Outside the Box

Financial Markets, Politics, and the New Reality

John Mauldin

August 16, 2012

If you've been following my newsletter, you're familiar by now with my friend George Friedman and the geopolitical analysis company he founded, Stratfor. And if you've read any of George's work, you know that his entire methodology is based on the premise that the actions of leaders and nations are predictable. George starts with the constraints – what can they not do, assuming they're rational actors – and moves forward from there. It's this methodology that allowed him to – in all seriousness and probably with an impressive amount of accuracy – write a book titled The Next 100 Years.

I've always encouraged my readers to keep up with George's work at Stratfor. His expertise is not in investing, but the understanding of global politics he provides is essential for any global investor. That said, this week George set his sights on the world of investing with a rather harsh accusation: that investors today lack both imagination and an understanding of political economy.

It's always uncomfortable, to say the least, when good thinkers turn a critical eye on your own profession. I don't necessarily agree with George's conclusions, but I respect him enough to give his ideas some careful consideration and share them with my readers. After all, my basic premise with Outside the Box is that there is little to gain by reading only the work of those with whom we agree.

If George's piece makes you think, I recommend you check out Stratfor. They offer a substantial discount on subscriptions to OTB readers, plus a complimentary copy of the aforementioned book, The Next 100 Years, for new subscribers. <<Click here to access the offer.>>

Your not so unimaginative analyst,

John Mauldin, Editor
Outside the Box

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Financial Markets, Politics and the New Reality

August 7, 2012 | 0902 GMT

By George Friedman

Louis M. Bacon is the head of Moore Capital Management, one of the largest and most influential hedge funds in the world. Last week, he announced that he was returning one quarter of his largest fund, about $2 billion, to his investors. The reason he gave…

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Comments

Albert DeLuca

Aug. 20, 2012, 5:20 p.m.

Another great perspective by Mr. Friedman, however, I think he misses one very important point - today’s politician lacks any fortitude, any moxie to make a decision. Leadership is no longer in the politician’s DNA. The best we can hope for is that they either tie each other up so that there is no harm and no foul or be so leaderless, like Mr. Obama, that we hardly know they exist. We have had no leadership on this globe since Mr. Reagan or Ms. Thatcher - agree with them or not at least they led the way. Once the entire system implodes on itself we can shovel the useless politicians to side of the road along with the creditors who made the bad loans and get on with it.

Robert Watkins

Aug. 20, 2012, 1:41 p.m.

Mr Davis,

I can only agree that our Capitalism has turned to Crony Communism in one respect i.e., our government bailing out companies they consider too big to fail. When governments meddle, we can’t have a true form of Capitalism. Passing a few laws to keep the government out would go a long way in fixing this problem! Term limits and contribution limits to name a couple. What worries me most,  is that it may be too late!

Also Mr Davis, I feel you left out one essential part of the “Cronies” you mentioned, pushing the number much greater than 1%! “Unions”... can anyone say GM / Chrysler?

Dallas Kennedy

Aug. 19, 2012, 10:03 p.m.

When hedge fund managers say, it’s not rational and they can’t figure out what to invest in, they’re using “rational” in a strictly economic sense, including the ability to manage quantifiable risk. They cannot deal with true “uncertainty” (as opposed to risk), because it can’t be easily quantified. So what Bacon said makes sense.

Friedman is using “rational” in a different sense, how a shrewd politician in an electoral democracy behaves in order to preserve and possibly expand power and influence. The two conceptions of rationality usually do not mesh, and it is an excellent reason why highly discretionary use of political power should not be mixed with economics. It may or may not produce politically bad results, but it almost always produces economically bad results.

Economic behavior does rely on politics in a different way, through a predictable system of the rule of law. It’s precisely in periods such as the one we’re living in, of “regime uncertainty,” a breakdown in the rule of law, that economic performance and stability are undermined. The politicians might think they’re accomplishing something else, but that is in fact what’s happening.

There’s also a tone of dismissive denial in Friedman’s piece, a refusal to see the large role that politicians played in creating the economic crisis we’re living through. That’s blatantly obvious in Europe, where a currency system adopted for political reasons has produced an economic disaster. But it’s also true here in the US, where politicians and central bankers played a large role in transforming and degrading the credit system, for the popular political result of making credit ever cheaper and easier to get. This is why, in contrast to the S&L crisis of 20 years ago, almost no one has been prosecuted for their role in the 2006-9 mortgage debacle. The potential indictees have friends in high places ....

Ben O'Grady

Aug. 19, 2012, 10:44 a.m.

Mr Friedman may have subconscious cognitive bias since his belief in strategic political insight has guided his career. I am not convinced by his sequence of logic and tend to agree with the fund manager who feels that if there is not an edge, it is wise to conserve capital and let others be heroic.

wayne finkelstein

Aug. 18, 2012, 6:30 p.m.

I can sum it up very easily - from biblical times on - understand the economics and you will understand the politics - it is always about the money…

Gordon Foreman

Aug. 18, 2012, 3:29 p.m.

I sympathize with the comment of Louis Bacon in the lead paragraph of Friedman’s essay about not being able to invest rationally in the market. The problem as I see it, both in Europe and in the US and many other places, is that there are trillions of dollars/euros in bad debts in the system that have not been acknowledged. These debts are bad. The money was borrowed and has been spent, with nothing of any value to show for it, and the borrowers do not have the means or resources to pay it back, so somebody is going to take the loss. The question is WHO will take the loss.

So far, governments have actively protected their large banks, as the collapse of any one of these could easily cause a system-wide crash, but acknowledging the bad debts will cause something to crash, despite all the efforts and promises of the politicians.

Included in these debts, but not formally acknowledged as debts, are the social promises to an aging population that have been promised medical and retirement benefits that cannot be paid, and thus will be defaulted on. The pensions may still be paid, but in devalued currency that will not even remotely provide the standard of living that the people were promised. And when these promised are defaulted on, that is, when large masses of people recognize that they are not going to collect what they were promised, the social unrest will collapse all sorts of things, including the fiction that bad debts still count as good assets on bank balance sheets.

But how the politicians will respond when this happens is still a mystery, even to the politicians. They still hope to avoid the problems entirely, or to kick the can far enough down the road that someone else will have to deal with it. Friedman assumes that we can always look at the options the politicians face and figure out what they will do. I disagree, first because it’s not clear what options they will have, and second because people under the pressure of crisis often do not think clearly, and their best (but still bad) options are often not feasible due to conflicting imperatives of different constituencies.

In conclusion, it appears that the experiment with worldwide fiat currencies may be drawing to a close. The fiat currencies allowed the creation of debts that are far beyond the capacities of the people and nations to pay them, and those debts are still growing far faster than productive capacity. I see no prospect, either in banking or in politics, that this mismatch will revert to balance. Rather, it is almost certain to continue accelerating until it blows up. And THAT is a really tough scenario to invest for. Gold and silver may preserve some purchasing power, if we can hang onto them, but in their death throes, governments are going to be very destructive.

John-Erik Horn

Aug. 18, 2012, 3:43 a.m.

The author does not differentiate between two completely distinct issues: a free trade zone (the EU) and a common currency (the Euro). If a member, or members, were to leave the common currency scheme, that would not necessarily incur the demise of the free trade zone. On the contrary, membership in the free trade zone would continue to offer a number of benefits to any peripheral country, once the current account imbalances have been rectified by a devaluated national currency.

And one other important political point overlooked: Complete integration into the European framework was the political price Germany had to pay for the “approval”, by their neighbors, of re-unification. This whole concept of an aggressive Germany forcing other countries into a stringent European corset is somewhat slanted, to say the least. Germany already had a decades-long history of a successful export economy, hence no real need for, despite the benefits of, a common currency zone. The French were scared s***less by a re-unified Germany. Germany was scared s***less of being dragged into a club of fiscally careless members just waiting to wine and dine on Germany’s tab. And that nightmare has basically come true today. Nobody forced Greece into the EU or the EZ. Germany had no choice and had to make the best of it.

Biene Vallee

Aug. 17, 2012, 11:31 p.m.

” ...that investors today lack both imagination and an understanding of political economy.”  I assume that this is the item with which you disagreed. I’m a newbie so to speak, and I do not invest, but I read your letters and I empathize with your feelings.  However, from my standpoint, the impression you have made on me is that you are teaching us the way into Global investing right now.  Merkel and Hollande and Draghi have become real people with real “visions” for their countries and how they are reacting to their financial/political disasters. We are watching you dissect the problems from a financial point of view and showing how politics is playing a huge role.  Apparently, it was never an issue in the past, so most investors did not have to be too concerned.  I am certain they are now, and are inhaling all the help offered.
I loved Mr. Friedman’s article.

Roger Davis

Aug. 17, 2012, 6:28 p.m.

Interesting article - mostly accurate - BUT:

“Political Econony” was actually a combination of (simplified somewhat by yours truly) - Political Science (the science of how people react in various forms of political societies), Sociology (how people react with each other) and Economics (the ‘math’ of the thing).

The SEPARATION of the “Three legs of Political Economy” was to DESTROY the combination of knowledge that would lead sane rational PEOPLE to act in their best interests and declaw Capitalism so it couldn’t have the FREEDOM to destroy - just the constrained FREEDOM to assist “Society” to elevate itself as a “Society” - NOT JUST (eventually) what we have now - the 1% versus the rest of us.

Capitalism has become malignant - cancer like it has adopted the idiology of “Growth for growths sake.” It is the idiology of the Cancer Cell - it is vehemently ANTI-HUMAN.

What we have now is the end game - Monopoly (The 1%). (Competition was the ‘accumulation stage’, oligolopy was the ‘early maturity’ stage and ‘monopoly’ is the ‘fully mature’ stage).

Adam Smith said that Capitalism was brilliant because by using it capitalists would make economic decisions to buy (let us say) turnips where they are abundant and cheap then sell then where they were rarer and thus dearer. Thus his “selfish” action was also good for society and worked for the betterment of all. BECAUSE Capitalism was GOOD FOR SOCIETY - Adam Smith endorsed it.

Marx agreed - but added an all too true warning - While a Capitalist would be right to do that a smarter Capitalist would “manipulate” the supply of turnips thus abusing Smith’s Invisible hand.

As to the disgusting monstrosity that today we call Capitalism (merely a form of Crony Communism for the 1%) neither Adam Smith nor Carl Marx would recognize the beast!

And BEAST, it surely is!

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