Ray Dalio-John Mauldin Discussion, Part 4

Ray Dalio-John Mauldin Discussion, Part 4

This week is the fourth in a series of five open letters responding to a series of essays by Ray Dalio, the founder of Bridgewater Associates. His original letters are Why and How Capitalism Needs to Be Reformed, Parts 1 and 2 and It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and ‘Modern Monetary Theory (MMT)’. My replies are here, here, and here. Today I continue my response.

I was quite pleasantly surprised to read a very generous and gentlemanly reply from Ray in Forbes last week, in which he clarified some of my understanding of what he wrote. I encourage you to read it after this letter for more context. I’ll continue responding to his original material but first a short piece responding to his letter in Forbes.

Dear Ray,

I want to thank you for your thoughtful and courteous reply to my first three essays. It was remarkably civil and I learned a great deal. Clearly you and I agree more than we disagree. Many of our differences are an emphasis on a different syllable in a word rather than the word itself. Much like tomato and to-mah-toe. I will continue my series in the spirit in which you replied, noting that my misunderstandings would have been cleared up in a few minutes in a normal conversation rather than a public internet back-and-forth. Part of the times we live in…

I will encourage my readers who are following this discourse to read your response, as there is much to be learned in your explanations of the nuances of MP3 and MMT. I somewhat conflated them in my first few readings of your letter, and your clarification helps immensely. I believe my fifth and hopefully last letter in this series next week will offer an alternative to this path we both agree would be perilous. These paragraphs from your response are at the crux of the matter:

Having studied these dilemmas in the past and thought a lot about the cause/effect relationships that determine how they work, it is my conclusion that central banks will have to turn to what I call Monetary Policy 3 (MP3) in the next downturn. MP3 follows Monetary Policy 1 (which is interest-rate-driven monetary policy), which continues until interest rate cuts can’t be big enough to do the trick. That’s when Monetary Policy 2 (which is central bank printing of money and buying financial assets) happens and continues until that doesn’t work anymore either. MP3 is fiscal and monetary policy working together with fiscal policy producing deficits that are monetized by the central bank. Modern Monetary Theory as it’s described is simply one version of many types of MP3. What I’m saying is that I believe that in the next downturn you will either see some form of MP3 from central banks or you will have terrible economic and social conditions.

To be clear, I’m not saying that such policies don’t have some undesirable consequences, and I don’t think that MMT is the best form of MP3. What I’m saying is that MP3 is the best of the bad alternatives and some form of it will likely happen, so one had better know how it works and how to deal with it. I welcome alternative descriptions of what will happen when both interest rate cuts and QE don’t work to stimulate the economy in the next significant downturn.

I quite agree that unless something is done there will be terrible economic and social conditions. As you say, we will have to choose between bad and perhaps even worse choices, none of which will be easy. The longer we wait, the more difficult and limited the choices will be.

I’m looking forward to hearing what form of MP3 will be best (or least bad). I quite agree that more QE will have its own attendant complications, creating the same problems as last time. The image of Christopher Walken demanding More Cowbell comes to mind. More QE may be far more annoying, if not destructive.

I look forward to continued conversation…


Comparative National Emergencies

(continuing from last week…)

While I am unsure wealth and income disparities, as obvious and politically charged as they are, rise to the level of a national emergency, I wholeheartedly agree that when 53-54% of America votes as if they are, politicians will agree it is a national emergency and do something, at a not insignificant cost. The resulting new debt could indeed spark a national emergency.

Let’s first look at this using historical data and Congressional Budget Office projections, which presume steady (though mild) growth and no recessions. Then we’ll tweak that data to see what happens if there is a recession at some point.

As noted above, the one seemingly bipartisan point of agreement is to never, ever discuss deficits in any serious manner. By “serious,” I mean actually suggesting specific solutions that would bring either higher taxes, lower spending, or both. Simply noting the debt exists, while important, isn’t serious discussion.

My associate Patrick Watson spent much of this week searching government websites to produce the charts and tables below. Let’s run through these to set up later discussions.

This first chart simply aggregates CBO spending and revenue figures. The CBO, of course, can’t predict a recession in the future and uses what it thinks are “best practice” projections. Note that tax revenue (the black line) is not enough to pay for mandatory spending, defense, and all of the net interest. Again, this is pretty much a best-case scenario. (Also notice how tax revenue dropped in the Great Recession. That will become important later.)

By the way, for this chart we treat Social Security and Medicare as if they were not separately funded. Payroll taxes are included in the revenue line and benefit payments are in the blue mandatory spending area. I think that is closer to reality, since taxpayers are liable for them regardless.

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Under these projections, total federal debt will rise to $25 trillion sometime in 2021. If there is a new president, he or she will not have enough time to change that. Total debt by the end of the decade will rise to the mid-$30-trillion range. Note that these projections do not include off-budget spending (more on that later) which is significant.

The CBO also assumes the bond market can and will absorb almost $35 trillion worth of US government debt. When combined with state and local debt it will easily exceed $35 trillion. (State and local debt is already over $3 trillion. It will certainly rise in the next 10 years.)


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What Happens if There Is a Recession?

Ray, I think you would agree that at some point there will be another recession in the US. I think we would also agree it is somewhat of a mug’s game to predict the timing of a recession more than a few months in advance.

That being said, we should still ask what would happen to the deficits and debt if there were a recession. I asked Patrick to find the percentage change in tax revenues in the last recession (2008 and following) and the recovery thereafter. Using that historical data, the revenue line in the chart below assumes the same percentage revenue change following a hypothetical 2020 recession. (Note, recessions also raise spending due to increased unemployment insurance, welfare, and other economic backstops, but we ignore that in this chart.)

Possibly the next recession will not see revenues fall as much as the last one. Then again, it is also unrealistic not to expect an increase in expenses, so in my statistical dreamworld they will hopefully balance out. I’m sure we can look back in 2025 and see how close to the pin we actually were.

This first graph assumes a recession in 2020. Note that revenues fall below mandatory spending by the middle of the decade, then never get back above mandatory spending plus defense spending. Then by the end of the 2020s mandatory spending will again have risen to consume all tax revenue. And again, these deficits don’t include significant off-budget deficits.

This next graph assumes recession in 2022 instead of 2020. The pattern is basically the same, except that the $2-trillion deficits don’t begin until 2023. Again, this uses actual CBO projections and reduces revenues by the same percentage they fell in 2008–2009, and recovered thereafter.

On-Budget Versus Off-Budget Deficits

Finding a simple projection for off-budget deficits is extraordinarily difficult. When you begin to look at the actual numbers over the last 20 years, you can understand why. There can be a difference of as much as $950 billion from one year to the next. A lot of it has to do with accounting vagaries and statistical timing, which of course are hard to forecast years in advance.

That being said, there is a remarkable consistency about the average annual off-budget deficit. It has averaged around $269 billion a year since 2000. Since 2009 the average is $271 billion.

The following table looks at the actual growth of the US debt since 2000 and uses CBO projections for both on- and off-budget deficits through 2021. After 2021 we conservatively assume that the off-budget deficit will average $269 billion for the next eight years. We also assume, for the sake of mathematical interest, a recession in 2022. We did not project a tax increase at any point in the future, which would of course have an impact on future revenues and deficits. For those curious, a recession in 2020 would increase the total debt by more than $2 trillion in 2029.

Under these assumptions, annual deficits rise to over $2.5 trillion by 2024 assuming a 2022 recession. It will be hard for any administration to raise taxes after recession for at least a few years. And as we saw last week, even a 25% tax increase on the highest tenth of income earners in America would only produce about $250 billion. And that is not net and does not assume any behavioral change that reduces total taxable income of that top 10%.

Under our assumptions total federal debt will rise to over $44 trillion by 2029. The CBO forecast that does not include a recession has total debt rising to over $33 trillion. There is one line on page 16 of the report mentioned below which discloses that factoid. The rest of the report talks about government debt held by the public, as if debt held in the Social Security “lockbox” and other similar inter-government debt won’t be paid by the public as well.

Explaining off-budget deficits can be exhausting. Literally. But essentially, it is Congress appropriating funds from government agencies that are theoretically used for future expenses like pensions and healthcare, spending the money this year and replacing it with government bonds. Social Security obviously, but the US Post Office, all kinds of government pension funds, and all sorts of funds go into this budget legerdemain.

Forget Turning Japanese, We Are Turning Greek

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The CBO produces a remarkably detailed report on the budget and economic outlook through 2029. It is very clear in its assumptions. Let’s look at its GDP projections for the next 10 years: slightly under 2% average growth with 2% inflation and modestly increasing interest rates. (Page 147 at the link above)

Source: Congressional Budget Office

On page 126 you find that a 1/10 of 1% decrease in productivity could increase federal deficit spending by $307 billion over the next 10 years. Clearly productivity matters. Labor force growth has about half the effect of productivity growth. But both are significant.

The CBO projects US GDP will be in the $30-trillion range by 2029, again without a recession, which would no doubt shave a few trillion dollars off that number, but let’s go with it. Without a recession debt is projected to be about 105% (give or take) of GDP and with a recession it is closer to 150%. Shades of Italy or Greece.

Paul Krugman and many others would say I’m being unduly bearish and foolish to worry about deficits and national debt. “We” just want to wear our hair shirts and force austerity on everyone. The Italians are vocally resisting such austerity, as they saw what happened to Greece when the EU forced it to live within a budget. It could only be called a six-year+ depression. “Brutal” hardly describes it. Why would I wish such a turn of affairs on the US?

Maybe I’m just afraid of finding out the answer to “How much debt is too much debt?” We will know the answer only when the bond market rebels, and then it will be too late. Much too late.

Can the Fed intervene? Surely. But at what cost?

The problem is the data and research, by Lacy Hunt and others, shows a clear correlation between higher debt, lower GDP growth, and lower productivity. This will increase the deficit and debt in a vicious spiraling downward cycle.

It also increases the likelihood of QE4, 5, and ∞ into the future after the next recession, which will produce outcomes you (and I) are clearly unhappy with. With reasonable justification.

As for raising taxes to make up the difference, total income taxes in 2018 were less than $1.7 trillion. If you literally doubled taxes on the top 10%, you would only get an extra trillion dollars and still not come close to balancing the budget. Not to mention the recession such a tax increase would cause.

After a recession? It wouldn’t even close half the deficit gap with a 100% increase. And that’s before any increased spending. Some of the ideas run into the trillions of dollars over the next 10 years. Maybe that’s just a rounding error given the actual deficits, but these things do matter.

Where Will the Money Come From?

The cash government spends in excess of its tax revenue has to come from somewhere. If somehow it comes from the bond market (read US investors, as non-US investors in government bonds are increasingly scarce), that reduces the amount available for more productive endeavors, and thus reduces growth. If it comes from QE it increases distortions and misallocations in the market and, as you pointed out, increases wealth disparity. I am not exactly certain what MP3 would mean, but I look forward to learning.


Or we could completely (and somewhat radically) restructure the entire tax code along with getting expenditures under control (and maybe even reduced in some areas) and over three or four years come to a balanced budget. Let’s speculate about what that might look like…

(To be continued next week…)

Boston, New York, Puerto Rico, New York, Maine, and Montana

As you read this, Shane and I are in Boston for Steve Cucchiaro and his beautiful bride Jama’s wedding Saturday night. The next day I meet with my business partners in Mauldin Economics (Olivier Garret and Ed D’Agostino). Monday morning I fly to New York where I am with CMG partner Steve Blumenthal, visit with Art Cashin, attend more meetings, have a CNBC shoot Tuesday afternoon for the Closing Bell, have dinner with accredited investor clients and prospects on Tuesday, and more meetings Wednesday before flying back to Puerto Rico on Thursday, July 4.

Early August sees me in New York for a few days before the annual economic fishing event, Camp Kotok. Then maybe another day in New York before I meet Shane in Montana and spend a few days with my close friend Darrell Cain on Flathead Lake.

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Shane and I celebrated her birthday and our wedding anniversary yesterday. It was quite glorious. We are really enjoying living in Puerto Rico, much more than I expected. I don’t think I can get Shane to move with dynamite. And if she’s not moving, I’m certainly not.

On a final thought, my editor Patrick Watson and I spent hours this week going back and forth over these deficit and spending numbers, along with my other thoughts you will read next week. As we talked, I asked him what he thought about my outlines. “John, you are being way too optimistic!” If $44 trillion is optimistic…

And with that I will hit the send button. You have a great week and I hope you get to be with some friends and family. All the best!

Your worried about deficits and debt analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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Don Braswell
July 1, 2019, 10:15 a.m.

Thanks for another good article.  Two comments. 
(1) the next recession will not be as long or painful at the 2007 “Great Recession.”  While the present recovery is very long, this recovery has been the least loved, AND the recession the most anticipated.  At least those two factors (plus the intervening 2015-16 earnings recession) imply that the next recession will not be as deep, and will likely have a V-shaped recovery.  I expect the USA to fall into recession last, and “recover” first compared to the EM and OECD, simply because we are the least bad neighborhood. 
(2) In you 2029 plan, I would not show a flat defense spending.  I would expect as other pressures come to bare, that 3% will decline to 2%, that 2% becomes the new line in the sand, and that those expenditures (and adventures) will decrease further to perhaps 1% in 2040.  Why?  Because every other OECD nation has done it, and we’ll get tired of defending the last Pole/ Lithuanian/ Ukrainian for an increasingly hostile France and Germany.
I think your article IS correct, forget Japan - we will out-Greek the Greeks…

Daniel Kennedy
July 1, 2019, 8:09 a.m.

The problem with government is its incentives. Bureaucrats are rewarded for growing the bureaucracy and centralizing power. Lowing a department budget reduces power and therefore status. Note for example how in the ace of massive debt every government organization or project makes sure that as the end of the fiscal year approaches every remaining cent of budget is spent.

John Eterno
June 29, 2019, 5:21 p.m.

Thanks for another well researched, and depressing article (as they all are when discussing deficits and our political blindness to them).  As you write further about MMT, can you sometime discuss the history of the Fed balance, and what it means, at least back to WW2?  I have a hard time understanding what would be wrong (from an accounting, not moral, sense) with central banks writing off their balances and canceling their portion of the debt. No private or foreign bond holder would be hurt, and the US, Japanese, and Euro debts would be drastically reduced.  But what’s the cost?  What am I missing?

June 29, 2019, 12:57 p.m.

The normal way of getting out of this kind of mess has always been to inflate out of it.  It must have been very disconcerting to the Fed to discover that shoveling cash into the system had no effect on inflation, as normally measured, instead merely inflating asset values.
Since by definition the total deficit has to be equal to the total privately held financial wealth of the country (plus whatever is owned overseas), it therefore follows that the only way to get rid of the deficit is to either confiscate that wealth (not a well-liked solution, no doubt) or to reduce its importance by inflation.  So the real problem is how to generate adequate but not crippling inflation, while safeguarding the poor and retired?  Perhaps the next QE will be helicopter money, continued until the dollar has declined by, say, 95% of its value.  If done gradually enough maybe it could be sneaked through without too many people caring.

Robert Tagtow
June 29, 2019, 12:42 p.m.

Some random thoughts:
The world is awash in debt along with U.S.
Why do we continue to spend so much on defense?
  Who is going to attack us?
Debt doesn’t matter…......until it does!
Will we ever have any politicians who will have the guts to do something about debt reduction?

David Theis
June 29, 2019, 11:22 a.m.

John, all I can say is “Thank You!” for these articles.  Will the worst come to pass?  Maybe not, but I do want to be prepared.  I also have fire insurance on my house and hope I never, ever have to use it.  But I have it. 


lawrence stirtz
June 29, 2019, 11:21 a.m.

Predicting without skin in the game?????

jack goldman
June 29, 2019, 9:52 a.m.

John, you and Wall Street are hypnotized and confused by your use of the word “money” for counterfeit currency and computer credits. We don’t have money. We have debt notes, a $100 that costs 5 cents. The Fed manufactures debt. The US Treasury coins real money. In money, gold ounces, the Dow is down 30% from 1966 to 2019. In man made debt notes, computer credits, the Dow index is up 2,500%. Question for elites in New York City is how can we keep raping Main Street children, families, renters, and employees of their life and time. Using debt as money is a Ponzi scheme. Unless you measure with gold ounces you will never see the real whole picture. Yes, in debt notes we are richer than ever and can print a Universal basic income, MMT. In real gold money we are poorer. Gold reveals the REAL story. Debt notes and computer credits reveal the fake, man made, metaphor madness score that is not real. It’s the Tulip Bulb Mania and South Sea Bubble all over again. Can’t we learn?

We are in a feeding orgy of infinite profits for those issuing computer credits to cheat the world out real labor. Automation and computers also help get something for nothing. I would suggest each of your readers get some REAL money, fifty ounces of gold and 1,000 ounces of silver for each person they wish to protect. All this confusion calling debt notes and computer credits “money”. Only gold is money, issued by the United States Treasury at $50 per ounce, when it sells for $1,400 debt notes. We have a disagreement about the true price of stocks and the Dow. In debt notes the Dow is $26,000. In real US Treasury legal MONEY, it’s 18 ounces of gold. Those 18 ounces of gold are worth $50 each, face value, so the REAL price of the Dow is $900. Elites and vampire squid want the party to last forever. Will it? How did we go bankrupt? Slowly at first, then very quickly. Protect yourself. No one else can or will. Good luck to us all in the next “reset”.

David Fitzsimmons
June 29, 2019, 9:27 a.m.

Let us assume that the world is serious, and that petroleum shall cease to be produced as of 2030.  How much stranded investment does that imply ?  Or, again assuming seriousness,  if carbon externalities were priced, even neutrally versus punitively, what do those numbers look like ?

There’s some civilization-changing thoughts for you - and the frontlines may change also.


Lee Irvine
June 29, 2019, 7:54 a.m.

I always have thought that if we put a value on the physical assets owned by the federal government, the debt would look more reasonable. Ranch land, oil and gas and other minerals, timber, ports, interstate highway system, for example. If these things were sold to a private party, the dollars received would pay down the debt. Of course, politicians would keep borrowing and spending so there we are. There may not be a solution.

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