borrowed money for all sorts of things, because times were good. Home prices would always go up and the stock market was back to its old trick of making 15% a year. And borrowing money was relatively cheap. You could get 2% short-term loans on homes, which seemingly rose in value 15% a year, so why not buy now and sell a few years down the road?

Greed took over. Those risky loans were sold to investors by the tens and hundreds of billions of dollars, all over the world. And as with all debt sandpiles, the fault lines started to appear. Maybe it was that one loan in Las Vegas that was the critical piece of sand; we don't know, but the avalanche was triggered.

You may not remember this, but I was writing about the problems with subprime debt way back in 2005 and 2006. But as the problem actually emerged, respected people like Ben Bernanke (the chairman of the Fed) said that the problem was not all that big and that the fallout would be "contained." (I bet he wishes he could have that statement back!)

But it wasn't contained. It caused banks to realize that what they thought was AAA credit was actually a total loss. And as banks looked at what was on their books, they wondered about their fellow banks. How bad were they? Who knew? Since no one did, they stopped lending to each other. Credit simply froze. They stopped taking each other's letters of credit, and that hurt world trade. Because banks were losing money, they stopped lending to smaller businesses. Commercial paper dried up. All those "safe" off-balance-sheet funds that banks created were now folding (what my friend Paul McCulley first labeled as the Shadow Banking System). Everyone sold what they could, not what they wanted to, to cover their debts. It was a true panic. Businesses started laying off people, who in turn stopped spending as much.

As I read through this again, I think I have an insight. It is one of the reasons we get "fat tails." In theory, returns on investment should look like a smooth bell curve, with the ends tapering off into nothing. According to the theoretical distribution, events that deviate from the mean by five or more standard deviations ("5-sigma events") are extremely rare, with 10 or more sigma being practically impossible – at least in theory. However, under certain circumstances, such events are more common than expected; 15-sigma or even rarer events have happened in the world of investments. Examples of such unlikely events include Long Term Capital in the late '90s and any of a dozen bubbles in history. Because the real-world commonality of high-sigma events is much greater than in theory, the distribution is "fatter" at the extremes ("tails") than a truly normal one.

Thus, the build-up of critical states, those fingers of instability, is perpetuated even as, and precisely because, we hedge risks. We try to "stabilize" the risks we see, shoring them up with derivatives, emergency plans, insurance, and all manner of risk-control procedures. And by doing so, the economic system can absorb body blows that would have been severe only a few decades ago. We distribute the risks and the effects of the risk throughout the system.

Yet as we reduce the known risks, we sow the seeds for the next 10-sigma event. It is the improbable risks that we do not yet see that will create the next real crisis. It is not that the fingers of instability have been removed from the equation, it is that they are in different places and are not yet visible.

A second related concept is from game theory. The Nash equilibrium (named after John Nash, he of The Beautiful Mind) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

A Stable Disequilibrium

So we end up in a critical state of what Paul McCulley calls a "stable disequilibrium." We have "players" of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their own personal outcome and to reduce their exposure to "fingers of instability."

But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. (Astounding. Was it less than ten years ago? Now Russian is awash in capital. Who could anticipate such a dramatic turn of events?) Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened: the historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.

The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

If it were not for the fact that we are coming to the closing innings of the Debt Supercycle, we would already be in a robust recovery. But we are not. And sadly, we have a long way to go with this deleveraging process. It will take years.

You can't borrow your way out of a debt crisis, whether you are a family or a nation. And, as too many families are finding out today, if you lose your job you can lose your home. People who were once very creditworthy are now filing for bankruptcy and walking away from homes. All those subprime loans going bad put huges numbers of homes back onto the market, which caused prices to fall on all homes, which caused an entire home-construction industry to collapse, which hurt all sorts of ancillary businesses, which caused more people to lose their jobs and give up their homes, and on and on. The connections in the housing part of the sandpile were long and deep.

It's all connected. We built a very unstable sand pile and it came crashing down, and now we have to dig out from the problem. And the problem was too much debt. It will take years, as banks write off home loans and commercial real estate and more, and we get down to a more reasonable level of debt as a country and as a world.

And, bringing this tale of instability up to date, we find that Ben Bernanke and his central bank colleagues worldwide have taken much of the burden of sovereign debt upon their mighty shoulders. But as they push their Sisyphean, quantitative easing boulders up the ever-steepening sandpile of the global economy, which side of the pile will collapse first? Will it be the European side, already dangerously unstable? Or the Japanese side, where the QE boulder is about to grow into a real whopper? Or could it happen over on the China slope, which is riddled with fiscal and financial crevasses?

And lest we be complacent here in the US, we only need Niall Ferguson to remind us, as he did here at the conference this morning, that the US may be in the grip of a profound structural malaise that neither easing nor austerity can relieve. I'll have much more to say about Niall's presentation and those of our other speakers in coming weeks. We were treated to some world-class thinking and synthesizing of views here today, with much more to come tomorrow! And I'll keep on asking everyone who comes to the stage, "But what about Japan?"

Our 10^th Annual Strategic Investment Conference is definitely shaping up as our best ever. And with intellects like Niall Ferguson, Lacy Hunt, and Nouriel Roubini, as well as premier investment managers that include the entire partner team from GaveKal (Louis and Charles Gave and Anatole Kaletsky), Jeffrey Gundlach, Kyle Bass, and Mohamed El-Erian, how could it not be the best? In his afternoon presentation, Mohamed did a beautiful job of tying together the themes we focused on today – and he was introduced by his best friend (and early-morning walking and debating partner), the irrepressible and incorrigible Paul McCulley, who was also our keynote speaker last night.

The conference is turning out to be everything that my co-host, Altegris, and I hoped and expected it would be. We are already working hard to get the conference videos ready, in order to send them to the attendees and all Mauldin Circle members over the coming weeks. In the meantime, here is a great montage from last year's conference for you to enjoy. If you are not yet a Mauldin Circle member, let this clip remind you of the unique benefits offered to those who .

Click here to initiate your membership in my exclusive Mauldin Circle Program for accredited investors and investment professionals. My partner Altegris and I have worked hard to enhance the program, which now includes access to webinars, conferences, special events, videos, accredited newsletters, and presentations featuring alternative-investment managers and other thought leaders and influencers.

The good news is that this program is completely free. The only restriction is that, because of securities regulations, you have to register and be vetted by one of my trusted partners, which in the United States is Altegris, before you can be added to the subscriber roster. This will be a quite painless process (I promise). I do not like limiting the letter to accredited investors, but those are the rules under which I work. This is not of my choosing, and I have worked in front of and behind the scenes to try to change what I think is a very unfair rule. (See important risk disclosures below. In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) Once you register, an Altegris representative will call you and establish access to the videos, presentations, and summaries from the speakers featured at our 2013 Strategic Investment Conference, as soon as they are ready.

Tulsa, Brussels, NYC, and Monaco

I am off to Tulsa in two weeks to "give away" my daughter Abigail Joy as she gets married on a Sunday. "Dad, do you have a tux?" came the call, as I think she might have noticed I am not wearing ties all that much these days. Actually, I had kind of planned to wear a tie at least one day here at the conference, but all my ties are still in storage, as are my shoes – I am down to one pair.

I was sitting outside during a break with Niall Ferguson and his wife, Ayaan Hirsi Ali, going over what she and I would cover when I did my Charlie Rose imitation and interviewed her at lunchtime. Mohamed came by and wished me well at the wedding. I paused for a second to think about which wedding he meant, and Niall gave me a hard time about not immediately getting the focus of his congratulations. "Aren't you involved?" he queried, and threw in a few other friendly jibes. I had to note my distraction over interviewing his wife in public (if you do not know the compelling story of Ayaan Hirsi Ali, Google her and then read her books, starting with her first one, Infidel. She is a powerful advocate for Muslim women, at great risk to her own life). While she is utterly charming and so gracious, she is also "formidable" (best said with a French accent), and I was intently focused on what we were going to discuss.

But trying to salvage my damaged reputation as a father, I immediately noted that Niall had clearly not gone through this process (though he and Ayaan do have a toddler at home). "The role of Dad," I said, "is to write a lot of checks and smile and show up at the wedding, walk down the aisle, smile, and hand off your precious jewel to some young kid – though you do get to dance with your daughter at the reception.” (And you have to resist the impulse to grab her by the hand and run off, as you remember her bouncing on your knee, running to the door to greet you, and sharing a thousand other treasured father-daughter moments.) Ayaan smiled and agreed. Niall just put on that fierce Scottish grin of his as he thought about his own kids and the costs of future weddings. (And congratulations to Ayaan, as she is now a US citizen. This country needs more people of her caliber to remind us of the "why" of who we are.)

The coming week starts another series of road trips – a day in Atlanta to attend the Galectin Therapeutics board meeting, followed by Nashville for Altegris, the weekend to Brussels and later the next week to Geneva, back to Dallas for a week, and then to Washington, DC, and New York.

It is not just time to hit the send button; as I close this, I also still need to finalize the PowerPoint of my brand-new presentation for tomorrow and host a reception on the lawn … and then do a series of meetings and video shots with guests (which will hopefully show up in this space one day soon)!

John Mauldin

subscribers@mauldineconomics.com

The Cashless Society

John Mauldin — Sun, 28 Apr 2013 20:18:00 GMT

The Underground Recovery
The Cashless Society?
Welfare and Incentives
Carlsbad, Tulsa, Nashville, Brussels, and Homeless in Dallas

But Mousie, thou art [not alone],
In proving foresight may be vain:
The best-laid schemes o' mice an' men
Gang aft agley,
An' lea'e us nought but grief an' pain,
For promis'd joy!

Robert Burns, To a Mouse, on Turning Her Up in Her Nest with the Plough

It is a common trope in science fiction novels. Economic transactions are handled seamlessly with a wave of a card or a physically imbedded chip, and whatever the author imagines money to be is transferred, far removed from the archaic confines of ancient physical monies. If you Google "cashless society" you get about 600,000 references in under a second, and 20 pages into the references there are still articles on a future world where physical cash is no longer needed. Some see it as a sign of the "end times," some as a capitalist plot, some as a frightening vision of socialists and ever-bigger governments, and some as a logical step in the evolution of a technologically driven international commerce.

And some of the "cashless society" references are showcase articles for the latest innovation that turns your phone or smart card into a functional wallet. I can attest it is quite possible to go for days without needing actual cash (as long as there are no kids around). The Bitcoin phenomenon (28 million sources on Google!) is a libertarian enthusiast's dream of not just a cashless society but a society with no need for fiat money and central banks.

Today we'll look at research suggesting that cashless future might be farther off than we either fear or hope. Not only is a cashless society farther away than some think, we are actually seeing an increase in the use of cash all over the world (and this is not just a US phenomenon). We will look at some interesting factoids that in themselves make for thought-provoking discussions, but when we couple them with research on the rise of the unreported economy (aka the underground economy) and the number of people who get some form of government assistance, we may find problematic consequences resulting from hidden incentives that work in unintended ways.

The Underground Recovery

In a recent New Yorker article entitled, “The Underground Economy,” writer James Surowiecki explores the import of a study by University of Wisconsin economist and professor emeritus Edgar Feige, who for many years has done research on the amount of actual cash in the US. Feige has recently updated his work.

What prompted me to follow up and then finally to discuss his work personally with a remarkably accessible Feige was his rather well-documented refutation of a common assertion I have long believed: that at least 2/3 of physical, printed US cash circulates outside the borders of the country. Indeed, you can find research on this topic at the San Francisco Fed and in serious economic journals, so this was not just some anecdotal belief I held from observing the impressively large number of dollars in use wherever I travel in the world. But no, this factoid was something "everyone" simply "knew." Well, everyone but a few people like Feige and evidently some people at the New York Fed.

And we are not talking about a small difference between perception and reality here. Feige asserts convincingly that only 23% of physical US dollars are outside our borders. The difference is $400-500 billion, not a small sum. He vigorously (and I think conclusively) dissects the assumptions in the research that has generated and promoted the larger number. (You can read his 28-page paper here. Let’s look at some of the more interesting parts of his research. (Emphasis mine, of course. This is an academic paper, after all, and polite academics do not use boldface for emphasis.)

The rapid growth of substitutes for cash, particularly debit and credit cards, has led economists to predict the advent of the "cashless society". Yet cash holdings in most developed economies continue to grow and in the U.S., per capita currency holdings now amount to $3000. This paper revisits the long-standing controversy concerning the whereabouts of U.S. cash. Specifically, we employ a previously confidential data source on net shipments of U.S. currency abroad to re-estimate the fraction of U.S. currency held overseas. Contrary to the widely cited figure that 65 percent of U.S. currency is abroad, we now find that direct evidence supports the notion that overseas holdings amount to less than 25 percent. With domestic cash holdings amounting to roughly $2250 per capita, we are far from a "cashless society".

He goes on to note,

Currently, the official figure for the percent of U.S. currency held abroad as published by the Federal Reserve in their Flow of Funds Accounts and by the Bureau of Economic Analysis in the U.S. Balance of Payments Accounts is 39 percent….

To put these figures in perspective, they imply that the average American’s bulging wallet holds roughly 91 pieces of U.S. paper currency, consisting of: 31 one dollar bills; 7 fives; 5 tens; 21 twenties; 4 fifties and 23 one hundred dollar bills. Few of us will recognize ourselves as "average" citizens. Clearly, these amounts of currency are not normally necessary for those of us simply wishing to make payments when neither credit/debit cards nor checks are accepted or convenient to use. Yet as shown in Figure 2, these surprisingly high U.S. per capita currency values were exceeded by per capita currency values for Europe ($3274); Hong Kong ($3963), Switzerland ($6335) and Japan ($7562).

(Very odd factoids for those of us currently obsessed with all things Japanese. Not only do the Japanese have the largest per capita currency in circulation, but surveys tell us that the Japanese people only admit to holding about 10% of that cash. This is indeed, as Feige first noted in research in 1989(!), a "currency enigma." Sidebar question with no immediate answer: Cash is by definition deflationary, and Japan has problems with deflation … and now Kuroda-san is going to crank up the electronic printing presses? I will pose that one to Kyle Bass and Louis Gave, among others, next week. If the answer is interesting, I will report back.)

As Feige noted, on average we are each holding 23 $100 bills. Wondering where your Ben Franklins are? Here, just for fun, is the new $100 bill, coming on October 8:

Interestingly, much of the cash outside the US is in $100 bills, so that may explain where some of the missing C-notes are. Here’s Feige:

Even a cursory examination of the growth and magnitude of the U.S. currency supply in circulation with the public reveals that predictions of the advent of the "cashless society" are unfounded. Despite financial innovations giving rise to convenient substitutes for cash, per capita cash holdings continue to increase and by the end of 2011, amounted to $3000 for every man woman and child residing in the U.S. While this figure does not comport with our common sense notion of how many dollars the average person holds in her wallet, we show that Europeans and Japanese citizens hold even larger amounts of cash. Two explanations are offered for these large cash holdings. The first posits that a large fraction of U.S. currency is held abroad, the second that large amounts of cash are employed to undertake transactions that individuals and firms prefer to hide from the government either to avoid taxes, regulations or punishment for illegal activities.

The Cashless Society?

Professor Feige soundly refutes the first theory. The second one is what is interesting here: there is a rather large cash economy in the US.

The above-referenced article by Surowiecki in The New Yorker was actually about another piece of research by Feige on the "underground economy." (Feige is at least in his mid-70s and is clearly still quite active for one with "emeritus" in his title. He has one very impressive, yea, intimidating resumé, with 80 publications to his credit. His first book was published 50 years ago, and he has been called "the father of underground economy analysis.")

In my conversation with him, Feige made it clear that he thinks it should be called the "unreported" rather than the "underground" economy. By whatever name, that economy apparently totals about $2 trillion a year in the US. And the "lost" tax revenue is in the neighborhood of $400 billion a year. That amount is downright puzzling if the cash in US circulation is only $250 billion (as would be indicated if 65% of US dollars really were outside the country). That would be pretty high velocity (the number of times money moves from one hand to another). But if cash is actually $750 billion, then that velocity becomes not so remarkable at all.

Surowiecki writes:

The percentage of Americans who don’t use banks is surprisingly high, and on the rise. Off-the-books activity also helps explain a mystery about the current economy: even though the percentage of Americans officially working has dropped dramatically, and even though household income is still well below what it was in 2007, personal consumption is higher than it was before the recession, and retail sales have been growing briskly (despite a dip in March). Bernard Baumohl, an economist at the Economic Outlook Group, estimates that, based on historical patterns, current retail sales are actually what you’d expect if the unemployment rate were around five or six per cent, rather than the 7.6 per cent we’re stuck with. The difference, he argues, probably reflects workers migrating into the shadow economy. "It’s typical that during recessions people work on the side while collecting unemployment," Baumohl told me. "But the severity of the recession and the profound weakness of this recovery may mean that a lot more people have entered the underground economy, and have had to stay there longer."…

The U.S. is certainly a long way from, say, Greece, where tax evasion is a national sport and the shadow economy accounts for twenty-seven per cent of G.D.P. But the forces pushing people to work off the books are powerful. Feige points to the growing distrust of government as one important factor. The desire to avoid licensing regulations, which force people to jump through elaborate hoops just to get a job, is another. Most important, perhaps, are changes in the way we work. As Baumohl put it, "For businesses, the calculus of hiring has fundamentally changed." Companies have got used to bringing people on as needed and then dropping them when the job is over, and they save on benefits and payroll taxes by treating even full-time employees as independent contractors. Casual employment often becomes under-the-table work; the arrangement has become a way of life in the construction industry. In a recent California survey of three hundred thousand contractors, two-thirds said they had no direct employees, meaning that they did not need to pay workers’-compensation insurance or payroll taxes. In other words, for lots of people off-the-books work is the only job available.

J.D. Tuccille, over at Reason.com, responds to the New Yorker article with an interesting analysis pointing to tax rates as the issue, among other things:

Surowiecki bemoans the "damaging effects of this trend," but he should pay more attention to the damaging taxes and regulations that caused this trend by pushing people to work off the books. People aren't depriving themselves of legal recourse and traditional benefits because it's suddenly hip to do so – they're hiding in the shadows because red tape and taxes are strangling the legal economy.

These are concerns. People respond to personal incentives. If the incentive to make their life better in the short term is to work off the books – and that is the basic choice – then that is what they will do. But that is not where I want to go with this discussion today. Let’s focus on another incentive to move out of the reported economy.

Welfare and Incentives

I think almost everyone participates in the unreported economy in one way or another. Do you tip a waiter or waitress? Pay cash for taxis or tip the bellman at the hotel? The baggage guys at the airport? The guys who do your lawn? Even if you write checks for a service, does that mean that income is reported?

I and most other businesspeople try to pay for everything that is a business deduction with a credit card. That can be tricky during IRS audits, but it is just easier than keeping receipts and documenting expenses when you get homeand then trying to add up your cash payments. And you can use a credit card or cash card without problems almost everywhere.

(When I travel outside the US, I am sometimes frowned at if I try to use a credit card. Singapore? No problem. Across much of Europe a credit card is not an issue, but cash is clearly appreciated. Then again, there was the time I wrote about last January, when I tried to use a credit card at a taverna off the tourist paths in Greece, and they had to hunt for their credit card machine and it didn’t work after they found it. And gods forbid you try and use a credit card in Argentina. My point is that the unreported economy is hardly just a US phenomenon.)

But there is a part of US society where unreported income is a particular problem, due to unintended consequences of poorly designed incentives. That is the segment of the country on welfare.

Let me note up front that this is not an argument for or against welfare or helping the poor and needy. I am just noting the large cash economy and offering another reason why it might be as large as it is: misaligned incentives.

In the last few months, conservative news outlets cited a Republican Congressional survey that shows that welfare is about $1 trillion of the US budget, or $168 per day for those below the poverty line. When you dig into the data, you find that a very loose definition of "welfare" was employed, one that most Americans would not use for many of the programs the survey lists. It might argued that the money in question should not be spent, but the survey does not pass the smell test in identifying actual welfare.

According to the Center for Budget and Policy Priorities, even when one uses a very expansive definition of "welfare," only "13 percent of the federal budget in 2011, or $466 billion, went to support programs that provide aid (other than health insurance or Social Security benefits) to individuals and families facing hardship." (Informationclearinghouse.info)

The St. Louis Federal Reserve database shows an even smaller welfare number, at $273 billion (chart below), but you can add about $140 billion at the state level and that gets you closer to the $466 billion mentioned above. That is still a large number per day per family below the poverty line. But let me hasten to add that is NOT what an actual recipient gets; it is just the budgeted cost, which includes what it takes to run the government offices and pay welfare workers.

Let’s look at a few quick statistics, which taken out of context can be misleading, so don’t be misled or assume that I am. The total number of people on welfare is about 4,300,000. The total number of people getting food stamps (the SNAP program) is 46,700,000. We just saw a new high for the number of families on food stamps:

In Texas if, as a single mother of two or three kids, you can figure out how to qualify for every type of assistance available, you can amass get the princely sum of about $980 a month (plus some healthcare). Other states are more generous. The popular meme is that 40 states pay more than $8 an hour to those on welfare, with seven paying more than $12 an hour. But if you work and make more than $1,000 a month (more or less, depending on the state) you will not likely qualify for welfare. The more you make the less you can get, until at some point you do not qualify at all. The theory is that benefits should decrease as your work income increases. (Source for some data: http://www.statisticbrain.com/welfare-statistics/)

Of course, there is the earned income tax credit (EITC), which is phased out once income reaches certain levels. To qualify for that, of course, you need to actually earn income. And WIC, housing subsidies, Medicaid, and other programs exist. (And we will not even get into disability payments. We have recently seen the number of people on disability rise faster than the number of people going back to work. Can a child or other member of a family get disability and another get welfare? Yes, the system can be gamed. Different letter.)

The following chart is from the generally liberal Urban Institute. Note that the maximum amount of total benefits is received by those who have the lowest levels of income, which makes a certain sort of sense. This chart is for a single parent in Colorado, a state that is middle of the road as far as benefits go. Benefits are considerably lower in Mississippi and far higher in Massachusetts and Alaska.

I am not arguing either for or against the level of payments or costs or the rationale for any particular program here. Different issue, different day.

No matter where you live, with few exceptions, being on welfare is not a pleasant lifestyle. Neither is living on $10 an hour, much less on minimum wage.

The point is that people on welfare have a clear need for more money than they get from whatever government check they receive. For most people, welfare is a temporary assistance program to help them out between jobs. But in the last decade, and especially in the five years since the beginning of the Great Recession, the welfare and disability rolls have simply exploded.

The clear incentive, it seems to me, is to work for extra cash in the unreported economy. If as a single working parent you make $10 an hour in the reported economy, you are going to lose most if not all of your welfare benefits (depending on the state); while if you work in the unreported economy, you keep your benefits.

You can view this situation several ways. For instance, perhaps the EITC should be higher, as in, the more you make the more you keep.

If you have a skill that pays you $20-30 an hour (closer to the median family income pay level) you are better off keeping the job and staying off welfare. But if you are minimum-wage labor or not far above it, the equation works out better if you work off the books for that extra income.

Is everyone on welfare working in the unreported economy? I would not suggest that for a minute. Obviously, they aren't.

While acknowledging that correlation is not causation, the parallel growth of the underground economy and the welfare rolls seem to me to be not entirely unrelated. The natural incentives are clearly there. What worries me most is that we are creating a generation of people who are getting used to working off the books, whether or not they are on welfare. They are outside the system and will come to see themselves as not being part of it. It becomes something "other" – except when they want medical care, which, with the advent of Obamacare, will now be available them even if they work in the unreported economy.

None of our kids, yours or mine, believe Social Security will be there for them when they retire. No need to be in the system for that.

There is a lot of controversial work in the economics profession, but I think pretty much everyone agrees that people respond to incentives. I wonder what message we are sending?

Carlsbad, Tulsa, Nashville, Brussels, and Homeless in Dallas

Next Monday I leave for Carlsbad and my conference, which starts on Wednesday evening; but there are lots of meetings and other things to attend to beforehand. Monday I will go to the Altegris office, where there is a lot to discuss, and then I'll meet with Jon Sundt and the other partners that night. The next day will see my Mauldin Economics staff show up for a long day of planning, as we try to deal with our rapid expansion.

And then when the meetings are over and the conference starts up, I get to enjoy again one of my favorite times of the year, when I get to see so many friends and have so many awesome conversations. I personally wish I could make it last for a week or more, as there is just not enough time to spend with everyone. But we take what we can get and savor it.

After the conference I'll be home for a bit before I make my way to Tulsa, where my daughter Abigail will get married May 19. (Her twin sister Amanda is doing fine with one-month-old daughter Addison!)

Later that week I'll fly to Nashville for a night, to speak at a meeting for Altegris, before returning to Dallas to write my letter and then head for Brussels for a week.

I am working on so many writing projects, plus my speech for next week, that I am quite busy. And there are just so many interesting things I come across that seem to demand my attention, not the least of which is working on the new-apartment design and contracting. But of course, we actually have to close the loans and make the purchase first. It seems like it takes forever, which is exactly what everyone told me to expect.

I am still "Homeless in Dallas," living in an extended-stay hotel. I don’t want to rent a temporary apartment until the new place actually closes, so that I can finesse the timing of everything. Therefore, most of my worldly possessions are in storage. It is an interesting experience, as I am finding out that I need far less than I have, and I'm sure I could cut even more. The important things, it seems, are the phone and computer, which are my lifelines to my kids and other family and friends and work. Those two possessions go with me everywhere. And with the new technology in hand, I am finding it easier to enjoy myself wherever I am – and to anticipate the next moment as well. Yes, there are always issues. Kids come with issues galore, and there are always things in the businesses that need tending to. Expenses pile up to more than I like. As do writing deadlines. And now I have to put up with a lack of air traffic controllers and a balky FAA. There is no end of things I could dwell on and stress over, if I wanted to.

There are also a lot of Big Things to worry about in this world of ours, but with an abundance of family and friends, the Small Things seem to work out just fine. You have a great week!

Your living in the moment analyst,

John Mauldin

subscribers@mauldineconomics.com

Austerity is a Consequence, not a Punishment

John Mauldin — Mon, 22 Apr 2013 21:45:00 GMT

The Bang! Moment
The Purpose of Debt
Austerity Is a Consequence, Not a Punishment
San Francisco, Carlsbad, Tulsa, Nashville, and Brussels

Two seemingly different questions and comments from readers and friends crossed my path the last few days, but I saw a definite connection between them. The first question was, Why do we pursue austerity when it seems not to work? And then many readers wrote to ask this week, What do I think about the real problems that are surfacing in the Rogoff and Reinhart assertion that debt above a ratio of 90% debt to GDP seems to slow economic growth by 1% (especially since I have quoted that data more than a few times)? We'll deal with each question separately and then see if we can connect the dots.

The first question comes from correspondence I have had with Ms. Aga Barberini, who works in the investment world in Milan, Italy. She came there from Poland some 20 years ago. The first part of her note contains the question on austerity, but I'll pass along more of her letter, as I think it will give us all some insight into the seeming chaos that voters are facing in choosing a path for Italy. (And I hope my editors leave some of the charming grammar in her letter. You can almost hear the musical tones of her Italian English.)

I am worried for Italy, too. When I came here 20 years ago Italy was beautiful and rich; it was very good for a girl from Eastern Europe. Nowadays a lot of Italians go to Poland and settle down.

I guess it's going to get worse, the austerity will be tighter. Please tell me why should we go ahead with austerity when IMF last month came out saying that for every point of tax lifting in Italy we lose 2.5 points of GDP? First they said that the tax lifting would produce only 0.5 points of GDP slip, now they say they were wrong.

The political chaos is lasting. My husband says, why don't we vote for the comedian in June (as it is almost sure we are going to vote again soon)? Sure, Grillo is right in a lot of things and would clean the politics a lot. (By the way, did you know that the oldest bank in the world, Monte dei Paschi di Siena's mess is reaching 20 billion euros? They took away the money doing ... the bank transfers ;-) The Banka d'Italia didn't see; CONSOB, the Italian SEC, didn't see...). But how can a serious person vote for the comedian?

But I say sometimes the one who is good for the revolution isn't necessarily good to rule the country. Do you remember the guy called Lech Walesa? Thanks to him the communism [in Poland] was fallen – we all agree. Polish people were so thankful to him that we appointed him for the first democratic president. Than we found that he didn't have enough background to rule the country and enough culture to represent us on the international stage.

I will vote Berlusconi again. I can't stand communists even if they call themselves "the left."

(Sidebar: I was in Siena last summer and visited the ancestral home of the bank mentioned above, the world's oldest, founded in 1472. I marveled that any bank could last so long. At the Palio last summer we met one of the senior managers of the bank. It turns out that it was local politicians who ran the board of the bank, and now the authorities are saying management hid the problems from them.)

So let me try to answer you, Aga.

Austerity has come to have a rather bad name of late. The complaint is that it just doesn't work. Which is somewhat like complaining that the roof is leaking because someone else hassn't fixed it. If by "working" we mean that austerity is supposed to produce growth, then of course it doesn't work. By definition, austerity means you are reducing a fiscal deficit, and doing so will reduce growth in the short term. That begs the question, why would you want to do that? Don't we want growth? Let's look at why a country might need to endure austerity.

"Austerity" is now the name we give to the situation where a government has to limit its spending during an economic downturn or recession. The governments of the developed world amassed huge sovereign debts in the course of what is known as the Debt Supercycle. As interest rates fell, borrowing to finance consumption and spending became easy. But now that decades-long supercycle has ended.

One way of looking at the problem of swollen sovereign debt is to tsay that it goes back to Keynes (although one cannot actually blame the current problems on his economic theory). Keynes argued (roughly) that when there is a normal business-cycle recession a government should spend money to counterbalance the private-economy slowdown. That means that the government should borrow money and run fiscal deficits to help boost spending and the economy. According to his theory, this would make the recession not as deep and help bring the economy back to recovery sooner.

This was tried after World War II in numerous countries in the developed world, and it seemed to work. "We are all Keynesians now" is a famous phrase uttered by Milton Friedman and attributed to US President Richard Nixon. It is popularly associated with the reluctant embrace of Keynesian economics in a time of financial crisis, by individuals such as Nixon, who had formerly favored less interventionist policies. (The phrase was first attributed to Milton Friedman in the December 31, 1965, edition of Time magazine. In the February 4, 1966, edition, Friedman wrote a letter clarifying that his original statement was, "In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.") (Wikipedia)

The problem that arose was that most countries rarely followed through on the second part of Keynes's prescription, which was to pay back the debt when times were good. Rather, the debt just continued to accumulate. But, because interest rates were dropping, the size and cost of the debt became less of an issue.

The Bang! Moment

And, as Rogoff and Reinhart showed through their massive data collection and work on sovereign debt crises, published in This Time Is Different and elsewhere, debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment.

I want to review some of their work, which will help us understand the reasons for austerity, but first let's deal with the controversy of the moment. There has been some considerable debate this week among economists about a paper Rogoff and Reinhart published after they wrote their book. Recent detailed work suggests the analysis in that paper is flawed and that there are actual programming errors in their spreadsheets. My inbox almost exploded the last two days as friends and colleagues sent me links to multiple sources talking about the problems with Rogoff and Reinhart's work and asked for my thoughts. Given that I find This Time Is Different one of the more important books of the last decade, let me provide some context.

In 2010, economists Carmen Reinhart and Kenneth Rogoff released a paper, "Growth in a Time of Debt." Their main result was that "… median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower." The work suggested that countries with debt-to-GDP ratios above 90 percent have a slightly negative average growth rate.

This has been one of the most cited stats in the public debate during the Great Recession. Paul Ryan's Path to Prosperity budget states that their study "… found conclusive empirical evidence that [debt] exceeding 90 percent of the economy has a significant negative effect on economic growth." The Washington Post editorial board takes the R&R conclusion as an economic consensus view, stating that "… debt-to-GDP could keep rising – and stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth." (from the Next New Deal site and many other links sent to me)

Next New Deal (nextnewdeal.net) had this analysis:

In a new paper, "Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff," Thomas Herndon, Michael Ash, and Robert Pollin of the University of Massachusetts, Amherst successfully replicate the results. After trying to replicate the Reinhart-Rogoff results and failing, they reached out to Reinhart and Rogoff, and they were willing to share their data spreadhseet. This allowed Herndon et al. to see how how Reinhart and Rogoff's data was constructed.

They find that three main issues stand out. First, Reinhart and Rogoff selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias in favor of their result, and without them you don't get their controversial result.

(You can get further details at http://www.nextnewdeal.net/rortybomb/researchers-finally-replicated-reinhart-rogoff-and-there-are-serious-problems. And there are other sources here and here.)

I and many others who are concerned about the growth of debt quoted that research. As we approach that 90% level in the US, it has become a prominent feature in certain circles. But I want to emphasize that The Rogoff and Reinhart paper mentioned above is a later work than their book. To my knowledge, no one is disputing the work in their book. Their book, This Time Is Different, is basically just an analysis of their very large and masterful accumulation of data about sovereign debt crises.

For the last two weeks I have talked about economists and their use of data. I pointed out that inflation as measured by the CPI is an average for the country and not reflective of any one person's actual experience.

Something similar can be said about the later work of Rogoff and Reinhart. Yes, there was an unfortunate formula in one cell of their rather complex spreadsheet; but more importantly, they made assumptions about what is important and what is not in creating their analysis, and the assumptions in their model gave one set of results. If you make different assumptions, you get other results that show that 90% is not all that bad. Just as economists argue about how we should compute inflation, there will now be arguments about what the debt-to-GDP numbers really mean. I am willing to bet that by this time next year we will see several studies, all arriving at different conclusions.

But in any case, whether in their original work or in the later paper, R&R describe a problem with excessive debt that is true on average. Actual experience shows that in some countries debt will create a problem at quite low levels, while Japan climbs toward 250% debt to GDP (and will get there all too soon) and hardly anyone blinks. Different pokes for different folks.

I'm going to toss in a quick note as I sit here in Hong Kong waiting for my next plane. I read the Financial Times while on the way up here from Singapore. There were several articles that seemed to rejoice in the fact that Rogoff and Reinhart's later paper has some flaws. They jumped on those errors to discredit the whole idea of austerity, the association between too much debt and a lack of growth, and the need to bring one's fiscal house into order. Why pursue austerity when it does not lead to growth, which everyone knows is the only real way to deal with debt?

You can almost hear the critics wanting to dismiss Rogoff and Reinhart's entire book, which clearly establishes the link between excessive debt and sovereign debt crises – a pattern that has played out some 266 times over the last few centuries, if I remember correctly. The point is that there is no magic number that says "This far and no farther." There is a mythical line where confidence and trust is lost, but no one knows where that line of demarcation is until it is crossed. And right up until the last minute, there are always those who look for ways to add more debt, who assure us, "This time is different." But it never is. A country can restore its fiscal house to order, pay back its debt, and grow its way out of the problem over time; there are numerous examples. But continuing to grow that debt-to-GDP number is to court a disaster that looms right in front of you.

If politicians want to keep the borrow-and-spend party going "just one more election cycle" and if no one takes away the punchbowl, the Bang! moment will most certainly arrive. That is the clear lesson of history. It is almost irrelevant whether that number is 90% or 120% or 80%. It will be a different number for each country, depending on the confidence that investors have in the ability of a country to pay back its debt. Investors in sovereign debt are almost by definition the most risk-averse investors there are. You do not invest in a country's debt to increase your risk exposure; you expect to get paid. There are other factors at play in determining the critical threshold, too: What was the purpose of the debt? How fast is the economy growing?

Can Italy, beset by recession, high unemployment, and a political crisis, grow its debt-to-GDP to Japan's 240% level? I think any serious observer would say no. Can it get to 130%? 140%? Maybe. We will not know until it's too late whether Italy or any other country (Spain, Japan, France, or the US) has more debt than the market is willing to absorb. But that is a line any politician should want to avoid crossing.

To cobble together an understanding of why Italy needs to deal with austerity – and to give Aga a good answer – we first need to revisit something I wrote in my own book, Endgame. One of the most important sections of Endgame is a chapter in which I review (and compare with other research) This Time is Different and include part of an interview I did with Rogoff and Reinhart. This chapter turned into a real economic epiphany for me, because the R&R data confirms other research about how things seem to go along swimmingly, and then the end comes all at once – the Bang! moment. Let's review a few paragraphs from my book, starting with a paragraph from the interview I did:

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

Now back to the book [quoting Rogoff and Reinhart]:

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

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

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

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

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

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

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

As Reinhart and Rogoff wrote:

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

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

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

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

The Purpose of Debt

Countries and governments, small and large, can go into debt for numerous reasons. As noted above, Keynes advocated going into debt during business contractions. But there are different types of debt.

There is debt that is used to build productive assets such as roads, airports, bridges, schools, and civic centers.

Then there is debt that is used for current consumption. When debt creates assets, future generations at least get some benefit when they have to participate in paying the loan back. In the case of current consumption, they get none. In essence, debt applied to consumption is spending today rather than spending in the future. You are borrowing money to spend on goods and services in the "now," with the promise to pay for that consumption later.

Next week, if all goes right, I am going to borrow money to buy two apartments in a high-rise in Dallas that will become, after we do a little remodeling, my future home. I will get an asset that I hope to pay off in about ten years. If I am lucky, that asset will then be worth more than I paid for it.

That is different from borrowing money to go on a vacation or to buy food or other goods that will have no future value.

Austerity Is a Consequence, Not a Punishment

But borrowing against the futureis what Italy has essentially done, Aga. Just like other countries all over the world, Italy borrowed for consumption and ran up a rather large debt. And then the crisis came, and lenders were not as willing to provide Italy money at low rates. That is the nature of investors who buy government bonds: if they perceive higher risk, they want higher rates.

The crisis arrived, and Italy lost cheap access to the bond market. The ECB had to step in and begin to buy bonds to lower their rates. But Italy had to promise to lower its deficits, and the way to do that is called austerity.

Italy is in a currency union called the Eurozone. A currency union cannot allow its members to run up debts beyond what the market is willing to finance, or the whole currency union will collapse. The central bank (in this case the ECB) can only print so much money before inflation and valuation becomes an issue. If the ECB allows Italy to run whatever debt it wants to, then it must allow everyone else the same privilege.

Eurozone officials may elect to help a smaller state like Greece paper over some of its problems, but at the end of the day countries must be able to handle their own debts you are going to keep your currency union up and running.

Italy must deal with austerity because if they don't they will lose access to the bond market. They ran up a huge debt and now must figure out how to pay it back. They borrowed money to spend, on the pledge that future generations would pay for it. Unfortunately, the future is now.

Yes, Germany and other countries could lend the Italians money, but they have their own problems. Egan Jones, the only truly independent rating agency, downgraded Germany this week. The Dutch too are having "issues," as my kids would say. Europe in general seems to be slipping into recession.

Some would argue that the ECB should just fire up the presses and print money, as Japan is going to do. Outright monetization. But that approach is highly problematic. Why should Finland want to see that happen if they are not also running large deficits? What about countries with lower debt ratios? The documents everyone signed when they joined the euro dictated that each country would be responsible for its own debt and that the ECB would not monetize debt.

It is one thing for a country to fall on hard times and for its fellow currency-union members to agree to help, but it is another thing to make that help open-ended. Italy has come a long way toward getting back to a sustainable fiscal situation in the last few years. I know it has been hard. I have always maintained that Italy has its own fate in its own hands. Aga, if you just cut the number of cars and drivers you provide to every small-time politician, you could eliminate about 20% of your deficit. Everyone in Italy knows there is a lot of waste and corruption. That is why a comedian like Grillo can get almost 25% of the vote!

The neo-Keynesians are right about this. In the short term, austerity will result in less growth. All but the mathematically challenged will agree with that. The scholarly literature seems to suggest that the short term is about 4-5 quarters, but that estimate is based on averages for a number of countries. Whether the actual interval is longer or shorter, it means that austerity will not produce growth in the short term. And if you have to cut 1-2% a year for several years, then that means little or no growth for those years. But the reason you have to do it is that you did not reduce your debt during the good times.

Austerity is a consequence, not a punishment. A country loses access to cheap borrowed money as a consequence of running up too much debt and losing the confidence of lenders that the debt can be repaid. Lenders don't sit around in clubs and discuss how to "punish" a country by requiring austerity; they simply decide not to lend. Austerity is a result of a country's trying to entice lenders into believing that the country will change and make an effort to restore confidence.

If Italy or any other country does not inspire confidence, then it must suffer the consequences when it loses access to the credit markets. Sure, the ECB or the IMF could lend you money, but their members are essentially investors as well. If there was unlimited money available, I can think of a country or two that might choose to run 10% and then 20% deficits. Why choose to tax when you can borrow and not repay? That is what politicians would all love to be able to promise.

Argentina has pursued such a policy for almost a century. After multiple devaluations, their currency is now a fraction of one billionth of a cent of what it was 100 years ago. It is rather hard to operate as an investor or businessperson in such an environment. One of the reasons why Italians wanted to get into the euro, Aga, was to take away from your politicians the opportunity to run up large debts and then devalue. The lira was a byword for fleeting value, not a currency for long-term investment.

You avoid austerity by not borrowing and consuming in the first place. After the market loses confidence, your choices are rather stark. If you default, then you are clearly out of the market for some time and suffer a very quick and deep recession as the government loses its ability to pay the salaries of government workers, provide healthcare, etc. If you elect to try to keep borrowing, you will have to implement a change in policy that will restore confidence – or find someone who will lend you money on better terms. Bluntly speaking, Germany and the EU might do that for Italy for a while but not unless they see the country actually controlling its deficit.

The problem Italy now faces is that any government that is elected will have to make hard choices. Trying to reverse the austerity already agreed to will almost certainly result in loss of access to the bond market. Is it possible to develop a plan to cut spending at a slower pace? Sure, if you can get the rest of the EU to agree, at the same time that Spain, Portugal, Greece (and soon France) all want the same policies.

If Italy were in control of its currency, might it make sense to print a little in the meantime, as the US, Great Britain, and Japan are doing? There is certainly a school of thought that says yes. But in a currency union of multiple countries that are all at different places on the economic journey, it is almost impossible to have a one-size-fits-all monetary policy. If the spigot is opened for Spain, Italy, et al., then Germany and others get inflation. That is a tough sell to German and Finnish voters (among others).

You cannot force the rest of Europe to fund your deficits. You can negotiate with them to try to lessen the severity of the crisis, but there is no pain-free path ahead from where Italy is today, Aga. Your debt to GDP is 126% and rising. Without ECB support, you would have already lost access to the bond market. If you want to stay in the euro, you just have to deal with it.

By the way, leaving the euro would be a VERY expensive option. The "new lira" would drop in value like a stone in Lake Como (Italy's deepest lake, for those not familiar with it, and one of the most beautiful lakes in the world). The cost of borrowing would skyrocket. The banks would be bankrupt overnight, requiring massive infusions of new currency that would further drive the lira down. You are frustrated with politicians now, Aga? What would it be like in the chaos of a depression? No one can manage well in such an environment. There would be no good choices, only a choice among disasters.

Tiny Cyprus might choose in the next few weeks to exit the euro. With bank accounts frozen and the economy shutting down, they might feel they have no choice. Pay close attention to what happens; it will not be pretty. (As an aside, I am seriously tempted to go to Cyprus in late June, just to see the country firsthand. I will be in Europe between speaking gigs and have not yet decided where to go.)

Italy must first of all choose a government. Cleaning up its political corruption and wasteful spending would be a good move, but even clean new politicians (if there is such a thing) will be faced with the same economic choices. Which, I should note, is roughly the same choice voters everywhere are faced with.

The US is also approaching an uncomfortably high debt level. It was less than ten years ago that I was writing about what the US investment market would look like with no government debt. Yes, that possibility now seems a distant memory, but we were paying down the US debt that fast. And then came the Iraq war and larger deficits and a Republican Congress that got drunk on spending increases. Cheney told them that deficits don't matter, and they took it to heart. They doubled down on debt.

If the US had entered the 2008 crisis with little or no debt, we could have spent that $1 trillion a year (or even several trillion and made Krugman and McCulley ecstatic), and no one would have really cared, from a total debt perspective. (We would have cared what the money was spent on). But we didn't. We squandered our surplus with new programs and spending. We borrowed and consumed. We wasted the good times by running up even more debt. And now we are close to paying a price.

So, Aga, I don't have any easy words for you, but I do think Italy will pull through. I will visit your country again and again in the future, because I love Tuscany. But if you can take comfort in the company of others in similar situations, then there are a host of countries in the developed world that are going to have to face austerity in one form or another. That is just what happens when you reach the end of the Debt Supercycle. You are no longer left with merely difficult choices; they are more like very tough, bad, and disastrous. The worst choice is not dealing with the problems as soon as possible. I only hope my own country can make the difficult choices soon, before we too are faced with a crisis.

San Francisco, Carlsbad, Tulsa, Nashville, and Brussels

I finish this letter in the Singapore airport before I begin the rather long journey back to San Francisco, where I will rest and recover from jet lag at the Fairmont, one of my favorite hotels over the years. I speak in SF Monday morning before heading back to Dallas and my "home hotel" for a week. As noted above, I am buying a property as my primary residence and had to move out of my leased home early, so I'm between places. As I have promised, when the deal for the new place gets done, I will write about my experience – the terms and negotiations and why I decided to buy now after all these years.

This is a bit of a first for me, as I fly to Hong Kong to catch a plane to San Francisco. I will leave very early Friday morning and arrive late on Thursday night, crossing the international date line and arriving the "day before" I left, getting back the day I lost coming here.

My Strategic Investment Conference is almost here. I am so looking forward to catching up with old friends. And I'm just as excited about the exchange of views we will have on how to navigate the coming economic transitions. It seems everyone is on the "short Japan" side of the boat, including me. Is the boat listing, or is there still room for others? The debate on whether there is a bubble in the US bond market will be intense. Europe will be a hot topic. China, too. Will the US see 3% growth this year or fall further behind?

And underlying our discussions will be an intense debate about the future of world growth and stability. I have purposely sought out thought leaders who steer independent courses. Kyle Bass, Niall Ferguson, Nouriel Roubini, Drs. Lacy Hunt and Gary Shilling, David Rosenberg, Charles and Louis Gave, Anatole Kaletsky, and Paul McCulley will all be there, among others. You can see the entire line-up for the May 1-3 conference (co-sponsored with Altegris Investments) right here, plus see highlights from last year's conference. There are still a few spots left, so I encourage you to register and join me and my friends as we think about our future. I think this is clearly the best investment conference of its kind this year, and I, along with Jon Sundt and his team at Altegris, am proud to be able to offer it to you.

I continue to be impressed with Singapore. This city/country just works. I was able to take a few hours and tour their magnificent Garden Domes. The entire place is a marvel of human engineering and vision. I want to return for an extended visit and explore the amazing variety of plants and trees they have assembled from the world's cloud forests. They built an indoor, 115-foot-high waterfall system and replicated a cloud forest that you can walk through.

Every time I come here there are new towering buildings and projects to reclaim land from the ocean. A sustainable future is a constant theme. Low taxes and a climate that is ideal for business have made this nation a center for commerce. Issues here and there? Sure, this is a human enterprise, and we come with built-in issues, but the problems are positive ones.

They are calling my flight, so it is time to hit the send button. Charley & Lisa Sweet, my long-suffering editors, will have extra work cleaning up this week's letter, but I don't think the plane will wait for me to go through it one more time.

Have a great week, and come see me in Carlsbad.

Your ready to read on the way home analyst,

John Mauldin

subscribers@mauldineconomics.com

Assume a Perfect World

John Mauldin — Sat, 13 Apr 2013 18:32:00 GMT

Assume a Perfect World
Objects in the Rear-View Mirror Are Larger
An Imaginary Recession
Peace in Our Time?
Government Spending Per Household Exceeds Median Household Income
What Do You Want It to Be?
Las Vegas, Singapore, San Francisco, and Carlsbad

An engineer, a chemist, and an economist are stranded on a deserted island. They are starving, when miraculously they find a box filled with canned food. What to do? They consider the problem, bringing their collective lifetimes of study and discipline to the task.

Being the practical, straightforward sort, the engineer suggests that they simply find a rock and hit the cans until they break open. “No, no!” cry the chemist and economist, “we would spill too much food and the birds would get it!”

After a bit of thought, the chemist recommends that they start a fire and heat the cans. The pressure in the cans will force them open and the food will conveniently already be heated. But the engineer and economist object, pointing out correctly that the cans would likely explode and splatter the food all over the beach.

The economist, after carefully studying the cans and reading the labels, starts scrawling a series of equations in the sand, which eventually cover the entire beach. After much pondering, he excitedly announces, “I’ve got it! I’ve got it!” as he points to the final equation. They ask him to explain, with their visions of finally getting a meal causing them to regard the economist with a new sense of respect.

The economist clears his throat and begins, “First, assume a can opener …”

I am not sure how old that joke is, but it dates to about the time when economists discovered mathematics and models, which is to say, about the time when economists developed physics envy and decided they would like to be regarded as scientists rather than philosophers. This week we continue to look at the data and models developed by economists, with a view to understanding both their usefulness and their limitations. The specific data we will examine this week is inspired by the release of the President’s FY 2014 US budget proposal this week. While it and the House and Senate budget proposals may appear to be widely divergent, there are some underlying and quite disturbing similarities among them.

Specifically, all three proposals assume away the real world. It does not matter which version you prefer; they all lack the basic precautions and hedges that those of us involved with preparing family and business budgets make sure to include in our own forecasts. While whole books could be written about the underlying assumptions in these latest budget proposals, we will examine (hopefully briefly) just a few of the more glaringly problematic ones.

Assume a Perfect World

Like our castaways with their abundance of canned food but no can opener, a US budget forecaster is faced with the problem of predicting the fiscal future of a very large, very real economic system, but without a crystal ball. And as we saw last week, economists are not particularly good at telling us what happened in the year that just passed, let alone in the year to come. (And we often see national budgets that presume to extend out for ten years or more.)

The basic challenge is pretty simple. There is a need to forecast revenues and expenses. Expenses are the more straightforward of the two. Most government expenses are line items in a budget. “We project we will spend $5 billion a year fixing roads and bridges, $1 billion on our national parks, $925 billion on defense, etc.” Social Security, too, is straightforward. Healthcare involves a lot of guestimates, and unemployment costs go up and down with the economy.

Revenues are a bit trickier. Income tax revenues obviously go up and down with incomes, as do corporate taxes and Social Security and Medicare taxes. If there is a recession, revenues will fall. If you get an economic boom, then revenues could turn out better than projected. I think I remember some economists predicting in the mid-’90s that the rest of the decade would be flat or trend down – we had a boom. In the middle of the last decade I predicted a Muddle Through Economy, which to me meant 2% GDP growth, down from the average of 3% we had experienced for decades. Two percent turns out to have been slightly optimistic, although I remember more than a few people telling me I was just too bearish. I would be very happy if we could manage 2% average growth for the current decade. As I wrote a few months ago (here and here), there are several respected forecasters, including Jeremy Grantham and Robert Gordon, who think 1% (or less!) is more likely.

Last year we were at a real inflation-adjusted growth rate of 1.7%. Nominal growth of 3.5% for 2012 was the lowest since the end of WWII. So what do our intrepid budget forecasters predict for the next ten years? Not content to project that current trends will persist, they have whipped on their rose-colored glasses to deliver us bright promises of spectacular growth.

David Malpass writes Thursday in the Wall Street Journal that Obama’s 2013 budget projections make a prediction of 3.6% growth by 2016, with tax revenues up by 50%. But Obama may seem to be conservative if we look at the projections of the Congressional Budget Office.

The next chart is from work done by Veronique de Rugy. It shows that the CBO projects that growth in 2013 will slow to 1.4% and then TRIPLE to 4.2% over the next three years! In the years 2015-2017 they project the US to grow 4% annually on average. And that is real growth they’re foreseeing, not nominal growth.

I read that and went straight to the latest CBO report to check. But there on page 40 and following were the actual numbers.

The next chart is from page 41 of that 77-page report, which contains extensive details as to how they arrive at their various expense and revenue projections. I should note that they are consistent in that they do not project low interest rates during their predicted economic boom of the next several years. The Obama administration, on the other hand, assumes in their budget proposal that interest rates will be only 1.2% in 2106, to accompany their 3.6% growth (and inflation of only 2.2%). Now THAT would be a very accommodative Federal Reserve.

Either way, interest costs are projected to rise dramatically as the decade progresses, more than doubling in real terms. In nominal terms, interest-rate costs are expected to increase almost FOURFOLD, from a current $224 billion to a projected $857 billion! That means interest-rate costs are projected to grow to roughly 16% of the federal budget within this decade (back-of-the-napkin estimate).

The increase in debt (in dollar terms), along with an anticipated substantial rise in interest rates as the economy strengthens, is expected to sharply boost interest payments on the debt. CBO projects that, under current law, the government’s yearly net interest spending will double as a share of GDP—from 1.5 percent in 2014 to 3.3 percent in 2023, a percentage that has been exceeded only once in the past 50 years. (CBO)

I should note that both the CBO’s and the Obama administration’s assumptions are much more optimistic than those of Federal Reserve economists (to the extent that they make projections). And the track record of the Fed is that, on average, they have projected 2.1% more GDP growth than actually occurred, just one year out.

Philippa Dunne & Doug Henwood of The Liscio Report supplied that surprising figure, and continued in their piece this week:

What does this mean for the future? Since the timing of the withdrawal of ease is highly dependent on these major economic indicators, we should take the Fed’s forecasts of their future course skeptically. Given the demonstrated difficulties they have forecasting a year or less ahead, forecasts two years or more in the future seem especially questionable. (Corroborating a remark from a CBO official we relayed back in 2007 that forecasting out even 2 years is a waste of time.) Since so many forecasts tend to be extrapolations of the present and recent past, the timing of QE withdrawal is likely to be more dependent on the real-time trajectory of major economic indicators than on imagined futures.

Even though at least one CBO economist thought it was a waste of time to make even two-year projections, they do attempt a ten-year projection. How optimistic are they? Well, let’s go the FRED database at the St. Louis Fed (a marvelous tool and one of the more important free sources I use).

This is the percentage change in GDP year over year since 1940. Note that we have to go back to the 1960s to find a period where GDP grew by 4% for three years running. In fact, we have to go to 1969 to find even one year when it was 4%!

Objects in the Rear-View Mirror Are Larger …

Optimistic GDP projections mean that whatever revenue projections accompany them are also likely to be overly optimistic. Given the federal government’s lack of control over expenses, and its track record in forecasting expenses, it is likely that expenses will be underestimated, making actual deficits larger than they expect. One example: we have already seen Obamacare costs rise by over 40% from the projections just two years ago.

(That 40% does not even take into account what your private insurance costs have already risen and are going to continue to rise. Obamacare is going to be a giant economic debacle. That is not meant as an argument for or against universal coverage or coverage of pre-existing conditions. It is just noting that the economics of the way we are going about achieving our healthcare goals are turning our national program into a daunting fiscal disaster.)

An Imaginary Recession

Go back and look at the chart just above. Notice the shaded gray areas. Those are recessions. Now notice that there is not one decade without a recession, and most have two. Obama, the Senate, and the House all assume that we have vanquished the recession virus and will not experience that economic malady again in our near future.

Can I get any of my readers to make a wager with me that the US will somehow get through the rest of this decade without a recession? Buehler? Anyone? I thought not.

But that is exactly the wager that Congress and Obama are making with your tax dollars. Their budgets show expenses rising for the next ten years. And if we get a recession they will want to run even larger deficits. Their argument will be that we can’t possibly cut the fiscal deficit during a recession – that would make things even worse! Austerity doesn’t work; we all know that.

What happens if we do get a recession? Revenues go down, of course. Unemployment goes up, as do associated costs like unemployment checks.

Note the graph below. CBO forecasters assume that GDP will recover back to its former trend line, instead of simply growing from a lower base; and that is where they get their obscenely rosy back-to-back-to-back 4% increases.

What happens if we land in a recession instead? Not only do we not get back to that trend, we drift farther from it! Will the CBO then project 5% GDP growth for three years running to get us back to the original trend? That would be no more absurd than what they are doing now.

The reality is that no politician or government agency can forecast a recession (unless, as in 2012, they are arguing against a sequestration that is projected to actually cut spending). None of us really know when the next recession will happen. Theoretically, we could go another 10 years without one. It is also possible that the government will reveal that there really are aliens in Area 51. I leave it to you to decide which is more likely.

While acknowledging that forecasting a recession is impossible and politically a non-starter, it would be nice if forecasters and politicians were to admit the possibility of lower-than-estimated revenues and willingly contemplate what might happen if a recession did transpire. As the US approaches a truly debilitating debt level, I want to ask them, “Will you please tell us what the plan is if we experience recession rather than expansion?”

I can hear the answer now: “I don’t want to speculate about possible recessions. That is pointless.” But my rejoinder would be, “You are perfectly willing to speculate that we will have no recession and that we will grow at a rate not seen in over 40 years, not even during the Reagan and Clinton boom years. How speculative is that?” (Where is Nixon when we need him? Or was the growth during his reign a legacy from Kennedy and Johnson? Or was it just American productivity?)

Peace in Our Time?

The defense budget is projected to fall about 13% in actual dollars from 2011 to 2014 and to fall as a percentage of GDP every year. The liberal Brookings Institution argues that Obama’s budget is unrealistic in that it cuts spending too much. (In Obama’s defense, he is not cutting entitlements very much and cuts everything else to preserve them as much as possible, which from his point of view is the correct policy choice.)

The president’s spending projections are even less realistic. Between 2013 and 2023, defense spending is projected to fall by 40 percent as a share of GDP, from 4.0 percent to 2.4 percent, while non-defense discretionary programs fall by one third, from 3.7 percent to 2.5 percent. This is barely imaginable, but highly unlikely. During the past half-century, defense spending has never gone below 3 percent of GDP, not even in the years between the fall of the Soviet Union and September 11, 2001. Non-defense spending has never gone below 3.2 percent, a level it reached near the end of the Clinton administration. (During the Reagan era, it never went below 3.5 percent.) It is hard to believe Obama’s proposals would allow us either to meet our basic security needs or to afford the level of public investments that have helped sustain economic growth throughout our national history. It’s up to senior administration officials to make the case that their numbers are realistic, and they’ll face a heavy burden of proof.

In short, even with substantial increases in revenues, the swelling pressure of entitlements and debt is leading our country to shortchange its future. Is that the course we want, or are we backing into it because we aren’t willing to challenge the assumptions that are producing it? Before we get mired in technicalities, that’s the threshold argument we should be having. (Brookings Institution)

Government Spending Per Household Exceeds Median Household Income

In fiscal 2010, according to numbers published by the Census Bureau and the Office of Management and Budget (OMB), net spending by all levels of government in the United States was $5,942,988,401,000. That equaled $50,074 for each one of the 118,682,000 households in the country.

In that same year, according to the Census Bureau, the median household income was $49,445. That means total net government spending per household ($50,074) exceeded median household income (49,445) by $629... As recently as 2000, the relationship between government spending and household income was dramatically different. Data from the Census Bureau and the OMB show that in that year net spending by all levels of government was 3,239,913,876,000. That equaled $29,941 for each of the nation’s then 108,209,000 households. In 2000, the median household income was $41,990... (A very interesting e-book called Completely Predictable)

What Do You Want It to Be?

The next oldest economist joke goes like this: A businessman interviews a mathematician, an accountant, and an economist for a job. He asks them, “What is 2 + 2 ?” The mathematician answers, “Exactly 4.” The accountant replies, “Depending on what your interest, depreciation, and taxes are, approximately 2.”

The economist walks over to the door, shuts and locks it, closes the blinds on the window, and leans over and softly asks, “What do you want it to be?”

Budget forecasts are a lot like that. A politician wants to enact a certain deficit-reduction policy. He wants to make assumptions that work to his benefit. So he calls in his friendly local economist, who obligingly responds, “You need 4% growth to make this work? No problem. Here’s the data and math to back up those assumptions.”

The CBO is supposed to be politically neutral. And it is: those 4% projections it came up with are good for both parties. If they projected a 2% real GDP growth for the next eight years, the agency would be disbanded. And gods forbid they pull a Jeremy Grantham or (Northwestern University professor) Robert Gordon and project 1%. Or a Bill Gross, at 1.5%. With those low growth expectations, the CBO’s projected budget deficits get blown sky-high, projected new expenditures seem just a tad extreme, and those tax cuts they’re talking about will be much more difficult to budget.

Government economists would like to assume a perfect world: no recessions; extraordinary, never-before-seen growth; peace, with no need to worry about nagging little military problems or defense; falling unemployment; rising tax revenues, when government spending is already taking a huge chunk out of the economy; interest rates staying under control; deficits falling over time; and on and on.

It's not easy being an economist. How would you like to go through life pretending you could predict the future and even knew what M1 was all about? It is absolutely necessary that we make forecasts as part of a responsible approach to government spending, but we need to be more skeptical of those forecasts and use some common sense in our budgets in order to allow for a rainy day here and there.

Liberal-socialist Sweden allows its pensions to rise and fall with GDP, so as to keep from blowing out their budget process. They made that hard choice in the midst of a credit crisis. Perhaps we too should make a hard choice now, in order to make sure we don’t have a major crisis of our own.

Waiting for our forecasts to be wrong before we adopt a yet another “solution” based on a temporary fix of yet another forecast that turned out to be wrong is no way to run a railroad, unless you want your train running off a cliff. I applaud the recent attempts in DC to come to a solution on the deficits and budget, but where are the leaders who want to get real with those forecasts?

Las Vegas, Singapore, San Francisco, and Carlsbad

I will be in Las Vegas as you read this, joining my doctor, Mike Roizen, at a fundraising event to benefit the Cleveland Clinic Lou Ruvo Center for Brain Health. The event will have Sir Michael Caine and Quincy Jones celebrating their 80^th birthdays together. Born in the same year, same month, same hour, and within minutes of each other, their lives have touched multiple generations. Michael Caine is one of my favorite actors. (Dirty Rotten Scoundrels? And Secondhand Lions, with Robert Duvall, is a classic.) I have never done an event like this (with so many stars performing) where I will actually be close to the action. I have no business getting on another plane to stay at another hotel this week, but when will I ever get a chance like this again?

I get back Monday to pack for my trip to Singapore. I am told the conference, sponsored by Saxo Capital Markets and The Business Times, is sold out. I will get to be with old friends Grant Williams (You know him from Things That Make You Go Hmmm… and Bull’s Eye Investor), his partner Steve Diggle, and Simon Hunt, who is a go-to source on China. I hope to get to Malaysia with Grant for a side trip, just for fun, one of the days I am there.

As a quick aside, and apropos of our theme of distinguishing the real from the fake, I did a recent video conversation with Grant that I really want to show you. Our publisher, Ed D’Agostino, was there to ask us just the right questions, and we developed some themes that turned out to be a bit surprising, even to us. You can drop in on the conversation here.

I leave Singapore Friday evening, only to stop in San Francisco to do a speech on Monday for the National Association of Surety Bond Producers annual meeting, before heading back home to rest up.

The next week I go to Carlsbad for my 10^th annual Strategic Investment Conference (ably run and co-hosted by my partners at Altegris Investments), May 1-3. We have been doing a lot of planning for this one and have worked hard to make sure there will be a lot of interaction among the speakers on the stage and with the attendees. We managed to free up a few more spots this past week, so if you haven’t registered, this may be your last chance. It WILL sell out. To see the lineup that I think will make this the best investment conference this year, go to http://www.altegris.com/sic .

I have spent time recently on the phone or face to face with most of our speakers (I was with Nouriel on Wednesday). David Rosenberg has a completely new presentation and theme for this conference. Kyle Bass and Louis Gave will offer up ways to play Japan. Interest rates? Why not hear from the guys who have been right for decades? Managers who run billions and have done so successfully, across the entire gamut of market environments. Have questions about QE in the global environment? (Forget whether QE was right or wrong: what will they do about it now?) France? Italy? England? China? We’ll cover all that and much more.

I am making progress on getting the new apartment squared away. The home owners association of the building approved the plans today, so now we turn to the bankers to get the deal actually papered. It is time-consuming but rather fun. I have never designed a place for me before, but rather just took what was there. Getting the “new media” features right is a priority for my kids, and we are all excited about that. Blending the old and the new is a talent I am trying to cultivate. I am in a hotel only a few blocks from the high-rise where I will move later this year when construction is complete (late 3^rd quarter?). I walked by it tonight while thinking about this letter. I think the energy of seeing the downtown Dallas lights will be helpful in the creative process. And I will have my writing desk and chair where I am a lot more comfortable, with a great gym a short elevator ride below.

It is late and I need to hit the send button. Harking back to our story about the economist and the can opener, I can’t just assume sleep. And I have to actually get some before I get on that plane. Have a great week.

Your wanting to move in already analyst,

John Mauldin

subscribers@mauldineconomics.com

You Can’t Be Serious

John Mauldin — Wed, 27 Mar 2013 22:21:00 GMT

You Can't Be Serious
The Serious Unintended Consequences
It Is Time to Break Up the Banks
New York, Singapore, and the SIC Conference in California

I admit to being surprised by Cyprus. Oh, not the banking crisis or the sovereign debt crisis or the fact that its banks were eight times larger than the country itself or even the fact that the banks were bloated with Greek debt that had been written down. I wrote about all that a long time ago. What surprised me was that all the above was apparently a surprise to European leaders.

While there is much to not like about what European leaders have done since the onset of their crisis some five years ago, they have demonstrated a prodigious ability to kick, poke, and massage the can down the road, to defuse crisis after crisis, and to indefinitely postpone the inevitable. They have demonstrated a remarkable ability to spend taxpayers' and others' money in order to keep Europe and the euro more or less in one piece. At every step they have been keenly intent on maintaining trust in the system. That they have been successful in keeping a majority of citizens in favor of the Eurozone and the euro, even in countries forced to endure serious austerity, must be recognized.

However, the shock in Cyprus reveals an absolute lack of preparedness in dealing with a problem that had festered for several years. By now it should be no surprise to anyone that sovereign nations can default, that banks can go bankrupt under the weight of defaulted sovereign debt, and that banks can be too large for some countries to bail out. That a clear and consistent response to Cyprus should have been worked out in the halls of Brussels and the ECB seems so, well, reasonable. Clearly, the large depositors in Cypriot banks, the majority of whom were Russian (according to Financial Times reports) thought the Eurozone had a plan. In fact, the apparent assumption, bordering on religious faith, that Eurozone leaders would not allow depositors in Cypriot banks to lose one euro, is almost touching. This snafu is going to have repercussions that spread far beyond this tiny island nation. Let's look at a few of the implications.

You Can't Be Serious

When we woke up to the Eurozone pronouncement that all depositors in Cypriot banks, no matter the size of their deposits, would take a loss my reaction was somewhat akin to John McEnroe shouting, "You can't be serious!" to a line judge whose call he infamously questioned.

While there was no official deposit guarantee in place in Europe, the implicit guarantee was €100,000, a number that had become all but sacred during the recent banking crisis. To wake up and find that European leaders not only did not consider this protection to be implicit but also planned to demand losses from all depositors, was quite the shock. I think this may have been the single worst "call" by European leaders since the beginning of the crisis in 2008.

Let's look first at what actually transpired. Cypriot banks held deposits of roughly €68 billion, four times the size of the total national GDP, while the total size of the banks was roughly eight times GDP. The "Troika" seemed to feel that Cyprus needed €17 billion in bailout money to be able to handle the crisis. But after finding hundreds of billions for Greece and Spain, they were only able to offer tiny Cyprus €10 billion (€10 billion is the equivalent of offering the US $8 trillion, give or take a few euros, just to keep it in perspective), and demanded that depositors in Cypriot banks be levied for most of the remaining €7 billion. They offered a formula by which small depositors would lose somewhat less than 10% and large depositors somewhat more (the actual number varied day by day).

The Cypriot parliament totally rejected the Eurozone proposal. Not one vote was cast for the deal. And when you look at the numbers, as any politician does, you can see why. This is an island of 1.1 million men, women, and children. There are (were) 370,000 bank accounts, with 360,000 of those containing fewer than 100,000 euros (per Dennis Gartman). In the recent presidential elections in Cyprus, there were 445,009 voters and a voter turn-out rate of 81%. Thus, a huge majority of voters had accounts with less than €100,000 in them. Call me cynical, but I think any politician could figure out which side of this fence to land on.

It now appears that "only" €5.8 billion is needed for the bailout, so the 10,000 or so accounts holding more than €100,000 will be docked an average of €580,000. "The tottering banks hold 68 billion euros ($88 billion) in deposits, including 38 billion ($49 billion) in accounts of more than 100,000 euros – enormous sums for an island of 1.1 million people, which could never sustain such a big financial system on its own." (NBC World News).

On the surface it looks like large depositors will lose about 15%. And if the Financial Times is right (and the betting line is heavily on their side), a significant majority of that money is Russian. Much of the remainder is tax-haven money (more on that later). "Not so bad," you might think; "things could be worse."

Well, actually they are worse. Some EZ officials suggest that the losses of large depositors could range up to 40%, and the Cypriots themselves suggest 30%. That is because if you are a Greek bank with a Cyprus branch your deposits are exempt from the levy. The logic behind that decision is just too arcane to explain in a brief letter that prides itself on rational explanations. Which is another way of saying that I actually couldn't understand it myself. But then, I'm just a country boy from West Texas, not a European financial wizard.

Things keep spiraling down in the Eurozone. One of the founding principles of the Eurozone was that a euro anywhere within the zone would be as good as one anywhere else. Euros would flow freely. All for one and one for all.

Except that now euros in Cypriot banks are no longer equal. Not only are they going to be "taxed" (or whatever euphemism they end up choosing – they're still debating that one – but if it were your account you might call it theft), but deposits will be subject to capital controls. Reports coming out of Europe this morning suggest that banks in Cyprus will stay closed until at least Thursday. It is not clear when you will actually be able to take your money and leave the sunny shores of Cyprus.

Cypriot banks will remain closed until Thursday, the government announced on Monday night, as President Nicos Anastasiades acknowledged that the country had come "a breath away from economic collapse" before its last-minute bailout. Speaking after he agreed a €10bn international rescue that includes the restructuring of the island's two biggest lenders with losses for bigger depositors, Mr Anastasiades also said capital controls would be imposed but as a "very temporary measure that will be gradually relaxed".

We will eventually learn what time frame a Cypriot politician has in mind when he says "temporary." And Mr. Anastasiades may have been speaking optimistically to the press. Other Cypriot politicians were rather less sanguine. From Dennis Gartman this morning:

They (bank depositors) knew for certain, however, that they were going toface massive losses when Mr. Averof Neofytou, the deputy president of the ruling Disy Party, said that those large depositors "Will [have to] wait for many years before they see what percentage they will get back from their savings – 30 percent, 40 percent, 50 percent, 60 percent, it will be seen…."

The Serious Unintended Consequences

Basel III standards require European banks to increase their deposit ratios. This European response to Cyprus is going to make that harder for banks in smaller European countries to accomplish. Very tiny Luxembourg has banking assets 13 times the country's GDP. Yes, I know that Luxembourg's banks are the very epitome of solid banking and that the majority of those assets are loans to central banks and other credit institutions, but there is no way on God's green earth that Luxembourg as a country could even begin to think about backing its banks. Of course, everyone knew that before this crisis, but if you are the treasurer of a large corporation, how soundly do you sleep at night after Cyprus? And God forbid you have an account in one of the peripheral countries. In the case of Ireland, the lesson was that the money would be found to back the banks, even if taxpayers suffered. But now? New rules for new times. And then you open The Financial Times this weekend and read (emphasis mine):

The chairman of the group of eurozone finance ministers warned that the bailout marked a watershed in how the eurozone dealt with failing banks, with European leaders now committed to "pushing back the risks" of paying for bank bailouts from taxpayers to private investors.

Jeroen Dijsselbloem, president of the eurogroup, was speaking after Cyprus reached its 11th-hour bailout deal with international lenders that avoids a controversial levy on bank accounts but will force large losses on big deposits in the island's top two lenders.

Evidently, Jeroen interprets the term private investors to mean depositors with over €100,000 in a bank. That has to be unsettling to anybody who has diligently saved for decades and is now retired and depending on those funds for sustenance. And for corporations that run a payroll account through a bank? The thought that you could see a lifetime of work building a business go down in an unelected bureaucrat's blink of an eye would keep me up at night. I do not think most corporate financial types see their deposits as an "investment" in the bank.

One of my favorite reads is Kiron Sarkar (who variously lives and writes daily in London, Ireland, and India). I talk and correspond frequently with Kiron. He is a retired but very senior investment banker with deep European political and business connections in many countries. As we say in Texas, he is "wired." (You can subscribe to his letter at http://sarkargm.com.) He shot out a special note on the rather incendiary comments of Mr. Dijsselbloem. I have seen other comments similar to these (but less well-said), expressing various levels of disbelief about the timing of Dijsselbloem's remarks, but here's what Kiron had to say:

Reuters quotes the Chairman of the EZ Finance Ministers, Mr Dijsselbloem, as having said:

"If there is a risk in a bank, our first question should be OK, what are you in the bank going to do about that? What can you do to recapitalise yourself? If you can't do it, then we will talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank and, if necessary, the uninsured deposit holders."

He is also reported as having said, "It will force all financial institutions, as well as investors, to think about the risks they are taking on because they will now have to realise that it may also hurt them. The risks might come towards them". These are very likely to be personal remarks, rather than an EZ finance minister's policy statement, but these comments suggest:

Uninsured depositors in EZ countries may well be bailed in in the future, ie Cyprus is a precedent;
EZ countries with large banking sectors will have to reduce their size and restructure;
EZ countries are seeking to shift risks away from the public sector and onto the banks; and
Bail-ins will reduce the need to use the ESM funds to recap banks, a policy which was proposed just under 1 year ago.

These are INCENDIARY remarks, especially given the timing and debacle over Cyprus. What happens to Malta? Slovenia is in trouble. Luxembourg has a massive banking sector, though it is an AAA-rated country. All 3 are in the EZ. I realize that Mr. Dijsselbloem is new to the job and has little to no experience of the financial services sector (why was he appointed, you may well ask), but to make such comments, especially at this time, is the height of irresponsibility. The comments Reuters reports seem accurate, as the FT carries similar quotes.

At the end of the day, Mr Dijsselbloem is, of course, right; but to say something like this, especially at this time, well …

[Now this is the key paragraph and takeaway. Read twice. – John]

Essentially, why will anyone keep more than E100k in any EZ bank – indeed, why deposit any amount in certain EZ banks, as the value of the EZ bank-deposit guarantee is worthless in a number of cases, as a number of the peripheral EZ countries can't afford to pay up. I repeat, the EZ bank deposit "guarantee" is not a joint and several responsibility across the EZ; it is the responsibility of individual EZ countries.

If these comments are not withdrawn/clarified, the weaker EZ banks in the troubled countries, in particular, are going to come under severe pressure. Even if withdrawn/clarified, this is yet another self-inflicted wound. The euro has declined materially since these statements by Mr Dijsselbloem were published by Reuters and the FT.

The euro has declined to US$1.2873 at present and continues to weaken. The European banking sector is being hit – no surprise. The peripheral countries (Spain and Italy) are also being hit, in particular. Bond yields of the safer countries are declining, unsurprisingly, whilst the yields in the EZ peripherals are rising. Italy and Spain look to be under pressure. A number of you may now understand why I am so negative on the EZ.

As I noted, Basel III makes it more necessary than ever for Eurozone banks to retain depositors, but this action on Cyprus will make getting large deposits more difficult for many banks. Note that less than 4% of depositors account for almost 60% of the deposits in Cypriot banks. Banks need those large depositors if they are going to grow their capital base to the required standards.

This unfortunate business underscores one of the most significant problems in the Eurozone, which is the lack of a collective deposit-insurance scheme. I wrote pessimistically about that topic over a year ago when European leaders promised they would create a Eurozone-wide deposit-insurance mechanism. That initiative has gone nowhere, primarily because the Germans have opposed it. (Ironically, so did Cyprus.)

Let me state this very clearly: if something as seemingly straightforward and necessary as deposit insurance cannot be achieved, then how can there be any hope for deeper fiscal union? And fiscal union will be necessary before all is said and done if the Eurozone is to survive.

It is not just tiny Cyprus or even Spanish banks that will be looked at with growing worry by large depositors. Let's examine this note from David Stockman on European banking, and in particular French banks:

BNP-Paribas is the classic example: $2.5 trillion of asset footings vs. $80 billion of tangible common equity (TCE) or 31X leverage; it has only $730 billion of deposits or just 29% of its asset footings compared to about 50% at big U.S. banks like JPM; is teetering on $500 billion of mostly unsecured long-term debt that will have to be rolled at higher and higher rates; and all the rest of its funding is from the wholesale money market , which is fast drying up, and from repo where it is obviously running out of collateral.

Looked at another way, the three big French banks have combined footings of about $6 trillion compared to France's GDP of $2.2 trillion. So the Big Three French banks are 3X their dirigisme-ridden GDP… By contrast, the top three U.S. banks which are no paragon of financial virtue – JPM, BAC, and C – have combined footings of $6 trillion or 40% of GDP. The French equivalent of that number would be $45 trillion for the U.S. banks. Can you say train wreck!

It is only a matter of time before these French and other European banks, which are stuffed with sovereign debt backed by no capital due to the zero risk weighting of the Basel lunacy, topple into the abyss of the shadow banking system where they have funded their elephantine balance sheets. And that includes Germany, too. The German banks are as bad or worse than the French. Did you know that Deutsche Bank is levered 60:1 on a TCE/assets basis, and that its Basel "risk-weighted" assets are only $450 billion, but actual balance sheet assets are $3 trillion? In other words, due to the Basel standards, which count sovereign and other AAA assets as risk free, DB has $2.5 trillion of assets with zero capital backing!

This is all a product of the deformation of central banking and monetary policy over the last four decades and the destruction of honest capital markets by the monetary central planners who run the printing presses. Furthermore, this has fostered monumental fiscal profligacy among politicians who have been told for years now that the carry cost of public debt is negligible and that there would always be a central bank bid for government paper. Perhaps we are now hearing the sound of some chickens coming home to roost.

Yes, yes, I know: "John, how can you even think that French debt could be at risk?" But if you look at France's income and balance-sheet statements, as if France were a stock rather than a country, you might not be so sure. Might I suggest that a good trade would be to be long German government debt, short French debt? Essentially, this is a bet that France will be worse off than Germany in the coming years, which seems like a good wager right now. And in a French debt crisis (well within the realm of possibility) that trade could work both ways! Just saying …

We will wrap up with this note that just hit my inbox from Louis Gave. (I am up late, as usual, and Louis writes from Hong Kong, where it is early). Remember that Louis is French as you read this.

So we now know that, in Europe, big depositors are the first in the line of fire to ensure that small depositors do not suffer losses. Needless to say, this raises the question of who wants to be a big depositor in a weak bank in a country undergoing a secondary depression?...

EU policymakers are probably not evil henchmen set on destroying the financial industry (even if it often looks that way from the City of London). The more likely explanation is that EU policymakers are simply ignorant of how financial markets work. For example, the fact that the two largest Cypriot banks' London branches have remained opened through the past week, allowing large depositors to take out millions of euros, hints that Europe's policymakers are simply clueless when it comes to how financial markets work. This also means that whatever pound of flesh the EU thinks it will be getting by wiping out the large depositors could turn out to be on the light side.

Or, for a second example of cluelessness, what could rival yesterday's declarations by the Dutch finance minister that the Cyprus bailout set a new "template" on how to deal with bust banks, namely make the rich depositors pay for the little depositors? What large depositor in a troubled bank in a country going through a secondary depression will want to stick around for that deal? We would venture that the next time that "solution" is applied, the eurocrats will find that the large depositors will not have waited around to get fleeced. In fact, as mentioned above, it might not even work this time (i.e., Cyprus), let alone the next one.

Going one step beyond the ignorance of how financial markets work, what seems profoundly shocking is the lack of recognition of this ignorance. Place yourself back in the fall of 2008. As the financial crisis was unfolding, the likes of John Mack, Jamie Dimon, John Thane and other banking heads were asked to meet at the New York Fed, the US Treasury or even the US Congress on a regular basis to explain what was unfolding (and what they planned to do about it). Meanwhile, how many times have the heads of Santander, Intesa, SocGen, Deutsche Bank, etc., been called in to explain what was going on, or for them to give their views on what should be done? If asked, perhaps these CEOs would have said that:

a) European banks are much more dependent on deposits than their US counterparts.

b) Owners of large deposits are likely to be more risk averse and much more active in moving their money than small retail savers (for whom moving money from one country to the next presents high costs and almost insurmountable hurdles). And this for obvious reasons: a 40% haircut on $1,000 is unpleasant but it's not going to change anyone's life. But a 40% haircut on a pensioner's life savings of $500,000 will have a huge impact—and a 40% haircut on any middle-sized company's $10mn payroll will be enough to bankrupt the business. In fact, this simple reality brings us back to Mark Twain's advice that it is always better to tax poor people as there are so much more of them—unfortunately, Europe keeps going the other way, with devastating consequences.

c) For these reasons, regulators and governments have never in living memory allowed big banks to default on their depositors, regardless of the wording of formal deposit insurance contracts. If this implicit guarantee is now removed in Europe (and it sure looks like it has been), then we should expect a big shift of large deposits out of the banks and into government bonds or credit market instruments.

d) This will prove very problematic, especially given the new Basel III regulations which encouraged a funding model whereby banks should rely more on deposits and less on bonds.

e) As savings shift out of banks and into credit markets, the "German bank" model based on bank-financing of industrial companies and long-term creditor-debtor relationships will inevitably erode, to be replaced by the Anglo-Saxon model credit-market financing along with the short-termism which it implies.

In other words, the law of unintended consequences is at work: the eurocrats will end up with exactly the opposite of the financial system they wanted. Either that, or the European banks will end up having to be nationalized in great numbers. These two possible outcomes seem to be the logical consequence of the EU's very unfriendly financial sector policies.

Louis is right. If you are a large depositor, you HAVE to be thinking about what country your deposits are in and how safe the actual bank is. Even if a bank is seemingly safe, is that any comfort? Is there any evidence that the depositors in Cyprus are better off being in one bank than another when the entire country's banking system has seemingly failed? Was every bank in Cyprus bankrupt at the same percentage rate? Who's to say, if BNP Paribas has problems, that a few finance ministers in Brussels would not demand that Societe Generale and Credit Agricole should be penalized, since they are in the same country? What is the logic here? Or is Cyprus a one-off because most of the losses are Russian and who really cares about those commies anyway? Except that the next time, comrade, it might be your bank account that is deemed expendable.

If you run a family office, large corporation, or just your own small pension account, you are not exercising reasonable prudence if you are not asking yourself, what are the risks as of today? You're calling European friends and trying to figure out what the new rules are. Who made these decisions and why?

After spending hundreds of billions and not flinching from potentially printing perhaps trillions of euros to shore up the periphery, the Eurozone leaders now balk at a mere €5.8 billion and raise questions about their whole enterprise? Over German politics? You can't be serious.

This may one day rank up there with "Let them eat cake" in the politically tone-deaf department. Merkel may have risked the entire euro experiment over local politics, after writing such large checks in prior situations. The Eurozone response to Cyprus indicates serious ignorance of how financial systems operate. Trust is an ephemeral thing. It is hard to build and maintain and can be so easily squandered. I suggest you go back and read (if you have not) the recent posting in Outside the Box of Dylan Grice's masterful essay on trust.

Last-second insert, which I haven't done in years, but this seems important:

As my editors and tech staff are literally ready to send this letter out, reports are starting to come across my desk that Russian depositors are finding ways to get money out of Cyprus, through branch banks in other countries. The ECB has supposedly told Latvia not to take Russian-flight money if they expect to join the Eurozone. Haircut estimates are ranging to 50%. If a lot of Russian money actually goes, it could be closer to 100%. I offer a few links, one from Reuters and one from ZeroHedge. I see some other reports and can't completely separate rumor from fact, but Reuters is usually reliable and has a policy of multiple sources.

No one knows exactly how much money has left Cyprus' banks, or where it has gone. The two banks at the centre of the crisis – Cyprus Popular Bank, also known as Laiki, and Bank of Cyprus – have units in London which remained open throughout the week and placed no limits on withdrawals. Bank of Cyprus also owns 80 percent of Russia's Uniastrum Bank, which put no restrictions on withdrawals in Russia. Russians were among Cypriot banks' largest depositors. (Reuters)

So, while one could not withdraw from Bank of Cyprus or Laiki, one could withdraw without limitation from subsidiary and OpCo banks, and other affiliates? Just brilliant. (Zero Hedge, citing the above Reuters quote)

If this is true (and Reuters makes it sound real), so much for sticking it to the Russians. This could escalate into something ugly. I rather think this weekend's Outside the Box will be on this still-brewing crisis. The Europeans are looking more and more like the Keystone Cops, in addition to being merely clueless. (And watching Jeroen Dijsselbloem trying to take back his words at this late moment is amusing. The Dutch are normally so disciplined. It just gets stranger, and if it was not so sad and scary it would be funny.)

It Is Time to Break Up the Banks

The problem we have been discussing is not just a problem in Europe. In a general sense, it is the problem of banks that are too big to be allowed to fail. It is time to rein in the size of large banks before the next crisis. BAC and C are not just too big to fail, they are too big to effectively manage. If banks want to get larger, they should pay more deposit insurance to offset the implicit guarantees they get from taxpayers to cover losses beyond the ability of an FDIC to underwrite. I would go so far as to increase the capital requirements of banks as they increase in size, giving an incentive for management to break them up into smaller (and more manageable) pieces. The number of top experts, economists, and bankers who agree with me is rising, as this recent post from my friend Barry Ritholtz over at The Big Picture demonstrates.

New York, Singapore, and the Strategic Investment Conference in California

In two weeks I will be in New York for a few nights. The following week I fly to Singapore (one of my favorite cities), where I will be featured at a conference sponsored by The Business Times and Saxo Capital Markets. I just now looked at the conference webpage and found I am in deep kimchee, as they have labeled me a guru. I have often noted that you get called a guru just before you make a major-league bad call. Full risk disclosure would suggest I tell you to ignore any of my upcoming prognostications until I really screw up bad. Then you can just ignore me at your usual discretion. You can read register to attend the BT Investment Dialogue at http://pbp.sph.com.sg/btinv2013/.

My Strategic Investment Conference, May 1-3 in Carlsbad, California, co-sponsored by my partners at Altegris (whose staff does the heavy lifting to make this one of the best-run conferences in the country) has almost sold out. Louis Gave (mentioned above) will be there. There will be a lot of discussion about Europe, and with Kyle Bass on hand you know we'll be talking about Japan. This is one you do not want to miss. In addition to the line-up I have mentioned past weeks, which I think is the best at any economic conference anywhere this year, Paul McCulley is going to come to kick off the conference on Wednesday evening. Paul has spoken at our conference nearly every year since we started, and I am grateful that he will come again. You can learn more and register at http://www.altegris.com/sic. Check out the speaker line-up. Even McEnroe would agree that this is a seriously world-class line-up.

As long-time readers know, I have written this letter from planes, trains, taxis, limos, and hotels all over the world, and from every continent except Antarctica (which is on my bucket list) and scores of countries. But this is the first time I have written to you from a hospital waiting room, as I wait to see my new granddaughter, Addison, who has arrived fashionably late. The old caricature, when I grew up, was of the useless father waiting nervously outside the delivery room. Times have changed, and it is now de rigueur for fathers to be at their wives' side. (It was something of a novelty when I was in there some 36 years ago.) Now the most useless thing in the waiting room is the grandfather, and I must confess to not being nervous (at least not that I will admit to). The clan gathered as the time wore on. I brought my computer to do a little work on this letter, assuming we were going late into the night; but after 14 hours of induced labor and not much going on, they elected to do a C-section, so it all happened rather quickly after I got here. I had an all-too-brief moment with mother and daughter and was then ushered out so the time could be shared with siblings and such. Amanda and Addison (6 pounds, 1 ounce, for those who might ask – I am just happy to see the requisite number of fingers and toes) are doing just fine. Son-in-law Allen has a huge Oklahoma grin on his face. It is one of those great nights to be alive.

And finally, for those who are nostalgic for a time when old warriors worked together when necessary for the good of the country, I offer this YouTube clip I ran across of President Ronald Reagan at a tribute dinner for his long-time political adversary and personal friend Speaker Tip O'Neill: http://www.youtube.com/Reagan&O'Neill. We need a little of that Irish magic now. Have a great week.

Your rather be a grandfather than a guru any day analyst,

John Mauldin

subscribers@mauldineconomics.com

Will the Real Unemployed Please Raise Your Hands?

John Mauldin — Wed, 20 Mar 2013 21:41:00 GMT

Can Someone Figure Out Cyprus?
Data, Information, and Opinion
Will the Real Unemployed Please Raise Your Hands?
BLS: Everyone’s Favorite (Whipping Boy) Agency
The Household Survey
Home(less) Again, California, New York, and Singapore

This week’s letter will be a very short part of a book I am writing with Bill Dunkelberg (the Chief Economist of the National Federation of Independent Businesses) on the future of employment. It has taken longer to write than I initially anticipated, for a host of reasons, chief among which is that the future is not as obvious as I originally thought. Diving into the data has brought a few surprises. It doesn’t help that I have (probably to the frustration of Dunk, although he is way too polite to say it) changed the focus from “merely” what we need to do to create jobs (which is still an important part of the book) to what kinds of jobs will the future bring and who will get them.

But to understand the future of employment, we have to be able to measure what we mean when we say employment. And the data that we all too often think of as hard and fast is anything but. Is unemployment in the eye of the beholder? We know what we mean when we say our brother-in-law is unemployed. But does the government data mean the same thing? The answer is “maybe, sometimes, and it depends.”

I selected this part of the book not only because it is toward the beginning but also as a result of a conversation I had this week that got me to thinking about data and its usefulness. It is in this context that we will look at unemployment data.

But first, a quick comment on why this letter is not about Cyprus, which seems to be the topic du jour. I wrote four weeks ago, after my visit to Athens, that Cyprus would be a problem and to pay attention.

Can Someone Figure Out Cyprus?

The story changes every few hours. It is not clear what the Cypriot parliament will do. They could quite possibly simply say no, or change any number of things. The whole thing is patently ham-handed. It illustrates what I mean when I keep saying that the EU is making up the rules as they go along. Why take money from widows and then exempt the branches of Greek banks? (I hear the reasoning, but I don’t understand it.) It is all about protecting banks and institutions and not the defenseless. I find the whole thing rather outrageous in the way that it looks through the wrong end of the telescope.

And dear gods, why risk creating a situation that encourages depositors in banks to question the ownership of their money? If the deposits of the citizens of a member country of the EU are not safe from bureaucrats, at least up to €100,000, then why should they trust any bank? And why in Hades is the IMF appearing to dictate that depositors will lose money? And why do Turkish depositors in non-Greek banks lose when Greek depositors in Greek banks don’t? Cyprus is complicated enough without poking that nationalistic anthill.

Cyprus is also a problem in itself. It is the size of a small city, not a country. My friend Frank Trotter of Everbank noted today that the agricultural subsidies Texas gets from the US government total more than the entire GDP of Cyprus. Would anyone blink if the banks in San Bernadino County went bankrupt? Cyprus’s banking system is around 8 times the size of the country’s GDP, so asking the country to back the deposits of its banks is ludicrous. Perhaps as much as half the deposit total is from outside the country (encouraged by the banking system and regulators), and it is widely assumed that Cyprus launders a great deal of Russian-oligarch and Russian-mafia money. Which of course does not sit well with Germany, especially in advance of its upcoming election. Try telling the good burghers of Bavaria that they should pay to bail out Russian oligarchs. Frau Merkel has made it clear she will not.

The EU contends that Greece was a one-off situation and no one else will get bailed out, at least not on sovereign debt. We will see.

While the bailout money needed is about the size of the entire economy (€17 billion), that is chump change to maintain the system. The banks are in large part bankrupt because they bought too much Greek debt and were forced to take haircuts on that debt. If the ECB bailed out Greek banks and depositors (which they did), then why is Cyprus a special case, demanding that some small depositors and not others lose money? Then again, if the banks go down, which they could easily do without a bailout, depositors stand to lose a great deal more, as Cyprus as a country can no longer access the bond market.

Does Europe want Russia to step in at the price of Russia’s getting a Mediterranean port? Is saddling one set of people with a tax and letting others off the hook even legal in Europe? There seems to be some debate.

This mess occurred because there is no clear eurozone banking policy or general deposit insurance, both of which were promised in the wake of the last such crisis and then soundly rejected by Germany (Merkel), which does not want to pay for the banking sins of other countries.

I fear that whatever I write will be both obsolete and wrong before I can even hit the send button, so I will forbear. We will revisit Cyprus when we can make some informed observations. But let me point out that I wrote a few weeks ago that the real challenge to the euro is, first, France (another country whose banks are far too large to be bailed out in a crisis) and, second, that the voters of more than one country are simply getting fed up. The way European leaders are handling the Cyprus situation does not inspire confidence.

Data, Information, and Opinion

As I wrote in last week’s Outside the Box, I visited Bill Bonner’s rather isolated hacienda in the Andes, where he lives two months of the year. (His ranch has expanded to some 500,000 acres, by the way.) Bill is the founder of Agora, now the largest investment-letter publisher in the world, but he started from scratch some 30 years ago in Baltimore. As the rest of the group was out riding horses, Bill and I stayed back, waiting for our turn; and we began to reminisce about old times. The first time I met Bill was back in 1982, when I went to Baltimore. The city had sold him two buildings for $100, and he had paid too much. To say it was a dangerous neighborhood back then is an understatement. As a rather naive young Texan, I was scared to get out of my car and walk a half block. (For good reason, I later found out.) But the price was right and the low overhead was an advantage to a young entrepreneur in an industry that was still just a hope and a dream in some of our eyes. We had lots of hard work and hard-won knowledge ahead of us!

We talked about the evolution of the newsletter business. We both started in the days of printed letters and large promotional mailings (remember those?) And we were both lucky enough to transition to what was to us a very new and unknown thing called the internet early enough to get some advantage. But some things stay the same. We are still dealers in information, trying to help readers understand what is going on and helping them with their investments.

There is a hierarchy to what is offered in publications these days. The first and lowest level is data, the raw numbers. On top of that come the levels of information, news, analysis, opinion, and actual actionable advice. Each adds to our depth and breadth of understanding. Yet, even as they add to our store of knowledge, we find ourselves drowning in information and knowledge. All too much of it is random noise, serving only to drown out clarity and wisdom .

The highest form of writing, I said to Bill, is storytelling, and he agreed. (Bill is the master of the story in our business.) Both of us, with our Irish ancestry and proximity to the Blarney Stone, come naturally to the storytelling medium. In an earlier time, we might have been fixtures at the local pub, spinning our tales for a pint of Guinness. But the fates have been kind to us, and we get to earn more than a few pints here and there.

Our goal (and that of many of our friends) is not to be the teller of old tales, but to seek to find the analogy, the resemblance of what is happening in the world to what we can readily understand. If the reader can come away with a fresh insight into the mysteries of life and markets, of our larger social contracts and how they impact our financial future, then we have done our work.

Our craft is part of the human heritage, harking back to when our ancestors sat around the fire at night relating the events of the day to the larger picture. (I once had a very-late-night discussion with Anatole Kaletsky about whether economists were not in fact modern-day shamans; but rather than discerning the future in the entrails of sheep, we deduced certainty from government data. I mused that some economists might be better off peering at intestines.)

Scientists have found that we humans actually get an endorphin rush when we arrive at an understanding of an event that that has perplexed us. Sadly, that understanding does not have to be true, but merely believed, to release that ancient chemical rush.

The problem is that we writers often have to challenge accepted wisdom. The “facts” are often slippery things, and it is our job to corral them carefully, lest we and our readers be led on a horseback ride into the high Andes of faulty assumptions.

And thus we come to employment. Each month in the US, on the first Friday of the month, we breathlessly await the release of the employment numbers. Markets move on the whisper of a trend, only to reverse when that whisper turns out to be just one more bit of random noise. It is said that one should not want to know how sausages or laws are made. I would add government statistics based on surveys to that list. But let’s now turn to the book Dunk and I are writing on employment, and take a look at our first draft of the chapter on government employment data.

Will the Real Unemployed Please Raise Your Hands?

The old saying about liars, damn liars, and statistics contains more than a grain of truth. Statistics are especially hard to swallow when we don’t like what they tell us. How many times do we question the validity of some statistic when it disagrees with our preconceived notions? (Statistical surveys say, a lot!) And unemployment numbers for the last few years haven’t given us reason to celebrate.

Let’s start with what you already know: millions of people are unemployed. How do you know this? The same way you know how many Americans believe UFOs are real, or how many watch the Super Bowl or own a foreign car. Almost all such data comes from surveys.

Surveys can be wonderful tools, giving us insights into data our minds can’t otherwise process. What we have to remember is that every survey is based on a sample. There is no name-by-name database (as far as we are aware) containing information on all our UFO beliefs. If there were it would be outdated almost instantly, as every minute thousands of people are born, die, enter the country, leave the country, change their minds, or get abducted and leave the planet.

Most national surveys use a sample of, at most, a few thousand people. From this, we extrapolate conclusions about a country of 300 million people. Real-world experience indicates this is usually sufficient, too – or at least close enough for most purposes.

Survey respondents can only answer the questions they are asked, however, so it’s important to ask the right thing in the right way. Otherwise the results won’t reveal the information you want to know.

BLS: Everyone’s Favorite (Whipping Boy) Agency

“Official” information about jobs, or lack thereof, comes from the Bureau of Labor Statistics, which is part of the US Department of Labor. BLS gathers, analyzes, and publishes a staggering amount of labor-related data. The bls.gov website is a treasure trove for people who are interested in employment trends.

For the purposes of trying to understand what the BLS does, let’s look at their “Employment Situation” report. The one we will consider emerged from the BLS womb on Friday, January 4, 2013, at precisely 8:30 in the morning, Washington time. The 41-page news release summarizes the survey data BLS gathered the prior month. A new report is born each month, typically on the first non-holiday Friday. It is the source of the “unemployment rate” reported in the media and closely scrutinized by economists.

The report began with the two key numbers:

The monthly change in nonfarm payroll employment, and
The unemployment rate

This particular month those numbers were 155,000 and 7.8 percent, respectively. The first number is supposed to reveal how many new jobs the economy generated that month. The second is the percentage of the workforce that was unemployed during the same month.

Figure 1: BLS News Release

How does BLS know? The numbers come out of not one but two different surveys the agency conducts every month.

The Establishment Survey asks a sample of employers how many people work for them. BLS adds up their answers and extrapolates the results to the whole economy. In other words, US employers collectively had 155,000 more people working for them in December than they did in November. Or so BLS believes.
A separate Household Survey calls on people – not businesses – to determine their employment status. The result this time is that 7.8 percent of respondents who “wanted” to be “employed” were not “employed,” as BLS defines those words.

Now, why does it take the BLS 41 pages to convey what we just said in a single paragraph? Details, details. Let’s consider a few before we move on.

Seasonal Adjustments: Unlike people, all months are not created equal. Some of the events that affect employment are unpredictable, like earthquakes. Others are semi-predictable, like hurricanes and blizzards, but don’t happen every year. And some are very reliable.

We know, for instance, that in the summer students are out of school and families tend to go on vacation. We know people do more shopping in December. We know car makers introduce new models in September, and that they order parts months before then. All these events happen every year, more or less.

BLS statisticians consider these factors and make “seasonal adjustments” to their numbers. This helps make each month’s report comparable with other months. However, since not everyone wants these adjustments, or may disagree with the methodology behind them, BLS publishes the unadjusted numbers, too.

Other, less frequent adjustments, such as new census data compiled every ten years or demographic changes like the Baby Boom help account for longer-term changes. These adjustments are not an exact science, but without them the data would eventually stop telling us anything useful.

Labor Force: An unemployment rate of 7.8 percent begs the question: 7.8 percent of what? You might think the answer is “everyone.” Not quite. Not everyone is able to work. Not everyone wants to work, either. The unemployment rate is a percentage of a subset of the population BLS calls the “labor force.”

In fact, the labor force is a subset of a subset. Unlike the US Census, which counts every human being it can find, BLS is interested only in the “civilian noninstitutional population.” People in prison may be chipping rocks or making license plates, but BLS doesn’t care. They are “institutional” and not competing for jobs (unless you are a license plate maker or a rock chipper, perhaps). People in hospitals, nursing homes, and various other categories are also excluded.

Figure 2: Household Survey, December 2012

As we see in Figure 2, in December 2012 the civilian noninstitutional population was 244,350,000. The civilian labor force was 155,211,000.

Now, how does BLS determine how many Americans are in the labor force? They call us, or at least enough of us to provide a statistically valid sample.

The Household Survey

Formally known as the “Current Population Survey,” the BLS Household Survey is a monthly sampling of about 60,000 households. It is actually conducted by the US Census Bureau, which then gives the raw data to BLS for further analysis.

The 60,000 households are called during a “reference week,” normally around the 12^th of the month. Whoever answers the phone is asked a series of questions about their work status. From their answers, BLS classifies each person age 16 or over in the sampled household into one of three categories:

Employed
Unemployed
Not in the labor force.

Every person who lives in a sampled household goes in one of these three groups. The only escape is to be in the “institutionalized” category, as we discussed earlier, or to be under age 16.

BLS considers a person to be “employed” if they were a paid employee at any point during the reference week. If you started a new job the day before, worked fifteen minutes, and then got fired, BLS still calls you employed.

People also count as employed if they worked in their own business or farm, or if they worked without pay at least 15 hours in a family business or farm. This is important. Suppose you were laid off last month, and instead of looking for a new job you decided to start your own business. This is a fairly common scenario during a recession. Even if no one has hired you, your start-up work means you are “employed.”

Also counted as employed are people who have a job but who were temporarily absent during the reference week because of illness, bad weather, vacation, a labor-management dispute, or for other personal reasons.

The BLS sample, when extrapolated to the entire nation, tells us the US had 143,305,000 “employed” people in mid-December 2012. To be classified as “unemployed,” on the other hand, people in the sampled households must meet all of the following criteria:

Had no employment during the reference week,
Were available for work the entire week, and
Made specific efforts to find employment sometime in the last four weeks.

(Note that the BLS unemployment data has nothing to do with unemployment benefits. That’s an important piece of information, too, but it’s not part of the BLS report.)

Under these definitions, BLS believed there to be 12,206,000 unemployed people in the US in December 2012. Add this to the 143,305,000 who were “employed,” and we get 155,511,000 either working or who want to work. This is the “civilian labor force.”

From here the math leads straight to the unemployment rate: 12,206,000 divided by 155,511,000 equals 7.8 percent. A year earlier it was 8.5 percent, so maybe we’re making progress – but don’t be too sure.

The “civilian noninstitutional population” is 244,350,000 people. Subtract the labor force, and we have a third category that BLS calls “not in the labor force.” At 88,839,000, it is a big group, all of whom are neither “employed” nor “unemployed”; they simply don’t “participate” in the labor market.

BLS tracks this group with a statistic called “participation rate.” They found that 63.6% of the population was either working or looking for work in December 2012.

The participation rate has been drifting downward for a long time, and the reasons are a big subject of debate. Most analysts agree that at least some nonparticipants could be in the labor force if they would only … participate.

Recall that you are not “unemployed” unless you looked for a job in the last four weeks. You can be physically able to work, and even willing to work if someone offered you a job, but you must still have made “specific efforts” to find a job in the last four weeks. If you didn’t, then BLS does not consider you unemployed.

Nonparticipants aren’t necessarily watching TV all day. At any given time, many people are in various kinds of in-between conditions. For example, someone might leave a job (or be fired) and spend a few weeks or months traveling, or caring for a sick relative, or engaged in volunteer projects. Obviously, they would need to live on savings or find some other means of support, but many people do so.

A more ominous example of a nonparticipant is the “discouraged worker.” Such people had a job, lost it, could not find another one, and are not making the “specific efforts” to find employment that BLS wants to see. They tend to start looking again when they think more jobs have become available. This leads to a seeming paradox in which the economy improves, enticing discouraged workers to look for jobs, which expands the workforce but makes the unemployment rate worse instead of better.

Say what? Yes, the unemployment rate can change sharply, even if no one is hired or fired, based simply on changes in the participation rate. In the December 2012 example above, we saw that 88,839,000 people were “not in labor force.” Suppose 1% of this number had instead been looking for work that month. Not finding work, just looking. That would be 888,390 people now counted as officially unemployed.

Look what happens. The number of unemployed people goes up from 12,206,000 to 13,094,390. The labor force is now 156,399,390 instead of 155,511,000. The unemployment rate isn’t 7.8 percent, it’s 8.4 percent. And what if not just 1% but 5% of those “not in labor force” start making “specific efforts” to find a job? Unemployment rises to almost 11%! Other surveys have suggested that 5% is not at all an unreasonable assumption as to how many “nonparticipants” are actually seeking employment, and that number might even be way too low.

This kind of massive change is entirely possible with the BLS methodology. Does it mean they are doing it wrong? No, it simply means they are trying to distill a complex situation into a comprehensible set of numbers. Distortions are inevitable.

What it really tells us is to take all the numbers with a pinch of salt. Political spin and media reporting are not much help, either. When the unemployment rate goes from 7.8 to 7.6, they all exclaim, it’s a huge improvement, we’re on the right course, we’re making progress! And a move the same size in the other direction is a sure sign of recession and the loss of hope. (Even including a number after the decimal point in the unemployment rate demonstrates that economists have a sense of humor, if somewhat distorted.)

The BLS, ever-helpful, also gives us other ways to measure employment, but they are largely ignored by the mainstream media because they paint a much bleaker picture. (The following note is from my friend Grant Williams, in his brilliant Things That Make You Go Hmmm...)

The fact that there are multiple unemployment rates, including one that is labeled as the 'official' rate (U3), should be enough to raise a red flag as to how easy manipulation of those figures can be — particularly as the most comprehensive unemployment rate (U6) is almost double the official unemployment rate. It includes

• part-time workers who want to work full-time but cannot due to economic reasons

• 'discouraged workers', or those who have stopped looking for work because current economic conditions make them believe that no work is available for them and,

• other 'marginally attached workers', or 'loosely attached workers', and those who 'would like to' and are able to work but have not looked for work recently.

And, as can be clearly seen from the tables below, this has been the case for a long, long time.

Source: Portalseven

Instead of fixating on any one month, we should all look at long-term trends. The various statistical anomalies tend to sort themselves out, given enough time. The unemployment numbers are repeatedly revised for several months, then revised annually, and even larger adjustments are made every few years, based on new and more accurate data. For instance, two months later, we find that the number of new jobs in December 2012 has risen to 219,000. That is almost 40% more than the original estimate. But the January 2013 number has been revised down by 38,000. Such large revisions are typical.

Remember the jobless recovery of the Bush years? Revisions made years later tell us that it was not a jobless recovery after all. The seasonal adjustment factors are based in large part on recent trends. If the trend has been down, the seasonal adjustment is likely to understate the number of jobs created. Likewise, the unemployment numbers in the recent credit crisis have been revised downward, as the employment trend prior to the crisis had been upward.

The BLS has to have some mechanism by which to make its estimates. They really do try to get it right, but they are working with imperfect data. The formulas they use are quite public, if a bit arcane. Contrary to the belief of some, there is no “spin” in their data. It is what it is. But the formulas they use can be quite controversial to those who care about such things and are be hotly debated (although hotly might be a bit over the top as a descriptor of econometric disputes).

Further, the BLS has to simply guess each month as to the number of new businesses that have been created and the number of businesses that have failed. The ratio of the two is known as the “birth/death ratio,” and it can make a big difference. The “real” birth/death number may not be really known for years after the initial report, until other sources of information (tax data, etc.) can be collected and analyzed.

This brings up two points to always keep in mind. First, it is generally the trend of the BLS revisions that is more important than just the revealed numbers. In general, the trend can actually give us a lot more useful information than the fresh monthly data. If you add the trend data to the information from other surveys and sources, it can give a hint as to the direction of the economy and the markets.

Second, anyone actually trading on the monthly employment data when it is released deserves whatever revenge the markets take. (If your investment advisor is prone to such nonsense, you might consider what else he or she is up to, and question whether the relationship is really contributing to your well-being. Just saying.)

With those caveats, let’s answer the question posed as we began this chapter. How bad is the jobs crisis? BLS data gives us at least a rough idea. For comparison, we’ll go back five years, to December 2007. We now know that the recession was already unfolding, but at the time economic confidence was still generally high.

	December 2007	December 2012
Monthly Change	+18,000	+155,000
Unemployment Rate	5.0%	7.8%
Civilian Noninst. Population	233,156,000	244,350,000
Civilian Labor Force	153,866,000	155,511,000
Employed	146,211,000	143,305,000
Unemployed	7,655,000	12,206,000
Not in Labor Force	79,290,000	88,839,000
Participation Rate	66.0%	63.6%

We could write an entire book exploring just the numbers in this one table. A few highlights and anomalies:

The unemployment rate was much better in 2007 – better, in fact, than the 5.5% some economists now consider “full employment.”
The civilian noninstitutional population grew approximately 11 million in five years, yet the civilian labor force rose by only 1.6 million.
The number of employed was actually 1.9 million lower in 2012 than in 2007.
The “not in labor force” category gained 8.5 million people in five years.

Anyone who grumbled at the December 2007 BLS report would probably be glad to have it back. The situation now is much, much worse. It is also worse for some than others. But therein lies a book, and it is time to draw this letter to a close.

Home(less) Again, California, New York, and Singapore

As this letter hits your inbox, I will be making my way back to Dallas. Three planes should just about get me there, in just under 24 hours. I see it as just another day at the office and a chance to catch up on my reading.

Speaking of which, if you’re having trouble keeping up with yours, I may be able to take the load off a bit with our new Thoughts from the Frontline audio service, which delivers my weekly letter to your cellphone, iPod, MP3 player, or computer, whenever and wherever you choose. You can check it out right here.

I will be speaking at a special one-day event in Sonoma, California, on April 5. My friend Mike Shedlock is holding a charity fundraiser to support research into ALS (Lou Gehrig’s disease.

You can find out more at Mish's Conference.

My own conference (co-sponsored with Altegris Investments) is May 1-3. It is filling up rapidly. The line-up of speakers is the best I have seen anywhere this year. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. I hope to see you there.

I will be in Singapore for a speech April 18-19. I then hop back to San Francisco for a speech for the National Association of Surety Bond Producers (NASBP) on April 22.

I got a text this morning from daughter Amanda: “Dad, when are you coming back on Thursday? My blood pressure is high and they might induce the baby a little early.” A quick call gave Dad some assurance that things are all right. It is a good thing I was scheduled to come home anyway, as I would have left friends and meetings in the lurch to get back to be with Amanda. There are few days as important as this one, and I intend to be there. Not that I am necessary to the happenings. I will probably be my usual useless self, trying not to get in the way but feeling the need to be around just in case. I am not sure what that case might actually be, but being there makes me feel better.

I will return to Dallas to a hotel, as my worldly possessions are in storage somewhere. I am between residences, and it is unclear when things will sort themselves out. Rather than making any sort of commitment, I will just find a room and live and work from there. It is not as if I am not used to hotel living. And this does offer the opportunity to do an acid test of the new virtual office we have been working on. We have been practically there for a long time. For all intents and purposes, I carry my office with me – but I will miss my Health Chair.

Have a great week. Learn to ignore the noise, unless it is the gentle cry of a new granddaughter. And then just enjoy it.

Your wondering what my grandkids will do when they grow up analyst,

John Mauldin

subscribers@mauldineconomics.com

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Argentina on Sale

John Mauldin — Wed, 13 Mar 2013 17:29:00 GMT

Argentina: A Lesson in Chaos
Argentina on Sale
Why Don't You Just Stop?
Can the US Experience Argentinean Inflation?
Webinar
The Andes, Sonoma, Manila, and Singapore

When I was younger, so much younger than today,
I never needed anybody's help in any way.
But now these days are gone, I'm not so self assured,
Now I find I've changed my mind and opened up the doors.

– John Lennon, the Beatles

(From Cafayate, Argentina) There are some who worry whether the path that Argentina has taken to monetary ruin on multiple occasions (and that it seems intent on taking again) is one that the US may also find itself on. That worry has crossed my mind a few times, I must confess. Today we will look at Argentina more in depth. From a monetary perspective, it deserves attention. And once again there will be opportunity.

Let me jump right to the conclusion: Just as Spain is not Greece, because each chose a unique route to economic malaise, the US is not Argentina. We are perfectly capable of avoiding Argentina's problems while cooking up ones that are all our own. But there are some worrisome and potentially instructive issues in Argentina.

Argentina: A Lesson in Chaos

At the turn of the 20^th century Argentina was one of the richest countries in the world, due primarily to its vast and fertile farmlands. In 1913, GDP per capita was about equal to those of France and Germany and close to that of the US. By 1950, though, Argentina's GDP per capita wasn't even half that of the United States. (You can read a short, graphic history of the economic chaos that has been Argentina from the 1930s on at http://en.wikipedia.org/wiki/Economic_history_of_Argentina.)

Currency values plummeted. Inflation reached 5,000% at one point in the 1970s. Prices increased by a factor of 20 billion from 1975-1991 – over 300% per year. In 1983, at the urging of the IMF, a new peso was introduced at a value of 10,000 to one of the old pesos. Ouch. And that was just the beginning!

The Peronist government of Menem, elected in 1989, made a deal with the IMF, which promptly collapsed, leading to a rapid 12,000% inflation. On January 1, 1992, a new monetary reform replaced the austral (the name of the currency at that time) with the new peso at a rate of 10,000 australs for one peso. Another 10,000-fold devaluation – twice within ten years! The peso was now fixed to the dollar.

The following chart shows the value of the peso in dollar terms since 1936. The numbers are in German, which makes the chart just too ironic not to use. Note that each one of the horizontal bars represents a devaluation of 90%! (The vertical axis is a log-10 scale.)

I first came to Argentina in 1993. The country had just emerged from economic chaos. Real per capita income had dropped by 20% in the previous 20 years. But even with the chaos, the restaurants were busy at 10 PM, when Argentines like to eat!

Over the succeeding years, with a fixed dollar exchange rate, some industries could not compete and trade deficits grew. As in Greece today, the only way to create a fiscal balance was labor-price devaluation, which was decidedly unpopular. So Argentina went off the dollar standard, and the value of the peso dropped by 50%.

In December 1999 Fernando de la Rúa was inaugurated President, seeking assistance from the IMF shortly thereafter. In March 2000, the IMF agreed to a three-year $7.2 billion stand-by arrangement with Argentina, conditioned on a strict fiscal adjustment and the assumption of 3.5% GDP growth in 2000 (actual growth was 0.5%). In late 2000, Argentina began to experience severely diminished access to capital markets, as reflected in a sharp and sustained rise in spreads on Argentine bonds over U.S. Treasuries. In December, the de la Rua government announced a $40 billion multilateral assistance package organized by IMF. The uneven implementation of fiscal adjustments and reforms, a worsening global macroeconomic environment, and political instability led to the complete loss of market access and intensified capital flight by the second quarter of 2001. Argentine debt, held mostly in bonds, was massively sold short and the government found itself unable to borrow or meet debt payments. [Shades of later Greece!]

In December 2001, a series of deposit runs began to have a severe impact on the health of the banking system, leading the Argentine authorities to impose a partial deposit freeze. With Argentina no longer in compliance with the conditions of the expanded IMF-supported program, the IMF decided to suspend disbursements. At the end of December, in a climate of severe political and social unrest, the country partially defaulted on its international obligations; in January 2002, it formally abandoned the convertibility regime. (Wikipedia)

The economic and political crisis that followed was arguably the worst since the country gained its independence from Spain in 1816. By the end of 2002, the economy had contracted 20% since 1998.Over the course of two years, output fell by more than 15%, the Argentine peso lost three-quarters of its value, and registered unemployment grew to 25%. Income poverty in Argentina grew from an already high 35.4% in October 2001 to a peak of 54.3% in October 2002.

My friend and Uruguayan business partner Enrique Fynn tells stories of coming to Buenos Aires and hearing new prices being announced hour by hour over a public address system in a grocery store. He had dollars, which bought him lots of goods to take back on the ferry.. People who were prescient and had money were able to buy apartments in BA and land in Argentina at what can only be called fire-sale prices.

Argentina on Sale

I remember coming to Argentina about three years ago. I thought prices in Buenos Aires were high – the peso was about 3.50 to the dollar. When I visited again last November, prices were "reasonable" by my travel standards, and here in Cafayate I found good value. I have friends who are building homes here much more cheaply than they could in the US. And the quality is high; there are some real craftsmen here. Their stonework is exquisite.

I was in Buenos Aires last Friday. The official exchange rate is now 5.50 pesos to the dollar. The street price is 7.75, on its way to 8. But the largest bill is a 100-peso note, which is now worth less than $13. Using a credit card costs at least an extra 10%, if not 20%; but the prices you are quoted for using a credit card instead of cash are higher to start with, before the surcharge, so using a card ends up costing you about an extra 40%. But you need to carry a lot of cash if you want to buy anything expensive. (Be very careful if you do not know your way around. I am told there are lots of counterfeit bills passed off on tourists. Not that I exchanged anything, of course this is all theoretical, for illustration purposes.)

I was staying in the Recoleta area, which is one of the most expensive areas of the city and a wonderful place to while away a day or two.

But things were cheap. A simple lunch for two on a fashionable street was around $15. We had a fabulous meal at a restaurant we stumbled on, called Sirop Folie. (I will go again!) It would have been $150 at a comparable place in Dallas or NYC (or Europe), but it cost us just $50, including tip. I left my computer mouse in Dallas but was able to pick one up for $6. Vegetables and cheeses were around half what I am used to paying in Dallas. I began to "shop" in order to look at prices. By US standards, Argentina is on sale. And this was in the high-rent district.

On the way to Cafayate, there were signs on the road for chicken dinners for the local trade priced at $2 equivalent. Our dinner last night for two was less than $40 (all in) at what is considered one of the better local restaurants, Vinas de Cafayate (fabulous menu!). The place was packed by 10 pm, as I was leaving. So Argentina seems inexpensive today. Not a definitive study, admittedly, but the trend is clear.

President Kirchner is again experimenting with price controls. (Peron infamously tried to control even restaurant menu prices in the late 1940s – you'd think he would have known better). The last time price controls failed was in 2005. Now, Argentina has limited beef exports in the futile hope that doing so will drive down beef costs. All that has happened is that cattle herds have been reduced and exports are down. Similar export controls to try to keep bread prices down have seen wheat production fall.

Brazil has seen its cattle exports explode in 20 years, while Argentina's have not grown at all as the government tries to control production and export prices. Argentina used to be the world's largest beef exporter, but Brazil now has a herd almost four times the size of Argentina's. How many jobs have been lost to Brazil? One long-time exporter says, "There are developed countries, emerging countries, and then there's Argentina.

Want to see something sad? An illustration of what governments can do to an industry by trying to control it? Look at this chart. Argentina is now down at #11. Tiny neighbor Uruguay exports twice the beef and veal.

The government is committed to a path of monetization. Inflation is denied by government statisticians, but it is at about 30% and rising. While the government is putting pressure on grocers to maintain prices, which always leads to shortages, as of this morning you can still find anything you want at the local equivalent of a well-stocked Hypermart.

Why Don't You Just Stop?

I sat down for what became a lengthy conversation with Juan Carlos Romero, the current senator from Salta Province. Juan Carlos is my age (which is to say a young 60ish) and is the very image of as an old-style patron, straight from central casting. He was governor of the province from 1995 to 2007 (it's the family business – his father was governor, too) and has been vice-president of the senate and on a national presidential ticket. He is a very successful businessman. We met last time I was here, and I hit it off with both him and his son, Juan Sebastian.

I related to him my surprise at prices and inflation. The last time I was in the Recoleta, in November, there was a protest march (quite peaceful and civilized, if enthusiastic and noisy) of some 700,000 people in the center of town, along 9 de Julio Avenue, which is the widest avenue in the world. It is impressive to walk down.

But things have only gotten worse since then. "Haven't you seen this movie before?" I asked. "Don't you know how this ends? What part of seeming insanity do you keep wanting to repeat? Why can't you stop it?" I will summarize Juan Carlos's answers from the notes I took.

Argentines don't want to hear bad news (does anyone?). Monti gave the Italians bad news, and he only got 9% of the vote. The bureaucracy is out of control in Argentina, and it just keeps growing and creating costs. There are too many subsidies to certain businesses. And, as a result of votes during the last crisis, power is now concentrated in the presidency and a few key positions. There are not the checks and balances we are used to between branches of government in the States. Both major parties voted to nationalize pensions. Government benefits and subsidies are given to a large number of people, who then vote for more government benefits.

"In Argentina, we have the ability to make the same mistake many times, and nothing happens to change things. Why? Because there is a pervasive belief that the state can provide all that people need: jobs, welfare, everything." Perhaps, he mused quietly, that attitude is a heritage from colonial days, when the King of Spain controlled the country and power and privilege and benefits came from the King.

Aerolineas loses $2 million a day, but people believe it is better than a private company. The government is not seen as something owned by the people but as something that exists to solve problems and take care of the people. Both parties and a majority of voters seem to agree that government is better than the private sector. Some sectors have few controls, and others are tightly controlled.

"Even so," I asked, "can't those in control see that inflation is bad?" The problem, he explained, is that those who have the ear of the president see inflation as a way to growth and thus a good thing. Those in power deny there is inflation and think it is caused by "commercial" interests that selfishly raise prices. Kirchner and those around her actually believe that their current policies will work. Meanwhile, 42% of GDP is government expenditures.

In a country of vast lands and unsurpassed beauty, more than half the people live in one city, Buenos Aires. (I think they all try and get out on the roads when I am going to or from the airport.) And that urban power base is central to Kirchner's control – she won the last election handily.

As I walked through the Recoleta, I thought I saw stress on the faces of the people I encountered. You can talk to businesspeople and sense the stress.

How do you cope with such repeated episodes of chaos? Argentines who have money keep it outside the country. As one person told me, "In America, you buy gold to protect yourselves. We buy dollars." The national sport – second only to fútbol – is tax evasion. (They come by both naturally, as about 60% of the population has Italian ancestors.)

And yet there is a thriving business community. The skyline is much more impressive in BA than it was 20 years ago. Argentines are an educated people. And things can and do get done.

Jon Malinski is a Minnesota businessman. He invested in a vineyard in Mendoza and recently bought a vineyard here in Cafayate, in one of the better growing regions. Two years ago, he broke ground on a massive, sophisticated, modern winery here. It is now open for business. He hosted a dinner on my first night here (accompanied by a huge lightning display back up in the mountains).

I have been to a few wineries in my time. This one was rivaled in elegance by only a few in the Napa Valley or France and the Ferragamo estate in Italy. Note: He bought the land and decided to build, and the winery was completed in two years. In the US, for an undertaking this large, you can't even get the approval process underway in two years. One of Jon's competitors told me he probably spent $20 million. For all the Argentinean government controls, in certain sectors you are free to do what you want.

This region is booming. Building is going on everywhere. People smile on the streets and are patient with your mangled attempts at Spanish.

There is a rather amazing contrast between the macroeconomic situation of the country and life on the street. Soon, the peso will once again come to be seen as a medium that will only be usable in immediate exchanges. Unless something is done, Argentina is going to repeat its past. Unlike Germany, which still remembers the Weimar hyperinflation, Argentina just seems to shrug off its past. The economy has recently survived on a boom in soybeans, but there is not much else to rely upon.

Argentina is on sale. I think prices relative to the dollar will rise. This is one sale where the last day is not yet known. Think about coming down here next fall and enjoying the time with me.

Can the US Experience Argentinean Inflation?

I know some readers think the worst of the Fed, and I am not a fan in general (and am opposed to the current QE policy), but I simply can't conceive of the FOMC voting to monetize if inflation tops 10% again. I think there would be serious efforts to curb QE (monetization) at 5-6% inflation, although until we reach that level I think it will be tolerated. With higher inflation than that, voters would simply rebel. Think the '70s: both Ford and Carter lost in part because of the economy and inflation.

In theory, any country can experience Argentinean-style inflation. It just takes a printing press (which today simply involves pushing some electrons around), a willing central bank, and a complicit citizenry. US citizens have an inherent distrust of government, although I admit that is slowly changing. Two factoids:

Nearly a quarter of the voters in the last presidential election were single women, and they voted 2:1 for Obama and thus a larger role for government. (Guardian) Romney won married women voters by a significant amount, but the singles went to Obama, and they are the fastest-growing voter group. Government is increasingly being seen in certain circles as a provider of benefits and support, both for healthcare and as a general safety net. Growing economic malaise and rising healthcare costs only fuel this trend.

And government is expanding the list of people who get direct benefits. Food stamps now go to almost 49 million people. Eleven states have welfare benefits that are higher than the minimum wage. And look at this chart on the growth of disability payments. Over half the recent rise above trend in disability benefits is for the treatment of mental disability and stress.

"How," I had asked Juan Carlos, "can you let it happen?" But how, indeed, can we?

Webinar

If you are a qualified purchaser or a FINRA licensed advisor, please join me and my partners at Altegris for an exclusive Mauldin Circle webinar on Tuesday, March 26 at 12:00 pm EDT/9:00 am PDT. Listen in as I interview Jacob Gottlieb, CIO of Visium Asset Management, a premiere long/short multi-strategy fund manager. We will learn more about Visiums' unique investment approach and how they're finding alpha opportunities in the current environment – both on the long and short side. Visium Asset Management is a firm that I follow closely, and I know you will find our discussion timely.

If you are a Mauldin Circle member and a qualified purchaser or an investment advisor, a webinar invitation will be sent directly to you by email. A replay will also be available to qualified registrants. If you are unable to listen in to the live discussion, be sure to register so that you can receive the replay information. If you are not a member of the Mauldin Circle and are a qualified purchaser, please join today. Upon qualification by my partners at Altegris, you will receive an email invitation . I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. I look forward to having you at this exclusive Mauldin Circle event. (In this regard, I am president and a registered representative of Millenium Wave Securities, LLC, member FINRA.)

The Andes, Sonoma, Manila, and Singapore

Tomorrow I venture off with Doug Casey, David Galland, and Olivier Garret to Bill Bonner's hacienda at Guafin, a few hours from here. A few years back, Bill bought this enormous (200,000-acre) ranch of mostly worthless land some 8,000 feet above sea level, but with magnificent views of the Andes, and he sneaks off there every now and then. I have been to his place in Ouzilly, France (a little easier to get to!) on several occasions, but this one sounds like a real fixer upper. Buying places that need lots of work seems to be his personal addiction (otherwise known as an expensive hobby), but it is a socially acceptable one and fun for his friends who drop in on him. I have known Bill for 30 years, since we were both young and starting out in the writing and publishing business. He has been a huge success, while I am hoping to be a late bloomer. But I have never had a moment with him that was not enjoyable, and most were thought-provoking. He does make me think.

He is one of my favorite writers in the business. I have often said that I feel like a house painter in front of a Rembrandt when I read Bill's musings. Actually, he is more than just a writer; he is a consummate storyteller, a raconteur worthy of the name. I am looking forward to magnificent vistas and a new adventure but also to great conversations with old friends – war horses who have seen lots of battles but are not yet ready to be put out to pasture.

I will be speaking at a special one-day event in Sonoma, California, on April 5. My friend Mike Shedlock is holding a charity fundraiser to support research into ALS (Lou Gehrig's disease. You can find out more at Mish's Conference.

My own conference (co-sponsored with Altegris Investments) is May 1-3. It is filling up rapidly. The line-up of speakers is the best I have seen anywhere this year. We offer an early-bird registration, which is about to run out. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. I hope to see you there.

I will be in Singapore for a speech April 18-19. I was going to go to Cambodia and Angkor Wat, but it is their New Year, so I will postpone that trip till the next Asia speaking trip and see Manila instead, where I have some old friends and have never been. I then hop back to San Francisco for a speech for the National Association of Surety Bond Producers (NASBP) on April 22.

Some final thoughts on Cafayate. This is just a hopping little town with a magnificent vista. Perfect climate in the tropics but at 5,000 feet. The mountains change color throughout the day. My friends have built a first-class resort. The spa is truly world-class, there is a great gym, and a massage will run you about $40. The golf course is the longest one in South America, which means there is more room for me to lose balls. There are very good to great places to eat. I am not one for road trips, but the drive through the canyon to get here is stunning, well worth a few hours' diversion.

The people who seem to collect here are about as eclectic as you can get. Nearly everyone has great stories to regale you with. And they are just generally nice people. This is going to be quite the community. I will plan to be here more, but when I am, let's see how much writing I actually get done.

Somehow, the memo that sequestration was supposed to be about austerity has gotten lost. There have been 2,600 new federal jobs posted since the introduction of the bill, 600 at Homeland Security, which was going cut workers, making lines longer at airports. I guess I am new to this off brand of austerity. But what do I know?

I know it is late, and I need a few hours' sleep. Have a great week.

Your living for places and times like this analyst,

John Mauldin

subscribers@mauldineconomics.com

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An Infinite Amount of Money

John Mauldin — Thu, 07 Mar 2013 06:13:00 GMT

An Infinite Amount of Money
Et Tu, Italy?
Moving, Argentina, and Sonoma

The three major blocs of the developed world are careening toward a debt-fueled denouement that will play out over years rather than in a single moment. And contrary to some opinion, there is no certain ending. There are multiple paths still available to Europe and especially the US, though admittedly none of them are bright and carefree. There are very few paths available to Japan, as they have skipped too far down the yellow brick road of debt. None of Japan’s remaining paths have good endings. In the US, even as numerous voices declaim on the crisis that awaits if we don’t act, there is seemingly no collective will to actually do anything as yet. Perhaps it will take… a crisis. In Europe, the peripheral countries can already be said to be in crisis.

This week we will look at the mindset that ignores warning signs, and reflect on a hard-to-believe comment from Mayor Bloomberg of New York. It is a teaching moment that does not bode well for my hopeful outcome in the US. Meanwhile in Europe, the risks have been heightened with the recent vote in Italy. We must remember that Italy is the world’s third-largest issuer of bonds – its problems matter on the world stage. While it may all be molto divertente for those of us sitting on the sidelines, the potential consequences are anything but amusing.

But before we get going, if you are a qualified purchaser or an investment advisor in the US, I would like to invite you to listen in as I interview Jacob Gottlieb, CIO of Visium Asset Management, on Tuesday, March 26 at 12:00 p.m. EDT, 9:00 a.m. PDT. Visium is one of the premiere long/short multistrategy managers in the investment industry and of great interest to me. I will ask where they are finding alpha opportunities today, as well as share my own thoughts on the global economy and outlook. This discussion will be hosted by my partners at Altegris Investments. Please register for this exclusive webinar through The Mauldin Circle. If you are already a member of the Mauldin Circle and a qualified purchaser, you will receive an email invitation to the webinar. A replay will be available to registrants unable to attend. I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

An Infinite Amount of Money

I am often asked, “How can anyone not see the problems of growing debt in the US? Why can’t we get a consensus to change?”

Part of the problem is that too many in power just don’t see the impending crisis that you and I see, or at least they don’t see the need to act now. That is changing – or so I thought until I read a most inexplicable statement by the billionaire entrepreneur mayor of NYC, Michael Bloomberg. This is the sort of thing that causes me to despair. Here we have a supposedly (well, relatively) fiscally conservative politician, someone who is no stranger to financial circles, giving us these off-the-cuff remarks last week, commenting on whether sequestration will affect the NYC budget:

“It depends on how long,” Mr. Bloomberg said on his weekly WOR radio show with John Gambling. “If it lasts a few weeks, no. If it [lasts longer], yeah. We get 10 or 12 percent of our budget from the federal government, not all of that is going to be cut back, but there would be effects – not good effects. But in the context of, ‘Is anything going to change tomorrow? Are we going to run out of money tomorrow?’ I’m sure I’ll get that question at the [next] press conference. No.”

Furthermore, while saying the federal deficit does indeed need to be curtailed, Mr. Bloomberg argued the United States could owe “an infinite amount of money” and there is no specific amount that would cause the country to default.

“We are spending money we don’t have,” Mr. Bloomberg explained. “It’s not like your household. In your household, people are saying, ‘Oh, you can’t spend money you don’t have.’ That is true for your household because nobody is going to lend you an infinite amount of money. When it comes to the United States federal government, people do seem willing to lend us an infinite amount of money.… Our debt is so big and so many people own it that it’s preposterous to think that they would stop selling us more. It’s the old story: If you owe the bank $50,000, you got a problem. If you owe the bank $50 million, they got a problem. And that’s a problem for the lenders. They can’t stop lending us more money.” (Observer.com)

I am not sure what his understanding of the word infinite is, but I am pretty sure he is not using the word to mean “limitless or endless in space, extent, or size; impossible to measure or calculate.” In the few times I have met him, he has seemed quite reasonable and in command of the English language. I think he was speaking in a metaphorical sense, as in, there is (to his mind) no practical limit. I certainly hope he was.

I am reminded of former Vice President Dick Cheney’s comment that “deficits don’t matter.” He is right, if the deficit never grows past the rate of the growth of the country (nominal GDP). It might not be wise to approach that limit, but it would not necessarily be a disaster. And, to be charitable to Cheney, I’m sure it never occurred to him that the US could run a deficit close to 10% of GDP. Such a notion would have been preposterous to him. Unthinkable. The US government would pull back from anything even close to that. And that remained true – until it happened and we didn’t pull back.

And that is the problem. Too many of our leaders do not yet think we have approached the limit – hey, we’re not to infinite yet! The political and economic repercussions of restraining ourselves are just too difficult for some of us to resist pushing the limits a little further. Too many in the current administration appear to truly believe that even minor spending cuts (and I mean just cuts to the increase in spending, not actual cuts!) will bring about calamity.

Spending cuts will indeed reduce potential GDP in the short run. And for most politicians, the short run is the world they live in. But at some point, the short run gets longer, and as infinity approaches the bond markets get very antsy.

Greece protested against the austerity imposed on it. But what choice did it have? If it did not cut its budget, the rest of Europe would not fund the new debt the country needed. It is not a God-given right for Greeks to expect Germans (and the rest of Europe) to fund their lifestyle. So the bond markets simply stopped funding Greek debt. Unless the Greeks had agreed to austerity (known in some circles known as “reality”), the budget cuts would have been far larger, as Greece cannot print its own currency. The rest of Europe gave Greece money to avoid the potential debacle of a disorderly exit from the euro, but they did extract a price. The object of the process was to get Greece back to a place where it could fund itself with a smaller government budget. (More on that subject later.)

Austerity is not fun. Ask any teenager whose parents have set limits where previously there have been few or none. Tantrums ensue. It is kind of like the five stages of grief: denial, anger, bargaining, depression, and acceptance. Except that when you are talking about seriously over-indebted governments, the depression (pardon the pun) can last a lot longer than any other stage.

Bloomberg and those who think like him project our current experience into the far future. “Look at interest rates,” they say; “they are telling us the markets are just fine with the levels of US debt and the deficit.” And they are right; there are no bond-market issues now. But those of us with an eye on history know that is not unusual. Bond markets are typically sanguine right up until the BANG! moment. Then they are not. Bloomberg is right to say that there is no specific amount of debt that would cause the markets to cease funding us. Would that there were some convenient, unmistakable line we could see as we approached it. But the experience of over 250 debt crises over the past few hundred years tells us that there is no specific point when the markets lose confidence in a government’s debt. When it happens, though, it is ferocious in its intensity.

That is why I and others are so deeply worried about Japan. The level of denial is majestic. The newly nominated governor of the Bank of Japan, Haruhiko Kuroda, has openly espoused the printing of money and monetization of debt. And Kikuo Iwata, one of the government’s nominees for central bank deputy governor, said the Bank of Japan should buy longer-term bonds to help it achieve a two-percent inflation target.

They both suggest that the monetization planned for 2014 under the old regime could be accelerated into the present. As if to reinforce the perception that Japan can borrow an infinite amount of money, the yield on Japan’s ten-year bond has fallen to 0.585%, the lowest in a decade. If the bond market is so compliant in the face of imminent massive monetization, what could possibly go wrong? The amount of debt Japan has amassed has now topped one quadrillion yen. Not trillion with a “T” but quadrillion with a “Q,” which coincidentally also begins the word “questionable.” You can see for yourself how confident bond buyers are, in this chart:

Infinite means “without limit.” If Japan can borrow such sums at a 240% debt-to-GDP ratio, the thinking surely goes, the US can borrow a few trillion more – or perhaps even an infinite number of trillions. And we have such a long way to go before we even get to a quadrillion!

I warned in Endgame two years ago that the markets could lose patience in 2014 if they do not see a serious attempt to curtail the US deficit. The recent gold standard for a bearish mindset, my friend Nouriel Roubini told me he thinks I am being too pessimistic – we can probably get through to 2015.

If we do indeed see some movement toward deficit reduction, then our date with destiny can be postponed for quite some time. If over time we can bring the deficit back to below nominal GDP, a true debt crisis can be averted. If pressed, I am sure Mayor Bloomberg would now express regret at using the words infinite and debt in the same sentence. I doubt he actually believes what he said; rather (I generously assume), he was trying to make the point that the current sequestration will not bring on a debt crisis.

Until we get enough leaders to press the point, leaders like Simpson and Bowles, et al., we will dig an ever-deeper hole for our children; and if we don’t stop digging pretty soon, we will find ourselves in that hole. Past performance is not indicative of future results: it is not preposterous to think there might be limits.

Et Tu, Italy?

Only last year I was a mild-mannered euro skeptic. My default position was that the eurozone would break up, at least partially, due to economic strains and the unwillingness of nations like Germany to write checks and endure outright monetization. If Germany et al. relented, then I would have to change my position.

Germany has clearly gone along with monetization (while protesting all along the way). I now assume that the eurozone will somehow stay together unless and until we see a political event that creates an exit crisis for some country. The will of European leaders to keep the euro experiment alive at all costs is impressive. Now, the cost of a breakup is almost unfathomable. A breakup is not impossible, but oh dear gods, what a cost. It is now probably cheaper just to continue to bump along, forcing austerity where one can. That is certainly the default political position in most of Europe.

For now, “austerity” is a bad word. It has been openly forsaken in France and Spain. There are massive demonstrations in Portugal. Greece has gone about as far as it can politically for the time being. The Dutch government finally conceded on Thursday that it would not meet the budget-deficit target set by the European Union this year, due to its weak economy and a reluctance to make more cutbacks.

I see two threats to the euro. The first is France. Its budget deficit and economy are getting worse, and so far all French attempts to maintain the EU deficit target have been cosmetic, much to the frustration of Germany, which has brought its deficit down to 1%. However, Merkel does not want a crisis before her elections in September, so she is giving a pass to France and Italy. But that is a topic for another letter.

The second threat is the possibility of a political crisis in a country where an anti-euro government takes actual control. Right now that seems unlikely to happen, but the recent election in Italy has given European elites a case of indigestion.

Some German leaders (pointedly not Merkel) spoke openly and derisively of the success of those they called the Italian “clowns,” speaking of aging comedian Beppe Grillo and his Five Star Movement and the even more aged (76) conservative leader, playboy, and billionaire Silvio Berlusconi, he of “bunga bunga” notoriety, who has refused to go away, to the consternation of much of the rest of Europe.

Italian politics are always difficult to fathom, even for Italians. When I am on vacation there and ask the locals questions about what is likely to happen, I am met with confused shrugs (at least in Tuscany). I don’t get the passionate lectures I heard in Greece or Spain.

The center-left coalition “won” the lower house with 29.6% of the vote. Berlusconi’s coalition won slightly less, at 29.2%. Under the Italian Constitution, which makes the US electoral college scheme appear sane, the party with the most votes gets an automatic 55% of the lower house. So with less than 30% of the vote and a win of just 0.4%, the center-left now controls 55% of the votes in parliament. But the Senate, which has equal power, is not apportioned the same way, and there Berlusconi won control. Unless some grand coalition can be finessed, there is no government that can be formed. Anatole Kaletsky writes at GaveKal:

This is not to say the situation is not pretty messy! The big winner of the Italian election is obviously the protest vote, as illustrated by a 5% rise in abstention, and, much more importantly, a super strong 25% score for Beppe Grillo’s Five Star Movement, a new party founded by geeks and bloggers with an anti-everything discourse (anti-Monti, anti-Berlusconi, anti-euro, anti-establishment, anti-debt repayment, anti-markets, etc.). Ex-comedian Grillo (who is not himself a candidate) has succeeded in gathering protest votes that were usually spread between the extreme-right and the extreme-left.

While the center-left party of Pier Luigi Bersani took 29.6% of the vote (with more than 99.9% of ballots counted) in the lower house, a touch more than Silvio Berlusconi’s 29.2%, Italians have sent a clear message of protest against fiscal austerity, and against tax hikes in particular. Mario Monti’s new party got just 9% of the vote in the lower house, and Berlusconi and Grillo’s combined vote is roughly 55%.

These split votes mean the emergence of a new government in the eurozone’s third largest economy is going to be extraordinarily problematic. Moreover, new elections cannot be called before late May at the earliest, since the president of the Republic (elected for seven years in May 2006) does not have the right to dissolve during the last six months of his mandate. In any case, new elections may not be what the establishment would want (Berlusconi included) since it would fear an even higher score by Grillo.

One possibility is a Bersani/Berlusconi grand coalition. This seems crazy, but after all the two parties “governed” together in 2012, since they were the two main supports to Monti’s technocrat government – until Berlusconi’s party withdrew its backing in a well-calculated move to campaign on an anti-austerity theme in the elections. Another possibility is a coalition between Bersani and Grillo’s Five-Star Movements – bizarre, but who knows with Italy? Whatever the solution, nothing will come easily – and there is the risk that a new market crisis might be a pre-condition for a coalition to be formed.

Anatole’s lifelong friend and partner, Charles Gave, sees the Italian elections much differently. He points out that a majority of voters selected parties openly anti-euro as well as anti-austerity. And I agree with him: that is the apparent outcome. However, when you look at polls, the 25% that Grillo won was clearly a youth protest vote. The vast majority of the Five Star Movement’s voters were under 50 and many under 30. The message was one of protest against the corruption of the current system as well as frustration with the technocrat government (which Berlusconi initially supported, before his polls numbers rose and he decided to stand in an election that he came within a hair of winning). The current prime minister, Mario Monti, got just 9% of the vote – a resounding rejection.

Grillo is an odd character. He refuses to talk to journalists. Italian reporters who have telephoned him and asked to speak to the general secretary of the party claim he has told them, “Hang on, I’ll just pass you to my 12-year-old son.” He said Italy was in such dire economic straits that “In six months, we will no longer be able to pay pensions and the wages of public employees.” He has called for a total repudiation of Italian debt (otherwise known as default).

In an interview with a German magazine, Grillo warned that “if conditions do not change” Italy “will want” to leave the euro and return to the lira. I refer those who are interested in the lurid details to a story in the Telegraph.

Like the Greek Syriza Party, which had to back off its earlier positions with regard to leaving the euro, Grillo may find that he cannot hold his coalition together if the real possibility of his governing ever materializes. He has refused to entertain being part of any coalition government, calling the center-left winner Bersani a “dead man talking.” Not exactly the stuff of which coalitions are formed. One young lady responded by starting an online petition to demand that Grillo not “waste” her vote, and work with Bersani to form a coalition government. In just a few days, she has already had 150,000 5SM voters sign her petition. Waiting six months for another election without a government would not exactly make for inspiring theater, and while no one likes the current government, the voters apparently like chaos even less.

If a grand coalition cannot be formed, it appears another election will be held this summer. And while the concern in Europe is that Grillo might even get more votes, it is also possible that his intransigence and unwillingness to capitalize on his surprise upset will cost him voters.

Throughout Europe, where austerity has been the order of the day there have been protest votes. But will the anti-euro forces actually be able to muster a firm majority? Not so long as Merkel allows relaxation of the Fiscal Compact, as she apparently has. The impetus for protest will wane and find another focus besides withdrawal from the euro.

But we need to keep an eye on these nationalist movements and an even closer watch on France. President Hollande has slumped in the polls to a 30% approval rating just ten months after his election, making him the most unpopular president in 30 years. He seems to feel that France can borrow an infinite quantity of euros. It will be a race between Hollande and Japanese Prime Minister Abe to see who can lose the confidence of the bond market faster. From my perspective, they are both running hell-bent for leather.

Incidentally, Anatole Kaletsky and Charles Gave will both be at my 10^th annual conference, May 1-3 in Carlsbad California, cosponsored by my friends and partners Altegris Investments. Louis Gave will join them on a panel that I will moderate. Having appreciated the vigorous disagreements between Charles and Anatole, and knowing how passionate Louis is, I think that will make for a fascinating panel. To my knowledge, it is the first time they have appeared together other than for their own client conferences. I am honored.

They will be joined by Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Jeff Gundlach; David Rosenberg; Nouriel Roubini; and Gary Shilling, plus a few surprise guests. This will indeed be the macroeconomic event of the year – you seriously need to think about coming. The conference is getting close to capacity and will likely sell out, as it has the past four years. I always seem to have people frustrated with me when I can’t find them a spot, but we really do have a hard limit on attendance, imposed by the size of the hotel. Next year we will move to larger quarters, but if you want to come this year you need to stop procrastinating and register.

We offer an early-bird registration, which is about to run out. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. I hope to see you there.

Oh, and I have just arranged for registrants to have access to the private research of many of our speakers for the two monthinfis prior to the conference. That in itself is worth the price of conference admission.

Moving, Argentina, and Sonoma

My bags are packed, kind of. The movers come this Thursday to empty my house and put everything in storage while we wait for the new digs to close. Apparently, my loan for the new place has been approved, which is a good thing, as I am committed to moving. Hopefully I will not be in a local hotel too long before I can move in, though I know I will be there for at least a few months, until we can combine two apartments into one more comfortable place. The process is longish, but I think the result will be worth the hassle.

I leave Thursday night for Cafayate, Argentina, to be with my friends and partners and a fun group of their friends. As a special treat, I will finally get to go to my old friend Bill Bonner’s (he of Daily Reckoning fame) estancia in the Andes near Cafayate for a few days. I am excited about that, and it will be nice to catch up with Elizabeth as well. It has been too long.

I will be speaking at a special one-day event in Sonoma, California, on April 5. My friend Mike Shedlock is holding a charity fundraiser to support research into ALS (Lou Gehrig’s disease). Sadly, Mike’s wife died last year of ALS, and his commitment to a cure is worthy of support. John Hussman, who is among the notables that are speaking (your humble analyst is there as comic relief), has generously offered to match up to $100,000 in conference registration fees. I have often exchanged notes with John and really look forward to meeting him. You can find out more at Mish’s Conference.

I am going to take most of the next two days to try and reduce the pile of things that I keep moving from place to place. Over the years, we all tend to accumulate stuff we somehow just can’t let go of. My closet is filled with clothes I have not worn in five years, or even in three. Shelves sag with so many books I will never even have time to touch again. Drawers are stuffed full of items I couldn’t imagine parting with at the time. Knickknacks I just don’t need are perpetually on the increase. I keep trying to get the kids to take more, but they know extraneous material (otherwise known as junk) when they see it.

The hard part will be to stay focused as I stumble on memories I don’t want to lose, in the form of treasured relics of an event or time past. That first card from one of the kids. Photos. Handmade gifts that are priceless. My intention is to leave with less than I came in with for the first time in decades of moving. We will see how my resolve holds up. I mean, I might want that sweatshirt someday. And that suit and tie might come back in style; you never know.

Have a great week. I look forward to a night in Buenos Aires before flying to Salta and driving through the majestic canyon that leads to Cafayate. I intend to finish my part of a book, lose a little weight, and enjoy my time with friends. And I will write next week, as always.

Your ready to move on analyst,

John Mauldin

subscribers@mauldineconomics.com

The Healthcare Blues

John Mauldin — Wed, 27 Feb 2013 22:51:00 GMT

On Being a Professional Worrier
The Healthcare Blues
China, Japan, and a Few Rocks
Stupid Sequestrations
Whiteboard Fun
Argentina, Cambodia, Singapore, Humiliation, and Homeless

It has been some time since we peeked into my worry closet. A few questions this weekend prompted me to think about things I am paying attention to but have not written about, and one thing that I am not worried about at all, despite the apparent media hysteria.

But first, a quick note. My tenth annual Strategic Investment Conference (May 1-3 in Carlsbad, California) seems to be filling up nicely. The speaker lineup is exceptional: Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Charles and Louis Gave; Jeff Gundlach; Anatole Kaletsky; David Rosenberg; Nouriel Roubini; and Gary Shilling.

Seriously, where else can you find a roster like that? And the attendee list has a "who's who" feel to it, as well. Those who come regularly know that the real value is in meeting the other attendees. David Rosenberg noted last year that this is the top investment conference he has ever addressed. The speakers all seem to bring their "A" game. The attendees agree, and this year we will have more interaction than ever.

The conference always sells out, and we offer an early-bird registration, which is about to run out. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page.

But before we go any further, did you know that you can now absorb Thoughts from the Frontline through your ears, if your eyes are otherwise occupied? That's right – our new audio service delivers my weekly letter to your cellphone, iPod, MP3 player, or computer, whenever and wherever you choose. You can check it out right here.

And now, let's peek into my worry closet.

On Being a Professional Worrier

I should note that I am a professional worrier. I get paid to think about what can affect our economy, finances, and investments. Over the years I have become quite good at it. But the sheer volume of things to worry about has grown so much that there is not enough time to worry about everything, so I have had to prioritize.

For instance, there was a time in my life when I worried about what the markets did on any given day. But serious study showed me that worrying about the day-to-day movements of markets was pointless (at least for me, and probably for most of you), so now I let the media and traders do that for me. Instead, I try to think about what could move markets longer term. And yes, I "worry" (as in ponder) what could make the markets go up as well as what could make them go down. It is enough to try to get the direction of the movement right, let alone the day-to-day gyrations.

Further, I do not worry (at least in terms of economics and investments, the beat of this letter) about things that I can either avoid or at least hedge against. I may pay close attention, but I do not spend time worrying.

I try to devote my actual professional worry time to things for which I don't have a solution, and to ponder the likelihood of their happening and what we might do about them.

This prioritization helps my worry closet remain a closet and not expand into the living room. I must confess that my living room is crowded enough with worries about how my kids are doing that I simply have to close the worry closet door every now and then, as they remind me of the here-and-now problems of life. However, problems that they deal with do often find their way into my worry closet. Problems like, where will the jobs come from? (Which is the subject of a book I hope to have off my desk in a few months.) Another such problem is the subject of my central worry in this letter: health care.

For new readers, I have seven kids, so I have lots of opportunity to worry. Five are adopted, so we've been tossed into a random lottery of past family health issues. Some we know about, and some we don't. Henry, my oldest son, is from the Virgin Islands. He played serious high school football (6'1" and 290 pounds, all Dallas-Fort Worth area tackle) and slimmed down a few years after to a ripped 230 pounds. Solid muscle. He is now 31 but still in good shape.

He was diagnosed a few years ago with type 2 diabetes. It is under control most of the time, but something seems to take him to the emergency room about every four months. This past month it was a liver and gall bladder issue. He has a good job with good insurance, except that his employer has cut back the hours he works. He has a union job, and the new employees make about half what he does, so they get the hours. Henry has a young son, and that makes it tough. And with diabetes, he can't afford to quit and take a new job without solid health benefits, yet because of his problem it seems he can't get a job with insurance. So part-time jobs are the order of the day, and they pay less.

Daughter Melissa was diagnosed with thyroid cancer last year, and her thyroid was removed. They were pretty confident they got it all, but recent scans showed some spots on the lymph nodes in her chest area. We are waiting for results from a recent and more detailed scan, which seem to be taking forever. She did not have insurance for the first operation, so I became intimately aware of the costs of medical care. The quality of the hospital and doctors was superb (Baylor in Dallas). In terms of costs, I was pleasantly surprised, as I was expecting a horror story. I thought that all in all it was reasonable. We now have insurance for her, but given her history there are limits to it.

Amanda (adopted from Korea) has a baby due in six weeks and is doing fine. Tiffani has given us a scare or two (the lump in the breast thing). Chad has been in a few serious accidents. Abigail (Amanda's twin) and Trey have nothing out of the ordinary.

I have written extensively in this letter about the unsustainability of the entitlement programs, especially Medicare and Medicaid. They are growing at a much faster rate than the economy. We simply cannot afford as a nation to maintain our current system without reform.

It is one thing to say in the abstract that we have to get the entitlement programs under control and another thing to see the unintended consequences of a healthcare system that works for most of us but can devastate more than a few of us at the wrong time. Melissa was given the best of care because she had a Dad who was fortunately able to help. What about the millions of Melissas who don't?

It's all so very complicated, and it can become very emotionally trying. I get the economic issues of insurance companies having to deal with pre-existing conditions. But I also see what can happen to young people when they have those pre-existing conditions. I deal firsthand with my kids and insurance and healthcare costs. It is very real to me and not at all abstract.

I have been told that in a few weeks or months I am going to be one of the first to receive a new type of genetic analysis. Rather cutting-edge, it will tell me a great deal about my genetic predispositions and tie them into the latest research. I am not sure of the cost (it will not be cheap), but in a few years it will be standard procedure for those who want it and reasonably affordable, as it is one of those things that can be computerized.

In a few months, I will know of a lot of my potential pre-existing conditions. What if my insurer also eventually knows them? Do we work together to prevent a problem before it happens, or will they dump me or limit coverage? I worry about such things. The day is not too far off when such genetic insight will be cheap and easily available to everyone. Should health insurance costs be based on the gene-pool lottery? (Let's not even go into life insurance!)

The Healthcare Blues

For this week's issue of Time magazine, the cover story is Bitter Pill: Why Medical Bills Are Killing Us, by Steven Brill. I had to have something to read while the plane was taking off, and that turned out to be it. (Since I got my iPad I no longer carry books, so I make sure I have something to peruse while waiting to be able to use my electronics in the air.) I have read work by Steve Brill in the past and like his style, so even though I don't usually read Time, I picked up this issue on health care.

I wish I could get every voter in America to read that article and then go to the Internet, Google the piece, and read the comments. I don't agree with all he wrote, but he does a marvelous job of giving us the picture on just how broken the American healthcare system is in terms of costs. He goes into detail about how hospitals create those staggering bills. If you have private insurance or a government plan, you don't have to pay those prices, but what if you don't? The billing system is out of control: $1.50 for a 1.5-cent acetaminophen pill (Tylenol). A simple niacin tablet marked up 240 times. Routine products like gauze marked up 10 times. Billing for a lamp shade? Are you serious? Double and triple billing for routine items that no insurance company or government agency will pay for, but that you will be billed for if you are on your own. You have read the stories or heard them from friends, but Brill makes it real.

We spend almost 20% of our gross domestic product on health care in the US, and that figure continues to climb. I could quote at length from the article, but let me just excerpt six paragraphs:

Taken as a whole, these powerful institutions and the bills they churn out dominate the nation's economy and put demands on taxpayers to a degree unequaled anywhere else on earth. In the U.S., people spend almost 20% of the gross domestic product on health care, compared with about half that in most developed countries. Yet in every measurable way, the results our health care system produces are no better and often worse than the outcomes in those countries.

According to one of a series of exhaustive studies done by the McKinsey & Co. consulting firm, we spend more on health care than the next 10 biggest spenders combined: Japan, Germany, France, China, the U.K., Italy, Canada, Brazil, Spain and Australia. We may be shocked at the $60 billion price tag for cleaning up after Hurricane Sandy. We spent almost that much last week on health care. We spend more every year on artificial knees and hips than what Hollywood collects at the box office. We spend two or three times that much on durable medical devices like canes and wheelchairs, in part because a heavily lobbied Congress forces Medicare to pay 25% to 75% more for this equipment than it would cost at Walmart.

The Bureau of Labor Statistics projects that 10 of the 20 occupations that will grow the fastest in the U.S. by 2020 are related to health care. America's largest city may be commonly thought of as the world's financial-services capital, but of New York's 18 largest private employers, eight are hospitals and four are banks. Employing all those people in the cause of curing the sick is, of course, not anything to be ashamed of. But the drag on our overall economy that comes with taxpayers, employers and consumers spending so much more than is spent in any other country for the same product is unsustainable. Health care is eating away at our economy and our treasury.

The health care industry seems to have the will and the means to keep it that way. According to the Center for Responsive Politics, the pharmaceutical and health-care-product industries, combined with organizations representing doctors, hospitals, nursing homes, health services and HMOs, have spent $5.36 billion since 1998 on lobbying in Washington. That dwarfs the $1.53 billion spent by the defense and aerospace industries and the $1.3 billion spent by oil and gas interests over the same period. That's right: the health-care-industrial complex spends more than three times what the military-industrial complex spends in Washington.

When you crunch data compiled by McKinsey and other researchers, the big picture looks like this: We're likely to spend $2.8 trillion this year on health care. That $2.8 trillion is likely to be $750 billion, or 27%, more than we would spend if we spent the same per capita as other developed countries, even after adjusting for the relatively high per capita income in the U.S. vs. those other countries. Of the total $2.8 trillion that will be spent on health care, about $800 billion will be paid by the federal government through the Medicare insurance program for the disabled and those 65 and older and the Medicaid program, which provides care for the poor.

That $800 billion, which keeps rising far faster than inflation and the gross domestic product, is what's driving the federal deficit. The other $2 trillion will be paid mostly by private health-insurance companies and individuals who have no insurance or who will pay some portion of the bills covered by their insurance. This is what's increasingly burdening businesses that pay for their employees' health insurance and forcing individuals to pay so much in out-of-pocket expenses.

I know about those business healthcare burdens. At my very small business, the fastest-rising cost is health care. I have my staff get bids on health care every few years and try to hold down costs. I should note that after reading the Brill article I am actually going to go back and check a few items to make sure we have proper coverage. You think you do until…

Let's be clear: the US has the best medical care on the planet. Expensive, yes, but our best is truly the best. As I get older and as my kids have issues, having access to good health care seems a very good idea. I want to live a very, very long time. Which is why I worry. I don't want to see our healthcare system get sidetracked.

Now, we are getting ready to dramatically change how we pay for 20% of our economy. I fear Obamacare is going to be a bureaucratic nightmare. Before you consign me to some Neanderthal Republican hell, let me quickly state that any necessary reform is going to be disruptive and expensive. Even if we adopted Paul Ryan's plan, it would be very disruptive. You simply can't change the incentives and payment structures of 20% of the economy without creating macroeconomic problems. There are more unintended consequences than we can imagine lying hidden in the grass of healthcare reform, like hungry lions.

Having to cover pre-existing conditions is going to raise the costs of private insurers. In my business, we are getting reports that our cost will go up by as much as 50%. Individual rates may rise even more.

Under Obamacare, businesses may have sufficient incentive to drop insurance coverage and pay a $2,000-per-employee penalty. I am not certain where they came up with that number, but $2,000 is cheap insurance. Insurance companies are going to lose business customers as they raise prices. If your employees can get government health care (mine can't, I hasten to add!), then from a financial perspective you are better off paying the penalty. When insurance costs rise, the pressure to drop coverage will rise as well, which will mean those still covered have to pay more. It will be an ugly trap until things get sorted out.

By the numbers, Medicare looks like a government program run amok. After President Lyndon B. Johnson signed Medicare into law in 1965, the House Ways and Means Committee predicted that the program would cost $12 billion in 1990. Its actual cost by then was $110 billion. It is likely to be nearly $600 billion this year. That's due to the US's aging population and the popular program's expansion to cover more services, as well as the skyrocketing costs of medical services generally. (Time)

I fear that the Medicare budget will rise even further unless we get aggressive on holding down costs. But that will not be easy. The systemic and political incentives to effect change are just not there until there is a real crisis. And while Brill talks about the excess profit in the system, when you take that away, things will change. Some think they will change for the better, but I am afraid we are all indulging in wishful thinking.

Obamacare may have brought forward the crisis that we all knew was coming. Rather than runaway entitlement spending being a problem for the latter part of this decade, it may soon be a topic for your child's "show and tell" time at school. We either get a handle on the problem this year or things could quickly spiral out of control. Medicare and Medicaid costs could quickly rise by 5-10%, which would blow a hole a mile deep in our national budget. Yes, that would mean that costs that had been absorbed by emergency rooms and picked up by charities would now be paid for by the government, but while they might amount to the same total (unlikely), they would not be part of cost and budget projections.

Maybe the government does a better job at estimating future costs than it did in 1965, but I worry that it won't. And the consequences of being wrong could be very disruptive to a healthcare system that is as vital as food and energy. Honestly, I do not get a good feeling when I think of Washington DC and crisis management. Call me silly, but I worry about that.

I don't have an answer, or at least not an easy one. Should we treat health care as a utility? That is anathema to my free-market sensibilities. Should people be without basic health care? That is also not acceptable. Can we afford universal health care? Not as costs are currently structured. Can we change? Sure, we will have to. But I expect a bumpy ride. I read and think a lot about health care because I am worried it is going to impact our economy in ways we simply don't yet understand.

China, Japan, and a Few Rocks

I also read a lot of material written by other professional worriers – as opposed to amateurs who worry about everything simultaneously, or even worse, the tin-hat crowd that feels compelled to conjure problems and conspiracies that don't exist in order to assign blame to some imagined cabal of bad guys.

(OK, let me generate a lot of negative comments with an example. I find the belief that there is a "Plunge Protection Team" simply bizarre. You know, the guys who are supposed to control the stock market? The "Working Group on Financial Markets"? If there is one somewhere, deep in the bowels of government, they are the most incompetent conspirators ever assembled. And no one has come forth and spilled the beans in a memoir after 25 years? Puh-leeze!)

But when I start to pick up similar themes from people I know and respect who don't know each other, I start to pay attention. And one of those themes has been coming to me from people, including some at very high levels, who have deep knowledge and experience of Japan and China.

They are getting concerned that the level of rhetoric surrounding the Diaoyu/Senkaku Islands dispute is starting to get out of control. The real estate in question is a very small chain of five uninhabited islets and three rocks in the middle of the East China Sea. They are located roughly due east of mainland China, northeast of Taiwan, and west of Okinawa Island (the largest of the Ryukyu Islands), as shown in the map below.

China and Japan have had an on-again, off-again relationship for centuries. At times, it has not been very pretty. China suffered a great deal at Japanese hands during WWII. Just when you thought the old wounds were finally healing, the off-again phase has come back in full force. Japan nationalized what were to them the Senkaku Islands last September. (Technically, Japan bought them from the Kurihara family for 2 billion yen.)

The earliest historical records we have indicate that the Chinese discovered the islands in the 15^th century. The Japanese nationalized them in 1895. After WWII, the US administered them but gave control back to Japan in 1971. Returning control to Japan angered both China and Taiwan, as both countries considered the islands as their own. China and Taiwan then began to officially declare ownership of the islands.

The rub is that these rocks may be perched in the middle of a rather large oil and gas field. The UN identified the petroleum potential in 1969, but no drilling has taken place.

The leaders of both China and Japan have made strong statements, and their citizens have expressed even stronger emotions. The Chinese are boycotting certain Japanese companies, and Japanese exports to China have dropped 14.5% (as of latest data). Recent meetings between the two countries have not been helpful. Recently, in what was supposed to be a speech to smooth things over, a top Japanese foreign policy advisor basically lectured the Chinese on their behavior in Hong Kong. Not the stuff of great diplomatic gestures.

And as I get ready to finish this letter, this timely note has come in from Stratfor:

Japanese Prime Minister Shinzo Abe has warned Beijing that Tokyo is losing patience with China's assertive maritime behavior in the East and South China seas, suggesting China consider the economic and military consequences of its actions.

In an interview The Washington Post published just prior to Abe's meeting with U.S. President Barack Obama in Washington, Abe said China's actions around the disputed Senkaku/Diaoyu islands and its overall increasing military assertiveness have already resulted in a major increase in funding for the Japan Self-Defense Forces and coast guard. He also reiterated the centrality of the Japan-U.S. alliance for Asian security and warned that China could lose Japanese and other foreign investment if it continued to use "coercion or intimidation" toward its neighbors along the East and South China seas.

It is hard for the world to understand the national emotion surrounding a few barren rocks. But stranger things have happened. Remember the Falklands (although they were at least populated)? I bring this issue to your attention not as something to worry about, perhaps, but as something to which you might want to pay closer attention. Let's hope cooler heads prevail; this is not something the world wants to choose sides over.

Stupid Sequestrations

The media and much of the political chattering class seem to think that the upcoming sequestration of certain government spending is going to bring down the republic. The actual reality is that we are talking about some $45 billion this year. In a $16 trillion economy, that is a rounding error. And with a $1 trillion+ deficit, it is not enough cutting.

Yes, across-the-board cuts are stupid. The Defense Department and, yes, even the other government departments should be given leeway to decide where to make the cuts, with proper Congressional oversight. But we need those cuts and more. We should be cutting the deficit by $100-150 billion a year every year until the budget is balanced (by which time we hopefully see some growth). If we simply held spending where it is, the problem would get solved with no cuts. Or if we cut the growth of spending in half, we could get close with some other adjustments.

I worry about a lot of things. But this sequestration is just simply not on the list.

Whiteboard Fun

I want to call to your attention a new whiteboard animation series by my partners at Altegris. Every single one of these videos is fun to watch. I love a good story, and great whiteboard animation is all about storytelling. Through these videos, Altegris has tackled some fairly complex and important alternative investments topics and made them easier to understand in a very engaging way. Take a look at the "edutaining" first video, called Common Myths About Alternatives. This video addresses ongoing myths circulating about alternative investments. I encourage you to watch and then go check out the Altegris premiere lineup of hedge fund managers, normally difficult to access otherwise. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

Argentina, Cambodia, Singapore, Humiliation, and Homeless

I am back home for a few days. Tomorrow Jon Sundt and Dick Pfister, my partners at Altegris Investments, are coming to town for a planning and strategy session (which must of course include a Mavericks game). The next day we drive out to see Kyle Bass and his team at his Barefoot Ranch in East Texas for more in-depth work, some thinking about Japan and global macro investing, and possibly a little skeet shooting.

I leave for Cafayate, Argentina, Thursday after next, for two weeks. I'll spend time with friends and try to relax a little, but mostly I'll work on finishing my part of the book Bill Dunkelberg (chief economist of the National Federation of Independent Businesses) and I are writing on the future of employment. As it turns out, healthcare costs might be partially responsible for the significant drop in new business formation. Go figure.

When I get back from Argentina, I will be living in a hotel until the new place (hopefully) closes. Homeless, sort of.

Last time I was in Cafayate for a few days, I played nine holes of golf with my friends and partners David Galland and Olivier Garret. I had not played any golf for about four years and had a very loose 29 handicap when I did play. I was not expecting much. After a very bad, cold start on the first hole, I slowed my swing way down and found myself hitting the ball where I could find it. I ended up shooting about 51 for the nine holes and was quite happy with that score.

So this past weekend I decided to play in a scramble format with my friends Victor Adair and Michael Campbell of Canadian business radio fame, whom I had never met except by phone during interviews. Victor knows I am good friends with Greg Weldon and arranged for him to be on our team. They were marvelous gentlemen, it was a beautiful day on a magnificent course, and I thoroughly enjoyed the outing.

Except. Golf can be so humiliating. I stepped up to the tee carrying the confidence from my Argentina outing... and sent the ball screaming right into some nasty brush. Oh well, there's always the next hole. And then I proceeded to lose exactly one ball per hole for nine straight holes. I got back in the cart with Victor and muttered something along the lines of, "That may have been the ugliest exhibition of golf you've ever seen." The silence and slight smile from Victor said it all. He was just too polite to agree out loud. Things did get better, though: I only lost three balls on the back nine. (On the plus side, I did make our five birdie putts for the team.)

In the middle of April, I will be speaking in Singapore and will take the opportunity to go see Angkor Wat in Cambodia. It has long been on my bucket list.

Ironically, since I've been writing about health care, I seem to have picked up a slight head cold in Palm Springs, so I think I will just call it an evening. I don't want to jinx myself, but I've been feeling amazingly good lately, so even losing 12 balls hasn't affected my mood tonight.

Have a great week. Don't sweat the small stuff. And remember: it's mostly small stuff.

Your having too much fun to worry too much analyst,

John Mauldin

subscribers@mauldineconomics.com

Whatever It Takes

John Mauldin — Wed, 20 Feb 2013 21:48:00 GMT

Who's Got the Map?
Monetization – A Rose by Any Other Name
Super Mario: Whatever It Takes
The New Policy Implications of the Irish Deal
Currency Skirmishes
Toxic Debt Scare
A Special Invite
My Conference, Palm Springs, and Vagabond Shoes

Lord Melchett: "Farewell, Blackadder [hands him a parchment]. The foremost cartographers of the land have prepared this for you; it's a map of the area that you'll be traversing. [Blackadder opens it up and sees it is blank] They'll be very grateful if you could just fill it in as you go along. Bye-bye."

– From the English comedy series Blackadder (Part 2, Episode 3)

Was it only a few years ago I visited the Emerald Isle of Ireland? So recently had this fair land come to such a sad state. The collapse of its largest banks foreshadowed the demise of many other European banks that had borrowed money from British, German, and other European banks to lend against homes and property. The Irish government had to guarantee deposits and bond holders in order to prevent a bank run. I think I am correct when I state that the Central Bank of Ireland was the first central bank to avail itself of large-scale use of the Emergency Liquidity Assistance (ELA) provision of the European Central Bank. This was before we became so familiar with the process in Greece.

The Irish banks had lost a combined €100 billion, borrowed largely from other European banks, which would also have incurred great losses had the Irish government not stepped in. You have to remember that this was before Greece and Spain needed assistance, although as Ireland stepped up to the table, the acronym "PIIGS" was coming into vogue; and some of us were writing about the debt problems that plagued Greece and other peripheral countries. The European Union compelled the Irish government to bail out its banks, and so the Central Bank of Ireland took on the debt (via the ELA) of the six main Irish banks that had failed because of the property bubble.

In the "bailout," Ireland received €67.5 billion (and in addition borrowed another €17.5 billion from its pension and cash accounts), which it pledged with a promissory note to pay back. The public was quite upset, and the government was then overwhelmingly rejected at the polls, in a clear show of sentiment demonstrating that the Irish people did not view that bank debt as something that should be on the public balance sheet.

Government workers had to take large pay and pension cuts and government services were cut, as one of the conditions for getting the money was significant austerity. This was before "austerity" became a bad word in Europe. Meanwhile, unemployment rose from 4% to 14%.

I visited Ireland after the new government took over. I met with some two dozen business leaders, politicians of all persuasions, journalists, and economists. I remarked at the time that the only thing they agreed upon was that Ireland would never pay that bailout money back. A former prime minister told me that they would not have to openly repudiate the debt, but rather were expecting, after Greece and other countries were allowed to default, to be invited not to pay it.

A leading Irish economist who was at the negotiating table told me point-blank that the IMF negotiator told them they would not have to pay it back. But you have to remember that at the time there was true panic and no road map for dealing with such a crisis. Something had to be done. That something was the issuance of bailout funds (which conveniently minimized losses at said German, French, and British banks), which came with a private assurance to Irish leaders that whatever was done for other countries would be available to them as well. "But please, just work with us right now?"

So the Irish, as we say in Texas, took one for the European team. The blow left a rather ugly scar, as the national debt ballooned into impossible-to-manage territory, crippling the national government.

But there was one group in Ireland that was aghast – horrified – at the idea of not paying back that debt: those were the people I met at the Central Bank of Ireland. And they did have a point. The document that created the European Central Bank did not allow a national central bank to not pay its debts. Governments could default (as we learned with Greece), but not national central banks. Those were the rules that everyone who adopted the euro played by.

At the time, I wrote that the Irish would not pay that debt. I had listened to the 99% of the people who told me so. Silly me. Yet, the last two weeks have seen the Irish convert their promissory note into government debt and agree to sell bonds. So it looks like the Irish will pay after all. Except that when you read the details, the Irish (after a great deal of controversy ensues) will end up either not actually paying or not paying anything close to the value of what they borrowed. So how can they both pay and not pay? That is the topic for this week's letter; and an instructive reading it is, not for what it tells us about Ireland but for what it tells us about the EU, the eurozone, and the future of the euro.

Who's Got the Map?

Fans of British comedy will recall fondly the early-'80s series Blackadder, originally about a self-serving courtier of Queen Elizabeth (played by Rowan Atkinson, who later became known in the US for his role as Mr. Bean). At one point, Blackadder is compelled to sail around the Cape of Good Hope in order to remain in the Queen's good graces. The voyage seems, of course, like a death sentence, and Blackadder never intends to sail. His nemesis, Lord Melchett, offers him a map and voices the lines quoted at the beginning of this letter. The map is a blank page. "It's a map of the area that you'll be traversing. They'll be very grateful if you could just fill it in as you go along. Bye-bye."

The document that created the eurozone is right along the same lines. Everyone thought they knew what it meant, or at least the Germans did. The Bundesbank (the German central bank) was quite sure that it prevented monetization of debt. It said so right there in Article 123. But the EU and the ECB (with their faithful companion the IMF) seem to be constantly wandering off into uncharted territory. Banking, credit, and sovereign debt crises seem to require legal maneuvering that was not explicitly detailed in advance. As the rest of Europe looks on, the ECB draws in lines on the map as it goes along.

Article 123, as every good Bundesbank member will tell you, explicitly says there will be no debt monetization. But it turns out that while everyone agrees that monetization of national debts is a bad thing, the definition of monetization is not as clear to much of the rest of Europe as it is to the good German burghers.

Wolfgang Münchau writes rather merrily about the recent "rescheduling" of Irish debt:

Everybody seemed to be talking about monetary financing of debt last week – the ultimate taboo in monetary policy. And hidden behind a veil of unbelievable complexity, the eurozone may have done just that.

Various European central bankers rushed to proclaim that the agreed rescheduling of Ireland's so-called promissory notes would not set a precedent for sovereign debt laundering. In legal terms, the agreement is probably watertight. It may be a borderline issue, but who cares? In economic terms, the situation is much clearer. This is monetary financing in all but name – and a jolly good thing it is too. (The Financial Times).

All this can get quite complicated (trust me). But it essentially boils down to this: Anglo-Irish Bank was bankrupt. The Irish government had to come up with some type of collateral that it could hand to what was in essence a bankruptcy trustee in order to be able to borrow at the ELA (Emergency Liquidity Assistance, sometimes referred to as "Lending Assistance"). The government gave the trustee a promissory note that was supposed to be paid off rather quickly (in ten years). It quickly became a large financial burden for Ireland's government – and a very sticky political problem. Only an Irish central banker could love that debt.

But someone in Ireland came up with a very creative solution. They turned that 10-year note into 25- to 40-year bonds. The interest that the government pays on the bonds to the Central Bank of Ireland goes right back to the government. Münchau is right: this is monetization in all but name. But there is a small fig leaf that keeps it from being outright monetization: the CBI agreed to sell the bonds into the marketplace over time, as the situation dictates. From the Irish Department of Finance press release:

The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.).

Let's put that in context. Ireland issued €2.5 billion in 5-year bonds last month, which are now yielding 2.8%, less than Italy's corresponding bonds. That is also less than the 5.9% the Irish paid last summer when they first came back to the market. (Someone made a rather large profit on those bonds!) The bank deal has evidently reduced the cost of Irish bonds for the government. They expect to raise about €10 billion this year. Right now, issuing another €0.5 billion in bonds is rather easy for them. Granted, the government has to pay the interest to what will be private bond holders, but that is far less than they were paying.

By switching to lower-interest-rate bonds and stretching out the burden of repayments over four decades, Ireland will save itself €20 billion ($26.78 billion) over the next decade and free up €1 billion for future budgets. Goodbody Chief Economist Dermot O'Leary was kind enough to send me a private client letter that shows what a large help this move will be to the Irish government. It gives them a much better chance to actually reduce their deficit to a European-standard 3% within the agreed-upon 2015 time frame. O'Leary thinks they will do even better.

The Irish ran their plan by the ECB staff before they announced this. I was told that initially they did not offer a specific schedule for selling the bonds, but the ECB (the Germans?) required at least a token schedule.

So, the Irish will pay those bonds back. Kind of. Perhaps. I say "kind of" for several reasons:

1. Think back 40 years to the US in 1973. Want a 1973 dollar? It's worth about 19 cents today. How about an Irish punt? An Italian lira? 25-40 years is a long time. And given that the ECB is going to have to print massive amounts of euros to hold the eurozone together, the betting is that when the Irish do pay that debt, it will be in a euro (or successor currency) that costs far less in terms of nominal GDP or buying power.

2. There is a reasonable chance that at some point the European Union, or at least the eurozone, will move to something close to the mutualization of debt and fiscal union. Debt that grew out of the crisis would seem to be a likely prospect for debt mutualization. This would reduce that burden of that debt. Of course, it would bring in other debt, but that's what the long term and central banks are for – or so the logic will go. I most definitely do not agree with that world view, but I will not likely be asked my opinion. In any case, the Irish debt will be so small relative to Spanish and Italian and French(!) debt that it will be considered a rounding error.

3. In the short and the long terms, this is a good deal for Ireland. Those who say the debt should be repudiated altogether would seemingly vote to withdraw from the euro. The time to reject the debt was at the beginning, and they should have. If German, French, and British banks lent money to Irish banks to invest in Irish property, then they deserve the fruits of their investment prowess (or lack thereof), not a taxpayer bailout.

4. Greece and Spain have also gone to the ELA, as have many European countries and banks. At some point, the eurozone is going to have to create some sort of banking union, as much as the Germans do not want to. There is the potential for these ELA loans to be considered banking-related losses. That is part of the negotiation process. Who knows what will happen, so why not cut your expenses in the short run, because the long run may make the whole thing go away.

Monetization – A Rose by Any Other Name

"What's in a name? that which we call a rose
By any other name would smell as sweet…"

There are those who oppose this Irish move. Jens Weidmann, the president of the Bundesbank, has been especially critical. But then, what would you expect? There is a genetic predisposition in Germany against monetizing debt, and has been since at least 1924. And make no mistake, this is monetization, no matter how much legal perfume you slather on it.

Quoting Münchau again:

This is monetary financing for all intents and purposes. The whole structure of this agreement is so convoluted that newspapers do not report all the relevant details. As always, convolution has a purpose. It renders legal what would otherwise not be, and it allows for obfuscation.

In this case, the purpose of obfuscation would be to hide what would otherwise be a contradictory message. You cannot admit publicly in the creditor countries that monetary financing is taking place – this is sacrilege. But then this is what it takes to save Ireland from a debt trap. It was then considered the best strategy to put back the debt repayment by a generation or two.

I am marginally encouraged by this, not so much because I believe that monetising is a good thing in principle, which I do not. What encourages me is that I can see this as one of several components of an ultimate solution of the eurozone crisis. Without some form of arbitrage between debtors and creditors, this would be hard to achieve.

I wrote at least three or four years ago that if you are going to keep the eurozone together, there will have to be monetization. It is going to take trillions of euros, whether they are monetized or in the form of extended debt – or however you care to characterize them – to solve this puzzle. And the only entity that has that type of money is a central bank, in this case the European Central Bank.

Super Mario: Whatever It Takes

You have to give Mario Draghi, European Central Bank president, high marks on your central-banker scorecard for style and creativity. Following hard on the heels of the bland Frenchman, Jean Claude Trichet, Super Mario has pushed the ECB to the point where it is, for want of a better word, central to the European enterprise. In July of last year, with the eurozone in crisis, he stood up in London right before the Olympics opened and stated (now famously):

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The Financial Times named him Man of the Year for 2012.

While I am told that the Irish came up with the plan to monetize the debt (excuse me, I mean to magically change an Irish government promise into German and French [and other eurozone] money; not exactly the same as monetization if you look at it in the right way, perhaps aided by a pint or three or four of Guinness), Draghi had to have approved it. And rather than saying he appreciated the creativity involved, he simply said that the ECB had unanimously decided to "take note" of the Irish actions, whatever that means. "There isn't any decision [to back the Irish debt swap] today. We simply took note," he said. I guess €28 billion isn't enough to officially mess with; you simply take note of it.

The Financial Times reports today that the ECB, rather than giving formal approval, wants to be able to pressure the CBI to actually sell those bonds; and it also gives the ECB some negotiating room with other national central banks, which will want to make similar moves.

The New Policy Implications of the Irish Deal

The ECB is going to need that room. Part of the controversy of the Irish deal is that senior secured creditors of banks are potentially going to lose money. This may represent new EU and ECB policy. That part of the map is not yet clear. Sovereign debt holders have lost money in Greece and will lose more in Spain (unless the ECB gets creative again). Predictably, those most critical are the ones losing money.

Some think that Draghi's recent comments mean the Irish deal will be reexamined. I can see where that might make political sense (to pretend to address concerns, etc.), but taking back this deal would create a major storm in Ireland. The bank debt is a deep wound, and the salve is a reduction in government costs. Taking away that salve is likely to create all sorts of voter backlash and possibly lead to a Sinn Fein government that would want to repudiate the debt outright.

Greece and Cyprus have to be watching very closely. As I wrote a few weeks ago, the chairman of the Council of Economic Advisors in Greece told me that the money they are being loaned to recapitalize the banks will not be repaid, because Greece does not have the financial ability to do so. Ireland was in the same spot, and with this magic they have changed the equation. Will the same deal be available to Greece in the future, if they keep on jumping through hurdles?

Cyprus will likely have a new pro-bailout government in a few weeks and will have to negotiate a €17 billion bailout from the EU and IMF – that's for a country with a population of 545,000, so about $40,000 per man, woman, and child of mostly new debt, taking their debt-to-GDP ratio up to 145%. A family of four will have to pay $10,000 a year (at 6.5% interest) just to cover the new debt. On top of the old debt. Where can a country get such income and remain competitive?

Will there be another haircut on European government debt? Someone somewhere is going to have to lose some money on this deal. Again, the Irish deal opens the way for a new brand of creative thinking in Europe on old debt.

Currency Skirmishes

I continue to think the euro is going to parity with the dollar over time. The ECB in conjunction with its various national banks is going to have to monetize and print (or we can call it by its polite name, "quantitative easing") to an even greater extent than the US Fed. Along with the money gushing from the Bank of Japan and the Bank of England, there are going to be sums injected into the global system that simply cannot be comprehended. And all this easing will force developing nations to compete at the printing press.

The recent G20 meeting basically said, "It is OK to print as long as you are doing it to stimulate your economy and not to devalue your currency. And for heaven's sake, don't talk about it. Shut up already!"

That's a loose interpretation, I admit. But read Super Mario's statement about the G20 meeting, and you make the call:

Most of the exchange rate movements that we have seen were not explicitly targeted; they were the result of domestic macro-economic policies meant to boost the economy… [and] In this sense, I find really excessive any language referring to currency wars… [but] What I did say at the G20 in Moscow, I urged all parties to (exercise) very, very strong verbal discipline.

In an article titled "G-20 Moves Toward Common Ground on Currencies," the Wall Street Journal reported:

… there was more agreement on the need for market based exchange rate and [the G-20] pledged Saturday to refrain from targeting their currency policies to gain a competitive trading advantage….

Germany's central bank president, Jens Weidmann, said it was clear at the meeting that G-20 members agreed that "politically driven devaluations can't sustainably improve competitiveness, don't solve structural problems and produce backlash reactions…."

"The understanding in this meeting was clearly that without going to extremes, developed countries will do what it takes to stimulate their economies, and developing countries—again without going to extremes – will do what it takes to protect themselves from hot-money inflows," said a senior official at a developing-country government that is part of the G-20.

We have not yet seen real currency wars. What we see today are mere skirmishes in what is shaping up to be a brutal battle to simply maintain a competitive stance.

I should note – as I almost hit the send button – that Ian Bremmer (who will be speaking at my conference in May) sent me a recent note about currency wars. He argues that Europe and China do not want to get involved in a currency war and that many emerging nations would also rather not. His argument makes sense, as a currency war is kind of like having an old-fashioned gunfight, except with hand grenades – there are no winners.

China will continue to allow its currency to appreciate slowly, for at least a few years. I can see Bremmer's argument with regard to Europe, in that they would really like to focus on inflation and the ECB would like to be a proper central bank; but Draghi's words keeps ringing in my ears: "… whatever it takes to preserve the euro." And what it takes may be money printing and a little inflation. We will get lip service, but the presses will run.

Korea? Taiwan? They have to compete with Japan. And the rest of Asia has to compete with all three. Can Brazil, Australia, and the other commodity-intensive countries allow their currencies to be priced out of the markets, thus weakening their economies? I think self-interest will trump all. This is the problem of the commons writ large.

Toxic Debt Scare

Finally, while researching this letter I came across the following post written by Colm McCarthy. I find it hilarious (by the standards of economics humor), and I hereby pass a few paragraphs along for your enjoyment. (For the young and those for whom English is a second language, a "knacker" is a person engaged in the trade of rendering animals that have died on farms and are unfit for human consumption.)

Teams of economists have detected traces of bank-debt DNA in samples of Irish sovereign debt in portfolios all over Europe. Genuine Irish sovereign debt is believed safe for humans but bank debt is toxic. The economists believe that as much as 30% of all Irish sovereign debt is not genuine. The source of the contamination appears to be a premises in Frankfurt, Germany. The contamination dates from 2010, when a sovereign debt knackering plant was run from the premises by a Monsieur Trichet, a French national. It is alleged that he gathered up large quantities of toxic bank debt and mixed it up with genuine sovereign debt in the middle of the night, when nobody was looking.

There is no licensing or supervision of sovereign debt knackerers at European level and it is understood that the Frankfurt plant was staffed by people with no previous experience in the trade. Genuine debt from several other European countries was processed through the Frankfurt plant in 2010 and 2011 and may also have been infected. The plant, which claims to be the only sovereign debt processing facility in Europe, is now run by a Signor Draghi, an Italian. Monsieur Trichet has retired from sovereign debt knackering and has commenced a new career in the aviation business.

The Irish Department of Finance has been seeking to return the infected sovereign debt to the Frankfurt plant with a view to removing the toxic component. They are afraid that retailers might remove the sovereign debt from their shelves. Signor Draghi has promised to do his best, but one of his assistants, Herr Weidmann, a German, believes that the toxic bank debt is harmless, and that anyway nobody will notice. He is refusing to operate the decontamination equipment.

A Special Invite

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My Conference, Palm Springs, and Vagabond Shoes

My tenth annual Strategic Investment Conference (May 1-3 in Carlsbad, California) seems to be filling up nicely. The speaker lineup is exceptional: Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Charles and Louis Gave; Jeff Gundlach; Anatole Kaletsky; David Rosenberg; Nouriel Roubini; and Gary Shilling.

The conference always sells out, so I suggest you register at your earliest convenience. Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. Registration is now open. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page There is a significant early-bird registration discount.

I will be in Palm Springs at the California Resource Investment Conference this weekend, February 23-24. My good friend Grant Williams, who writes the blockbuster Things That Make You Go Hmmm… and the Mauldin Economics Bull's Eye Investor letter, will be there, as will the best resource investor I know, Rick Rule, along with my favorite data maven, Greg Weldon. There is a full two-day slate of speakers. The event is free to investors and is always fun, and it's a great time of year to be in California (hate the pensions, love the weather). Come see us! You can read all about it and register at the Cambridge House website.

It has been almost four years since I have moved, and I tend to forget (kind of like childbirth, I suspect) how difficult a process it is. The home-buying part of the process seems to be proceeding apace, with the usual caveats. But I have to move out of my current home before I can move into the future one, so I will have to live in a hotel for a while. Oh, wait, hotel rooms are where I spent most of last year, so no big deal. Then it looks like I will move into one-half of the new apartment (in a Dallas high rise) while waiting four months for the other half to vacate, and then move back into a hotel again for 90 days while renovations are being done. And then, sometime in November – if all goes right – I will be in my new digs. So far, the mortgage process has not been painful.

With this move, I really am going to get rid of all that stuff I have been accumulating for decades. Since I intend to live in the new place for at least ten years, I need to be careful what I bring with me. Interestingly, I think we are going to seriously downsize the office space and more or less go virtual. With the new Internet phones we can be anywhere, and the new condo has a nice board room for the rare larger meeting. Video conferencing, email, texting, etc. all make a physical office less necessary.

I'll put in a small room for staff, for when we need to get together, but the days of a larger office may be over. I have my office in my home now, but we use over 1,000 square feet. All those old files I feel compelled to keep? Now scanned and stored in the cloud. My "office" (which is now simply a desk where my larger monitors sit) will be even cozier if I design it right... with a better sound system and some floor-to-ceiling windows looking out on the Dallas skyline.

Somewhere in the background I think I hear Old Blue Eyes singing These Vagabond Shoes. Have a great weekend.

Your actually trying out buying a home analyst,

John Mauldin

subscribers@mauldineconomics.com

How Not to Run a Pension

John Mauldin — Thu, 14 Feb 2013 22:23:00 GMT

How Not to Run a Pension
Stupid Government Tricks
Illinois Is Digging a VERY Deep Hole
Catastrophic Success
Time to Buy a House?
Looking Over My Shoulder
Palm Springs, Argentina, and Singapore

"The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what."

– A journalist in Greece

For all the focus on the unfunded liabilities of Social Security and Medicare, there is another unfunded crisis brewing, and this one is in your own back yard. It's coming to you even if you live outside of the US; it just might take a little longer to get there. I wrote ten years ago that state and local pension funds might be underfunded by as much as $2 trillion. It turns out that I was being overly optimistic. New government research suggests that the figure might be as high as $3 trillion. But what if you take into account that retirees are living longer? An IMF study that we'll look at in a few minutes does just that. And if we live a lot longer? Oh my. The problems are not universal – some cities and states will do fine, while others are already in deep kimchee – but it's a big problem and getting worse.

At the end of the letter, I'll add a personal note on housing. Longtime readers know that I was bearish on housing well before the bubble. I sold my home (for personal reasons) and decided to lease until things became more settled. I have said several times that I would tell you if and when I decided to buy a home. Now, I have put an offer in on an apartment and it has been accepted. But it's more complicated than that. (Isn't it always?)

Before we get rolling, though, I want to announce the speaker lineup for my 10^th annual Strategic Investment Conference, May 1-3. Here they are, in alphabetical order: Kyle Bass; Ian Bremmer; Mohamed El-Erian; Niall Ferguson and his wife, Ayaan Hirsi Ali; Lacy Hunt; Charles and Louis Gave; Jeff Gundlach; Anatole Kaletsky; David Rosenberg; Nouriel Roubini; and Gary Shilling. The noted geopolitical analyst Ian Bremmer (a professor at Columbia and founder of the Eurasia Group) has now been added to the list. I heard Ian last year speak on his theme of a G-Zero World and was blown away. You have to hear this one. We subsequently met in NYC and compared notes. I am really happy we could get him.

The conference is cosponsored by my longtime partner Altegris Investments. All the credit for hosting a first-class conference goes to the staff at Altegris, who do a massive amount of work to pull off an event of this size and scope. All I do is get a few friends to come and speak. Oh, and this year Bloomberg will cover the conference live.

The conference always sells out, so I suggest you register at your earliest convenience. Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. Registration is now open. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business. You can start the process by going to the Strategic Investment Conference page. There is a significant early-bird registration discount.

How Not to Run a Pension

It is almost too easy to pick on California and Illinois, but I am going to do it anyway in order to create a teaching moment. Plus, this sorry tale will make us think about the nature of the social contract and the fabric of society. It would be almost be funny if it were not so serious.

Let's start with a few paragraphs that appeared in the Wall Street Journal. Carl Demaio writes this week:

Consider California, where just 10 individual pensioners will cash $50 million in pension checks from state and local governments over the next 25 years. Already some 30,000 retired California government employees pull in pensions higher than $100,000 a year. One retired librarian in San Diego receives a $234,000 annual pension. Beach lifeguards in Orange County are retiring at age 51 with $108,000 annual pensions plus health-care benefits.

Note that those benefits are cost-of-living-adjusted. But the problem is not just in California; it is nationwide.

A 2011 study by the Congressional Research Service pegged the combined liabilities faced by state and local pension funds at over $3 trillion. That is more than all the bonded debt officially listed on state and local balance sheets combined. To put the issue in perspective, all the federal tax hikes approved by Congress on Jan. 1 would pay less than 20% of America's state and local pension debt over the next 10 years. (Wall Street Journal)

Another study by the Congressional Budget Office comes to the same general conclusion. You can read it here.

Steven Malanga wrote a powerful essay for the City Journal exposing the huge problems in just one California pension fund, CalPERS (California Public Employees' Retirement System). It is a well-written chronicle of how one fund has locked California into a debt spiral that threatens the solvency of the state: The Pension Fund that Ate California.

It is almost impossible to read Malanga's report without comparing it to Michael Lewis' essay on Greece. For the past two weeks I have written about regulatory capture in Greece and how the Greeks must break the control of vested interests over government. The corruption that Malanga chronicles is similar: the vested interest of public employee unions trying to get the "best deal" for their members is no different from what I described going on with various Greek industries. Whether it is Greek or California taxpayers, someone has to pay for all those promised benefits.

The State of California recently passed a "balanced budget." But it is only balanced if you ignore the sound accounting practices detailed in the Congressional Research Service report cited above. And even that report assumes investment returns that CalPERS has not achieved for the last five years.

CalPERS manages $230 billion. The fund now calculates that it is underfunded by $80 billion. The management arrives at this number by assuming they will make 7.5% (which they only recently dropped from 7.75%). In 2009, they estimated that the fund was underfunded by only $49 billion. That means they missed their targets by $30 billion in a roaring bull market.

In a December 2011 study, former Democratic assemblyman Joe Nation, a public finance expert at Stanford University, estimated that CalPERS's long-term pension debt is a sizable $170 billion if CalPERS achieves an average annual investment return of 6.2 percent in years to come. If the return is just 4.5 percent annually – a rate close to what more conservative private pensions often shoot for – the fund's long-term liability rises to a forbidding $290 billion. (Malanga)

I was just in Norway. It has a sovereign fund that is larger than CalPERS but that benefits from some of the best management in the world. My talks with people involved in the fund and those who are very familiar with it suggest that they would be very happy to get 4% over the next 5-10 years. And CalPERS ranks in the bottom 1% of all pension fund managers. Given all the resources they have, they are spectacularly bad at managing money. And when I say "they," I mean the board of directors.

Malanga points out that CalPERS is a wholly owned subsidiary of the government-employee trade unions that control the board. He painstakingly chronicles the extent to which the unions dictate policy and investment decisions, leaving the professional management shackled.

Remember the Greek journalist who told us this?:

The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what.

The number of regulations differs from Greece to California, but the principle is the same: regulatory capture of the bureaucracy by government workers' unions has handcuffed government, not just in California but all over the US.

Let's think about what it means for a pension fund to be $290 billion underfunded in a state with a (plus or minus) $100 billion annual budget. And bear in mind that instead of the $3 billion a year in taxpayer support CalPERS assumes it will need, it could soon be 4-5 times that much. Go to your own state budget and figure out how to carve out 10-15% from it. Given that a huge percentage goes to health care, education, and security, there is just not that much "waste" in state budgets. And the states with pension problems tend to be the ones with higher taxes already.

CalPERS now consumes (or will shortly) more than the 23-campus California State University System, which gets $2 billion annually. And that is not the entire shortfall in California; it is just one fund, albeit the largest. Other funds have similar issues. Taxpayers' costs are projected to rise to more than $7 billion by 2014-'15 – if you believe the funds' own expectations for investment returns. You shouldn't.

Above we see a chart of projected CalPERS returns, showing what they would be over the next 30 years if they ran at 7.5% or 5% or 2.5% (hat tip to Mike Shedlock). The numbers on the left are in billions. The fund might be doing quite well in 30 years at a steadily compounded 7.5%, but at 2.5% or even 5%? Not so good.

The next chart shows that even if you assume a 5% return, you are down almost $1 trillion in 30 years.

Think 5% or 2.5% is pessimistic? CalPERS made a 1% return over the past year it reported, to June 2012. In a bull market, thank you. Over the last five years? A negative 0.1%, basically flat. (CalPERS annual report)

Let me say a small word in defense of the CalPERSes of the world. If you are a fund this size, you don't invest in the market; you are the market. The fund did very well in the '90s. CalPERS has lagged its peers badly, but I know of no very large ($50-100 billion+) public pension fund that has gotten 7.5% over the last five years. There may be one, but I can't find it. Smaller funds can be more nimble in selecting investments. CalPERS has to invest an average of $230 million in 1,000 different assets and funds and strategies. That is an impossible task and one that will only get harder as it grows, which it must if it is to meet the needs of its 1.3 million (and swelling) current and future beneficiaries.

I must admit, it is fascinating to Google "California pension problems." You can spend hours swept up in the sheer scandal of it all. Hundreds of state employees who are managers and who theoretically get no overtime are allowed to work second jobs in their departments and get paid for them. Doctors in the prison system can make hundreds of thousands of extra dollars a year. Prison guards retire with $100,000 a year – and can then take another job and get more benefits from another pension fund! Cool.

Stupid Government Tricks

Until this past January 1, California state employees were allowed to buy "air time" of up to five years to shorten their required time on the job before they would qualify for a full pension. The rationale by CalPERS was that as long as the fund got 7.5% annually there would be no risk to the fund.

"Ultimately, we don't truly know until everybody who has purchased dies," said Amy Norris, a Calpers spokeswoman, referring to the size of the payouts. "Our actuaries say that it is safe to say it is cost-neutral at this point." Fifty thousand employees have elected to participate.

California public-sector employees now earn approximately 30% more for doing the same jobs as workers in the private sector. California did pass some modest pension reforms last year, mostly affecting future workers and retirees. Current retirees saw no reductions. But within a few months legislation was introduced that exempted 20,000 workers, and unions are looking for other such exemptions. In a Democrat-controlled legislature, they could quite possibly pass.

"Double dipping" is my personal favorite of the scams that are being run. Why not retire with your $100,000 pension and then take another job and earn another $100,000 pension? One San Jose police chief now gets over $400,000 a year, after he retired from his San Jose job and went to work in San Diego.

The current San Jose police chief will retire at 51 with a $150,000 pension, and he too can take another job, although he has "no immediate plans." He is not alone.

Illinois Is Digging a VERY Deep Hole

Illinois has a $33 billion state budget – and five pension funds that are officially underfunded by almost $100 billion. Remember that sky-high projection of investment returns by CalPERS? Illinois pension funds estimate they will earn anywhere from 7.5% to as much as 8.5%. But the state-employee fund made less than 0.1% last year, barely beating out CalPERS.

(By the way, you can see the projected returns of your state funds in a January 2013 NASRA Issue Brief. Scroll to the bottom. I was aghast to see that much of Texas was looking to make 8%! The Houston firefighters project 8.5%! I keep reading about problems with the funding of liabilities in Houston. As I said, this is a nationwide scandal. California and Illinois are just the easiest to pick on.)

Without 8% returns, the shortfall for the Texas Employees Retirement System (ERS) could be twice the current projections. The system is scheduled to pay out $133 billion between now and 2045. It has $11 billion. For these assets to cover future payouts, ERS would need to see average investment returns of 21.5% per year – or see big-time payouts from the government budget. Think they can find an extra $5 billion a year for the next 20 years? From a $30 billion budget? And get 8%?

But back to Illinois, which has a legal problem. It is one of two states (New York being the other) that in its Constitution is prohibited from impairing promised retiree benefits. This makes for a rather tough negotiating stance.

You can find the same exotic stories about large pensions in Illinois that you do in California; but it seems to me the pension for rank-and-file teachers is not overly generous, considering that they pay 9.5% of their salary into the pension fund, while the state is supposed to fund less than 10% of that amount and then doesn't even manage to do that. Putting the teachers on Social Security would cost the state a lot more (6.2% in matching funds).

Yes, there are the 28 Illinois state troopers who retired at 51 and draw over $100,000 a year. And the politicians get eye-popping amounts, but their retirement fund is underfunded by 74%. Care to make a wager which pension fund gets enough money to survive, the teachers' or the politicians'?

And while all this sounds delectably scandalous, it is actually very sad. Consider this story:

Last Thursday night, 57-year-old Dick Ingram, a bald guy in a dark suit, stepped onto the stage in a cramped, muggy auditorium at a south suburban high school. In his remarks to an audience full of teachers, Ingram repeated the same message he's been delivering for months: Be afraid. Be very afraid.

Ingram is in charge of Illinois' biggest pension fund, called the Teachers Retirement System. With $52 billion in unfunded liabilities, it's arguably worse off than any state pension fund in Illinois – which is saying something, considering Illinois has the worst-funded pensions in the country.

"I don't think it's any secret that finances in the state of Illinois are a train wreck," he told the crowd of about 350 working and retired teachers. "We cannot, today, feel secure in telling a 45-year-old or a 25-year-old teacher in Illinois that they're gonna get their pension," he told the crowd. "We face the possibility, and the real likelihood, of insolvency."

Several teachers at last week's meeting excoriate Ingram for talking too much, saying he's just providing fodder to politicians who want to cut teachers' retirement benefits.

But if you stop and consider what's going on here, it's pretty radical: Ingram, the guy in charge of the retirement savings for 370,000 people, is telling anyone who will listen that the money may not be there when they quit working – that teachers, in his words, have "been getting screwed for decades." (Illinois Public Media)

These teachers put in 9.5% of their salaries, and their retirement could be in jeopardy. Think about what it would be like to work for 35 years, doing the right thing and saving. You make your retirement plans, and then at some point, say 10 or 15 years into your career, the deal changes.

This is rubber-meets-road sort of stuff. Much of our society is finding itself severely burdened to meet past promises made by politicians. It is pretty easy to make them when you are spending someone else's money, especially when that someone is 30 years in the future. Except that now the future is here. The bellwether is San Jose, whose citizens voted last year (70% in favor) to cut current pensions and benefits for municipal employees. That's liberal, socially progressive San Jose, which finds itself under severe funding pressure just to fulfill basic city services.

I have talked about the "abuse" of the California pension system, with double-dipping by policemen, et al. – except they are doing nothing illegal or even unethical. They are taking deals offered to them under terms both parties agreed to. The fault, dear Brutus, is not in our stars but in our politicians and we who elect them.

Catastrophic Success

Underfunded pensions are not a problem that is going to go away. Let's assume that the secular bear market finally runs its course, the financial repression of the Fed and ECB ends, and interest rates go back to normal so that pension funds again have a chance at those juicy 7% returns. We make up for lost time with a few more dollars of funding, and then it's problem solved, right? That is the line you hear from pension consultants.

But what almost no pension fund does is to plan for the current trend of people living longer to continue. We have added almost two years of life expectancy every decade for the past century, although the number of additional years you can expect to live if you make it to 65 is not as dramatic. Still, the increase is significant.

The International Monetary Fund did a study last year that asked, "What if we live three years longer by 2050?" That is far less than trend for the last century, but even that small increase yields some very interesting conclusions:

...if individuals live three years longer than expected – in line with underestimations in the past – the already large costs of aging could increase by another 50 percent, representing an additional cost of 50 percent of 2010 GDP in advanced economies and 25 percent of 2010 GDP in emerging economies.… [F]or private pension plans in the United States, such an increase in longevity could add 9 percent to their pension liabilities. Because the stock of pension liabilities is large, corporate pension sponsors would need to make many multiples of typical annual pension contributions to match these extra liabilities.

Thus, we may need to add 50% to the pension underfunding I highlighted earlier. It gets ugly. (You can access the IMF study and see commentary here.)

I can hear a few of you objecting that this is a problem that remains far in our future. Why worry about 2043? Well, because pension returns rely upon compound interest, the eighth wonder of the world. A dollar in a pension fund doubles every 10 years at 7.5%, and in 30 years that dollar invested now is $8. If we wait for ten years to invest it, it only becomes $4 in 30 years. And there will be only $2 in the pot if we wait 20 years to find out that today's retirees are living another three years on average.

Pensions require initial savings and compound interest to work. If you fail to properly fund your pension or if you get low returns, your retirement will suffer. We all know that is the case for private funds, but it is the same for public funds as well. Taxpayers will have to make up the difference if returns are lower or benefits rise due to longer lives. Or retirees will not get what they were promised. Ask Irish pensioners what a 15% cut in their pensions feels like. Ask people in any country that has seen the ravages of inflation.

When you sit down with your financial planner, you make assumptions about how long you will live. And then, if you are prudent, you make plans to live much longer than that. You want to make sure you will have enough funds to meet your needs for your entire life. And that means planning on living a few years longer than the average person in your family has in the past.

Yet we don't do that with our pension funds. Just as we assume that the past performance of 8% returns in the last bull market will somehow materialize in our future, we also assume that the actuarial tables of the past will continue to apply, even though they have been regularly updated for a century.

Most of us would deem it a success if we lived ten years longer than the current average. Yet such a success on the personal level would be catastrophic for our pension funds, if we all managed it. Thus, living longer may turn out to be a catastrophic success!

I happen to be part of the bunch who thinks the biotech revolution is just beginning and that we will end up living a lot longer (on average) than anyone now expects, and be healthier to boot! Of course, the counterargument is that many of us won't get there because we refuse to take care of the basics of eating right, exercising, not smoking, and taking our medicines.

Whatever your view on longevity, a three-year average increase over the next 40 years seems a most reasonable and conservative assumption – which means that every dollar our public and private pension funds save now is even more important for future retirees. Unless we want to burden our children and grandchildren in the rapidly approaching future, we need to deal with our pension issues today, before we find them consuming the funds we need for basic services or forcing tax increases that will hurt overall growth and job creation. The choices are difficult now, but they will only get harder if we wait.

Time to Buy a House?

Let's move briefly to another topic. The lease on my home here in Dallas was going to be up at the end of this year, and I more or less intended not to renew it and to start to pay attention to what the housing market is doing, come fall. Then my landlord dropped me a note a few weeks ago saying he would let me out of my lease if I moved out in a month. He evidently thinks the real estate market is good in Dallas, which is what I am hearing from my realtor friends.

A few months ago I dropped by the new apartment of my good friend David Tice. (Some of you will remember him as the man who started and ran the Prudent Bear funds.) He had purchased two apartments in a local high-rise with stunning views of downtown Dallas, and combined them into one apartment. I fell in love with the energy of the views and the location.

As it turns out, I can get two adjoining spaces in the same building with slightly different views but still that dramatic downtown view I love. The odds of getting two adjoining apartments to come on the market at the same time are not high, so I decided to go ahead and accept the offer to move. Prices have dropped considerably for comparable places in Dallas and are now beginning to find a market. So we made an offer, and it was accepted. Now comes the hard part: getting financing, taking on a construction project to turn the two units into one, finding a place to live in the meantime, and then moving.

I am finding out that financing is not straightforward. I asked my investment-banker friends what the loan would be and got quoted a very nice rate for a ten-year ARM. But the mortgage desk would not do it (this is a very large, name-brand bank). Since it is two apartments and two titles and someone is leasing one of the units right now, and since there will be significant construction costs, what I want to do does not fit into a simple, check-the-box home mortgage. No exceptions allowed! I was rather surprised that it would be that hard. I clearly qualified, or so I thought. I dropped back to punt, and the realtor quickly introduced me to two local banks that do custom projects like this. So that process begins this week.

Additionally, David (and another local friend) did something that I want to do, too. He got a yen-denominated loan. We are working out how to do that. (I would love to speak to a senior investment-bank executive of a large Japanese bank. I sense an opportunity here.)

As I promised years ago when I last talked about buying, I will let you know the details as they develop – costs, interest rates, interim loans, etc. But at least here in the Dallas market (and I know it's true in other markets as well), this bear is coming out of hibernation. Stay tuned.

Looking Over My Shoulder

The world doesn't sit still, and as you all know, neither do I. Each week I delve into 100-plus articles, economic forecasts, investment outlooks, financial reports, etc., all of which come to me through my own extensive network. My goal, of course, is to be constantly building on my own research, staying right on top of what's going on out there. This learning experience is a labor of love for me, and one I'm pleased to share with you through my Over My Shoulder service.

As I filter through my weekly reading, I pick out the 5-10 items that I think will be most important to your investments and money management. This research, compiled by my contacts, is generally information you will not come across in your own ongoing reading – and that's why I think you will find a subscription to Over My Shoulder very useful. Subscribers have given me very positive feedback, and I encourage you to join us in reading, thinking, and preparing for the events of 2013 – this most pivotal of years.

Palm Springs, Argentina, and Singapore

I will be in Palm Springs at the California Resource Investment Conference February 23-24. My good friend Grant Williams, who writes the blockbuster Things That Make You Go Hmmm… and the Mauldin Economics' Bull's Eye Investor letter, will be there, as will the best resource investor I know, Rick Rule, along with my favorite data maven, Greg Weldon. There is a full two-day slate of speakers. The event is free to investors and is always fun, and it's a great time of year to be in California (hate the pensions, love the weather). Come see us! You can read all about it and register at the Cambridge House website.

I will be in Cafayate, Argentina in the middle of March, working on a book and relaxing a little while with my partners and friends at their resort. (If you are interested, you can come as well. Just click on this link.) In April, I will do a speech in Singapore and hope to take a few days off to visit Cambodia and Angkor Wat. My old friend Tony Sagami is planning to come over from Bangkok to show me around Cambodia.

It has been an emotional day for me. I attended the memorial for Chris Kyle, whom I wrote about last week. He is the former Navy SEAL and author of American Sniper who was tragically murdered last week. They had to hold the service in the Dallas Cowboys stadium. His casket rested on the star in the center of the field. I will never again be able to look at that star without thinking of him.

A remarkable number of former SEALs and other military attended, honoring a gentle man who is now legend. Hearing the stories from his comrades and friends made for the most moving memorial service I have ever attended. You can donate to a family trust fund being set up for his wife and two young children at Craft International.

Then I went to yet another funeral service, this one for an elderly relative, only a few miles away. The contrast in emotions was palpable. And then on the way home, I got a text from my daughter Melissa. Last year about this time she had her thyroid and some large tumors in her lymph nodes removed. They felt they got it all, and subsequent checkups seemed OK. But today they noticed some large lymph nodes in various parts of her chest and neck. They got her in to see her specialist on an hour's notice, which seems fast. It could be just an infection, but more scans are now on order.

And now I face the joys of jury duty in a few hours, although no sane attorney would want me on a jury. At least I will get in some reading time, waiting for them to reject me. And with that I will hit the send button.

Your contemplating life more than usual analyst,

John Mauldin
subscribers@mauldineconomics.com

The Good, the Bad, and the Greek (Risks)

John Mauldin — Wed, 13 Feb 2013 18:11:00 GMT

Save the Dates: May 1-3
Prisoner of the Bureaucracy
A Deep Sense of Injustice
The Good, the Bad, and the Greek (Risks)
Chris Kyle, R.I.P.

"The euro will not survive the first major European recession." – Milton Friedman, 1999

"It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." – Milton Friedman, 1999

"… there will be asymmetric shocks hitting the different countries. That will mean that the only adjustment mechanism they have to meet that with is fiscal and unemployment: pressure on wages, pressure on prices." – Milton Friedman, 1998

"Barry Eichengreen (1990b), in a detailed analysis of the potential lessons for EMU from the U.S. experience, concluded that monetary integration would limit fiscal independence. He argued that the extent of fiscal transfers in the European Union would have to significantly exceed the extent of fiscal transfers in the United States to be successful, as regional shocks were likely to be significantly greater in EMU countries than in the states of the United States." – From a lengthy (and exhausting) paper at the Econ Journal Watch, analyzing the writing of scores of US economists about the euro from 1989-2002. The paper was humorously titled "It Can't Happen, It's a Bad Idea, It Won't Last: U.S. Economists on the EMU and the Euro, 1989-2002."

Greece was (and is) the first real test of the euro. Until the Greek crisis, there was no real need for any eurozone country to actually write a check for any other member. Ireland obligingly shouldered the responsibility for its own bad bank debts, paying off mostly German, French, and British bankers. But Greece required someone else to take the losses and write the checks to bail the country out. The European Central Bank had to agree to allow the Bank of Greece to create euros to bail out its banks (with the fig leaf that somehow Greece will pay them back). As the Greek economy collapsed in the aftermath of the recent crisis, it became evident even to European bankers and regulators that Greece could not pay its debt. Money began to flee Greek banks.

Greece is a small country with large implications. Last week we began to explore what I learned from my recent trip to Greece. In this week's letter we will finish those observations and in particular look at some of the comments from my meetings with over 40 people: owners of small businesses and large ones, billionaires, taxi drivers, politicians, central bankers, investors, ex-patriots, wives, and mothers. I believe we can arrive at some small understanding of the problems Greece faces. Then we will consider the broader consequences for Europe.

Save the Dates: May 1-3

But first, I take great pleasure in announcing the speaker line-up for my 10^th annual Strategic Investment Conference, May 1-3. Here they are, in alphabetical order: Kyle Bass, Mohamed El-Erian, Niall Ferguson and his wife, Ayaan Hirsi Ali, Lacy Hunt, Charles and Louis Gave, Jeff Gundlach, Anatole Kaletsky, David Rosenberg, Nouriel Roubini, and Gary Shilling. We are finalizing a few other well-known names as well. Seriously, where else can you see a roster like that? Those who come regularly know that the real value is in meeting the other attendees. The conference is cosponsored by my longtime partner Altegris Investments.

Invitations have been sent out to past attendees and those who are members of the Mauldin Circle. We are now going to open up registration. Because of security regulations, we do have to limit attendance to accredited investors and those in the securities/investment business.

If you think you should have had an invitation or missed it, call or write your Altegris representative. Otherwise, you can start the process by going to http://meetings.StrategicInvestmentConference10. There is a significant early-bird registration discount. The conference always sells out in a few weeks, so I suggest you register at your earliest convenience.

Prisoner of the Bureaucracy

As I noted last week, I visited Athens with my friend Christian Menegatti, who is head of research for Roubini Global Economics. Between the two of us, we stayed very busy with meetings. Below is some of what I learned. (I will put generalized quotes in italics, and the commentary after them will be mine.) Let's start by recalling the story we finished with last week:

The next night offered quite a contrast. In the evening we walked to the base of the Acropolis, found what looked like a promising venue, and entered. It was early by Greek standards, but a performer was playing a guitar and singing Greek tunes to a table of six (ahem) older gentleman, clearly old friends eating and drinking together. (Later we found out they had been gathering once a month like this for 20 years.) As the evening went on and the wine kept flowing, they began to sing. A second guitar appeared. The aromatic cigars came out and were smoked directly beneath the no-smoking sign, with no sense of irony. One patrician gentleman stood a few times to have his picture taken with locals who dropped by that evening.

The singer sang on for three hours without a break, clearly into the moment. Evidently, you cannot sing certain songs without using your arms. At first it was just one participant providing the counter-melody, but then others joined in a multi-part chorus of practiced harmony.

The young owner of that tavern came by, and we started out as we had the night before, asking questions. When he found out what we were looking for, he went to the table and pulled one of the elderly gentlemen away and introduced us. It turned out that he was an economic journalist and chairman (emeritus) of a Greek journalism society. I quickly borrowed a pen and began to take notes on a paper placemat.

He was an odd mixture of pessimism and hope, a perfect living metaphor for what I found from top to bottom in Greece. This was the best government he had seen in his life: "I trust this government." But when asked if he was optimistic, he shook his head wearily and said no. When we pressed him as to why – and we had heard variations on this throughout the trip – he said, "The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what."

Another of the gents added, "The problem is a problem of laws: you get new laws and yet the old laws don't go away; who knows what to do? If you don't know what laws to follow, that becomes the biggest problem. Actually there are two problems: the number-one biggest problem in Greece is the legal system – there is no rule of law. Number two, the legal system is slow; you can't get a ruling." A lot of heads nodded in agreement with this statement.

The first guy continued, "Remember the spectacle a few years ago, when a new government came in and found massive debts and accounting irregularities? They blamed all the problems on the old government as they negotiated for new loans from the EU. Of course, the people they were blaming were bureaucrats they themselves had appointed, the last time they were in power.

"The government still to this day does not know how money is spent. They will try to change. But even if they pass new laws, under the rules a minister does not have to enforce them."

It seems the bureaucracy is the prisoner of the associations – what we refer to in the US as regulatory capture. This results when a regulatory agency, "created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as an encouragement for firms to produce negative externalities. The agencies are called 'captured agencies.'" (Wikipedia)

And that is a common theme we heard in meetings with businessmen. There is general agreement that the bureaucracy must become smaller and some frustration that it has not: "We lost time by not restructuring. The most important problem is the inefficiency of the public sector; it simply costs too much money start a business."

The Greek banking system has collapsed. Banks simply have no money to lend. First they had to take huge losses on their Greek government debt. Then they incurred large losses on their regular bank portfolios, as Greek GDP shrank 20% and businesses had no ability to pay and went bankrupt. Finally, their deposits dropped significantly (€86 billion fled), either converted to cash or sent to banks in other countries, as Greeks worried that the country would leave the euro and return to the drachma.

Depending on what document you read (or who you listen to), Europe has arranged up to €50 billion to help recapitalize the Greek banks. €27 billion has been injected to capitalize the four largest banks; but they have to be able to come up with about 10% of the money from private sources, and that money is just not showing up. The Financial Times writes this weekend: "Greece's banks have begun a frantic lobbying of the bodies behind the country's bailout, in an effort to ease the conditions imposed on their recapitalisation and avoid full nationalisation." (Sound familiar? Shades of TARP!)

The only other option on the table right now, other than laying hands on the rather paltry amount of private money, is full nationalization. "One banker who declined to be named said Greek banks' books were worse than many realise, given that asset valuations and recapitalisation estimates date back to 2011. 'Greece has performed worse than in the adverse scenario,' the banker said. 'The macroeconomic contraction was much bigger in 2012 than forecast. Loan portfolios are still deteriorating.'" (FT)

All the other, smaller banks will be nationalized outright. This will certainly help. More than one businessman told us he or she was no longer worrying about profits but simply managing for cash flow and survival, hoping that at some point a stable banking system would return. "New investment laws, maybe the approval of some large project, must give people a reason for money to come back. Greek investors and citizens must be assured that Greece will be a part of the euro. We must do things to make long-term money feel safe. There is a dilemma: money has left because of fear of leaving the euro, and now it is not coming back because of concern about taxes. But if we grant amnesty for repatriation, it will create ill will. This is not easy to do."

And taxes are on everybody's mind. They have gone up, and there are serious efforts to collect them. But there is still suspicion everywhere that others are not paying. I heard from numerous sources that the worst offenders are doctors and lawyers, the upper-income earners.

A Deep Sense of Injustice

And that opinion was echoed by the leader of the left-wing SYRIZA parliamentary group, Alexis Tsipras, who spoke to Wall Street Journal columnist Bret Stephens last week:

But Mr. Tsipras takes a dimmer view of health delivery in his native land. "Why in a public hospital, in order to have an operation, do [patients] have to slip [doctors] an envelope with a certain amount of money?" he asks. "Why indeed? " I ask back.

"Because the state gives low wages to doctors, thinking it's completely natural for them to add to their salary" by accepting those cash-stuffed envelopes.

I suggest to Mr. Tsipras that maybe the difference between Greek and American doctors is that the latter have so far operated in a mainly private market, though that's about to change. He demurs and instead says something about the need to have a "revolution in conscience" by Greek citizens, plus "the will of the state" by Greek leaders. It sounds like the sort of thing you'd expect from someone who names Karl Marx and Antonio Gramsci as sources of intellectual inspiration – romantic in its impulses, repressive in its implications.

But I don't think Mr. Tsipras is the budding totalitarian or demagogue his detractors say he is. He talks of the "deep sense of injustice" that pervades Greek society, the sense that they have been systematically used and betrayed by their own economic elites and elected officials.

The short article is well worth reading. Stephens is a very good writer.

That sense of betrayal Tsipras mentions, palpable to me while I was there, is also part of the system. In the '70s a leftist government came in and began to put "cousins and nephews" of their supporters into jobs in the bureaucracy. And when a conservative government came to power they did the same thing. I kept hearing that 30% of government workers don't even show up for work. (I'm not sure where that actual stat came from, but it gets repeated.) Some bureaucrats even hold down jobs in the private sector while they continue to collect a government pay check. And because the government is such a large sector of the economy, everyone has someone in the family or a friend's family who is part of the problem. If you change things, they lose their jobs. Up until recently, the impetus for change was just not there. But that may be changing:

"In the '60s every Greek wanted to own his own business, in the '80s they wanted to be public servants, and now they want to be in business again."

But the problem is that there are no jobs. Unemployment is 27% (the government's number); and the Chairman of the Council of Economic Advisors, Panos Tsakloglou, told us he was worried it could rise to 30% before it finally begins to turn around.

Tsakloglou was quite candid. He said that the IMF, ECB, and EU would have to accept some form of debt forgiveness and not just put it all on the private sector. Greece still has too much debt for the private sector to be able to service.

Evidently, more is needed than just debt extension. That has happened already. The chart below shows extensions out for 35 years. I invite my US readers to think back to 1978 and ponder the notion that the US national debt was extended for 35 years from that point, and then try to imagine what the dollar would be worth by now if it had been.

Unemployment among Greek youth is over 50%. That worries Tsakloglou, because young people are leaving the country. If things turn around quickly, they can come back. But if you stay away long enough, you have kids, and then it's harder to come back. That was echoed in other meetings: "The problem is, young people are leaving as salaries are going down. There is opportunity if these guys leave and then come back, but in five years we'll need to repatriate the Greek diaspora."

Greeks think about Europe a lot. Many are ready to see a stronger Europe, with less sovereignty for their own government. "But something must happen about the trade imbalances."

Remember that quote from Econ Journal Watch at the very top of the letter? It noted Barry Eichengreen's conclusion that "monetary integration would limit fiscal independence. He argued that the extent of fiscal transfers in the European Union would have to significantly exceed the extent of fiscal transfers in the United States to be successful, as regional shocks were likely to be significantly greater in EMU countries than in the states of the United States."

(I met Barry in South Africa last year when we spoke at the same conference. Really thoughtful on a very wide set of topics.)

I was already writing a few years ago about the extremely unfavorable balance of trade that Greece endured. That imbalance is going away (that happens in depressions, as there is no money to buy imports), as is the wage differential with the rest of Europe. Estimates are that by the end of 2014 the wage gap will be nearly gone. One business manager said that his Greek plant was as productive as his German plant. The cost difference came in dealing with the bureaucracy. "Not just the cost of bribes, but even worse is incompetence."

Let's look at another chart from Morgan Stanley:

There was general agreement on the need for foreign investment. There is no domestic saving to speak of, which limits deposit growth, which means banks will be tight-fisted, even with the new European money to help recapitalize them.

The Good, the Bad, and the Greek (Risks)

Even with all the problems, there was a hint of tempered optimism in the air. One formerly highly placed government official said, when asked if he was willing to invest his own money in Greece, "In six months if things go well." And that time frame was on everyone's lips.

There is more austerity coming, and it will have to be agreed to. It will not be popular. The coalition government has already seen defections and is left with a majority of only 13 votes out of 300, with 16 lost since last May. They can't take many more breakaways.

There is worry about political unrest this spring, which could cause some coalition members to withdraw support. New elections would have economic consequences. It is the lack of certainty that is one of the biggest problems in Greece. Everyone seems to expect that the tourist season will be robust and things will begin to turn around by summer. But getting there is risky, and that has people focused.

Many were candid that their optimism was based in part on the prospect of the government having to give in to the Troika on reducing bureaucracy and the size of government. They welcome the new controls on the government and worry that they might go away.

And to its credit, Greece may be that rarity in Europe, a government that actually hits it budget targets. They are close to a "primary surplus" (a surplus if you ignore debt service), which is the first step in recovering access to the bond market. With increased tax collections, major new austerity measures may be avoided.

We met with Notis Mitarachi, the Deputy Minister of Development. Two years ago he was a private investment banker in London. He came back to Greece and ran for parliament and won. For his sins (for working in finance), he was given a very important post, one that requires him to sort through the bureaucracy and help foreign investors put money to work in Greece. He brings that experience with him and wonders why Greece can't become as easy to do business in as London. He dreams of structural reforms but is not waiting for a committee to act. He is there to help larger investors cut through the issues. Greece needs foreign investment if the government is to survive, and that is his current mission. If there are more like him, then Greece has a chance.

The risks inhere in something old and something new. While Europe has so far been willing to write checks in return for significant budget cuts, if there is "Greek fatigue" in some capitals of Europe that results in demands for even more austerity, it would be difficult to sell to the populace. Greece is going to be on some type of support program from Europe for a long time.

One source of risk that kept coming up seemed odd to me on first hearing, and that is tiny Cyprus, whose banking system is also bankrupt – but those banks are four times larger than the country, financially. And there is considerable political turmoil in Cyprus, with elections due in two weeks (February 17). While the cash problem amounts to only about 10 billion euros, the procedural problem is challenging. When you deal with Cyprus, you will be establishing a precedent for dealing with the rest of Europe. Ireland will be watching very closely, wondering why it too doesn't get debt forgiveness. There is no consensus on what to do about Cyprus among the nations of Europe. Russia would like to be a player (and hopes to gain a foothold in the banks, I assume) and is offering the possibility of money to what might be a communist government. If the Cypriot government takes on enough debt to address its banking problem, then the government becomes insolvent. Bottom line: Cyprus is closely tied to Greece and will affect the Greek economy.

The good news on Greece is that I see little reason or even any serious movement on its part to leave the euro. I have long been a euro-skeptic from a pragmatic economic viewpoint. At the same time, I hope the euro experiment succeeds, as I think the world is better off with a united and strong Europe, and the fledgling eurozone is part of that process. In any case, I am not the one who has to write checks to bail out the various and sundry countries; but among those who do write them – the citizens of the eurozone – the sentiment is distinctly pro-euro, and they seemed to be prepared to pay the costs.

I look at how difficult it was to get the US government to release aid to victims of Hurricane Sandy. I would have thought that would go through easily. The votes were, however, highly regional, and it took way too long. Then again, I think about what will happen when Illinois comes to DC hat in hand, asking for a bailout. I don't think many states will want to help it address its lack of budget discipline with US taxpayer money.

And that is the larger lesson of Greece. Europeans wrote a check for Greece. You know they were not happy to do so. They had to wonder why they let Greece in. Yet they looked at the mess that was Greece and held to their vision and found the money, even if it was from anonymous taxpayers. Such decisions can only be made through strong general agreement. The consensus in Europe is to do what is necessary. If that means austerity for some and taxes for others, then that is the price.

Merkel's opposition is even more pro-European than she is. The determination on the part of Europe to "hang together" is strong. I applaud it. I hope it can stay that way when it is time to call for France to deal with its own budget imbalances. We shall see.

The challenge for Greece is not to become Germany or the Netherlands. Every country and region in Europe has its own personality. The challenge is for Greece to become a better Greece. That means changing its systems and cleaning up its bureaucratic mess.

Greeks are renowned for their patriotism. It is time for them to move past being just Greek patriots and become Greek citizens, working together to build their future.

Chris Kyle, R.I.P.

I first met Chris Kyle a few years ago at an economics event at Kyle Bass' ranch in East Texas. That was before he had written his book, and Kyle Bass pulled me aside and briefed me on who would be taking me out that afternoon for my first ever attempt at skeet shooting. Chris had recently retired from the Navy SEALs. He had been in all the major Iraq confrontations and had the most confirmed kills of any special-operations soldier in the history of the US, as a sniper. His longest shot was a 2,100-yard strike against a man armed with a rocket launcher.

We went out to the range, where he patiently worked with a few of us. Despite being from Texas, I did not grow up with guns. They were around, just not around me. Chris was soft-spoken and polite – the best that West Texas breeds. I recognized the roots that ran deep in him. We wandered over to the pistol range, where I shot a real pistol for the first time in my life. I was rather surprised by the kick of the gun –it was hard to hold it on target. It looks so much easier in the movies. I remember expressing my frustration.

Chris came over, gave me a few pointers, and then showed me how it was done. He took the gun from me, slipped in a new magazine, and turned to the target. He emptied the gun as fast as he could pull the trigger, which was fast. The target had one small, round hole in the middle where every bullet had gone. I may never again personally see such skill with a weapon. Later that day he worked with us on rifles, showing us some of his skills. Governor Rick Perry came by, and Chris set him up to shoot the 50-caliber sniper rifle, treating the governor in the same manner as he did everyone else.

That night I heard a few stories about Fallujah that amazed me. They sounded a lot like those of my son-in-law Allen, who was a very young Marine when he went into combat there. Chris was one of the snipers who kept Allen and hundreds of others like him alive.

Chris went on to write a searing story of life, family, and combat called American Sniper, which became a major best-seller. I read it last year and shuddered at what we put our young men through and the courage it takes to do what they do. The book gave me insights into battle, combat, and the mind of a warrior that I had never experienced.

There were two times when Chris was literally counting down the seconds until he ran out of ammo and his site was overrun, yet he kept protecting his fellow soldiers. The cavalry did show up at literally the last second, so he survived; but I marvel at a man who could calmly do his duty right up till the moment he thought was his last. And then go out and do it again the next day.

Chris took no pleasure in killing, but of course there was tremendous satisfaction in saving the lives of "his boys." His regrets were for the lives he could not save. And he was the best at what he did. There are a lot of young men like my son-in-law, the father of my next granddaughter, who are alive today because of Chris. I looked forward to getting to meet him again from time to time.

Chris was tragically murdered this weekend while helping another soldier with post-traumatic stress disorder. They were at a gun range, where he would go with soldiers and ex-soldiers to help them out. It was one of the ways he gave back. There are many accounts in the news today, if you want to know more.

I and all those who knew him are shocked and profoundly saddened at something that is so seemingly senseless. My heart goes out to his family (he leaves a wife and two children) and to his friends. He was an American hero and a true Texan. And now he is legend. R.I.P., Chris Kyle.

I am sure there will be a charity to which you can donate to honor his life. Drop me a note at warrior@2000wave.com and I will let you know when I find out. And with that, I will hit the send button.

Your marveling at how life works analyst,

John Mauldin

subscribers@mauldineconomics.com

Prisoner of the Bureaucracy

John Mauldin — Fri, 25 Jan 2013 22:46:00 GMT

Greece Must Stay in the Euro
Beware of Greeks Bearing Bonds
Contagion, Thy Name Was Greece
Prisoner of the Bureaucracy
Toronto, New York, Washington DC, Las Vegas, and Argentina

I wrote some time ago that Greece had a choice between Disaster A: staying in the euro; and Disaster B: leaving the euro. I have recently come back from four days in Greece, meeting with lots of people at all levels of society, and will share with you in this letter my analysis of their choices and the results. I'll also have a few things to say about what the developments in Greece might mean for the rest of Europe and the developed world.

I penned these words in January of 2010:

"Everyone knows the problems of Greece. There is no political will in the country (so far) to do what Ireland has done, and really cut their budget. I think Spain is an even bigger nightmare for the EU when compared to relatively small Greece. Italy? Belgium? Portugal? All those countries (and their voters) will be watching to see how the EU deals with Greece."

Which was good for Greece, as it gave good reason for the rest of Europe to care about what happened to Athens.

Greece Must Stay in the Euro

Let's start with the conclusion: they have chosen to stay in the euro. If a depression meets your definition of an economic disaster, then it is reasonable to conclude that their choice has been a disaster. Greek GDP is projected to be down by 25% by the end of 2013, as measured from the beginning of the crisis. Exiting the euro at this time would only double the disaster. They must now finish what they began. As we will see next week, this may be the story all over Europe. The cost of breaking up the euro, or of a country leaving on its own, is simply now too high. For better or worse, the marriage must endure.

Let's rewind the tape to see what I meant when I said that whatever Greece decided to do would be a disaster. At the beginning of the crisis, Greece was totally dependent on borrowed money both to finance its government spending and its massive trade imbalance in the private sector. While the cause of the crisis was too much debt and a deficit (both public and private) that was out of control, the immediate trigger was the loss of access to the bond market as interest rates rather quickly spiraled out of control.

Let's look at two graphs. The first is the Greek ten-year bond for the last five years. Notice that three years ago Greek interest rates had not yet moved up. The bond market was clearly not seeing what I and other observers (and multiple hedge funds) were seeing: Greece simply could not pay its bills. Greek (and peripheral-country) debt had become the new subprime. But European leaders were in massive denial about Greek solvency. You only have to do a simple Google search to find dozens of quotes from said leaders assuring us that Greece would not default, almost right up until the moment they did! (One even admitted that it was necessary to lie about it!)

The second chart is Greek two-year debt. By this time last year interest rates had skyrocketed to 177.37% (and bond values had plunged!).

As the crisis was unfolding, a narrative developed about the Greek national personality. "They don't pay their taxes." (There is more than an element of truth there. Tax evasion was a national sport at which they excelled, perhaps matched only by the Italians.) "They are overpaid and don't work hard." (Verifiably false.) "They cheated to get in the eurozone." (True, but they were in good company.)

Beware of Greeks Bearing Bonds

The classic piece was the story written by Michael Lewis for Vanity Fair, delving into the systematic corruption of the tax system, among other national issues (more on which later). I have written about that article in this letter and quoted it here and in Endgame. It is a brilliant piece of narrative journalism.

It became easy to dismiss Greece as a failed system. "Spain is not Greece," Prime Minister Rajoy told us in the midst of their own crisis. Indeed, we were told by leader after leader that their countries were not Greece, that somehow their crises were different and that helping them was not the same as helping Greece.

We were greeted almost daily with the spectacle of riots and demonstrations, of political chaos. It seemed like the news was "all Greece, all the time." Was Greece going to be the first in a series of dominoes to fall as it exited the euro? Those of us who characterized the euro as an experiment and not yet a currency (as it had not gone through a crisis) saw even more reason to be skeptical of a currency union that existed without a fiscal union. The term "PIIGS" (Portugal, Italy, Ireland, Greece, and Spain) entered the vernacular as a euphemism for debt-ridden profligates.

Writing that Greece had only a choice between two disasters was not being dismissive on my part. It was simply recognizing the cumulative effects of the failure to make difficult choices. Once Greece lost access to the bond market, the game of borrow and spend was over.

(By "lost access" I mean that they could not borrow money at interest rates that gave them any hope of being able to pay off their debt. The compounding nature of their debt and deficits would mean that soon the interest payments would be more than government revenue. Bond markets will exit long before that point.)

Since we know what happened as a result of Greece in the euro, let's undertake a thought experiment and imagine what Greece would look like if they had exited the euro. The "good news" is that the new drachma would have immediately dropped by 50%, thus eliminating almost overnight the trade imbalance, as any imports would require a "hard" currency (euros, dollars, pounds) and that money would only come from exports. Greece would have been plunged into an immediate and steep depression. While government workers would get paid in drachma, banks would have gone bankrupt and been forced into nationalization. Businesses that needed to import materials to make goods, either for local use or to turn into exports, would have been cash-starved. It would have been chaos.

True, Greece could simply have walked away from their debt and then appealed for emergency and humanitarian aid from the IMF and others. But it would take time for any such institutional response to happen.

At the time, I thought that Greece might indeed elect a government that would leave, because of the pain involved in staying. If you remember, there were several elections, keeping politicians throughout Europe on edge for months on end. It was close. Last year it took two elections to come up with a coalition government. In the end, a real majority of Greeks wanted to stay in the euro, whether they were politically left or right. A crisis-management coalition government emerged to try and figure a path out of the mess. And it has not been (and will not be) easy.

Greece has been, is, and will be on financial life support for some time. That means money from the "Troika" (the IMF, the ECB, and the European Union). But that money has come with strings. It has meant a regimen of "austerity," otherwise known as living on a budget.

As I have written about at length, the European banking system is a systemic disaster. The regulators ENCOURAGED (there is no graphic strong enough to express the outrageousness of such a design) their banks to buy government debt and allowed them to leverage that debt by up to 40 times.

This was on the theory that no sovereign (European) government could actually default, so therefore there was no need to actually reserve capital against the possibility of a default. And if Greek (and Portuguese and Irish, etc.) debt returned a modest premium (2-3%) over German or French debt, then the spread was worth it to the bank managers and shareholders. After all, the regulators had said there was no risk; it was easy money. Even economists can figure out how to make money at a "modest spread" on 40 times leverage with no risk. Just ask those clever guys at Long Term Capital. And if the spread was 2%? Then back up the truck and give me some more. 100% on your capital per year with no risk? Where do I sign up?

And thus the EU found itself in a credit crisis when Greek debt started to rise in risk, having already been decimated by the subprime crisis. Someone finally noticed that Greece could not hope to pay off its debt. However, German and French banks had so much Greek (and other peripheral-country) debt that if Greece defaulted they would be bankrupt. That would of course force the respective governments to capitalize their banks to keep their countries afloat. But then that would call into question their own credit worthiness as we are talking a great deal of money.

Contagion, Thy Name Was Greece

And if Greece were allowed to default, then what would that imply about other peripheral-country debt? The word contagion slipped into the economic lexicon as Merkel and Sarkozy (and many other European leaders) openly worried that if Greece were allowed (or forced) to exit the euro, the entire euro experiment might be called into question.

So the easy fix was to simply loan Greece the money to allow them enough to pay the banks until the loans were small enough that what remained could be written off. Of course, the loans from the Troika were considered sacred and have not yet been written down (more below). But private holders of Greek debt are down some 90% on a mark-to-market basis (as I predicted). And I may have been optimistic. We shall see.

So, let's fast forward to my four days in Greece. I was in Europe for a series of speeches in Scandinavia for the Skagen Funds. I had to be in Geneva eight days later, so rather than return home to Dallas just to fly back again, I decided to stay in Europe. I had been writing about Greece for many years but had not visited, though I had corresponded with Greek readers during that time. So after Scandinavia I spent the weekend in the south of Spain, a day in London, and then flew on to Athens.

I had asked my good friend Christian Menegatti, managing director and head of research at Roubini Global Economics, to come with me. Christian is Italian and married to a Greek wife (with a new baby!). Between the two of us, we stayed extraordinarily busy with meetings. We saw business leaders and entrepreneurs, politicians, economists, central bankers, and investors. And at night, neither of us being shy, we made a point of frequenting the tavernas and meeting the locals.

Let's review a few quick facts, and then I'll share with you some of what I learned, starting with some anecdotes gleaned from those evening sojourns.

The Greek economy is down some 20% in terms of GDP since the beginning of the crisis. This year it is forecast to be down another 5% or more. Indeed, The Economist projects that Greece will be the worst-performing economy in the world in 2013. A glance at the table below shows the best and worst nations among their forecast. (Question for the people putting this forecast together: How can Greece be worse than Syria? Seriously?)

Unemployment, I was told, is close to 27%, still rising, and could approach 30%. Youth unemployment is over 50%, and young people are leaving. Over €80 billion has left the banking system for other countries. Banks are basically depending on emergency Greek central bank lending in order to maintain liquidity. Theoretically, these loans will eventually be a debt of the Greek government.

Greek banks are totally bankrupt, having had to take massive haircuts on their Greek debt. Banks that are considered "systemic" will be required to raise 10% of the money needed to recapitalize them, in order to get the 90% available from EU funds. Banks that are not considered systemic will simply be nationalized. This is a point we will revisit.

That all sounds so grim. And indeed, there were reports of bombs being set off as I left the country. Apparently, no one was hurt. And there was a demonstration of sorts arranged for me on Saturday afternoon. They blocked the streets off in front of our hotel (the Grand Bretagne), which is on the plaza in front of the capital building. When you see pictures of Greek demonstrations, they are likely taken from the same vantage point we had. After experiencing a march with 700,000 protesters when I was in Buenos Aires last November, this seemed rather tame. Mostly it looked and sounded like a rock concert with bad music. I was told by the doorman that it was a protest by the "radical left" against the racism of the "radical right."

"If no one shows up, then they will open the streets pretty soon." I waited, and when the only assault was upon my ears, I went back to my room.

All the economic devastation and political talk conjures up a mental picture of a war zone, yet it all seems so normal when you are there. The setting is somewhat surreal, with the Acropolis and 2,500-year-old Parthenon dominating the view, beautifully lit up at night. (Athens really should be on your bucket list. It is off-season now, but the streets are not empty at night, and the restaurants and tavernas fill up, mostly with locals, as the evening progresses.)

Christian and I ended up taking the same early-evening plane to Athens. We quickly parked our luggage and set out to find dinner, walking to an area that Christian knew. We sat outside, ordered some simple fare, and planned our next few days. Eventually the owner came by, noticed the odd accent (mine), and stopped to chat. When he found out we were trying to learn about the situation in Greece, he opened up. We peppered him with questions about business and his feel for the economy. How was he making it?

It struck me as odd at the time that he emphasized several times that he had cut his overhead by going directly to local farms for his food (which was good). No middlemen for him! I wondered why you would wait until a crisis to source better and less expensive food, but I didn't ask. We shook hands and he started to walk away, and then on a whim I asked him what he thought about the new coalition government.

He looked down and then glanced around. He said quietly that he had voted for the Golden Dawn Party, looking to see if we would turn away. When we simply asked more questions, without commenting, he warmed up. (Note: this is the party of the "radical right" that was mentioned by the doorman. Golden Dawn gets about 8-10% in the polls. When it is mentioned in the global media it is often referred to as neo-Nazi.)

Within a few minutes he was quite upset – not at us, though! He pointed animatedly in the direction of the capital, punching the air for emphasis, and exclaimed (without raising his voice too much), "They stole billions and put it in Swiss accounts and now they want to tax us more to pay for their theft. They're all the same!"

The next night offered quite a contrast. In the evening we walked to the base of the Acropolis and found what looked like a promising venue and entered. It was early by Greek standards, but a performer was playing a guitar and singing Greek tunes to a table of six (ahem) older gentleman, clearly old friends eating and drinking together. (Later we found out they had been gathering once a month like this for 20 years.) As the evening went on and the wine kept flowing, they began to sing. A second guitar appeared. The aromatic cigars came out and were smoked directly beneath the no-smoking sign, with no sense of irony. One patrician gentleman stood a few times to have his picture taken with locals who dropped by that evening.

The young owner of that tavern came by, and we started out as the night before, asking questions. When he found out what we were looking for, he went to the table and pulled one of the elderly gentlemen away and introduced us. It turned out that he was an economic journalist and chairman (emeritus) of a Greek journalism society. I quickly borrowed a pen and began to take notes on a paper placemat.

Prisoner of the Bureaucracy

He was an odd mixture of pessimism and hope, a perfect living metaphor for what I found from top to bottom in Greece. This was the best government he had seen in his life: "I trust this government." But when asked if he was optimistic, he shook his head wearily and said no. When we pressed him as to why – and we had heard variations on this throughout the trip – he said, "The government is the prisoner of the bureaucracy. We have 4,021 associations and 6,200 codes. You simply cannot change things. There are 600,000 tax elements. No one really knows who pays what."

He continued: "Remember the spectacle a few years ago, when a new government came in and found massive debts and accounting irregularities? The blamed all the problems on the old government as they negotiated for new loans from the EU. Of course, the people they were blaming were bureaucrats they themselves had appointed, the last time they were in power.

The government still to this day does not know how money is spent. They will try to change. But even if they pass new laws, under the rules a minister does not have to enforce them."

It seems the bureaucracy is the prisoner of the associations – what we refer to in the US as regulatory capture. This is when a regulatory agency, "created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as an encouragement for firms to produce negative externalities. The agencies are called 'captured agencies.'" (Wikipedia)

Which brings us back to the comments by the first restaurant owner about cutting out middlemen. I asked one of my hosts (and got someone to confirm) that the rules are set up so that very few suppliers of a product get to compete. You buy your oil or produce from a very limited group of suppliers. Going direct is legal but evidently not all that easy. Is it the same in every business and industry? No, but enough to be an issue.

One businessman told us that he has a factory in Germany and one in Greece. The one in Greece is just as productive as the one in Germany, but he needs five times the number of accountants and lawyers and clerks to deal with the system.

This letter is getting long and I am only halfway through (but just getting going on Greece!), so I will pen a second part next week, detailing my impressions from meetings with businesses and government officials, along with some new reports and quotes. But I don't want to end here without giving you some sense of my conclusions.

I found guarded optimism in Greece that things can change, and from people that six months ago would have been deeply pessimistic. The source of that change, as we will see, is somewhat ironic. Greeks are natural entrepreneurs. As I noted a few weeks ago, it was the son of a Greek immigrant who pioneered horizontal drilling and fracking here in Texas. And new Greek businesses are sprouting everywhere. There is real potential for an upbeat finish to what was a disastrous beginning to this crisis.

I heard time and time again, "If we can get through the next six months without real protests or …" More cuts are coming, and deep ones. Things must change, and there is a real constituency, especially in the bureaucracy, that does not want to see change, at least for their part of the world. But all that will have to wait for next week – just remember, what happens in Greece will not stay in Greece.

As I noted three years ago, the rest of Europe is watching. This Greek song will be sung in tavernas and inns and bistros and gasthäuser and pubs and osteria all over Europe. The words will be different, but the tune will be the same. Sung by old men who wish for better times for their grandchildren.

Toronto, New York, Washington DC, Las Vegas, and Argentina

I leave Sunday for Toronto, where I will spend the evening discussing life and economics with good friend David Rosenberg, and then meet the next day with Rick Rule and the team at Sprott Investments. That evening I will be speaking for my Canadian partner, Nicola Wealth Management, at the Trump Hotel. I will be on the Suns News Network in the morning and guest host on BNN at 3 PM with Andrew Bell and Saijal Patel, old friends whom I have only met so far through the camera, so it will be fun to be with them live.

The following day I fly to New York for some meetings and, I think, a spot early with Tom Keene on TV and then radio at 8 AM. Then a few more meetings and some media still being worked out, before I head off to Washington, DC to be with my good friend Newt Gingrich and have some meetings on the Hill the next day, before flying back to Dallas that evening.

The next week I fly into Las Vegas to give a speech to the Turnaround Management Association. (I can see my opening line: "I just came back from Europe, and ladies and gentlemen do I have an opportunity for you!")

I am making plans to go to Argentina for two weeks in the middle of March. My friends and partners at Casey Research have built a magnificent resort in the north of the country (Salta Province), just outside the city of Cafayate. It is magical horse and wine country, set in the foothills of the Andes, with a year-round perfect climate. One of the best golf courses in South America (at least the longest!), world-class spa and gym, and the wonderful Cafayate plaza at night. They do a semi-annual event for property owners and people who are interested in having a special getaway place.

I will be spending most days there working on my latest book, getting in workouts and visiting the spa, and just taking in the beauty of the place. There will be evenings with friends Doug Casey, David Galland, Olivier Garret, Bill Bonner, and whoever else shows up. (This is one of the few places I go where I am the tolerated liberal; but these guys, being libertarian by nature, tolerate almost anyone as long as they are interesting.) I intend to spend more time there each year, I think. They still have a few spots open if you want to join me. You can check it out here. You can view photos of the area and the resort on the website; but realize that pictures don't capture how breathtaking this place is when seen live. And the ride to Cafayate through the canyon is simply not to be missed.

Ed D'Agostino, the guy who really runs Mauldin Economics, wants me to note that they are looking for a few good marketing copywriters, who know the difference between marketing copy and the hype that sometimes gets associated with economic letters. You can contact him at Talent@MauldinEconomics.com.

It is time once again to hit the send button. That time in the Greek taverna with the elderly gents is a special memory for me. It was like a setting from Zorba the Greek. It is what we imagine Greece to be, so rich and fruitful and full of heart. Now I just need to figure out how to get to a Greek beach this summer!

Your thinking about how things must change everywhere analyst,

John Mauldin

subscribers@mauldineconomics.com

Forecast 2013: Unsustainability and Transition

John Mauldin — Tue, 15 Jan 2013 04:39:00 GMT

Unsustainability and Transition
One Bubble to Rule Them All
The Year of the Windshield
Godzilla Redux: Disaster A or Disaster B
France Is the New Greece
US: The Crisis Games
Entitlement Unsustainability
London, Athens, Geneva, Toronto, and New York

“There are decades when nothing happens and there are weeks when decades happen.” – Vladimir Ilyich Lenin

"People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them." – Jean Monnet

"If something cannot go on forever, it will stop." –Herbert Stein

As we begin a new year, we again indulge ourselves in the annual (if somewhat futile) rite of forecasting the year ahead. This year I want to look out a little further than just one year in order to think about the changes that are soon going to be forced on the developed world. We are all going to have to make a very agile adaptation to a new economic environment (and it is one that I will welcome). The transition will offer both crisis and loss for those mired in the current system, which must evolve or perish, and opportunity for those who can see the necessity for change and take advantage of the evolution.

This is my most-read letter of the year, by the way, and if you’re not yet a subscriber you can join my “one million best friends” and receive both Thoughts from the Frontline and my other weekly letter, Outside the Box, as well as Grant Williams’ rollicking Things That Make You Go Hmmm…, all for free, by simply entering your email address on my site: http://www.mauldineconomics.com/go/bwbsl/CAS

Unsustainability and Transition

Think back to 2001. It was the opening of a new millennium. While that was auspicious enough, several events then ensued that shaped the future for decades to come. China was admitted to the World Trade Organization, leading to a revolution in its production and global trade. The euro was launched with much fanfare – and a minor chorus of criticism. We are now in a midst of a great trial that will determine whether the euro will be a brief experiment or a durable currency. This has dramatic implications not only for Europe but for the world. And, of course, the tragic events of 9/11 shaped a new global perception of what constitutes threats to democracy and security.

Also as the century opened, a secular bear market had just begun, which diminished returns for retirees. Economic activity in the developed world has yet to recover to the pace of the previous century; and many analysts, as we saw in the last letter for 2012, predict an even slower pace of global growth for the rest of this decade. A fear of deflation prompted Alan Greenspan to lower interest rates to levels that eventually created a housing bubble and encouraged Congress, through lower debt costs, to run up huge deficits prior to the economic collapse of 2008. Since then, our deficit and debt have only gotten worse since.

You can read all sorts of economic predictions for this year. Some expect a return to the growth rate of last century and a new bull market. Some see a recession, a major downturn. But no matter what your view of the next 12 months, there is a pervasive sense that the current system of swelling government debt and entitlement promises cannot be sustained. Politicians may persist in kicking the can further down the road, but anyone with third-grade math can see that the system is unsustainable. The US cannot pay an estimated $200 trillion (and growing) in entitlement obligations (Burns and Kotlikoff, The Clash of Generations), although others say that we owe a “mere” $80-plus trillion. Japan cannot continue to borrow 45% of its government budget at 1% when debt is at 230% of GDP and rising over 10% a year. Europe cannot postpone the consequences of an unequal currency union forever.

We live in an unsustainable world. To extend the thought of Herb Stein, we must change the world to one that will be more sustainable. That has been an implicit theme in this letter for years, but this year it will be an explicit theme that we will visit often. That transition to a more sustainable world is going to involve uncomfortable changes for many, if they do not prepare for it.

At the outset, let me state that this “unsustainability” is not a reference to the Malthusian arguments that the world is running out of food, energy, or the other necessary commodities to insure economic progress for a growing world. I reject those arguments. I have a great deal more faith than that in our ability to transition to new forms of food and energy production. I am in fact quite optimistic about the future of the world. No one will want to go back to the good old days of 2013 in 2033. Our age will seem a quaint time of poor health care (“Can you imagine, people died of cancer back in those days?”), scarcity, and a soul-sappingly dreary manufacturing system. The transition we are undertaking to a new world of innovation and technology will be unsettling to many people, but those changes are by and large positive ones, and they will be welcome.

As I was finalizing this letter, my friend Barry Ritholtz at The Big Picture sent this note:

The deficit scolds have been warning for years that hyperinflation is imminent. I have been hearing these ominous warnings my entire adult life. “This is unsustainable! Inflation is about to explode!” But inflation has been rather tame, and we are not experiencing anything remotely like hyperinflation. They keep using that word “unsustainable,” but with all due respect to Inigo Montoya, I do not think that word means what they think it means.

I am definitely in the deficit (and debt!) scold camp, but I give little credence to the US hyperinflation believers. Very different animals. I also believe that we can get the deficit under control if we so choose – or the market may force us to do so.

One Bubble to Rule Them All

The unsustainability I refer to is that of the largest bubble in human history: government debt in tandem with government promises that cannot be fulfilled. And unlike 1993 when only the developed countries of Canada and Sweden had to deal with unsustainable debt, bloated budgets, and unrealistic promises, this time the bubble countries comprise the largest economies and the majority of global GDP.

This is not a short-term matter. There are three distinct economic ecologies that will have to change and will do so on their own timetables. And owing to their size and the significant abilities of a committed establishment to resist change, no matter how inevitable, we are talking years of transition, not months.

The economic ecologies I refer to are of course Europe, Japan, and the United States. One could argue that a fourth center of unsustainability exists: China. However, I am not convinced that anything more than the usual garden-variety recessions are in store for China.(I’m not forecasting Chinese recessions, just pointing out that not even the Chinese can repeal the business cycle forever).

We will not get into detail on each of the three economies mentioned but will touch on each. And I’ll end with a note on where investors should look to make the transition a new era of sustainability. Let’s start with Japan.

The Year of the Windshield

Back in late November and December I commented in several radio and TV interviews that the title for my annual forecast issue would be “The Year of the Windshield.” I changed the actual title only recently as I thought more about the upcoming year in its totality, but perhaps the most dramatic shift this year will be that Japan at last begins its descent into that dark night, from the twilight that has been its economy for 20 years. The subtitle comes from my book Endgame, where I whimsically titled a chapter “Japan Is a Bug in Search of a Windshield.”

The problems, which we will look at briefly in a few paragraphs, are well known. Yet Japan has soldiered on, borrowing yet more massive amounts of money, never bringing its budget into line, spending huge amounts on stimulus and infrastructure, and muddling through with an economy that is no bigger today than it was 20 years ago. Japan’s stock market is still down some 75% (give or take) over the last 23 years, though some were celebrating a 23% move last year. Given the frustration that investors have endured from the Nikkei over that time, I suppose you take solace when and where you can. The chart below is current as of this week. You can get more details on the index performance over the last two decades at http://www.forecast-chart.com/historical-nikkei-225.html.

Japan now has a breathtaking 230% ratio of government debt to GDP (the last estimate I have seen), and it is growing at 10%-plus a year. The government will borrow almost 45% of its budget this year. Has there ever been a more clear disaster in the making? Yet shorting the Japanese bond has been called “the widow-maker.” I think it was Soros who once quipped that you can’t call yourself a global macro trader until you have lost money shorting JGBs (Japanese government bonds).

The new Japanese government, led by Prime Minister Abe and former Prime Minister and now Minister of Finance Aso, have very explicitly demanded that the Bank of Japan target 2% inflation. They have made clear their intention to replace the governors of the current BoJ board with members who agree with this policy. They have the political clout to do so. Whether at the upcoming meeting or after April, when a new head of the BoJ is appointed, that is going to happen. These moves mean there will be a massive printing of yen. In response, the yen has already weakened by over 10%.

You can control the quantity of money or the price of money but not both. (Yes, I know that one influences the other, but I am referring here to large-scale printing of money.) One has to assume that the law of gravity will not be repealed and that investors will want something more than 2% on the ten-year bond if inflation is at 2%. If the ten-year bond were to rise by 2%, Japan would soon be spending over 50% of its tax revenues on the interest carry alone. I submit that this is not a workable business model.

Why now and not sometime during the past ten years? I see a number of factors coming together this year:

1. The Japanese had a 15%+ savings rate in 1990. That is now down below 1%. (Exact numbers are difficult, because Japanese data on this topic has severe lags, and thus my number is an extrapolation but a reasonable one, I think.) Due to the nature of their retirement system, they have channeled the vast bulk of these savings into JGBs. When the savings rate goes negative or is no longer sufficient to buy all the issued debt, the choice will be to monetize the debt or cut spending. The latter choice does not appear to be part of their national conversation. Cutting spending by the amount required will mean a serious recession and further deflation, an option the new government explicitly rejects.

2. Both the trade deficit and the current account have recently turned negative. The vaunted Japanese export machine seems to have hit a wall, and this will limit options in controlling the price of the yen, even if the government wants to. Understand, inflation targeting is also currency-valuation targeting. They clearly want the yen to devalue. I have been writing for years that the yen would eventually be 125, then 150, then 200 to the dollar. It has been 300 in my lifetime, and unless the Japanese change direction, there is no reason it can’t get there again. This means that Mrs. Watanabe will see her energy bills double. This will call into question the Japanese decision to close their nuclear energy plants – something that Abe is already reconsidering.

Think the Koreans will be happy when you can buy a Lexus cheaper than you can buy a Kia? (Disclosure: I love my Japanese Infiniti, the first “foreign” car I have bought, except for a two-month dalliance with a disaster of a Volkswagen 30 years ago.) Think Samsung and LG will be happy when Panasonic and Sony can eat their lunch pricewise? Welcome to the era of real currency wars.

Today this note is worth about $11. In the future? Not so much.

Godzilla Redux: Disaster A or Disaster B

Japan is now committed to either Disaster A or Disaster B. Remember those really bad Japanese “horror” movies of the ’50s and ’60s? Godzilla first released in 1954, and there were dozens of remakes and follow-on movies. It seemed endless. And while the current government policy will not trash downtown Tokyo, it will seriously damage the savings and buying power of two generations. Disaster A is monetization, which is clearly not good when the Japanese want to buy anything not made in Japan (like energy, steel, commodities, a lot of food, etc.) Disaster B is the deflationary depression that budget balancing will yield. Which leads us to the next factor:

3. Once the government is committed to the new strategy, any retreat will cause a market upheaval. This is not a short-term commitment. It seems to me that the Japanese truly believe that their lack of economic growth can be solved through inflation. Their politicians seem to be channeling their inner Paul Krugman, or at the least taking Bernanke’s advice from 2000, when he published a paper called “Japan’s Slump: A Case of Self-Induced Paralysis?”

When your debt and deficit are as massive as Japan’s, the only way to resolve the issue is to inflate away the debt or willingly enter into a depression. They obviously think they can control both the debt and inflation.

This means you should NOT run out and short Japanese government bonds. Repeat, NOT. The only way for the Japanese to make their plan work without having to battle the Godzilla of a destitute bond market is for the BoJ to move out the yield curve and monetize the debt. They will eventually hit all bids on JGBs. For all intents and purposes, the BoJ will become the yen bond market. You will get all the yen they promised when you bought those bonds … but the contract never stipulates what those yen will actually buy.

The plan is evidently that, with a little inflation, they will jump-start the economy; and with growth they can eventually balance the budget and return to a normal bond market. Rots of ruck, guys.

Just a couple years ago this letter seemed as if it was All Greece, All the Time. Since Japan is, say, about 100 times more important than Greece, we will be revisiting it at length in the coming months. But before we move on,three notes:

First, some full disclosure. Even though I have been suggesting that Japan is a “bug in search of a windshield” for almost three years, I have not actually put any money on the table. Until this month. I have now invested a sizeable portion of my pension funds into a short Japan strategy (not simply a short yen and clearly not a short JGB strategy) and will increase that position as time goes on. This is going to be a long-term trade, so no need to rush out and short the yen this morning. Please don’t. Think about this. There is little difference between 90 yen to the dollar and 100 yen, with a target of 200 or more – at least if I am right. If I am wrong, which is quite possible, then the name “widow-maker” will once again be appropriate. I am not suggesting that you do anything, just start your investigation. I will be writing more soon. And for the record, I will be putting this trade on slowly, because the yen market and the Nikkei have moved a lot already. I think this may be one of the most asymmetrical trades I have seen, but this will require endurance, not speed..

Second, the results of this whole Japanese central bank kabuki theater piece will serve as a warning to other governments (especially the US Fed and Congress) not to attempt to reproduce this strategy. Right now, though, it seems to them like a good idea. And this is precisely the policy urged by Paul Krugman. Conveniently, Japan is getting ready to conduct a massive experiment based on Krugman’s ideas. While Krugman has only his reputation on the line, there are 127 million Japanese who have real skin in the game. If Krugman does not think that monetization is appropriate, he should publicly say so now. No Monday-morning quarterbacking allowed. And since I am in Spain tonight, I request that he show some huevos. Go explicitly on the record.

It would be nice to know just how much monetization Krugman thinks is enough. At what point should the Japanese stop? Four percent inflation? Six percent? 200 yen to the dollar? 250 or 300? Should they continue until the economy is growing at 2%? 4%? How should they then withdraw from monetary stimulus? Will withdrawal cause a recession when they do? Do deficits matter at all? Is there a theoretical limit to monetization and stimulus if the economy is sputtering? Of if withdrawal of monetary stimulus is likely to cause a recession and economic hardship, should it be continued past “normal” bounds? What are those boundaries?

If the Japanese strategy (as I think I understand it) is successful, then I will have to lay my right hand on a copy of the General Theory and convert to the gospel according to John Maynard Keynes, as interpreted by his disciple Paul Krugman. If the facts change then I suppose I must change, too. But the jury is out on this one. The world will be watching.

And finally I should note, all humor aside, that I recognize this is not a B-grade disaster movie. This is as real as it gets for Japan and its people. The Japanese are hard-working and clearly brilliant business people. They are not doomed. They will be forced to adapt, but they have done this before, as have many countries. I wish them well, I truly do.

France Is the New Greece

Four years ago I wrote about Greece, and two years ago I wrote about Spain (in detail in Endgame). I was early both times. I was looking at the math of their budgets and only saw the numbers, staring me in the face. For the record, France is on its way to becoming the new Greece. Not in the same way, of course: France will blaze its own path to economic chaos. Hollande seems to have a good mental map for that journey and a good head start. I am early again, but unless something very new and different unfolds, the die is cast.

If Greece causes heartburn for European politicians, what will economic chaos in France mean? There seems to be no polite word for even a soupçon of austerity in the French language.

The French are not going to meet their budget forecasts. They will lose their AAA rating, which they will claim is a conspiracy against them and completely unjustified. And when their interest rates climb by 2% they will demand that the ECB buy their debt, just as the ECB is doing for Spain and Italy. Watch the screaming when their rates climb above 4%. We will be told, “Four percent is clearly a temporary lack of market understanding and simply not rational.”

It is going to be interesting to watch how the Socialist government of Hollande tries to maneuver in the coming months and years. Will they try to cut spending? Where? Agricultural subsidies? Pensions? Move retirement (temporarily, of course) back to 62? (Zut alors!) Try and force the economy to grow with more deficit spending and borrowing and hope the ECB intervenes? Will French workers and farmers quietly accept austerity? Will Germany want to subsidize France? Is France a bridge too far for European solidarity? Stay tuned.

Paris was recently ranked as the most expensive city to live in. I can attest that the city is trop cher. I must admit that Paris is one of my favorite places in the world, especially in spring. I love going to my friend Bill Bonner’s place in Ouzilly, in the deep countryside of France. It is extraordinary. The only good thing that will come out of this debacle the French government is creating is that Paris is going to get a whole lot cheaper. Well, that and the total discrediting of socialist policy.

Europe has its own sustainability issues, which I have chronicled in the past, and we will of course visit them again. This will be a source of serious volatility in the coming year.

US: The Crisis Games

In my opinion 2013 is a make or break year for the US. If we are going to get the deficit on a glide path to balance, then it needs to happen this year. (I should note I have been saying 2013 since 2010.) 2014 is an election year, and it will be muy difícil to get anything of substance done then. Will Obama be any more willing to compromise in 2015? At that point I think it is too late and the bond market, having watched Japan and France and much of Europe descend into chaos, will simply begin to demand higher rates, no matter what the Fed does. If it doesn’t happen even sooner.

This American fiscal issue is first of all going to mean crisis after crisis if the Republicans are serious at all about the deficit. Will they blink, or will they allow the government to shut down? It was shut down twice in the 1990s. The world survived. I wish we had a more collegial system. Who knew we would be nostalgic for the era of Clinton and Gingrich?

Again, this letter is getting long and we all know the problems. I will write more on all this in future letters. But before we leave the issue, let me offer a suggestion to House Republicans and some thoughts on the unsustainability of entitlements.

First, let me humbly suggest that the House pass two budgets. Not one, two. First, pass one that assumes that current tax policy remains intact, but that puts us on a glide path to a balanced budget in seven years. Then pass one with the same goal but with sweeping, pro-growth tax reform. Like a 15% corporate tax but no deductions for anything. Total elimination of tax expenditures. Maybe get crazy and substitute a VAT for the Social Security tax. No halfway measures. Get radical.

Then send both budgets to the Senate with a note that says you will be glad to vote to extend the debt ceiling for a period of time, when they pass a budget the president will sign. After all, they have 55 Democratic senators. They do control the Senate. They have not passed a constitutionally mandated budget for three years. What’s to think they can pass anything? Stop negotiating with yourselves and make them put something on the table that the president publicly agrees with.

The debt ceiling then becomes the problem of the Senate and the president. They can get an increase any time they pass a budget that they can find just five Republicans to vote for. It doesn’t have to be one of your two options, but it does have to be something that is public. The Senate is supposed to be where compromises happen. So let them compromise, and then and only then sit down to talk.

In the meantime pass true immigration reform. Go the extra mile on this one. It is good policy and good politics. Pass any House Democratic proposal that makes even a little sense. Show some true bipartisanship. And no negotiating on the budget until the Senate passes a bill that Obama will sign. Then get serious and get it done.

A few final thoughts on the US. The tax increases are going to add up to more than advertised in the mainstream media, perhaps as much as 1.5% of GDP. This is not going to make for a robust first half. A quarter or two of outright recession is quite possible. At the least, growth will be very weak. And the hidden tax of increased healthcare insurance costs as a result of “Obamacare” will be more than 1% in the latter half of 2013, as insurance companies adjust to rising mandates and costs in 2014. Insurance companies are announcing major increases in premiums. My own company healthcare costs are up an eye-shocking amount. And for labor-intensive businesses? Workers are going to be left to the tender mercies of the new healthcare system.

Obamacare is going to be the mother of all bureaucratic nightmares to implement. I am in sympathy with the need for change in the healthcare system, but how we think we can radically adjust 15% of the US economy with no collateral damage to it is beyond me. On top of the tax increases, Obamacare will mean a very lackluster year for the US economy.

Entitlement Unsustainability

One of the things foremost in my mind is the unsustainability of entitlements, especially healthcare. We all know that Social Security can be resolved rather quickly, but healthcare is going to be difficult. Not the least of the problems is that Americans live manifestly unhealthy lifestyles. Data suggests we are actually 40% sicker than our European counterparts, which explains why healthcare costs so much more here in terms of GDP. Further, healthcare policy was formed in an era of big business and labor unions, and that time is passing.

As I was discussing this with Pat Cox tonight, he mentioned that Michael Barone used nearly those exact words in his op-ed today. I stopped and read it and found myself nodding in agreement. He noted a repeating 76-year cycle in American politics (only modestly forced) that suggests a new era is upon us. Not too far off from Neil Howe’s Generations cyclical thesis. You can read the whole column here. Let me quote from the ending:

The original arrangements in each 76-year period became unworkable and unraveled toward its end. Eighteenth-century Americans rejected the Colonial status quo and launched a revolution, then established a constitutional republic.

Nineteenth-century Americans went to war over expansion of slavery. Early-20th-century Americans grappled with the collapse of the private-sector economy in the Depression of the 1930s.We are seeing something like this again today. The welfare state arrangements that once seemed solid are on the path to unsustainability.

Entitlement programs – Social Security, Medicare, Medicaid – are threatening to gobble up the whole government and much of the private sector, as well. Lifetime employment by one big company represented by one big union is a thing of the past. People who counted on corporate or public-sector pensions are seeing them default.

Looking back, we are as far away in time today from victory in World War II in 1945 as Americans were at the time of the Dred Scott decision from the First Inaugural. We are as far away in time today from passage of the Social Security in 1935 as Americans then were from the launching of post-Civil War Reconstruction.

Nevertheless our current president and most politicians of his party seem determined to continue the current welfare state arrangements – historian Walter Russell Mead calls this the blue-state model – into the indefinite future.

Some leaders of the other party are advancing ideas for adapting a system that worked reasonably well in an industrial age dominated by seemingly eternal big units into something that can prove workable in an information age experiencing continual change and upheaval wrought by innovations in the market economy.

The current 76-year period is nearing its end. What will come next?

I can see multiple paths, but all must inevitably lead to some form of sustainability. Avoid the rush. Go ahead and begin adapting now!

By the end of this decade and probably much sooner we will have transformed the unsustainable current system into something more manageable. The secular bear market will have ended. Healthcare and medicine are due for a radical upgrade, and science-fiction-like technologies await.

The new era (I am searching for a name to call it) will be most welcome if you make plans to transition from where we are to where we are going. And this letter will chronicle the journey. Stay with me. For those of you who are interested in alternative investments to address the kinds of challenges we’ve covered here, I’ve written a piece on the global macro environment, which you can access at http://www.altegris.com/MauldinGlobalMacro. (In this regard I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

London, Athens, Geneva, Toronto, and New York

I am in the Costa del Sol of Spain tonight, where I decided to spend the weekend talking to the locals and exploring. Tuesday I fly to London for meetings and a rather cool gathering that is one of my favorite things to do: a dinner with interesting people. Then I fly off to Athens where I will meet Christian Menegatti, the managing director of research at Roubini Global Economics. We are going to spend three days meeting with business leaders, politicians, bankers, and just regular people, getting a feel for what’s happening on the ground. Drop a note if you want to meet later in the evenings at my hotel in Athens.

All that, coupled with what I learned as the guest of Skagen Funds in our tour of Scandinavia, will be the topic of next week’s letter, which I will write from Geneva, amidst meetings with clients. (Which is why I stayed in Europe rather than going back to Texas just to return to Switzerland a few days later. And this “tour of duty” does not exactly amount to hardship.)

I will be in Toronto on January 28 for a speech with my Canadian partner, Nicola Wealth Management. Lots of media (times later) and meetings with long-time friend Rick Rule and Sprott Management. And of course a lengthy confab with Rosie (David Rosenberg). I will learn a lot, I am sure. Then it’s on to NYC on the 29^th and possibly DC later that week before returning home for a time. You gotta love it.

I was in Sweden speaking to about 200 investors and money managers (lots of pension money) for Skagen Funds over lunch last Friday. Sweden, as noted above, went through its own crisis in 1993. I have talked with many Swedes involved in the markets at the time. I have not met anyone who enjoyed it, although when I asked that question during lunch I did see one person raise his hand. I found out later that he was a government bond trader.

I also asked, “Did anyone here propose in 1988 anything resembling what eventually became the difficult compromises of 1993?” I saw no hands raised this time. And if the US does not make the difficult choices today, then we will be forced to make disastrous choices not very far down the road. Taxes will be raised and healthcare and other spending cut far more than any of us can imagine. That is the time-honored pattern, and there is no reason to think the US is any different.

It is very early in the morning and time to hit the send button. Have a great week. I will take notes and report back to you.

Your feeling the need to learn Spanish analyst,

John Mauldin

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