Outside the Box

Greatest Moral Hazard, Says Paul McCulley, Is Austerity Here And Now

John Mauldin

October 4, 2011

The last Thoughts from the Frontline featured an interview of me by Kate Welling. I promised another interview she did with my friend Paul McCulley, who (warning) is a consummate Keynesian. For him (paraphrasing closely), prescribing austerity for the US is like putting an anexoric patient on a diet. While Paul and I are very good friends, we do not agree on what to do about the current morass. But this is Outside the Box, and the point is to have views that I don’t agree with. And Paul is nothing if not an articulate proponent of the neo-Keynesian view. The original publication of his interview in Kate’s letter drew some very pointed comments. Right up the OTB’s alley.

Kate Welling is simply the best at doing interviews and teasing out controversy, but her work is hard to for the average person to access, as it is now just for institutional clients. I have convinced her to break out of her shell and offer it to the retail world. She is working on the “details,” such as price, etc., but in the meantime you can go to

welling.weedenco.com and click on How to Subscribe (Individual Investors) and put in your email address and she will get the information back to you. I assume she will offer a free sample or so. Check it out.

And in the interview, Paul talks about what his new “gig” will be after PIMCO. He is working with David Kotok to launch the Global Interdependence Center Global Society of Fellows, a most worthy group and effort, which I heartily applaud. The GIC encourages the expansion of global dialogue and free trade in order to improve cooperation and understanding among nation states, with the goal of reducing international conflicts and improving worldwide living standards. You can learn more at www.interdependence.org.

Tonight I am in Geneva and was hosted by Lord Alex Bridport, founder of one of the largest bond brokerage firms in Europe (if not the largest). I will report back Friday. It is an interesting time to be in the markets. OK, one tidbit. He confirmed that banks (and not just in Europe) are really as bad as they look. And with that note, have a good week!

Your going to be 62 in a few hours analyst,

John Mauldin, Editor
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Greatest Moral Hazard, Says Paul McCulley, Is Austerity Here And Now

Is Paul McCulleyfeeling liberated by his retirement from Pimco? A mere glance at the accompanying likeness, drawn from a snapshot I took of him at "Kamp Kotok" (Cumberland Advisors’ annual Maine economic conference and fishing party) in early August says it all. Not that Paul has ever been one to…

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vincent lloyd

Oct. 6, 2011, 9:21 a.m.

I dwell just a little on the rhetorical discussion above concerning Paul’s father-a world war two vet-who took advantage of the GI Bill and housing loans available to him precisely BECAUSE HE SERVED his country.  Is it such a difficult concept for McCulley to understand that we don’t consider this welfare when his father paid into the system that subsequently rewarded him for his sacrifice.  My eternal gratification to our veterans.  But he chides those of us who believe that if you are going to reward fiscal behavior, then you should reward those doing the responsible thing.  Giving those upside down on their mortgages a break on the principle , while not doing the same for those who have behaved much more fiscally responsibly is in my opinion precisely the wrong message.  It may help solve the foreclosure glut, but ensures a repeat in the future since you reinforced the idea that if you foolishly overextend yourself, the government will take from someone who was more responsible and give you what they worked hard to save so that you get more than you deserve and they less.  Are you sure Paul that you are not a little bit of a socialist?

I think the Keynsian arguments fail in this end of the game.  As a physician, the analogy of the anorexic being placed on a diet is not accurate.  The glutton (those who consumed more than they could afford) is in need of a diet.  The glutton will think he is going to die when he is restricted to the proper number of calories to maintain good health- but he will not.  To take the nutrients from the athlete and ask him to give them to the glutton is unlikely to help the athlete perform better, nor help the other to improve his health.

Craig Farmer

Oct. 5, 2011, 11:42 p.m.

If they are going to “reset the mortgages”, I’d like in on that.  I am one of the chumps that have faithfully made their mortgage payments.  Just compare my house to the short sales in the neighborhood, then knock off from my mortgage the difference.  That way, we are all in on the bailout and nobody has any resentment.  Maybe life would then be closer to being fair.

Richard Davis

Oct. 5, 2011, 3:04 p.m.

The point that Melvin Andrews raises is a good one, and I believe it is the essence of the confidence crisis.

For the Keynesian machine to work, government spending must be PRODUCTIVE - creating tangible economic benefit.  That could be in the form of improved transportation, utilities, or other projects.  But if the same amount of money is spent on NON-PRODUCTIVE activities, then the debt hole is dug deeper with no offsetting value created.

For me, the question is not whether austerity is “right” or “wrong” but whether ANY discretionary spending by a government so out of touch with the people is better or worse than austerity. 

If you re-state the question as “Are we better off with austerity, or inefficient spending?” you have the key to the puzzle.  Because folks have seen careless borrowers and irresponsible corporations bailed out with no benefit to the average citizen, they have no reason to hope (let alone BELIEVE) that the government will spend in the best interest of its citizens.

Until the public sees a sensible, well-managed government project provide measurable benefit - that is “felt” by the people, and not left to the usual “lies, damned lies and statistics” method of persuasion, then I’m afraid the crisis of confidence will continue.

And until there is sensible, rational discussion about what constitutes “productive” spending, we will remain on the cul de sac, getting madder and madder until the name-calling turns to violence.

JOSEPH HAGEDORN

Oct. 5, 2011, 9:28 a.m.

U.S. consumers do pay much more for health care than Europeans who have much better results from health care at far less cost, using national health care systems or a combination of national/private health care systems.  U.S. physicians are not even required to report outcomes (results) to an existing data basis.  This is crazy.  How can you choose a physician?  An acquaintance?  Another physician?  Ridiculous.  A data base of outcomes (results) is the only reliable way to choose.  Mr. Andrews indicates U.S health care costs are high because U.S. consumers do not have to pay the bill and over consume.  How can this be?  Europeans pay much less for health care than the U.S.

The Wars in Iraq and Afghanistan did not stop the Great Recession like World War 2 stopped the Great Depression, because World War 2 involved a much greater part of the economy, had forced austerity (rationing), weapons (planes, ships, etc.) production was much greater and required a gigantic amount of manpower, and huge infrastructure improvements have been wasted by tremendous corruption in Iraq and Afghanistan while U.S. infrastructure is wasting away with unsafe bridges and roads, lack of public transportation, etc.

Melvin Andrews

Oct. 4, 2011, 8:14 p.m.

John and Paul are both right and wrong, or are more importantly missing a key factor.

But first two important premises to remember
1)  All net new Job growth comes from start-ups and new companies.  This means we need enable employees to be more mobile to pursue these opportunities.
2)  If citizens donâ??t have to pay for a good or service (at least directly), they will over consume.  And the political and business elite, that make commitments to people about compensations and benefits, do not really have the responsibility to pay for them, make promises that their organizations canâ??t afford to pay for.

The discussion today is on 1) too much government debt (which is true), and 2) the â??liquidity trapâ?, that government austerity and increased consumer savings (and thus less consumption) will make matters worse (also true).  There are two other factors not being taken into account they are:
A)  Public Sector Cash flow (receipts less expenditures) is structural out of balance in the long term, irrespective of the existing debt.  This is both to its employees and to its constituents (its voters).  This creates a year after year cash flow deficit that does not go away.
B)  The country has structural trade deficit that has increased to unsupportable levels in the last 5 years.

A major reason for a lack of jobs and investment is lack of consumer and business confidence.  There is a general malaise in the economy. In the 1930s, all the Keynesian efforts did not solve this.  If we put in place long term policies and programs that address the â??cash flowâ?? problems of A and B above, then the debt levels can be addressed, even if we add to them selective government investment.  Here are the some of the major issues that need to be addressed.

Healthcare (I take this first since it partially address the structural out of balance of government cash flows.)
â?¢  The US spends 16% of GNP on health care, compared to 8-11% for the other developed economies, and does not achieve better general health care results. That is a minimum of 5% of GNP or $750 billion per year of wasted expenditures.  Why? When consumers donâ??t have to pay the bill they over consume, and they want to give excess health service to others.  But they do pay in the end which is one of the causes of stagnant
â?¢    real wages. This will require tort reform

â?¢  The Obama health care bill of mandatory health insurance is a major deterrent to the formation of new jobs.  In fact employer paid health care is a deterrent to new jobs.  GM established it in the 1940s to limit worker mobility â?? and look where it got them.

â?¢  Universal basic health care should be funded via a Value Added Tax on all goods and services, approximately 10-12%.  For government and quasi government entities this should be a fee of say 10% of salaries.  This does not mean it is government provided health care.  There can still be private provides.  Critics want to look at the Canadian and British systems, but there are other systems in the developed counties that have a combination of public and private providers.  Also people can buy premium coverage, or perhaps get free premium service or bonus coverage if they lead healthy lives. This takes away preexisting coverage issues, covers people when they are not employed or retire, and gives people the freedom to pursue new employment opportunities.

Structural Public Sector Operating Deficits â?? Public sector compensation costs (wages and benefits) need to be reset to a structure that is comparable to the private broad general economy.  The required changes will vary widely from entity to entity.  Far too many receive privileged compensations structures, that were given them from the political elite, because of political patronage, and because the grantors of these these benefits did not understand the long term cost, or were not going to be accountable for the long term impacts.  This does not mean two tier systems, nor necessarily layoffs, but a reset compensation structure for all.  It also means developing a culture of efficiency and service, not entitlement.  The Federal government needs to take the lead in this and set an example.  That means congress actually has to lead â?? a novel concept.  The excessive compensation structure for federal employees is buried in a large budget which hides the issue.  Note under the health plan proposed above, public employees have the same coverage as everyone else.

Stimulus efforts:  I think much of the initial stimulus money was wasted; it simple subsidized public entity budgets and put off the day of reckoning.

â?¢  Johnâ??s infrastructure program and a gradual increase in the gas tax is a good idea.  It could be jump started with $100 to 200 billion of Federal commitment.

â?¢  We need an energy policy that supports domestic energy production. Yes, reasonable drilling; better distribution of natural gas; with this perhaps a conversion of trucking to natural gas;  and a smarter electric grid; a smart use of atomic energy ( maybe smaller, unitized reactors, that can burn up the millions of gallons of spent nuclear fuel which still contains 90% of its energy potential).  This means a structure of known and stable pricing to payback these investments.

â?¢  Also the electric generating plants in the United States are getting dated (average age, a reported 35 years old).  A more streamlined regulator process, together with known and stable pricing structures would greatly support this.

â?¢  Mortgage relieve â?? I agree with John we need a program of mortgage relieve and refinance programs.  Many will think it unfair, but we need improved worker mobility and this would reduce the economic malaise. 

â?¢  Cost and Benefit Analysis â?? Much government action, regulatory and otherwise, do not take into account the cost and benefit of their action.  This should change. 

â?¢  Forgive interest on state unemployment borrowings from Fed

Education â?? Proper education and training is critical to job creation.  We spend a lot of money on education and donâ??t get the results.  We need more effective efforts and need to spend money more wisely. I donâ??t think society can support an education structure where costs escalate above inflation.

Taxes- we need a simpler and more efficient tax structure, one that recognizes that job growth comes form start ups.

â?¢  Eliminate; phase out, most personnel deductions
â?¢  Adjust and index the AMT
â?¢  Added tax bracket for higher income earners.  But recognize the person who gets a salary of say $500,000, should be taxed more aggressively that the entrepreneur, who may have reported income of $500,000, but reinvests income to grow his business, employs others, takes on lease obligations and business loans etc.
â?¢  Eliminate or at least reduce our corporate income tax.  Realize that the owners of these companies are our pension funds, and IRAs that depend on corporate and economic success to pay our future retirement.

Deficits and Government Debt â?? John has referenced the work of, of Ken Rogoff and Carmine Reinhart which is excellent.  They point out that deficits will last a lot longer than people want to admit.  They will be needed to support a gradualâ? muddle thoughâ? environment, and to avoid the pitfalls of the â??liquidity trapâ?.  So there will be more deficits for a while.

But that does not mean the political elite canâ??t put measures in place now that create a frame work to burn off these excess debts.  This combined with a resetting of compensation structures can set a message to the world and our citizens that we have a plan to put the economy and our fiscal house back on track.

James Peterson

Oct. 4, 2011, 7:50 p.m.

The idea that austerity, or living within your means, creates moral hazard is pretty ridiculous.

The reason we are in such a pickle is about 40 years of not living within our means.  That is, of false prosperity created by borrowing money to buy us things, and leaving the tab to be paid by our grandchildren.

I wish, O wish, that Keynesians such as Mr. McCulley would at least address (1) the consequences of borrowing money from the productive sector of the economy to transfer it to the unproductive sector, and (2) the effects upon long term growth of the need to repay the borrowed money, with interest.

We are paying the price now, and will continue to do so far into the future, for drinking the koolaid.

Saint Pitbull

Oct. 4, 2011, 7:33 p.m.

It seems that Mr. McCulley is a huge advocate of the multiplier effect.  Maybe at some time the multiplier effect was valid, but I would say that the way that money is currently spent has little, if any, multiplier effect.  Do you want to stimulate the economy?  Give the banks an impetus to lend.  A flat yield curve is just making matters worse, btw.  Operation Twist the knife in the consumers even further.  Of course, the gov’t has less interest expense they owe on debt (and watch them try to pawn that off as they now have additional capacity for more debt!)  Reduce regulations, repeal Ã?bamacare, stop silly talk about carbon taxes and let businesses know that there will be no onerous new regulations or taxes and watch new spending from them come forth.  Everything the gov’t touches they screw up so why should we allow them to print more “stimulus” when they’ve got less than nothing to show for their last few bouts.

norman schafer

Oct. 4, 2011, 5:59 p.m.

HAPPY BIRTHDAY JOHN!!!  THIS INTERVIEW-PLEASE SEND HE AND PAUL KRUGMAN OFF TO DISCUSS THE NUMBER OF ANGELS WHICH COULD FIT AN A PIN..FOR HIS RESEARCH, THIS MAN SHOULD NOT SIT DOWN IN FRONT OF A COMPUTER OR GO TO THE LIBRARY, HE NEEDS TO GO OUT AND FIND OUT WHY SMALL BUSINESS IS NOT HIRING BY ACTUALLY INTERVIEWING THOSE,” WHO DO NOT KNOW WHO RICARDO IS” PICK SEVERAL DIFFERENT BUSINESS AND FIND OUT EXACTLY WHAT FUNDING, HEALTH AND REGULATION ISSUES ARE IN THEIR PATH AND COME UP WITH SOME SOLUTIONS. ASK WHY NEW CLOSED END FUNDS ARE SETTING UP IN LONDON INSTEAD OF NEW YORK (SUPPOSEDLY REGULATIONS) ASK WHY HE IS ABLE TO RETIRE AT 54 AND WHAT THE MEANS OF SHELTERING HIS INCOME FROM TAXATION HAVE TO DO WITH WEALTH DISPARAITY?  THANKS FOR THIS VENUE!  NJ SCHAFER MD

Karlheinz Ramm

Oct. 4, 2011, 12:54 p.m.

One wonders which animals’ spirit these people are trying to invoke. Lizards?

Dave Kretzmer

Oct. 4, 2011, 11:32 a.m.

I could not disagree more with Paul’s analogy.  The situation is more like an anemic patient (the economy) and Count Dracula (the Government) has been put in charge of the blood transfusion!!

From a long time reader under 50, and I do remember the malaise of the 70’s.

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