I'm Worried



The first quarter of 2012 ended on a high note. The stock market (S&P 500) was up 12.6%, the NASDAQ was up 19.0% thanks to Apple, and the Dow was up 8.8%. The bond market (Barclay’s Aggregate) was up 0.3%. As the U.S. economy appeared to be under control, investors bought stocks. As we enter the summer the market will start to worry about the Bush era tax cuts expiring, which will have a negative affect on spending. It will continue to worry about the deficit that is approaching $16 trillion. It will worry about unemployment and housing. These issues will be with us for many years. The Federal Reserve has given mixed signals as to whether there will be a QE3 or not. The stock market believed we would get it, but the Fed has thrown cold water on that recently and the stock market dropped. A presidential election year is usually good for the stock market, but because we are in such unusual times, who knows.

Dr. Lacy Hunt, Chief Economist at Hoisington Investment Management, was interviewed in a publication by Weeden & Co. in January 2012. Lacy continues to point out that the large debt to Gross Domestic Product (GDP) ratio is causing the U.S. and global recovery to be tepid. As you can see in the Market Data section of this book, The U.S. Debt as a % of GDP, the total debt is approximately 350% of GDP. You see the blue line, Private Debt, declining as consumers and businesses desperately try to pay their debt down; but you see the green line, Federal Debt, rising to offset the decline in Private Debt. Lacy says this is a problem and will keep the economy from growing more than very slowly at best. Lacy quotes some famous economists:

Debt and Economic Activity

Conventional View

Beginning with Irving Fisher (1933) and A. G. Hart (1938), there is literature on the macroeconomic role of inside debt. Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior.

Footnote: I do not deny the possible importance of irrationality in economic life: however, it seems that the best research strategy is to push the rationality postulate as far as it will go. 

Ben S. Bernanke (2000). Essays on the Great Depression, pages 42-43.

Vs. New View

The U.S. economic recovery has been weak. A microeconomic analysis of U.S. counties shows that this weakness is closely related to elevated levels of household debt accumulated during the housing boom. The evidence is more consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery. King (1994) provides a detailed discussion of how differences in the marginal propensity to consume between borrowing and lending households can generate an aggregate downturn in an economy with high household leverage. This idea goes back to at least Irving Fisher’s debt deflation hypothesis (1993).

Federal Reserve Bank of San Francisco Economic Letter January 2011. Atif Mian University of California Berkeley, Haas School of Business and Amir Sufi, University of Chicago Booth School of Business.

Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be a disaster. For individual households and firms, over-borrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government’s ability to deliver essential services to its citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corporations and 85% for households. 

The Real Effects for Debt by Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli. September, 2011. Bank for International Settlements, page 1.

The bottom line is that we are in the aftermath of a very severe debt crisis, globally, that will not go away anytime soon.

John Mauldin writes in his free online publication Outside the Box (JohnMauldin@2000wave.com) dated April 10, 2012 entitled “I’m Worried” that the deficit is the single most important political and economic question of our time.

He quotes David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors:

When I get worried, I read and re-read in my library. I can honestly say that I have had my nose in a thousand of those books. The library holds many texts by giants. They wrote about history, economics, and finance. They took the strategic view. George Akerlof, Jared Diamond, Niall Ferguson, Carmen Reinhart & Ken Rogoff, Robert Shiller, and Nassim Taleb are among the modern writers. Milton Friedman, Martin Gilbert, Friedrich Hayek and his polar opposite John Maynard Keynes, Ludwig von Mises, R.R. Palmer, and Adam Smith are among the classics.

A favorite of mine is Paul Kennedy. Twenty-five years ago, this Yale historian concluded his monumental work The Rise and Fall of Great Powers with a profound observation:

"In the largest sense of all, therefore, the only answer to the question increasingly debated by the public of whether the United States can preserve its existing position is no for it simply has not been given to any one society to remain permanently ahead of all the others, because that would imply a freezing of the differential pattern of growth rates, technological advance, and military developments which has existed since time immemorial."

Kennedy then argued that the United States has the ability to moderate or accelerate the pace of decline. Such is also the case for other great powers, many of which are in a state of decline from their centuries-old power peak. Among others in his treatise, Kennedy's history lessons examine Spain, France, Rome, and the Austro-Hungarian Empire.

I think I just covered a lot of the euro-zone geography.

In 1987, Kennedy warned us, "The task facing American statesmen over the decades, therefore, is to recognize that broad trends are under way, and that there is a need to 'manage' affairs so that the relative erosion of the United States' position takes place slowly and smoothly." He added the additional warning that it not be "accelerated by policies which bring merely short-term advantage but longer-term disadvantage."

Unfortunately, America's leadership has not heeded such warnings.

For decades futurists have complained about the rising use of government debt financing by the United States. They predicted calamitous outcomes, which did not arrive as expected. Paul Volcker and Alan Greenspan applied monetary policy in ways that allowed inflation and, hence, interest rates to spend a quarter century in decline. The Volcker-Greenspan era opened with the highest interest rates since the Civil War. Building on this downward momentum, Ben Bernanke has taken the target short-term interest rate to near zero and held it there.

During the same three decades, the US altered its fiscal policy, first under Ronald Reagan and almost continuously since. (The Clinton administration was the exception.) Rising deficit financing has been facilitated by falling nominal interest rates. That combination leads to level, or even falling, aggregate debt service. You can owe more and more and have smaller and smaller monthly payments. That is the magic of falling interest rates. Until they hit the zero boundary.

What happens when the music stops and the chairs are full? Are we reaching that point in the United States? It appears we have done so in Europe, certainly in Greece, the eldest of the declining great powers. We are also getting there in Japan and the UK. All four confront similar financial straits: zerobound interest rates coupled with expanding national government debt.

About 85% of the capital markets of the world trade by means of the dollar, yen, pound, and euro. The G-4 central banks have collectively expanded their holdings of government securities and loans from $3.5 trillion to $9 trillion in just four years. At the prevailing very low interest rates, the functioning of monetary policy and the role of fiscal policy merge. Is there any difference between a million-dollar suitcase of one hundred dollar bills and a million-dollar, zero-interest treasury bill? You need an armed guard to protect the first one. With the second one, you need to clear an electronic trade in a safe financial institution, not an unsupervised (no more Fed surveillance) Federal Reserve primary dealer like MF Global. Your earnings on either the cash or the T-bill are the same: you earn zero. You can use the treasury bill to secure a repo transaction at a near-zero interest rate. You can use the cash to conduct many types of black-market or gray-market trades. Is it any wonder that the hundred-dollar bill is so popular? Isn't it understandable that roughly two-thirds of US currency circulates outside the United States?

Is this a healthy situation? How long can it persist? What happens next? When interest rates eventually rise, what will be the result of this blend of monetary/fiscal policy as its unwinding turns malignant?

Moreover, who then will be the politicians that inherit this mess? Who will occupy the central banker's chair?

I worry because there is no rationally explained strategic-exit plan in the G4. Not in the US. Not in Japan. Not in the euro zone. Not in the United Kingdom.

I also worry because the direction of taxation is up, if certain politicians continue to have their way. I worry because US business tax rates are now the highest in the entire world. In addition, I worry because of the increasing power that national governments wield in the mature economies of the world.

Applied power eventually leads to serfdom.

Increasing taxation is a characteristic of a declining great power.

Governments are failing to heed Paul Kennedy's warnings. They are worsening the longer-term outlook. The Western world's leaders ignored Kennedy when he wrote "accelerated by policies which bring merely short-term advantage but longer-term disadvantage."

Zero-bound interest rates are a short-term advantage. We enjoy them. We profit from them. We expect them to continue for a while. They are like the oxygen administered to a very ill patient. If the patient dies, the oxygen has eased the pain in the terminal phase. If the patient lives, the lungs have been scarred and need many years of healing and repair. Today, the patient is receiving oxygen in the G4. Death is being delayed (Greece) or, perhaps, thwarted (elsewhere in the euro zone, Japan, US, and UK).

We do not know how this will play out. History only warns us that many of the likely outcomes may be unpleasant. The authors I cited have articulated their differing and diverse views. Their conclusions have tended to be in the form of warnings.

Paul Kennedy favors candor. In his second, exquisite work, Preparing for the Twenty-First Century, he wrote: "Many earlier attempts to peer into the future concluded either in a tone of unrestrained optimism, or in gloomy forebodings, or (as in Toynbee's case) in appeals for spiritual revival. Perhaps this work should also finish on such a note. Yet the fact remains that simply because we do not know the future, it is impossible to say with certainty whether global trends will lead to terrible disasters or be diverted by astonishing advances in human adaption."

Of course, we hope for the latter and worry about the former. History gives us little comfort. For the time being we shall remain on the sanguine side with regard to this global experiment with increasing debt, zero-bound interest rates, and a monetary/fiscal policy compromise that obfuscates the difference between them.

As long as this persists, it means financial markets do well, stocks rise, risk assets regain favor, bonds with hedges yield results, and cash continues to earn zero return.

That is now. It may change tomorrow, next week, next month, next year or not for quite some time. There is no way to know.

How do we deal with this? Stay diversified; stay to the conservative to protect assets; be flexible when necessary.

We look forward to seeing you at the next meeting.

Jamison Monroe, CIMA®
Chairman & CEO