Beneath Lilacs

This post could be titled "The New Economy" or "The Perversity of Rent Seeking Behavior", but I prefer a title that brings to mind an image of sitting under blooming lilacs and contemplating how much more pleasant life would be if generations of politicians hadn't thrown our futures away with a ruinous public debt.

The Work of Nations

In 1991, before he had become President Clinton's Secretary of Labor, Robert Reich published The Work of Nations, in which he described an increasingly globalized world and the the impact that this world was having on society and the workforce.  At a time before these changes were quite as widespread as they are today, Dr. Reich described how information technology and global wage arbitrage enabled global wage arbitrage, enabling workers in emerging nations to compete with workers in the more advanced economies, bringing about both a convergence of wages across borders, within different job categories, and a stratification of wages according to the scarcity and demand for each type of labor, within national borders.  One outcome of this process was to be possibly increasing divergence in economic outcomes for individuals at different strate of the labor force within the developed nations.  It was well established even before the time of Reich's writing that the less skilled, less educated members of the advanced societies were suffering lower wages and lower employment because of international competition and increasing mechanical and information productivity.

Roll Back the Enlightenment

Economic statistics demonstrate a long-term trend to greater inequality in American society, with a widening gap between rich and poor. Wealth is being concentrated into fewer and fewer hands, and the rising debt loads of the past thirty years or so have greatly depleted the wealth and the ranks of the middle classes.  This increasing inequality may look like nothing more than the inevitable results of greater global competition, greater financial complexity, or the folly of overconsumption, but there are yet other forces at work that threaten to continue the trend toward inequality and to drive it to barbaric extremes. 

In an interview in 2008 the economist Michael Hudson said:  "The economy has polarized to the point where the wealthiest 10 percent now own 85 percent of the nation’s wealth. Never before have the bottom 90 percent been so highly indebted, so dependent on the wealthy. From their point of view, their power has exceeded that of any time in which economic statistics have been kept."

About the wealthiest members of our society Hudson said:  "You have to realize that what they’re trying to do is to roll back the Enlightenment, roll back the moral philosophy and social values of classical political economy and its culmination in Progressive Era legislation, as well as the New Deal institutions."

He feels that the move is a deliberate attempt to transform society fundamentally to their advantage, no matter the consequences to everyone else: "So what you find to be a violation of traditional values is a re-assertion of pre-industrial, feudal values. The economy is being set back on the road to debt peonage. The Road to Serfdom is not government sponsorship of economic progress and rising living standards, it’s the dismantling of government, the dissolution of regulatory agencies, to create a new feudal-type elite."

By the way, there is more than one "Road to Serfdom".  Hayek's book of that title described one, undeniable route, which is the socialist state.  Hudson's interview describes another route, which is feudal domination by a conservative, exclusivist elite.  Both routes lead surely to serfdom and must be defended against.

New Feudalism

Although "rolling back the Enlightenment" sounds like an extreme view, there are identifiable forces working on the world to transform the economic and social system in a pre-industrial direction, as discussed in an article by Parag Khanna last year in Foreign Policy.  In "The Next Big Thing: Neomedievalism,"  Khanna pointed out a seeming incongruity, that globalized financial systems have spread economic crisis around the world at a time when increased corporate and local concentration of power may be dragging us all back to a more localized, feudal condition.  He called this state of affairs "a new Middle Ages".

The argument begins with the observation that:  "The state isn't a universally representative phenomenon today, if it ever was. Already, billions of people live in imperial conglomerates such as the European Union, the Greater Chinese Co-Prosperity Sphere, and the emerging North American Union, where state capitalism has become the norm. But at least half the United Nations’ membership, about 100 countries, can hardly be considered responsible sovereigns. Billions live unsure of who their true rulers are, whether local feudal lords or distant corporate executives."

Given the weak positions of many nation states, "This diffuse, fractured world will be run more by cities and city-states than countries. ... Today, just 40 city-regions account for two thirds of the world economy and 90 percent of its innovation. ... Add in sovereign wealth funds and private military contractors, and you have the agile geopolitical units of a neomedieval world. Even during this global financial crisis, multinational corporations heavily populate the list of the world's largest economic entities ..."

We wonder if America will be dominated increasingly by feudal elites, corporations, or new transnational organizations.  Or maybe this is the wrong analogy with the Middle Ages, which saw some remarkable progress in many spheres of European life, and which were perhaps even more remarkable in other parts of the world.  The medieval world in Europe was one of city-states, local military strongmen, and the loose international network of the church. In contrast, China developed national commerce under the Sung dynasty, and then a universal (if foreign ruled) state under the Mongol Yuan dynasty.

A Predatory Financial Sector

In the western world, government's role in finance has been shrinking for hundreds of years as new financial enterprises and instruments have been developed -- banks, bonds, insurance, stock markets, bonds, futures contracts, etc.  Economies and governments benefited as new financial institutions directed capital flows to where they were needed.

Any system can be perverted, however, and in recent decades financial activity has comprised a growing percentage of gross product -- but with no corresponding contribution to economic efficiency or growth.  Heaven knows, economic stability has certainly been sacrificed to financial interests.

The Rent Seekers

The financial sector and the elite clientele that it serves have been looking for new ways to maintain and increase their wealth.  This includes influencing legislators and bureaucrats to pave the way for more effective rent-seeking behavior.  In economics, rent seeking is the capturing of "economic rent" (income) by means other than economic transactions or the creation of economic value added.  That is, rent seeking requires manipulating the rules of the economy or exploiting special relationships, e.g., getting the government to regulate commerce in a way that effectively confers a monopoly advantage.  Other examples would be getting control of public resources or charging "fees" rather than usurious rates of interest.


As "real" economic activity wanes (from foreign competition or economic depression), you can be sure than rent seeking behavior will increase among the privileged.  They have to maintain their life styles, after all, and poor peons can't afford the lobbyists and corporate attorneys.  The growing role of government in financial affairs, in the wake of the credit bust, is sure to provide even more fertile grounds for nefarious rent seeking.

You can be sure that this does not bode well for new "real" economic activity.  People are always trying to get something for nothing.

Where Are We Going?

You will have to consider whether this story is realistic or other-worldly.  Should I say beneath lilacs or Bene Tleilax? 

List of graphics:

Photograph of lilacs
Harry Sternberg, Bethlehem Steel in Moonlight, 1937
Jean-Honore Fragonard, The Reader, c. 1770-1772
Page from Les Tres Riches Heures du Duc de Berry
Otto Dix, Machine Gunners Advancing, from Der Krieg, 1924
Close up of Alia in Dune (David Lynch, 1984).

U.S. Credit Rating at Risk

El Greco, The Annunciation

As I Was Saying ...

I just wrote a post warning that the U.S. debt is at risk of becoming unsustainable.  Immediately after, along came a news story warning that the crisis may be even closer than we imagined.  Zero Hedge reports "Moody's Sees US Rating Under Pressure After $3.8 Trillion Budget", and they quote the report:

The ratios of general government debt to GDP and to revenue are deteriorating sharply, and after the crisis they are likely to be higher than the ratios of other Aaa-rated countries.

If the current upward trend in government debt were to continue and become irreversible, the rating could come under downward pressure. The trend and the outlook would be more important than any particular level of debt.

The italics are mine.  As Zero Hedge asks:  "IF it becomes irreversible?"

Dollar No Longer the Safe Refuge?

The article says that, if trends continue, the U.S. ratios of debt to GDP and debt to revenue will be HIGHER than the ratios of other Aaa-rated countries.   Many people have been counting on the U.S. being in no worse position than other advanced economies, and they have been allocating assets as if the dollar will remain strong relative to the Euro, Yen, Pound, etc.  Maybe that is not a good assumption.  Those are flawed currencies, but the dollar is flawed too.  Maybe Treasuries will tank as rates rise on the sovereign debt of all these indebted countries.

MSN Money added this tidbit:  "Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating."  This means, that in the absence of an economic miracle, we can expect (a) deflationary pressures from higher taxes and lower expenditures, (b) higher deficits, or (c) a ratings downgrade of the U.S.  Or maybe all of these.

An Actor?  We Move on the Word of an Actor?

That's what Martin Sheen (as General Lee) said in Gettysburg, after receiving a scouting report on the Army of the Potomac.  We all know that the credit rating organizations are corrupt liars, and no one believes them anymore.  They proved that they will do anything, utter any lie to make a buck.  If one of those sycophants comes this close to impugning the credit rating of the U.S., there must be a real problem with our credit.  You would be justified to complain that this crisis has been obvious for so long that it isn't news anymore.

When and What to Do

Whenever a ratings agency issues a more directly worded warning, you can be sure that the Treasury market and the dollar will tank immediately.  When it gets so bad that a Treasury auction finally fails, it will be too late to act.

What to do about it?  Short Treasuries?  Buy gold and foreign currencies?  I lean more toward stockpiling guns, food, and ammo.

When to act?  It seems a little early to act against the dollar, given the problems of Europe, Japan, and the U.K., whose problems are likely to benefit the dollar.  With weak economies weighted down by heavy debt loads, it also seems early to short Treasuries.  When the day will come is hard to tell.

The U.S. Budget Deficit

Walker Evans: Truck and Sign, 1930. 

Walker Evans Archive, The Metropolitan Museum of Art.

The federal budget deficit is larger than thought, and it is becoming a national-security threat.

The National Security Threat

The Wall Street Journal reports that the Federal government will borrow one of every three dollars it spends this year.  The problem is that U.S. citizens cannot lend the money, because they save so little.  Much of the money will have to be borrowed from foreign countries.

"We've reached a point now where there's an intimate link between our solvency and our national security," says Richard Haass, president of the Council on Foreign Relations and a senior national-security adviser in both the first and second Bush presidencies. "What's so discouraging is that our domestic politics don't seem to be up to the challenge. And the whole world is watching."

The Journal listed four ways that such a severe budget deficit threatens America's national security:

• It makes America vulnerable to foreign pressures.  Because half of America's debt is in the hand of foreigners, a foreign central bank could put pressure on the U.S.
• By accepting vendor financing from China, we are conferring a lot of financial leverage to them in particular.
• Long-term national-security budgets are put at risk.  Debt service will crowd the defense budget.
• The American model is being undermined before the rest of the world.

To this list I would add the following ways that the growing national debt harms national security:

• America is saving so little that it is not able to invest in the human resources, plant and equipment, etc. needed to increase productivity and build a competitive position in a modernizing world.
• The U.S. will become less socially stable as debt service crowds out social programs.  Citizens will become desperate, angry, and more prone to take extreme solutions.
• The resulting brittleness of U.S. systems will amplify the impact of any future terrorist attacks, resource scarcity, environmental change, inflation, war, or other adverse events.

The last bullet could be expanded into a number of issues.  Living standards will decline because the Federal budget will be unable to afford the social safety net that US citizens have already paid for and are depending on: Social Security, Medicare, Medicaid.  Support for already stretched cities and states will wither.  Essential city and state services (roads, schools, police, fire, etc.) will have to be sacrificed.  Benefits for the unemployed will be cut.  Increased tax loads will discourage businesses, increase unemployment, and squeeze impoverished citizens even harder.  As America sinks, its disappointed citizens will see other areas of the world gain improving living conditions.  They will see "progress" fail in the U.S. and succeed elsewhere.

Otto Dix, Stormtroops Advancing under Gas, etching and aquatint, 1924.

Growing Deficit Estimates

In "White House to Paint Grim Fiscal Picture" Reuters reports that the budget deficit is larger than previously believed.  According to the White House's Office of Management and Budget, the deficit for the current fiscal year will be significantly higher than the $1.35 trillion figure forecast by the nonpartisan Congressional Budget Office last week.

Despite the President's proposal of a three-year freeze on some domestic programs to save $20 billion next year and $250 billion over the coming decade, that will not be enough to get deficits down permanently to the 3 percent of gross domestic product that most economists consider sustainable.  Deficits will still average roughly 4.5 percent of GDP over the coming decade, according to the White House estimate.  That's not all.

What happened to the entitlement problem that we have been expecting for some time?  It's still coming.  Deficits are expected to rise again toward the end of the decade due to the increasing cost of retirement and healthcare programs as the "baby boom" generation retires.  If we cannot bring the current deficit problems under control, we will be utterly swamped when the deficit is hit by the coming wave of baby boomer retirements.

Where to put the blame?  Despite the criticism of President Obama and his administration, most of the fiscal mess has been inherited from the previous administration of Republican George W. Bush, who cut taxes and created an expensive prescription drug-benefit while pursuing wars in Iraq and Afghanistan.

Blame also falls on Bush for the shortfall in tax revenues to fund the budget.  It was his administration whose monetary policies provided the loose money for the housing bubble, and it was his administration whose laissez regulatory policies failed to rein in the investment banks and mortgage companies.  The shortfall in revenues during the resulting depression is putting cities, states, and the Federal government further in the red.

Unsustainable Debt Levels

Bert Dohmen wrote a sobering piece last month in Forbes about "Trillions of Troubles Ahead" for U.S. debt.  He quotes his colleague Rob Arnott that "at all levels, federal, state, local and GSEs, the total public debt is now at 141% of GDP. That puts the United States in some elite company--only Japan, Lebanon and Zimbabwe are higher."

In adddition, household debt is 99% of GDP and corporate debt is 317% of GDP ("not even counting off-balance-sheet swaps and derivatives") -- both being the highest in the world.  Adding those to government debt at all levels, "our total debt is 557% of GDP."

Dohmen warns:  "The interest on the debt will consume all the tax revenues of the country in the not-too-distant future. Then there will be no way out but to create more debt in order to finance the old debt."

The article likens the situation of the U.S. to Japan, which has the highest debt-to-GDP level (227%) of any industrialized country.  Japan's recession has lasted for 19 years now and the stock market is down 75% from the 1990 high.  As bad as things have been for Japan, they could get worse.  Japan's demographics will make it more dependent on foreign creditors in the future, and Fitch has warned about a potential downgrade of Japan's debt.  This is not a good precedent for spendthrifts like the U.S.

Fundamental Valuations and Forecasts

GMO's 7-Year Forecast by Asset Class

Jeremy Grantham of GMO has long been one of my favorite asset managers and financial commentators because of his value-based approach, his long-term investment horizon, and his warnings about fads, national debt, and growing asset bubbles.  The GMO January Letter is interesting for its 7-year forecast of annualized returns by asset class.

Seven Lean Years

The forecast begins with the prospect that a continuing Fed policy of low interest rates will promote another speculative asset bubble, again endangering the economy and the financial system.  This bubble may boost stock prices in the near term but the bubble will eventually burst.

Grantham believes that the economy faces what he calls "Seven Lean Years", because "after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios ..."

The US stock market is already overpriced, but it may continue advancing and become even more overpriced, Grantham believes.  He estimates that the Standard and Poors 500 index is worth only about 850 but becuse of Fed policy may go to around 1200 before declining.

Expected Returns by Asset Class 

He considers the "high quality" component of the US stock market to be "relatively cheap", however.  I don't know GMO's criteria for high quality, but investment strategists commonly use criteria such as a good balance sheet, cash flow, decent current valuation, and good business prospects, as is the case as with a subset of US consumer staples companies.  Except for managed timber, other assets are overpriced relative to history -- international equities a little so, fixed income very much, and cash extremely so.  I've included GMO's chart of forecast annualized 7-year real returns by asset class.

 
Note that the chart includes no other commodities than managed timber, nor any other real estate.  GMO's long run inflation assumption is 2.5% per year.  International equities are ex-Japan.  Note also that there is a wide band of uncertainty around the central estimates.

In case the chart above is not legible, here are the 7-Year Asset Class Return Forecasts: US equities: large cap 1.3%, small cap 0.5%, high quality 6.8%. International equities: large cap 4.7%, small cap 4.6%, emerging 3.9%. Bonds: US government 1.1%, international government 1.3%, emerging 2.1%, inflation indexed 0.8%, US Treasuries (30 days to 2 years) -0.6%. Managed timber 6.0%.

Risks in This Environment

The most salient feature of this chart for investment strategies is that expected returns are much lower overall than historical averages.  In this environment, GMO feels that professional managers, being more concerned with comparison to their peers than with absolute returns, will be "seduced into buying equities because cash is so painful."  The problem with that approach is that "Equity markets almost always peak when rates are low,so moving in desperation away from low rates into substantially overpriced equities always ends badly."

GMO Investment Strategy

GMO's solution to this dilemma, Grantham says, is to only slightly underweight international equities, but "tilted to quality", because the EAFE index is priced not far below historical norms.  The rest of their portfolio is in fixed income, despite the meager expected return, although they do not specify the composition within fixed income.  The equity allocation will be slowly reduced, however, if the equity markets continue to advance.

PIMCO's Ring of Fire

In contrast to GMO's expectations for asset classes, Bill Gross's recent PIMCO commentary discusses investment prospects across countries. As explained in "The Ring of Fire", Gross's approach seems to be based in part on fundamental valuation methods, as GMO's is, although he uses a different set of metrics more suited to fixed income.

Gross finds similarities between PIMCO's New Normal and a book that I have written of in earlier commentaries -- a study of eight centuries of financial crisis titled This Time Is Different by Carmen Reinhart and Kenneth Rogoff.  PIMCO's thesis is that financial crises are followed by a process of deleveraging (shifting debt from the private to the public sector) which reduces economic growth and lowers returns on investment for a protracted period.  PIMCO categorizes countries as red, yellow, or green based on public sector debt and the public sector budget deficit, both as percentages of GDP.

In PIMCO’s chart “The Ring of Fire”, the most vulnerable countries are shown in red.  "These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth."

PIMCO Investment Strategy

The conclusion that Gross draws is the difference "between emerging and developed economic growth, forecasting a much better future for the former as opposed to the latter."  His investment strategy divides assets into growth, emerging markets fixed income, and developed markets fixed income:

1. Growth assets (as well as currencies) should be allocated to developing countries that are less levered and less prone to asset bubbles. "Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples."
2. Fixed income assets should be allocated to emerging countries when the opportunity occurs. However, reduced liquidity and less developed financial markets (e.g., property rights) make the emerging economies less appealing for fixed income, which means that "most bond money must still look to the “old” as opposed to the new world for returns."
3. Most fixed income assets should be allocated to a carefully selected subset of the developed nations, but the large, traditional bond markets should be avoided -- Japan because of demographics and the need for external financing, the US because of deficits and entitlements, Europe because of  the debts of nations on the southern tier, and the UK because of its high debt.  His top preference is Canada because of its fiscal balance and conservative banks, which did not participate in the housing crisis.  His second choice is Germany "the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched".

This is a much different strategy than GMO's, which does not give so much weight to emerging market equity and allocates to fixed income only grudgingly, but it is useful to see the investment world sliced and diced in different directions.

Woodcuts by Gustave Baumann (1881-1971), known for his work in Santa Fe, New Mexico and his depictions of the southwest

Back in Michigan

Here I am, emerging from a kiva in the ruins of a pueblo at Pecos National Historical Park, New Mexico.  As you can see, I am leaving no source unexamined in the quest to understand the repricing of global financial assets.  More on the topic of asset valuation later, as I re-acclimate to the Michigan winter.

The Fate of Debtors

Late last year I wrote a commentary titled "Eight Centuries of Financial Crises" about the book This Time Is Different—Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth Rogoff. I felt that this book would be of particular value to today’s investors because it analyzes the differences and similarities of over 250 financial crises in 66 countries over the past eight centuries. Today I would like to discuss lessons that other observers have drawn from that book and the application of those lessons to the current financial crisis. The findings are especially timely as the Fed appears headed toward an exit from quantitative easing, and as the US, Japan and Europe face the prospect of funding extremely heavy debt loads in the coming year.


Sources


These thoughts appeared in The Big Picture blog, in the weekly commentary of John Mauldin titled "Thoughts on the End Game". The majority of the post reproduced the fourth quarter 2009 review and outlook written by of two of Mauldin’s colleagues, Van Hoisington and Dr. Lacy Hunt.


Based on the book This Time Is Different, all of these commentators conclude that the outcome of the present process of deleveraging will be an era of deflation, continued low interest rates, and outperformance of US Treasury securities compared to alternative investments. Now, this is not a point of view that I necessarily subscribe to, but we should take a look at the evidence and the arguments.


Five Lessons


Hoisington and Hunt abstracted five lessons from This Time Is Different concerning today’s financial predicament. I’ve quote these five lessons in bold and added my own comments:


First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.


Ever since the 1970s, I’ve heard politicians justify their pet programs and dismiss complaints of rising Federal debt, saying that critics “don’t understand” how government finance works. After all, they said, “we owe the debt to ourselves” and it all balances out in the end. What liars! Domestic debt does matter, no matter who the creditor is. If you are crushed by debt, you cannot obtain the credit needed to grow your business or support your family. You have to cut spending and pay down your debts, even if you don’t enjoy your reduced standard of living. Unfortunately, our collective debts are getting more unsupportable. That’s where we are now as a nation.


Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.


So, politicians were lying when they said that it didn’t matter that we owe our debts to ourselves. Domestic debt does matter, and the size of the debt is the critical parameter.


Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, “Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”


Rather than “reigniting” the economy, government stimulus will have only temporary effects. The underlying debts will remain and they will continue to act as a drag on the economy. The “green shoots” will wither once stimulus runs out, and we will face years of high unemployment, constrained spending, and recessionary economic conditions.


Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.


It isn’t different this time. Debt crisis ends badly.


Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.


Systemic risk is what precipitated this crisis. It is totally self-defeating to try to kick start economic activity by prompting banks to lend and consumers to borrow, because high debt levels brought down the system in the first place. The Federal government is only exacerbating the problem by running up astronomical debts trying to solve the crisis, and placing our financial system at even greater risk. Low interest rates help people finance their debt loads and speculate in the financial markets, but low interest rates will end someday, at a time when the bubble is even larger.


The Deflationary Outcome


There is much widespread debate today as to whether the current crisis will end up in inflation or deflation. In their book, Reinhart and Rogoff presented evidence that major debt crises have deflationary outcomes. In their quarterly commentary, Hoisington and Hunt extrapolated to conclude that interest rates will remain low for an extended period and say: “We are buyers and holders of long term U.S. Treasury debt.”


Comments


This is a sobering conclusion, but we must be cautious when interpreting historical cases. There are still important questions to answer, of which only a few are: Wouldn’t outcomes be different when countries lacked a well developed domestic credit system, such as banks and bond markets? Doesn’t a transition to fractional reserve banking confer enough flexibility to make a difference? What about the introduction of central banks? What about the effects of markets for securitized mortgages, consumer credit, accounts receivable, and credit default risk?


For example, colonial Spain defaulted on its debts numerous times, but that was when Spain depended for financing on marketing its plentiful supply of New World silver rather than a domestic system of commercial credit, as was developing in other parts of west Europe. Germany had budget problems after the Great War but didn’t experience hyperinflation until the victors forced the payment of reparations and limited the country’s options to printing the money.


The overall pattern of crises may appear similar over a long period of history, yet occurrences and outcomes may differ in essential details that matter critically. Details do matter, and we must exercise some caution in our interpretations. I can only advise reading the book, at a minimum. Fortunately, Reinhart and Rogoff go into more detail in This Time is Different than I can do justice to in this space.


As I said earlier, I don’t necessarily agree with all of this, but I also believe that historical precedents should be included in our deliberations when analyzing something as complex as the world financial and economic system.

Between Scylla and Charybdis

A number of Wall Street investment banks are calling for a positive year in the US stock market, and many others are calling for a good first half of the year, followed by a weak second half, as the Fed cuts back on its easing. As suspect as Wall Street’s pronouncements may be (who would believe Goldman Sachs?), it must be admitted that the Fed’s accommodation is a very friendly environment for the markets, and a tighter stance would likely end the good times.

Although many commentators say that they are expecting a tighter Fed policy this year, when we look more closely, there is a variety of viewpoints about likelihood and timing. Let’s look at three opposed viewpoints : (1) a declining stock market due to Fed exit, which is the prevalent viewpoint, (2) a prolonged market advance because the Fed finds it impossible to exit, and (3) a new financial bubble in commodities (triggering another economic downturn) once it is understood that the Fed cannot exit.


A Fed Exit in 2010


Bill Gross of PIMCO is one of the most vocal and most visible proponents of the view that the Fed will cut back on quantitative easing this year. As described in his January 2010 commentary, Gross summarized his view this way:

If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector.


If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.


… 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.

The reason that 2009 was so dominated by the government sector was the extraordinary amount of fiscal and monetary stimulus, including:

… the global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars … the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP.

The reason he believes that this stimulus must end in 2010 is that:

… the check writing is ultimately inflationary and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.


Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance.

Despite the Fed’s apparent plans, Gross thinks that the exit from quantitative easing will not be so graceful:

Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. … foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds.

Although Gross doesn’t say so explicitly, the implication is that, in the absence of further Fed purchases, the market for Agency mortgages will be, to say the least, weak. Also, given that PIMCO and other funds have already loaded up on Treasuries, the US may face problems selling the new Treasury issuance that will be coming to market in 2010. Higher interest rates on mortgage securities and Treasuries would discourage investors, businesses, and consumers, providing strong headwinds against stock and bond markets and the economy.Putting this all together, Gross is predicting a “double whammy” resulting from (1) heavy debt loads in the “spendthrift” nations and (2) the withdrawal of government support from the financial markets:

Gross doesn’t see the Fed exit strategy as the only problem. Like others, he feels that budget deficits already incurred will be a drag on both the economy and the Treasury securities market for years to come. Interestingly, he quantified the impact:

Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.



Using 2007 as a starting point and 2014 as a near-term destination, the IMF numbers show that the U.S., Japan, and U.K. will experience “structural” deficit increases of 4-5% of GDP over that period of time, whereas Germany will move in the other direction. Germany, in fact, has just passed a constitutional amendment mandating budget balance by 2016.

Putting this all together, Gross sees a "double whammy" of debt loads for many nations plus the end of easy fiscal and monetary policies:

If these trends persist, the simple conclusion is that interest rates will rise on a relative basis in the U.S., U.K., and Japan compared to Germany over the next several years and that the increase could approximate 100 basis points or more.

… the shifting of private investment dollars to more fiscally responsible government bond markets … in 2010 and beyond.


Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009.

I recommend looking at Gross’s commentary for the chart comparing the deficits and debt levels of a number of large economies. It is fascinating that PIMCO is quantifying the impact of the US budget deficit in terms of bond pricing relative to more prudent countries.

Also, it is interesting to compare Gross’s statements to those of another PIMCO executive, Mohammed El Erian. In Fortune’s 2010 investment guide, El Erian expressed great doubts about the US economy’s ability to sustain any kind of recovery this year. That’s hardly the right environment for Fed tightening, but maybe PIMCO thinks that the Fed has run out of ammunition.  Credit rating agencies have warned that the US must cut back spending or else risk a downgrade.

 No Fed Exit in 2010

The RGE Monitor, Nouriel Roubini’s website recently published an article that argued against any tightening during 2010. The core of their prediction was:

But we expect carry trades to resume in 2010 as policy rates stay at or near zero in the major economies and inflation leads to further EM and commodity-country rate hikes …. We expect the Fed to stay on hold throughout 2010 ...

This is a complete turnabout for Roubini, since not long ago he was writing about the danger that accommodative monetary policies would fuel a continued carry trade on the US dollar and fuel dangerous bubbles in financial markets around the world.

Perhaps Roubini has a point about near zero rates. With unemployment running around 10%, will the Fed dare to tighten ahead of the November midterm elections? With fiscal stimulus running out in the second half of the year, monetary tightening may be out of the question.

In contrast to Roubini, Gross’s prediction is based on Fed and Administration expectations of a self-sustaining economy (do we believe that?) and the supposition that the Fed is being forced to clean up its own balance sheet.  Given the extent to which much of the world is dependent on the US economy, it hardly seems likely that anyone would encourage the Fed to tighten when the economy is at best fragile.  Thewarnings of Fitch et al. hardly matter compared to the stances taken by the central bankers of the world.

 No Fed Exit and a Commodities Bubble


In "Roubini v. Gross on Outlook for 2010", Yves at the Naked Capitalist blog points out that if Roubini is correct and the Fed does not tighten in 2010, the markets will create their own organic problems. The reasoning is that continued accommodation will encourage risk-seeking trades (carry trade in the US dollar) that will push money into “hot” assets. In this view, the most dangerous recipient of these flows is commodities. As we saw during the last oil bubble, rising commodity prices produce a drag on the economy – a drag that 2010’s fragile economy can hardly afford.

Warnings about rising commodity prices are already appearing in the press, such as this recent article this recent article  in the Wall Street Journal, and a growing global asset price bubble is depicted on the latest cover of The Economist.  There is some justification for these warnings, because the valuation of the US stock market is approaching historical highs on fundamental measures, and a number of emerging stock and real estate markets are looking overheated.  As we have seen during the past decade, inflating bubbles can persist for a quite some time before they burst.

Negative feedback from a slowing economy would eventually burst the bubble – but damage would already have been done to both the economy and financial markets.

The Fundamental Problems Remain

I don’t know which, if any, of these views will turn out to be correct, but the Fed is in a dilemma. Despite massive quantitative easing last year, the underlying problems weren’t solved, they were only postponed. We still have heavy public and private debt loads, banks holding impaired financial assets, and unaffordable home prices. Remove the lax monetary and fiscal policies and the financial markets will dry up, credit will tighten, and the economy will suffer. Continue the laxity and money will flow where it can find a return, into bubbles, not into the basic US economy.

Whether the Fed tightens or not in 2010, the financial markets and the economy are still caught between the Scylla of crushing debt and the Charybdis of unbridled speculation.