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Thoughts from the Frontline

The End of the World, Part 1

August 27, 2011

Choose your language

Fine, then. Uh oh, overflow, population, common food, but it'll do to

Save yourself, serve yourself. World serves its own needs,
listen to your heart bleed – dummy with the rapture and
the revered and the right, right. You vitriolic, patriotic, slam,

fight, bright light, feeling pretty psyched.

It's the end of the world as we know it.
It's the end of the world as we know it.
It's the end of the world as we know it and I feel fine.

R.E.M. song from 1987

It’s not really the end of the world, but to read some of the analysis and data over the past week, it’s hard not to wonder if it’s not the beginning of the Endgame at the very least. There is more to cover than I can really do justice to, but we will just start. We HAVE to look at the US data first (briefly) and then on to Europe, where it will may be the end of the euro experiment, depending on two voting populations. Can you spell “Banking Crisis,” gentle reader? A nod to Bernanke’s finger-pointing speech, some links on the scourge of high-frequency trading, and we end on a positive note about the Boomer generation growing older. And, I answer the question that is burning in your brain: “How many years of US corn production will China’s dollar reserves buy?” Write your answer down now. This letter may print out longer than usual, as there are plenty of charts. Let’s skip the “but firsts” and jump right in.

What Is the CBO Seeing (or Smoking?)

Last week I finally stopped being wishy-washy (with my 50-50% chance of a recession call) and said the US would be in recession within 12 months. And suggested that you consider moving to the sidelines your longer-term equity investments, except your conviction stocks. (I have some of those in the biotech space and simply intend to buy more if the prices go down. But remember, I…

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Richard Commins

Aug. 29, 2011, 12:52 p.m.

I find it very interesting that Germany was at the center of WWI and Germany was at the center of WWII and Germany is at the center of the Euro crisis.  World War is nothing more than an economic rebalancing of its economies through other means when the ruling bodies cannot agree.  Watch out for what follows if the Euro fails.

Jon Parker

Aug. 29, 2011, 10:14 a.m.

The Bloomberg graph of GDP shows very weak growth during the last decade (2000-2008).  It was much weaker than the 70’s, 80’s and especially the 90’s.  This weak GDP would seem to be a bad omen for future recoveries.  I would like to hear John Mauldin’s comments on why the 90’s were so weak in spite of tax cuts, deficit spending, and a booming housing market.  My simplistic view is that it is the result of the substantial decline in manufacturing.

Mark Knodel 28544

Aug. 29, 2011, 9:13 a.m.

John - I believe that what you write is correct, but the equity markets are telling us something else as of late.  It is very difficult to know which side is right when you have every major Wall Street firm saying that we will NOT go into a recession and that equities will be higher by year end vs. what you write.  I’m wondering how their research on what is going on in Europe is so different than yours?  Do you think that the recession has already been factored into our markets?  Being on the sidelines has been painful over the last week and a half.  Interested in your thoughts.

Dan Haggarty

Aug. 29, 2011, 6:22 a.m.

Hmmmm, I see that the 3 month LIBOR-OIS spread (http://www.bloomberg.com/apps/quote?ticker=.LOIS3:IND) is up again this morning.  It’s been gradually opening up over the last 4 weeks.  It’s too soon to panic, but something is making the bankers a bit nervous these days.

Robert Flora

Aug. 28, 2011, 10:19 p.m.

John, you are right to question the veracity of the Congressional Budget Office, however, did I see more than just a hint of sarcasm in your parenthetical note:“these are the same people that told us in 2000 that all government debt would be gone by 2010.”  How could they have known that the incoming administration would detune the regulatory apparatus, ratchet-up the public’s fear factor, start two pre-emptive wars, and decide that having a budget surplus was not in the National interest and thus cut taxes?  You, as a good Republican, should still be able to call a spade a spade.

Frank Blangeard

Aug. 28, 2011, 1:25 p.m.

“We could see a real bear market rally lure investors back in, just to crush their hopes this summer.” John Mauldin, March 14th, 2009

marshall pagon

Aug. 28, 2011, 9:06 a.m.

While I agree with many of your points in re. the EU and its banking sector, I think that the analysis is inverting the causation - the EU problem began as a problem of misalignment of relative valuations between Germany and its supply chain on the one hand and the periphery on the other (Germany undervalued and the periphery overvalued); the problems in the banking system are the consequence of being the medium through which the current deficits of the periphery that resulted from this misalignment have been financed.

Misalignment in a fixed exchange rate regime inevitably will manifest itself as current account surplus in the undervalued country and a current account deficit in the overvalued countries.

Of course, a country can not run a current account surplus without simultaneously financing the countries who are running current account deficits with it. (That is why China, Japan, Taiwan and Korea hold foreign exchange reserves and/or sovereign debt of the countries that are in current account deficit with them.)

If you look at the chart above setting forth the European cross-border claims, it is essentially a cumulative rendering of the intra EU current account surpluses and deficits, which is a manifestation of the misalignment between Germany and the peripheral countries.

Put simply, the European banking system is in crisis, because it has been the medium through which these current account surpluses and deficits have been financed and because many of the assets backing the financial system’s deposit liabilities are sovereign and private debts that are the result of that misalignment.

There can therefore be no solution of the European banking crisis that does not also solve the misalignment, as such a solution can only be temporary - continuing misalignment will just generate more current account deficits that will have to be financed.

This is the nub of the European crisis - they must find a way to revalue Germany and the periphery (either internally within the Euro, or via the periphery or Germany leaving the Euro). However, they must also socialize the losses that the banking system will suffer on the cross border liabilities of the periphery if the periphery is revalued downward (whether within the Euro or by expulsion). (If, instead, Germany exits the Euro, the problem will be slightly different - the deposit liabilities of the German banks will increase relative to the Euro assets that they hold resulting in a comparable need to socialize the resulting loss to equity.)

In sum, a solution to Europe’s problems requires BOTH revaluation of Germany and the periphery AND a simultaneous socialization of the consequent losses that the European banking system will suffer. One without the other is, at best, a temporary fix.

Russ Abbott

Aug. 27, 2011, 5:58 p.m.

Even though I give you a hard time, I read your letters and find them insightful.  With respect to the state of the US economy, what do you think of the recent discussion of <a href = “http://www.calculatedriskblog.com/2011/08/real-gross-domestic-income-above-pre.html”>GDI</a> which suggests we may not be in as bad shape as GDP makes it look?

Charles Yaker

Aug. 27, 2011, 4:46 p.m.

John your friend Scott may be correct about the corn but if we don’t start investing in infrastructure they will never get the corn to market

Ron Bolin

Aug. 27, 2011, 4:38 p.m.

The movie which best portrays our probable future is:
a) Soylent Green
b) Bladerunner
c) ???

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