Outside the Box

Flirtin’ with Disaster

John Mauldin

June 19, 2012

This week I offer a main course, a veritable piece de resistance, for Outside the Box readers, from my friend Rich Yamarone. Rich is Chief Economist for Bloomberg and one really sharp talent. He helps write Bloomberg Brief: Economics, a daily notebook that comes out every business morning with an all-encompassing view of what's happening and will happen.

I have been on stage with him several times recently and have spent even more time with him over dinners. He keeps reminding me to pay attention to the slow-motion slowdown and eventual (he says) recession that is coming right here to the US. He thinks ten-year bond rates could scare 0.5% (not a typo!) if/when both Europe and China have a simultaneous crisis and the US is seen as a real – and perhaps the last – safe haven (to which I would add: besides gold). Certainly 1% on the ten-year and 2% on the 30-year will be on offer in such a scenario.

I asked him to give us a brief tour, based on some of the graphs in his latest presentation, and it arrived today. If you like, you can subscribe to their regular research by going to bloombergbriefs.com/economics.

But we can't ignore Europe entirely, so for an appetizer I offer this small note from Rob Arnott, founder of Research Affiliates (you may know them as the Fundamental Index guys) and manager of the extremely popular (for good reason) All-Asset Fund at PIMCO. Rob will be with me in about a week in Italy, and I look forward to great evenings over Italian food with friends and family.

Here, Rob looks into the future (something he does with great success in his funds) and walks us backward in time. But I will let him tell his story and then we'll get on to the main course. Quoting:

"On another topic, one of my favorite games as an asset manager is to look past current travails and ask what *must* happen in the years ahead. Then we can turn attention to working backwards, identifying the intervening "path of least resistance." Sometimes, this is *way* more powerful than looking at the near-term decision tree and working forwards.

"The EZ travails lend themselves elegantly to this treatment. What will happen in the months ahead? No one really knows. What will happen in the years ahead? Nations addicted to debt-financed consumption will have to balance their books. All of Europe (and the US and Japan) will be spending no more (or very little more) than their tax receipts, a few years hence. Why? Because – as with any family – debt-financed consumption is ultimately unsustainable.

"Likewise, some years hence, entitlements will need to be on a pay-as-we-go basis, give or take a little wiggle room, in order to not crowd out all other forms of spending. Debt service will need to be part of the nations' spending, crowding out other forms of spending; a 'primary surplus' will be irrelevant.

"When will this transition take place? It's impossible for the status quo to continue more than a few years, though Japan shows that debt-financed government spending can persist far longer than most observers might suppose. And it's impossible for status quo to persist after the capital markets begin looking these few years ahead, which telescopes this transition into the coming handful of years. The more a nation relies on foreign investors to fund its spending, the faster this cliff arrives.

"So, working backwards from these inevitabilities ...

· "Since government spending roughly equals tax receipts, less interest payments, collecting more in taxes is a very dubious path by which to arrive at balance.

· "This leaves us with spending cuts. Entitlement spending roughly equals tax receipts attached to the entitlements. So the same logic applies: entitlement spending will be cut. Age of eligibility, means testing, and rationing are the paths of least resistance; but this will require an evisceration of the public sector and empowering of the private sector, which will in turn require a stark liberalization of regulatory and employment law.

· "*Or* there will be a collapse of GDP, as public spending drops without allowing the private sector to pick up the slack. Increasing global pressure for financial transparency, to facilitate tax collection, will become the norm.

"As we move back closer to the present, the near-term implications are less clear.

· "Nothing in this end-point *requires* that countries leave the EZ. Greece can simply slash public-worker salaries or head count to be fully covered by tax receipts. Likewise, Spain, Italy, Portugal, France (!).

· "If any country does exit, its banking sector must rebuild from scratch. The domino effect here is obvious: countries exiting en masse becomes a possibility. Italy and France are not assured to remain in the EZ in this circumstance. So, it's implausible that one, and only one, country exits.

· "All of this means that EZ exits may prove to be too messy to be allowed to happen, in which case defaulting countries will simply default, then cut spending to balance their budgets ... and then move on, with sharply diminished public sectors and GDP."

And back with John. It all sounds so simple when he explains it. But we will lurch from crisis to crisis in Europe, and then Japan will enter the picture in a big way. Hopefully we in the US can learn a lesson and deal proactively with our very similar problems, about which I will write this week.

And now I have to go to my next meeting, although it will be a pleasant one over a low-cholesterol dinner. Have a great week. The next time you hear from me I will be in Madrid on my way to Italy. So adios and ciao for now.

Your ready for a little downtime and conversation analyst,

John Mauldin, Editor
Outside the Box

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Flirtin' with Disaster

Rich Yamarone
Chief Economist, Bloomberg

I'm travelin' down the road and I'm flirtin' with disaster
I've got the pedal to the floor and my life is running faster
I'm outta money outta hope it looks like self destruction
Well how much more can we take with all of this corruption

Molly Hatchet

The U.S. economy is flirting with disaster. Traditionally policy makers adopt a monetary-fiscal policy…

Discuss This

9 comments

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Comments

Jay Mackey

June 25, 2012, 11:29 a.m.

Can someone give a proof that pump-priming has ever worked? Is there some scientific method of determining how much priming is required. Is this even a good analogy? Seems like if it is, you also have to say that we have to prime the pump with gasoline, and there is a chance we blow ourselves up each time we try, and then if/when water starts to flow, we have to deal with the effects of having used gasoline to prime the pump.

Gregory Gheen

June 24, 2012, 1:48 p.m.

Yamarone thesis is basically wrong.  Printing money and having the government spend money it doesn’t have will only compound problems.  Any money spent will be spent politically, which means that it will be wasted.  One needs to ask: where does the money come from?  Well it basically comes from pulling it out from the private sector.  Dipping water out of the deep end of a pool and pouring it into the shallow end doesn’t increase the water level of the pool.    Basically a whole bunch of people have spent beyond their means and now it is time to pay the Piper.  There is no easy or painless fix.  There is only kicking the can down the road and making the ultimate demise more catastrophic.  The economists who somehow think that the Great Oz only needs to jigger a few levers, flash a few of lights and have some smoke billow forth and all will be put right are fools.  I find it very scary that such a cadre of nincompoops are in charge.  No wonder things are so messed up.

Bob Salsa

June 20, 2012, 3:55 p.m.

Yamarone gets much of it right; Arnott is just another of the 99.9% ignorant of how our monetary system actually works.

What Yamarone gets right is FED monetary policy has no real impact: at best, it puts those looking for inflation around every corner into hysterical fits and bidding up assets; at worse, it replaces interest-bearing securities (T-bills) with non–interest bearing securities (bank reserves) that just sit there because banks aren’t lending.  Contrary to the big myth, bank lending is not constrained by reserves but constrained by lack of demand or risk aversion – pumping up reserves is not going to change that.  That interest on those FED-purchased securities goes to the Treasury and goes poof back into the ether from which it was issued; last year, the FED took $80 billion out of the economy by such means and sent it to the Treasury as “profit” where it went poof, i.e. gone.

Yarmarone is also correct that only federal fiscal policy can provide the net spending to get the economy going.  Households are still at unprecedented debt levels and they are saving (i.e. deleveraging) on net, not net spending.  And with a trade deficit, there is no foreign net spending in our economy either.  Federal deficit spending is what is keeping the economy up; however, it is coming down fast at the margin (and thus, our current slowing economy) and schedule to fall off the cliff at EOY.

Yarmarone is also correct in having the needed increased federal deficit spending be done through job programs.  It should be done by simple block grants to states and locals to pay people willing and able to work to do a myriad of desperately needed things in communities as determined by those communities to avoid big govt waste, fraud and abuse.  Such block grants could replace much of the spending and bureaucracy of unemployment benefits, food stamps and a myriad of welfare programs.  More importantly, it would avoid taking the direction of giving the money to the banksters and the financial sector, and relying on the false hope that at least some pennies will trickle down to where it is actually needed.

Overall, good stuff from Yarmarone.  Just the opposite from Arnott.

First, Arnott conflates the US and Japan with European nations that have forked over their monetary sovereignty to a foreign entity (i.e., the ECB).  Those Euro countries essentially owe their debt in a foreign currency and are at the mercy of the bond vigilantes.  The US and Japan govts owe their entire debts in currencies that they issue; it is impossible for them to default.  The EZ countries are like one of our state or local governments or for that matter a business or a household with debt; they all can default.  Unless you know of a business or household that holds its debt in money it can print (if you do, you should call the FBI), you can’t compare the US govt to a household, business, state/local govt or to Greece, Spain or Germany.

Whenever you hear someone say “as with any family – debt-financed consumption is ultimately unsustainable” run away as quickly as you can - that person is, at best, ignorant.  Our national govt has been debt-finance consuming since its beginning.  Our govt pays off its entire debt (now at $15T) about every three months – it rolls it over from one set of bond holders to the next (most often the same people/institutions) set that want to continue to hold interest-bearing US securities (T-bills) rather than non-interest bearing securities.  With the unwise exception of Andrew Jackson (who then suffered a huge economic depression), our federal govt, like any monetary sovereign, doesn’t pay off its debt, it rolls it over;  always has, always will – it is essentially the held equity of our country’s economy from the beginning.

The only concern for too much federal deficit spending is that, when combined with private sector spending, it results in too much aggregate demand for the economy’s capacity to supply.  If that happens, you get demand-pull inflation that MAY get a wage-price spiral going.  Here’s the deal about that, however –

YOU CAN’T GET THAT INFLATIONARY BUBBLE WITHOUT FIRST GETTING AN ECONOMIC BOOM.  You got a problem with an economic boom?

History is not going to fondly look back on our collective monetary ignorance.  Try to smartin up about it; don’t believe the false myths you’ve been brainwashed with for 30-40 years.  Get there so you can tell the grandkids, you were not one of ignorant masses that did so much harm to our economy, our nation.

Doug Graves

June 20, 2012, 1:04 a.m.

Only two things are going to fix this: a debt jubilee and reset, or a protracted disintegration ending in a piffle.  This is simply a pre-Weimar moment before the state nationalist phase, because the only way a jobs programme like Yamarone’s will happen is under a dictator, and why pay people when the prison’s are bursting at the seams.

Norman Leet

June 19, 2012, 9:46 p.m.

John - The Fiscal Stimulus may work if we have a psychological fear-of-the-future problem and just need a little short term push to recognize a bright future.  But that will not right a massive excess debt problem.  The only effective historical approach to the problem, that I have come across, is to freeze the debt and debt servicing growth (consols, anyone ?) and drive productivity to make that debt an ever smaller portion of GDP (eliminate corporate income and capital gains taxes and unilaterally kill off corporate subsidies and tariffs).  The Fed’s low interest rates tend to keep the low productivity outfits in a semi-coma state without a real path to the future. Without them, a businessman is faced with real Chapter 7 auction block bankruptcy which is the ultimate incentive to focus on adjusting, adapting & moving ahead.  Killing off the federal level welfare state will take some very artful political leadership, someone who can paint a picture of an economic foundation for the future and how everyone can fit themselves to it.  “Banking and the Business Cycle” (1937) is a fun read on how the Great Depression came to be.  Spooky….

Jay Mackey

June 19, 2012, 4:08 p.m.

Wow, this is an absolutely brain-dead ‘solution’. John, I’m having a WTF moment here. You can’t have seriously put this forward in an OTB newsletter. But you did! Sigh.

Ski Milburn

June 19, 2012, 10:36 a.m.

So, after 30 years of Supply Side Economics, what have we got?  A demand collapse.  Well, duh!  Thirty years of stagnant real wage growth and massive debt growth led to what?  Deleveraging and the deflation that goes with it.  Assets pledged as collateral are turning up worthless, undermining the banks.  None of this should a big suprise to anyone, especially those few that know more than a bit of history and economics, or read more than “Adam Smith for Dummies”.

Now the pendumlum is stopping, and it feels like the end of the world in the instant before it swings the other way.  The Right is doubling down on the policies that got us here, and the Left has run out of ideas, completely unprepared for a wind that is about to blow in its direction.  Both sides are increasingly strident and impotent at the same time.  It truly is “the best of times and the worst of times”.

We all know what happened the last time we got here.

Art Eatman

June 19, 2012, 9:48 a.m.

“..a direct work relief program like in the 1930s…But it may be the only choice. Cutting taxes haven’t helped; it’s not exactly clear how reducing a tax burden on an underemployed individual or on a business that has fewer people passing through its doors will employ more people?”

Direct work relief?  At a time of incredible deficits?  Whence cometh the money?  Printing?  And what will it buy, after inflation?  Sorry, but I am far more prone to believe John Williams’ ShadowStats than the federal government’s numbers.  Sorry, but I keep track at the grocery—among other points of purchase of necessities.

Historically, every time tax rates have been reduced, the tax-take for the federal government has increased.  JFK, Reagan, Bush II.  More business activity and thus more taxes therefrom.

As far as citing Adam Smith’s views about education, good luck with that.  “Federal Aid To Education” has been an abysmal failure.  The more involvement from the federal government, the worse the educational quality of our public schools.

Perry Noblett

June 19, 2012, 7:25 a.m.

I notice, week to week, the same comments about the lack of wage growth among the mass of working folks. having been a “working folk” all of my adult life this is not news to me. I have been an advocate of higher wages, at least for the lower paid folks for many years. Having been fortunate enough to be in an industry that pays well, and cannot yet outsource, I am contnt for myself and my co-workers. But I see many folks around me every day who struggle very hard working multiple jobs to keep their heads above water.
The solution to part of our problem seems so simple to me. Raise the minimum wage!. I know, it’s inflationary, it’s socialist thinking, employers will lay people off. I heard all of that when the 1st president Bush was in office. Once Bill Clinton actually did it, and raised taxes to boot, the economy suddenly got moving again. All of this sounds backwards to me. But lets face reality, the Bush tax cuts have not created any jobs in ten years. I don’t see any coming either. All the business people talk about uncertainty. The media and the pols say it is uncertainty about taxes and regulations. But when you ask business men they all say it is uncertainty about customers and cash flow. They can deal with the rest, it is what businesses do.
If the health care package goes through the SCOTUS, it shouild be a real source of jobs for the future, and that means real stimulus for the economy as another million or so folks start spending that income and moving money through the economy. You know it is going to take lots and lots of clerks just to do the paper work, not to mention the need for many more healthcare workers and facilitys. Am I wrong on all of this?

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