Tuesday Articles: Case Shiller, Roubini, John Mauldin

Courtesy of The Big Picture: Case Shiller Index Declines 19.1% in Q1 2009:

Well, I asked for lower prices earlier, and that’s what we got:

Home prices continued falling at record paces, according to the Case Shiller Home Price Index.

Annual (-19.1%), quarterly (-7.5%) and monthly (-2.2%) data continue to show prices reverting back towards levels not seen for years.


March 2009 Case Shiller Home Price Index


As of the most data, prices have returned to 2002 levels; Will pre-2000 levels be next?


S&P/Case-Shiller U.S. National Home Price Index



Nationally, Home Prices Began 2009 with Record Declines
S&P, May 26, 2009


Nouriel Roubini in a Forbes article on why we shouldn’t believe the economic optimists (ie. The “Green Shoot”-ers).


John Mauldin’s Frontline Thoughts letter for this week is The Paradox of Deficits. He is increasingly concerned about the escalation of the US deficit and concludes that US investors may be better serve thinking globally in the coming months and years. Some excerpts:

And now let’s look at what is bumping in my worry closet. The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion. Maybe. Look at the yield curve on US government debt below (Bloomberg). US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn’t do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

I think the bond market is looking a few years down the road and saying that $1- trillion deficits are simply not capable of being financed. And if the debt is monetized, then inflation is going to become a very serious issue.

When you run deficits that are 4-6-8% or more than nominal GDP, at some point things simply back up. Can we ride along for a few years? Certainly. Japan is getting ready to see its debt-to-GDP ratio rise to almost 200%. But everybody can’t do it all at once. Call it the Paradox of Deficits. We have been running a large trade deficit in the US for years, because the people (China, Japan, and the Middle East) who wanted to sell us “stuff” were kind enough to turn around and invest the money in our bonds. This in turn created Greenspan’s conundrum, as it helped keep down US (and global) interest rates. Combine that with a massive increase in leverage, a few bubbles, and we now arrive at a true crisis. Deficits are not necessarily a bad thing if kept in check and restraint is shown. But everyone cannot run deficits at the same time. If we don’t buy $700 billion in goods, then that money cannot be recycled back to our debt. It is that simple.

Europe, Japan, and the US cannot try to borrow $5 trillion in the next two years without a serious distortion of the bond market, not to mention the entire economic landscape. I have long thought that “crunch time,” the end game, would show up around 2013-14. But I never in my wildest imaginings thought we could run an almost $2 trillion deficit. That crazy guy on the corner telling us “The end is nigh”? He may be right.

Long before we get to 2015, let alone 2019, I think the bond markets will have called a halt to $1 trillion deficits. There will be a real crisis. The deficits will not be funded at anywhere close to an interest rate that will not break the budget. Taxes will get raised beyond what they were in the Clinton years. And Obama’s budget makes some very optimistic judgments about how much will be saved in medical costs, as if no one has tried to rein in medical costs before. The crisis may come much sooner if his universal health-care bill is passed as proposed without offsetting cuts somewhere else.

Watch the bond market. Rates should be going down, not up. The bond market is telling us the deficit simply can’t be financed down the road. Now, maybe a few cool heads in the Democratic Party will prevail in the US Senate and the deficits will be brought under control. (The Republicans have so far seemed as clueless as they are impotent.) We could (theoretically) run $400 billion deficits for a very long time, as GDP would be growing somewhat faster.

It would be best to run budget surpluses, but the game does not end if there are reasonable deficits. It ends with deficits that cannot be funded except by monetization. And that will tank the dollar, except against all the other countries that are monetizing their debt.

I am increasingly inclined to think that as the world comes out of its current malaise – and it will – US investors should think more globally with their investment portfolios. That is something we will explore over the coming year. But that’s enough for today.

Barrons: Do Be Wary of Green Shoots

Barrons: Do Be Wary of Green Shoots:

family:Verdana,Arial,Sans-Serif;font-size:11px;">family:Verdana,Arial,Sans-Serif;font-size:11;" >By RANDALL W. FORSYTH | javascript:document.byAuthorForm.submit()" id="ArticlesByAuthor" style="padding: 0pt 14px 0pt 5px; text-decoration: none;" class="p10 unvisited">MORE ARTICLES BY AUTHOR

Hold your horses on calling a new bull market — the bear has several years to go.

BLAME THE BRITS. WHEN STANDARD & POOR’S SUGGESTED last week that the credit of the United Kingdom mightn’t be exactly sterling because of its deficits and bailouts, it cast a worse light on America’s standing. But an even worse blight has spread across the Atlantic.

It’s said we are two nations separated by a common language, though English is hardly the lingua franca it once was on these shores. Be that as it may, Yanks have adopted a turn of phrase originated on the other side of pond, the “green shoots” that keep popping up everywhere.

It was originated by former British Chancellor of the Exchequer Norman Lamont, who was quoted as spotting green shoots in the British economy back in 1991, recalls Mark Turner, who heads the Pentagram Fund, a hedge fund that scored a 70% return in last year’s collapse. Of course, Lamont would go on to oversee the ignominious withdrawal of the pound from the European Exchange Rate Mechanism the next year, which netted an infamous $1 billion windfall for George Soros.

So, why the attraction of green shoots? One can only speculate that they must be in some ways intoxicating. Perhaps not the shoots exactly, or the stems or seeds, but the leaves of a certain plant. Those might be smoked or otherwise ingested to bring about a euphoric effect. From what I’ve read, the current crop is far more potent than the commodity available in years past. How else to explain the mind-bending notion that an economy that is declining less quickly is somehow improving?

Yet, in a world going to pot, nothing should be dismissed. Prior to the resounding rejection by California’s voters of various patches for the state’s budget deficit, Gov. Arnold Schwarzenegger seemed open to a legislative proposal to legalize marijuana and tax it. Now facing a $21 billion budget deficit, the “Governator” isn’t in a position to just say No to anything.

As an alternative, the state’s treasurer called on the federal government to guarantee California’s borrowings in a way the Ford Administration declined to do back in the New York fiscal crisis of the 1970s. That, of course, led to the immortal New York Daily News headline, “Ford to City: Drop Dead.”

Having bailed out the banks and provided a lifeline to Chrysler and General Motors, how does Washington tell California, the eighth-largest economy in the world, to drop dead? That’s the slippery slope that America’s credit rating is on.

LAST YEAR, MANY CELEBRATED THE 40TH anniversary of the tumultuous events of 1968, a year that changed history, at least in the view of Baby Boomers who date it in terms of BE and AE (Before Elvis and After Elvis.)

Market historians have been pointing to 1938 as an antecedent for this year’s action, as Mike Santoli has noted in his Streetwise column. So, too, has Louise Yamada, the doyenne of technical analysts, who now counsels clients via her LY Advisors after her long career at Smith Barney. Citigroup (C), in one of its many deft moves before it became a ward of the state, decided to axe Smith Barney’s highly regarded technical-analysis group back in the middle of the decade.

“It is almost uncanny the degree to which 2002-08 has tracked 1932-38,” Yamada writes in her latest note to clients. She has posited in her so-called Alternate Hypothesis that the structural bear market would be less like its most recent predecessor, from 1966-82, and more like 1929-42.

So the dot-com collapse parallels the Great Crash and its aftermath, followed by a rather nice recovery in 2003-07, similar to 1933-37. The parallels continue, with the collapse from late last year into this March tracing a similar, sickening trajectory to late 1937-38, as illustrated in Louise’s chart nearby. That drop led to a strong reaction rally, not unlike the current one, for a total gain of 60%. But that was broken into three segments: an initial rally of 46%, similar to the move from the March lows. Then we saw a 10% pullback, not unusual in a rally, then another gain of 22%.


From there comes the hard part. Starting in November 1938, there was a 22% drop, qualifying for the 20% rule-of-thumb definition of a bear market; then a rally of 26%, fitting the definition of a bull market, into the fateful month of September 1939, the start of World War II.

Then came a series of bull and bear trades — down 28%, up 23%, down 16%, up 13%, and the final decline into 1942 of 29%. After this nauseating roller-coaster ride, the market was down 41% from the 1938 highs (analogous to where we are now) to the 1942 lows.

The positive aspect of this, writes Yamada, is that the arduous process permitted individual stock consolidations to develop over years ultimately provided the base for a bull market in 1942.

But, she emphasizes, that means investors probably face years of frustration if they think a new, sustained bull market has begun. Structural bear markets typically last 13 to 16 years. Given the declines that have been suffered so far — topped only by 1929-32 — the structural bear has several years to go to complete the repair process.

As for the current rebound, it is rather like a bungee jump, with an elastic snap-back after a terrifying plunge. And it has been a kind of worst-to-first move.

David Rosenberg, ensconced at Gluskin Sheff in Toronto after years of distinguished duty as Merrill Lynch’s North American chief economist, observes that the best performers have been the lowest-quality stocks or those with biggest short interest. “In other words, this was a rally built largely on short-covering, pension-fund rebalancing and the emergence of hope wrapped up in ‘green shoot’ data points,” he contends. That makes its sustainability in doubt.

But the move has left many on the platform as the train pulled out of the station, including some of the biggest swingers in hedge funds, who are known in the market just by their first names.

WHAT IS LIKELY TO DISAPPOINT THE BULLS is the pace of recovery in corporate profits, according to the perspicacious Smithers & Co. of London. Earnings per share — the sustenance of equity investors — will be hampered by punk economic growth ahead and the need to repair corporate balance sheets.

Investors had come to regard the record profit margins of recent years as the new norm. Last year’s were above average, despite the general perception they were squeezed.

Profits typically grow when the economy is expanding above trend, and vice versa. With U.S. growth likely to stabilize at only 1% into 2010, the outlook for earnings is apt to be, in a word, lousy.

Apart from the economic forces on profits, financial forces — depreciation, leverage, interest costs and taxes — are likely to push earnings per share down, Smithers observes. Deleveraging means share issuance rather than buybacks — a reversal of the trend of recent years that worked to the benefit of corporate chieftains’ bonuses. “The growth rate of earnings per share is thus likely to be worse than that indicated by profit margins alone,” his report logically infers.

The bottom line, as it were, is that when the economy recovers, the benefits to corporate earnings accruing to stockholders will be disappointing. That could make for a frustrating equity market until the healing is complete, a moment that, as Yamada’s profile suggests, could be years away.

Rising Job Losses = Rising Foreclosures

Barry Ritholtz of The Big Picture and other endeavors, gives his take on a recent NYT article. The article hammers home something so obvious–rising unemployment will lead to rising foreclosures even among prime borrowers–yet we barely hear about it in the media amid talks of ‘green shoots’. Ritholtz’s take:

“We’re about to have a big problem. Foreclosures were bad last year? It’s going to get worse.”

-Morris A. Davis, a real estate expert at the University of Wisconsin.

This is a theme I have been hammering on for some time: As more people lose their jobs, we will see increasing foreclosures, adding further stress to banks’ already ugly balance sheets.

As the New York Times notes, the number of prime mortgages that were “delinquent at least 90 days, were in foreclosure or had deteriorated to the point that the lender took possession of the home” jumped enormously as job losses accelerated. Over the period when BLS was reporting 500k plus job losses a month, from November’08 to February ‘09, the numbers of distressed properties “increased more than 473,000, exceeding 1.5 million.” Total loan value = more than $224 billion. (Sources: The Times, First American CoreLogic).

Thus, even if the recession ended tomorrow, the US will still have another 500k – one million foreclosures. And if the recession continues for another 6 months to a year, well, you do the math. (Hint: About 2 – 3 X as many)


“In the latest phase of the nation’s real estate disaster, the locus of trouble has shifted from subprime loans — those extended to home buyers with troubled credit — to the far more numerous prime loans issued to those with decent financial histories.

With many economists anticipating that the unemployment rate will rise into the double digits from its current 8.9 percent, foreclosures are expected to accelerate. That could exacerbate bank losses, adding pressure to the financial system and the broader economy. . .

Economists refer to the current surge of foreclosures as the third wave, distinct from the initial spike when speculators gave up property because of plunging real estate prices, and the secondary shock, when borrowers’ introductory interest rates expired and were reset higher.”

Note that these foreclosures are not the exotic no money down I/O ARMs from the early phase of the housing collapse. Rather, these are “modest borrowers whose loans fit their income.”

A few last data points to consider (as of February 2009):

• Foreclosure rates among prime borrowers have been growing fastest in states with higher unemployment.

• Economy.com expects mortgage defaults in 2009 caused by unemployment to double, from 29% in 2008 to 60% in 2009;

• Prime mortgages that are distressed (90 days delinquent, foreclosure, REO) are greater than 1.5 million;

• Alt-A loans — those given to people with slightly tainted credit — rose to 836,000.

• Subprime mortgages that were “distressed” reached 1.65 million;

• From February 2008 to Feb 2009, total dollar value of distressed mortgages increased 60% in dollar terms;

• More than four million loans worth $717 billion were “distressed” in February.

All told, that’s about 4 million problem mortgages out there. My guess is half go into foreclosure. So far, the Obama admin aid to homeowners have seen less than 55,000 mortgages modified.

What this means, for those of you still paying attention, is that we will see lower RE prices, more bank stress, a lot more distressed sales, and no normalization of RE markets for some time.

The best you can hope for is some “stabilization” — if you consider 60% or more of all existing home sales (and many new home sales) to be distressed sales, foreclosures or bank owned properties — as “stable.”

I got your real estate bottom right here . . .


click for larger graphic




Job Losses Push Safer Mortgages to Foreclosure


NYT May 24, 2009 http://www.nytimes.com/2009/05/25/business/economy/25foreclose.html

GMO Asset Class Forecasts, Rosenburg’s Economics Commentary

Happy Memorial Day Weekend!

GMO’s 7-year asset class return forecast is released monthly and this month’s report can be viewed here (pdf). Of the asset classes they track, they are projecting High Quality US Stocks to have the highest 7-year annualized return as of the end of April.

Compliments of Investment Postcards from Capetown, we have David Rosenburg’s (Gluskin Sheff & Associates) Economics Commentary (pdf) for May 20th. An easy to understand commentary on general economic conditions. Some highlights:

We are concerned that the market may have become just a tad too confident over the second-half inventory rebuild story. We have now had two, not one, declines in retail sales and we can see based on the incoming weekly data that May could be three-in-a-row. The ICSC-Goldman Sachs weekly retail sales index fell 1.2% in the May 16th week and is running at -0.5% sequentially from the April average. The Redbook results show pretty much the same degree of softness. We know that incomes are being supported by the Obama tax relief and social security payments so the savings rate must still be on a discernible rising trend. How that plays into sustainable reflation trades is truly anybody’s guess.

Not only have retail sales fallen for two months in a row, but so have housing starts, industrial production, and come to think of it, employment. So the view out there that the recession is close to being over and done with may have to go through a reassessment. Martin Feldstein (the dean of business-cycle determination during his tenure at the National Bureau of Economic Research)
put it best when he told the Wall Street Journal recently that “the optimistic interpretation of a number of recent statistics are incorrect – too optimistic. There’s a grabbing for good news, and when you dig down a little deeper, the news isn’t good”.

Markman, Mauldin Articles

Jon Markman discusses the bullish potential for natural gas in a recent article. Once again, Markman does his best to throw out some speculative penny stocks. XTMCF does look intriguing though…

John Mauldin features an article from Horace ‘Woody’ Brock in his Outside the Box series. Mauldin calls it “one of the most important Outside the Box letters I have sent out.” Here is a brief highlight:

Policies aimed at augmenting real growth are arguably the more important here. This is because more rapid growth not only reduces the Debt ratio, but also causes swelling tax revenues which can help to reduce the deficit each year. That is, stronger growth drives both the numerator and the denominator in the right directions.

This reality underscores why “It’s the real growth rate” must become the mantra of recoveries not only in the US, but almost everywhere else as well. Note that this “strong growth” mantra is a far cry from the Obama administration’s counsel to the world at the recent G-7 conference: “Stimulate everywhere by running higher deficits!”

Twelve policies are then laid out by the author that can help drive down the debt-to-GDP ratio. The article in its entirety is below:

The End Game Draws Nigh – The Future Evolution of the Debt-to-GDP Ratio

By Horace “Woody” Brock, Ph.D.

Preface: In this new report, we link together three quite different concepts that have been discussed in these publications during recent years. First, the problems posed for classical fiscal and monetary policy when extremely large deficits must be financed; second, the critical importance of the rate of economic growth as primus inter pares of all economic variables; and third, the all-important concept of “incentive-structure-compatibility” introduced by Leonid Hurwicz in the 1960s, and recognized in the award to him in 2007 of the Nobel Memorial Prize.

We weave these three concepts together so as to make possible an extension and generalization of “macroeconomic policy” as normally understood. Central to this extension is the need for policies that drive down the nation’s Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time.

Doing so not only points to a new set of policies for exiting today’s quagmire, but also permits an appraisal of the Obama administration’s current policy proposals. Regrettably these proposals do not fare well. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere.

A. Introduction and Overview

In our 2008 research programme, we focused on three issues. First, what exactly caused the worst credit crunch the nation has arguably experienced since the depression of the 1930s? Second, how did the downturn in the US morph into a collapse in Planet Earth’s GDP rate from nearly 5% in June 2008 to -0.5% in winter 2009? Third, can traditional macroeconomic policy suffice to turn around the economy? More specifically, will a killer application of classical fiscal and monetary policy truly restore the economy to a stable growth trajectory? Or is there an internal contradiction within macroeconomic policy that could prevent it from succeeding this time around?

To explain the “perfect storm” in the credit market, we drew extensively on the new Stanford theory of endogenous risk to demonstrate that there are three jointly necessary and sufficient conditions to predict and explain the perfect storm we have experienced: (i) A mistaken market forecast of some exogenous event that impacts security prices (in this case, a vastly higher than expected default rate on mortgages); (ii) A high level of Pricing Model Uncertainty bedeviling bank assets (the true cause of the “toxicity” of those complex securities that have clogged the

arteries of the banking sector); and (iii) An unprecedentedly high degree of leverage in the financial sector (money center banks had off-and-on balance sheet leverage of about 40:1 in contrast to the socially optimal leverage of 10:1). The reader can tack “greed” and “incompetence” onto this triad, although doing so diverts attention from the real causes of today’s crisis.

To explain the collapse of economic growth worldwide in an astonishingly short period, we utilized a game theory model that explained how the cessation of inter-bank lending amongst the principal money center banks of the world precipitated the first known case of global credit market emphysema: The availability of credit dried up almost everywhere in the course of six months, from Auckland to Iceland. We stressed that this credit contraction had little to do with “globalization” as properly understood, and had no counter-part in history.

To explain the potential failure of fiscal and monetary policy in restoring growth, we demonstrated how the financing of exceptionally large government deficits usually causes a sharp rise in longer-term real interest rates—a rise that bites back and offsets the GDP impact of the fiscal stimulus being applied. The logic leading to this conclusion is reviewed just below in the context of Figure 2.

B. The Good News — A World of Greatly Reduced Uncertainty

A year ago, even six months ago, the great debate centered on whether the credit market crisis would precipitate either a US or global recession. A majority predicted a manageable recession in the US, but nowhere else with the possible exception of the UK. Uncertainty was great, and kept increasing until recently—but no longer. The good news today is that this uncertainty has disappeared. For we now know with probability 1 that everything sucks everywhere. Welcome to a risk free world!

To wit, the G-7 economies are all in recession, and more astonishingly the economy of the planet earth is growing at about -1% or even less. Earnings are crumbling, global trade has decreased by nearly 10%, rising global unemployment foretokens social unrest in many quarters, industrial production has dropped more than ever before, and excess capacity is rising in almost all manufacturing sectors globally. Stephen Roach of Morgan Stanley believes that the “world output gap” could reach a mind boggling 8%–10% by year end. All in all, we have witnessed problems that originated within the US give rise to global scenarios that were virtually unthinkable as recently as the summer of 2008, and do so with blinding speed.

Within the US, there are two parallel problems. First, the nation faces a hitherto unprecedented growth of Federal debt, over both the short and long run. Second, there is the severity of the recession itself. Figure 1 offers a simple way of understanding what killed growth in the US economy. The variables shown remind us of the old adage that “History rhymes, but does not repeat.”

Figure 1: Essence of the US Economic Crisis

History Rhymes: More specifically, the contents of the figure will disturb those seeking to identify today’s US recession with earlier ones in 2001 or 1991 or 1981 or 1973 or even 1931. No such identification is possible since the three developments highlighted in the chart and their improbable synergies are different from anything we have seen before. This sui generic nature of today’s crisis explains why traditional theories of recessions and “debt super-cycles” possess little explanatory and predictive power.

For example, according to standard business cycle theory, “pent-up demand” on the part of consumers is a principal driver of recovery—but it will not be this time around. The shift towards less consumption and more savings due to the implosion of household balance sheets and to demographics is most probably permanent. If so, this bodes poorly for hopes of a pent-updemand-driven recovery.

History Repeats: While the context of today’s crisis differs from those in the past, history repeats itself in that the common denominator of this and all other debt crises has been excess leverage—our mantra in these pages for three years. Our greatest fear was that the all-important role of leverage would be sidestepped in the rush to assign blame and reform the financial system. In this regard, it is dismaying that, whereas we have now vented our anger at bankers and capped bonuses, we have not capped leverage. To be sure, there are calls for “improved bank capitalization” and related reforms, but the crucial role of excess leverage in bringing down the global financial system has not been properly recognized. Instead, excess “greed” has been the principal focus.

Then again, from a game theoretic viewpoint, it may not be surprising that the role of leverage has been underplayed. For leverage is precisely what is required for financiers to reap those huge incomes needed to fund both political parties in Washington, not to mention those “blockbuster” exhibitions we all love so much at the Metropolitan Museum of Art in New York. Stay tuned for Loophole Analysis 101.

C. The Bad News — Two New Uncertainties

Two new uncertainties are now rising to the fore. First, will traditional fiscal and monetary policy suffice to restore economic growth—and in the process restore the viability of the financial sector? Without the latter, there is little hope of revived growth. Our concerns about the inadequacy of traditional macroeconomic policy were discussed at length in our February 2009 PROFILE, and are summarized in Figure 2 taken from that analysis. The flattening out of the stimulus curve in the figure reflects that, when fiscal stimulus exceeds a certain level (e.g., 7% on the horizontal axis), the financing of deficits is likely to cause a sharp increase in real longer-term interest rates. Importantly, this holds true regardless of whether the huge deficits are monetized for reasons we carefully articulated. Higher real yields in turn neutralize the original fiscal stimulus, thus causing the curve to flatten out.1

We concluded that the risks of policy failure in today’s context are disturbing. Moreover, even if traditional policies do prove successful in the shorter run, there is a genuine risk that the huge amount of debt that accrues and must be serviced in the future could transform the US into a “banana republic” in the much longer run. This risk is heightened by the need to fund soaring Social Security and Medicare “entitlements,” as record numbers of baby-boomers retire during the next two decades. Moreover, as time goes on, it is precisely these longer-term risks that will matter most to the market, and will increasingly be discounted. Investors of every stripe will be impacted.

Figure 2: Decreasing Impact of Fiscal Stimulus

The second new uncertainty focuses on whether new and different fiscal and monetary policies can help salvage matters, and guarantee a happier ending.

If the effectiveness of traditional macroeconomic remedies is in doubt, can its arsenal of policies be expanded so as to restore strong longer-term equilibrium growth? The answer is yes, and it is the purpose of this new essay to sketch such an extension of classical macroeconomics.

D. The Critical Dynamics of the Debt-to-GDP Ratio

There is nothing new about a nation running into trouble and running up large amounts of debt in bailing itself out. There is also nothing new about attempting to monetize (via “quantitative easing”) the resulting accumulation of debt. The good news for the US is that its total federal debt of some $10T at the outset of the crisis in 2008 was a manageable 70% of current GDP of $14T.2 Suppose debt rises $3T by the end of 2011 as the Congressional Budget Office now predicts, and then rises $7T more by 2020. The result will have been a doubling of federal debt between 2008 and 2020, rising from $10T to $20T.3 While this increase is shocking, some forecasts are much worse.

Suppose, moreover, that GDP rises conservatively to $17 trillion in 2020 from today’s $14T as a result of a modest 2% GDP growth recovery between 2011 and 2020. Then the federal Debt-to-GDP ratio would rise from today’s 0.7 to 1.18. Interestingly, this does not represent the disaster many observers assume. To begin with, there are nations where a disturbingly high Debt-to-GDP ratio proceeded to fall way back down over time. Thus, the US Debt-to-GDP ratio was 1.25 at the end of World War II, yet it fell to 0.25 by 1980. Britain’s Debt ratio upon defeating Napoleon in 1815 was over 2.7, and it fell back to 0.2 by the end of the 19th century.

In other cases, the Debt-to-GDP ratio has stayed persistently high, neither increasing nor decreasing dramatically over time. Thus Japan has had a very high ratio of 1.5 to 1.8 for the past decade. Italy and Belgium, too, have sustained high ratios in the range of 1 to 1.25. Finally, there are the countries where the Debt ratio continues to rise after some initial shock with either hyperinflation or outright default being the end result. Such has been the fate of myriad banana republics including some large players such as Brazil, Argentina and Russia. What exactly determines which nations dig their way out, or else go under? This will be our primary focus in the pages ahead.

Rebounders versus “Banana Republics”: To begin with, note that what matters is not a onetime rise in the Debt-to-GDP ratio due to a particular shock (e.g., today’s US housing and credit crises), but rather the dynamic trajectory of the ratio in the years subsequent to the initial rise. It is the direction of this trajectory that is all-important. If the Debt ratio continues to rise, then it tends to accelerate due to the ever-rising cost of servicing this ever-rising “primary” deficit. Not only does the increasing debt-load itself cause ever-higher servicing costs, but the rising real rates that typically result from ever-greater debt make the spiral ever worse. The result can be economic and social collapse.

If, on the other hand, the Debt-to-GDP ratio stagnates, it tends to be associated with very low real growth, political paralysis, and a degree of social disenchantment. If the ratio falls, it is usually because of a combination of two developments: higher real growth and vigorous fiscal discipline. Rising living standards, dreams of a better future, and a sustained belief in democracy are associated with this happiest of trajectories.

Three Sets of Scenarios: Figures 3.A – 3.C illustrate the stunning range of outcomes that can result from sustained differences in the growth rates of debt versus of GDP. We have adapted the analysis here to the case of the US. We assume an initial federal debt burden of $12T for 2011, and an initial GDP value of $14T. We then grow these forward at the stipulated growth rates.

At the one extreme of very low economic growth and very high debt growth, the Debt ratio rises to an arresting 18—a half-way house to Zimbabwe. At the opposite extreme, the ratio falls to a paltry 0.4, half of today’s level. These two extreme outcomes are circled in the table.

The data in the tables represent real growth rates of both debt and GDP.

Figures 3a and 3b: Federal Debt Growth Scenarios

Figure 3c: 8% Federal Debt Growth Scenario

E. The Case for Driving Down the Debt-to-GDP Ratio – “It’s the Growth Rate, Stupid!”

We can deduce from the foregoing analysis that sustainable long run economic recovery from a debt overload requires two sets of policies: One set must be dedicated to curtailing the growth of government spending and hence, the growth of the deficit. The other set must be dedicated to maximizing real economic growth. In this way, both the numerator and the denominator of the killer Debt-to-GDP ratio will be managed so as to maximize future social welfare.

Policies aimed at augmenting real growth are arguably the more important here. This is because more rapid growth not only reduces the Debt ratio, but also causes swelling tax revenues which can help to reduce the deficit each year. That is, stronger growth drives both the numerator and the denominator in the right directions.

This reality underscores why “It’s the real growth rate” must become the mantra of recoveries not only in the US, but almost everywhere else as well. Note that this “strong growth” mantra is a far cry from the Obama administration’s counsel to the world at the recent G-7 conference: “Stimulate everywhere by running higher deficits!”

The True Payoffs from Strong Growth: Looking at matters from a game theoretical “Who wins?” standpoint, strong economic growth is the rising tide that lifts all ships. Within a given nation, it alone offers win-win strategies whereby most all interest groups can come out ahead. Externally across nations, strong growth generates expanding trade. Happily, the game of trade between nations is that all-important positive-sum game that encourages peace and discourages war. It creates “the ties that bind.” For example, the recent globalization of the supply chain is a principal reason why the business community has been so strangely silent in demanding protectionist policies during the present crisis. When a significant portion of your own manufacturing inputs come from “abroad,” do you really want trade barriers?

Finally, and perhaps most importantly, productivity-driven strong growth alone increases living standards that boost the hopes and dreams of people everywhere for a better tomorrow for their children. When citizens have realistic hopes of a better tomorrow, social unrest is minimized. Conversely, when prospects for the long run are grim, voters are easily swayed by demagogues to vote for the Hitler of their day.

Three Important Books: Are these points obvious? They should be, but they frankly are not. Moreover, they are never sufficiently emphasized, and virtually no orientation towards rapid future growth is evident in the policies and “reforms” proposed by the Obama administration, as we see in Section G below. The arguments set forth in three books support the view we are taking as regards the critical role of growth.

First, a widespread lack of understanding and appreciation of growth led Professor Ben Friedman of Harvard University to write his superb book, The Moral Consequences of Economic Growth (A. Knopf, 2005). This is the best work we know of that makes the case for growth and (more implicitly) for globalization at an appropriate economic and moral level of analysis.

Second, and at a more practical level, Alan Beattie’s brand new book False Economy: A Surprising Economic History of the World (Riverhead Press, 2009) provides myriad case studies of how nations chose between success or survival or ruin by the specific policies they adopt. His case studies make very clear indeed how policies that depress the Debt-to-GDP ratio of Figure 3 correlate strongly with success, whereas policies that inflate the ratio correlate with ruin.

Third, at an even deeper and more theoretical level, there is the late Mancur Olson’s magisterial The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities (Yale University Press, 1982). Olson explains from first principles how special interest groups become entrenched and, in defending their turf, usually cause nations to go bust. [Our “entitlements lobby” anybody?]

Olson’s logic is game theoretical: He shows that special interest groups become the principal players in a generalized Prisoner’s Dilemma game whereby individually group-rational strategies lead to the collectively irrational outcomes of declining growth, diminishing dreams, increasing social unrest, and ultimately ruin.

This book should be required reading by anyone serving in government. It is one of the best books the present author has ever read in the field of political economy.

F. Four Debt-Minimizing Strategies

Before turning to those all-important strategies for maximizing the growth in the denominator of the Debt-to-GDP ratio, consider several different strategies for minimizing the growth of the numerator.

First, counter-cyclical policies should consist of temporary increases in spending—spending that automatically expires with no Congressional vote when good times return. The Obama administration policies largely amount to permanent spending increases, and have been widely criticized as such.

Second, a new set of government accounts must be introduced that clearly distinguish government investment expenditures from non-investment expenditures. The former should not be included as part of “the deficit.” Only an appropriately amortized portion should be included. Moreover, for reasons stressed below, infrastructure investments should take priority when discretionary government spending decisions are made. The current administration has not proposed the required accounting changes. This is, of course, consistent with its failure to propose serious investment spending in the first place (see below).

Third, true leadership—not to be confused with fine rhetoric—is needed to alert citizens to the true disaster we face if the growth of long-term federal debt is not curtailed. This is particularly true given the demographic realities that now lie around the corner. Nobody has made this point better than Stephen Roach in a recent commentary in Morgan Stanley’s “Debating the Future of Capitalism” series, March 26, 2009:

I believe that Congress and the White House should collectively declare a formal “fiscal emergency” and empower a bi-partisan task force to develop new guidelines for federal budgetary control.

Washington did this once before in an effort to contain the runaway budget deficits of the Reagan era—deficits that now look like child’s play when compared with what lies ahead. The automatic spending caps and sequestration mechanisms prescribed by the GrammRudman-Hollings Balanced Budget and Emergency Deficit Control Acts of 1985 succeeded in taking some of the optionality out of the fiscal debate.

This problem is too big—and the long-term stakes are too high—for fiscal sustainability to be entrusted to the oft-politicized whims of the year-by-year discretionary budgeting process.

Slam Dunk! Given the reality that today’s deficit crisis far exceeds that of the Reagan era, it is all the more irresponsible that the President has not already proposed the “fiscal emergency task force” that Roach correctly calls for. Paul Volcker: Where are you when we need you the most? The reforms that such a task force would propose are all pretty obvious, including “sunset provisions” for all manner of government mandates, entitlement reforms, an end of ear-marking, etc.

Fourth, as noted in Section E above, policies must be adopted that maximize economic growth since faster growth is the best way to generate those higher revenues needed to reduce a given deficit. We identify specific growth policies just below.

Lingering Doubts: Even longstanding Democratic Party liberals are now expressing shock at the staggering growth of long-term government debt the US now confronts. Nonetheless, the President’s cheerful rhetoric suggests little concern with the growth of the numerator. To be sure, his administration’s OMB budget projections blithely assume that very high growth rates will magically return after the next three years, and nothing solves fiscal problems as well as rapid growth. Yet everyone acknowledges that these projections are smoke-and-mirrors, constituting a leadership default of the first magnitude.

Yet could all of this be deliberate? Could the administration’s choice to tax and spend ad infinitum have been politically strategic in nature? After all, haven’t both President Obama and his chief of staff Rahm Emanuel openly admitted that “the new budget is a means to altering the very architecture of American life, with government playing a much larger role than before”? The likelihood that their new architecture would drive the growth of numerator of the Debt-to-GDP ratio ever-higher and the growth of the denominator lower was never mentioned.

Do financial commentators even understand this risk? While the press has expressed appropriate “concern” about the sea of red ink to come, there is little sense of the true End Game at stake: Which of our Figure 3 scenarios will occur, and what will it imply?

The answer may well determine whether we face a future of peace and prosperity, or of war and privation. As a personal aside, this author has never been more concerned than he is now about the economic state of the nation.

G. Growth-Maximizing Strategies

We now identify a plethora of growth-maximizing policies. Before doing so, however, we must recall the true origins of economic growth itself. Only by understanding these origins can we identify meaningful pro-growth policies.

G. 1. The Two Principal Sources of Real Economic Growth

At the most basic level, trend growth is the sum of workforce growth plus productivity growth. Intuitively, this rate of growth equals the rate of growth of the number of workers producing the pie, plus the rate of increase of pie production per person hour. In the latter case, we distinguish between productivity increases that result solely from “working smarter” versus increases that result from increased investment per worker, or “factor stuffing” in economics jargon. The former is called pure labor productivity growth (e.g., take a weekend off and invent the differential calculus), whereas the latter is referred to as total factor productivity growth.

The very rapid growth of emerging economies is usually due to a very high rate of increase in total factor productivity growth as workers gain access to roads, computers, medicines, and other productivity-improving (but not free!) endowments for the first time. Developed economies cannot replicate this strategy, so their growth rate is much lower than the “catch-up” rates in newer economies.

Thus, policies that augment growth must operate through two channels: Increasing productivity growth (via enhanced skills and investment), and/or increasing workforce growth.

Incentive-Structure-Compatibility: In proposing pro-growth policies of both kinds, we shall keep in mind the requirement that such policies be “incentive-structure-compatible” with growth, a concept first articulated by the economist and philosopher Leonid Hurwicz in the late 1950s. Everyone acknowledges the importance of incentives in a given situation, e.g., the appropriate carrots and sticks needed to raise children, to motivate workers, etc.

What Hurwicz first articulated was the way in which the totality of incentives throughout society—its “incentive structure”—could be conducive to achieving a particular societal goal, such as maximal growth. The great importance of Hurwicz’s concept is that it provides the correct analytical bridge between the micro and macro domains of social life. This was a stunning achievement, and earned him the 2007 Nobel Memorial Prize.4

Most “policies” and “goals” promulgated by politicians turn out not to be incentivestructure-compatible with growth, or with any other defensible objective. That is to say, most policy proposals are hot air.

Figure 3 summarizes the structure of our argument up to this point.

Figure 4: Requisite Policies

G.2. Productivity-Enhancing Growth Strategies

During the past three decades, a great deal of research has been done to understand the true sources of productivity growth. In particular, Paul Romer of Stanford University developed his theory of “endogenous growth” in which the rate of productivity growth is determined within the economic system, as opposed to being modeled as an external “residual” as it previously had been. In what follows, we draw on this and related research in an informal manner.

1. Infrastructure-Orientated Fiscal Stimulus: Economists increasingly believe that consumption will fall by 7% from its 72% share of US GDP in 2007 to around 65% over the next three years. Moreover, they believe it will remain at a significantly lower level. Pessimists conclude that “without a recovery of household spending to previous levels, the economy will suffer for a long time.” Yet this is not the case.

Should investment spending (both in the corporate sector and in government infrastructure spending) rise by an offsetting 7% of GDP, the growth rate of GDP will not only match, but in fact exceed its old rate of growth. This is due to the role of classical macroeconomic “accelerator/multiplier” theory: A dollar invested will generate much greater future output than a dollar of transfer payments or consumption-stimulating tax cuts.

As regards today’s humongous fiscal deficits, this reality implies that, the more the deficit is dedicated to infrastructure investment each year, then (i) the greater productivity will be (recall that investment raises productivity), and (ii) the greater both job growth and output will be over time via the Keynesian multiplier theory. Since virtually everyone recognizes that US infrastructure spending has been woefully inadequate for decades, and that consumption has been excessive, the current recession has, in fact, presented the government with a golden opportunity to “rebalance” the composition of GDP in a highly desirable manner.

Yet there are two additional reasons why the increased deficit should be infrastructure-investment-orientated. First, government expenditure on productivity-raising investment is not, in fact, “an expenditure” that raises the deficit and frightens bond market vigilantes. For as explained above, government investment spending of this ilk should be amortized over time. Thus, the larger the investment share of a given stimulus package, the smaller the resulting deficit. Second, to the extent that today’s deficit explosion burdens the young with much more debt to be serviced, then it is our moral obligation to dedicate the extra spending to investments that raise the productivity growth and thus the size the future GDP. Doing so clearly reduces the real burden on future tax payers of servicing the debt being accumulated today.

Given this rare opportunity—and moral obligation—to tilt the economy towards long overdue investment spending, how can the Obama stimulus package have fallen so short of the mark? It is frankly embarrassing to witness Chinese policy advisors like Professor Yu Qiao of Tsinghua University scolding the US about something as basic as this:

Most of Mr. Obama’s stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America’s over-consumption problem and delay sustainable recovery.

Financial Times, Editorial page, April 1, 2009

Qiao’s point parallels a principal point we are making in this essay. Why are we not reading this from Christina Romer or Larry Summers in Washington? Have the Best and the Brightest once again lost their moral integrity as they did during the Vietnam War era? Can they seriously believe that more transfer payments to Democratic Party special interest groups is what the nation needs in this hour of its distress? The author considers the composition of the proposed $3 trillion of discretionary stimulus over the next five years a moral travesty.

Case Study of Energy: As a case study in how poor the administration’s policies are in this regard, consider its energy policies. Is anyone in the new administration reading about the disastrous 9% annual decrease in the output of “old” oil (yes, “peak oil” turned out to be true), in conjunction with a collapse of previously scheduled investments in exploration and development, and in refining capacity? Are they blind to the supply-crisis that is unfolding, one that calls not only for “renewable energy,” but also for a major expansion of traditional oil and gas production?

By now, has it not become crystal clear that the increased production of traditional fuels should come from within the US, given the devolution of both the political leadership and the infrastructure of those thugocracies upon whom the US increasingly depends for 40% of its consumption? Is no thought being given to the rising probability of $500 oil prices—or perhaps outright rationing—when global energy demand recovers? [Recall how jointly price-inelastic demand and supply curves cause huge changes in price both upward and downward, as we demonstrated mathematically five years ago.]

Elementary arithmetic is all that is needed to ascertain that the administration’s BTU gains from increased renewable energy production and conservation from increased “weather-stripping” will not yield even 10% of the BTU shortfall that the nation will confront. The reality, therefore, is that the country needs a vast expenditure of funds on novel and traditional sources of energy, as well as on our deteriorating energy infrastructure. Expenditures of this kind would create several million jobs of precisely the kind that are needed during the next decade. And they would leave the next generation with an improved infrastructure, in addition to lessening our extraordinary dependence on imports from rogue states.

But what do we get from the Obama team? A present value tax hike of up to $400 billion on “big oil” in one form or another, along with weather-stripping tax credits and expenditures on renewable energy alone. And who is the newly appointed spokesman for national energy policy? A highly credentialed academic who strikes virtually everyone as indecisive and ineffectual. Does even one reader of this essay know his name? [Steven Chu] Of course, his Nobel Prize supposedly substitutes for his lack of political skills. By extension, are we about to witness the “quant” financial theorist Myron Scholes appointed as Treasury Secretary after Tim Geithner steps down? After all, Scholes too, is a Nobel laureate, even if his notorious “pricing models” helped to bring down Long Term Capital Management and then the world economy a decade later. The Lord save us from “The best and the brightest!”

2. Stimulation of Innovation and Venture Capital: While increased infrastructure investment is one channel to higher productivity growth (and hence higher GDP growth), innovation is another. As someone who lived in Menlo Park, California for two decades between 1980 and 2000, the author was privileged to witness first hand the stunning comeback of the US from its “rust bowl” status of the 1970s.

The comeback was almost entirely due to a broad array of venture capital sponsored innovations, starting with the micro-processor. In a Memo he wrote for Mssrs. Clinton and Rubin in 1996, the author demonstrated that the US had an “Innovation Quotient” 17 times higher than that of our next competitor. [Finland. Think Nokia!] As a result, US productivity growth doubled from its depressed level of 1.4% in the 1970s to 3% by the late 1990s and early 2000s. No other nation came close to this achievement.

Yet now, when we need renewed innovation and enhanced productivity growth as much as we did in the 1970s, we read that the Obama Treasury Secretary Geithner has proposed to regulate the venture capital industry. Specifically, he has called for mandatory SEC registration of large firms, lest the sector become a “systemic risk” like hedge funds and proprietary trading desks. As Jack Biddle of the VC firm Novak Biddle Venture Partners has pointed out in a Wall Street Journal interview (April 9, 2009):

I cannot imagine any venture capital firm being of a size to pose ‘systemic risk,’ so they (the administration) either do not understand the nature of the business, or…What Washington needs to understand is that bank-style regulation could destroy the culture that created the micro-processor.

3. Education and Elitism: In contemplating the sources of productivity growth, we would all do well to recall Isaac Newton’s celebrated confession that, in developing his theory of mechanics and the differential calculus, “I stood on the shoulders of giants.” Politically incorrect as it is to admit, we need policies that identify and reward elite young people and entrepreneurs from a very early age, and do so regardless of where they come from. Indeed, we should be seeking young scientific talent worldwide and paying for immigrants to come to the US and study.

Instead, the stimulus package dedicates significant funds to lowest common denominator educational expenditures. In particular, virtually nothing is being proposed to end the monopoly of teachers’ unions that discourages qualified teachers from attempting to teach. The consequences for productivity growth of the longstanding decline of our public schools is by now well known, and has been articulated by public figures ranging from Bill Clinton to Bill Gates and Steve Jobs.

4. Taxation that Rewards Innovation and Success: Both the president and his chief of staff Rahm Emanuel have been completely candid about their redistributionist agenda—an agenda that has even alarmed European liberals. Were they at all concerned with innovation, productivity, and growth, the administration would not publicly espouse taxation policies that punish success and reward failure. In particular, they would not have declared war on small business, since small businesses typically generate the bulk of new jobs and innovations that determine the rate of economic growth.

To be sure, disparities in the current tax code do permit Warren Buffet to incur a much lower tax rate than his receptionist, as he quipped. Such inequities must be remedied. But the fact remains that the top decile and quartile of income earners in the US pay a larger share of government tax revenues than in any other G-7 nation. If so, why does the president assume it is “fair” to hike the tax rates on top income earners, and only on this group? From an employment standpoint, the new tax rates may well send talented young Americans to live elsewhere. Starting in 2011, a New York City wage earner will pay a marginal tax rate (federal, state, and local) of over 60% on “high” incomes of $200,000. This rate is higher than comparable rates in Germany and France where taxes paid secure decent schooling and medical care, which they do not in the US. Yet even so, France has witnessed a veritable diaspora of young talent to London, the US, and Switzerland during the past two decades.

5. Incentives for Investment in the Private Sector: Productivity growth comes not only from government-sponsored infrastructure of the kind discussed above, but also from investment by private businesses of all sizes in new capital stock. It is not clear what the new tax policy will be towards investment tax credits, but such credits have not yet been identified as important. They are important, especially at a time when the search for higher productivity and hence higher economic growth must become the nation’s number one priority.

6. Less Regulation, Not More: “Re-regulation” is back in vogue. But increased regulation where it’s not needed chokes off innovation and growth. While the financial sector clearly needs re-regulation, it is not clear that other sectors do. Should the new administration become growth-oriented, then it must be very careful not to choke off the all-important forces of “creative destruction.”

Even in the financial sector, overkill is likely. In our own view, two general forms of regulation are needed. First, incentives must be properly aligned (e.g., banks issuing securitized products must hold a certain proportion of such products in-house.) Second, leverage must be radically curtailed, a point we have stressed for three years. As for “excess pay,” the limitation of leverage and proper alignment of incentives will automatically remedy most excesses of recent years. In brief, the less regulation the better.

G.3. Workforce-Enhancing Growth Strategies

1. Strong GDP Growth: The six growth-maximizing strategies above will do more to boost workforce growth than anything else. The strong correlation of workforce growth and GDP growth is well understood at both an empirical and theoretical level. Most important, perhaps, is the need to stimulate innovation so that new industries can rise and replace old industries via the unfettered forces of creative destruction. Indeed, new industries have contributed over 75% of job growth in the US during recent decades. Numerous studies have shown how policies preventing creative destruction within most of Europe depressed private sector job creation during recent decades. Most job creation occurred in the public sector. Regrettably, none of these employment realities have been discussed by the new administration.

2. Deficit Composition: Utilization of today’s huge deficits for boosting investment expenditures triggers those accelerator/multiplier effects cited above that boost employment far more than transfer payments or tax cuts do. Yet the administration’s stimulus package is very infrastructure-lite, as was discussed above.

3. Deregulation of the Labor Market: Labor unions have long wanted to return to the practices of card-check balloting (or majority sign-up) without secret balloting. Yet such practices are definitionally anticompetitive, and retard employment growth. The administration initially supported card-check legislation or the so-called Employee Free Choice Act, but does not have enough votes to impose it. As to the tricky issue of immigration, the Obama team is doing a good job to date supporting rights for undocumented workers who have played such an important role in the nation’s economic history, and must continue to do so in the future.

4. Managing Demographic Change within the Labor Market: There will be new and important tensions within the US labor market, given the likely influx of millions of post-65 year old boomers. It is becoming clear that the retirement planning of this generation was woeful, with up to half of boomers expecting they could afford a retirement financed by the ever-rising values of stocks and houses. Such expectations have been shattered, and many boomers will have to work until age 75 to afford the lives they expect.

In many ways, this is a good development. However, it presupposes that the requisite jobs exist. Yet they will not exist unless labor markets are deregulated, not re-regulated. In particular, minimum wages and guaranteed hours of work must go by the boards. Maximum flexibility will be needed to equate supply and demand in the labor market, thereby reducing tensions between older and younger job-seekers. Such tensions have already begun to appear in today’s scramble for jobs.

A welcome dividend of elderly workers joining the workforce will be the reduction of the Social Security Trust Fund deficit. If the average retirement age de facto (not de jure) rises from 64 to 70, trillions of dollars of unfunded liabilities will evaporate as people draw upon their Social Security entitlements later, and contribute longer. The present value of the resulting fiscal savings is truly huge, making it all the more important that the US labor market become as flexible and efficient as possible. The administration has never touched upon this issue.

5. Tax Policy: Any student of public finance will recall that the best kind of tax is the tax that least distorts the efficiency of the economy. The Value Added Tax (VAT) is well known to be optimal in this regard. Conversely, taxes on labor (e.g., income taxes) distort workforce growth and thus, economic efficiency the most. But the administration is wedded to higher taxes on labor, and has never proposed a VAT.

This concludes our identification of over a dozen policies that can drive the Debt-to GDP ratio down. Please note that each of the pro-growth strategies is incentive-structure-compatible with growth, as desired and as promised up front.

H. Conclusion: When Being “Smart” Is Not Enough

This essay began with a demonstration of the all-important role of the evolution of a nation’s Debt-to-GDP ratio. The direction of this evolution is a good proxy for the future success or failure of the nation. We argued that a one-time shock (like today’s US recession) that drives the initial Debt ratio way up does not pose the problem most people assume. Long run recovery is possible, but only if policies are adopted that drive the growth rate of the numerator down, that of the denominator up, and thus that of the ratio down.

We then identified over a dozen policies that can achieve the goal of driving down the Debt-to-GDP ratio in the longer term. The End Game that is now being played is whether policies of this kind are adopted, or whether they are not. In our view, the Obama administration has adopted both a philosophical perspective and a set of policies that will drive the ratio up. If this is indeed the price of a “new American social architecture,” then it is a price that is too high.

We also proposed that these “ratio management policies” should be viewed as a refinement, and indeed an extension of classical monetary and fiscal policy. They add a new dimension to the concept of “macroeconomic policy,” and to its objectives.

Why do so few administration spokesmen or economic commentators seem to share our views? Is “politics” the problem? We do not think so, at least to the extent that growth-maximizing policies are win-win policies that any good politician should be able to sell. No, the problem is rather one of the mind-set of a generation that has never before needed to confront the problems lying ahead, and that is tone deaf to philosophical issues, as opposed to “policy wonk” issues.

Today’s True Challenge — Governance: In this vein, we proposed at the end of our February 2009 PROFILE that the root problems of today are not macroeconomic as much as they are political philosophical: How can democracy save itself from itself? How can people be made to realize that a reform of governance is what is now most needed—more so even than a reform of Wall Street? And even in the financial sector, it is increasingly clear that regulatory lapses in Washington were more responsible than “greed” for what has happened. Messrs. Rubin, Summers, and Greenspan actively encouraged the most pernicious of the deregulatory policies that brought down the system.

By now, it is clear that we need bold new constitutional amendments that mandate (i) sterilization of excess money creation during cyclical recoveries, (ii) fiscal surpluses during recoveries to pay down past fiscal deficits, and (iii) deficits during recessions tilted towards growth-enhancing infrastructure spending, not towards goodies for special interest groups.

In this regard, economists Martin Wolf and Stephen Roach have both correctly identified financial market “credibility” as the key to future growth, inflation, and interest rates. Can today’s administration end up with any credibility when it blithely ignores the very existence of the End Game we have identified, much less those policies needed to solve it correctly? Will there be any credibility if the three proposed amendments just cited are not adopted?

In his magisterial The Rise and Decline of Nations, Mancur Olson understands that these are the topics that matter—not greed management 101. Yet barely a word is being said about these issues by the Best and the Brightest now staffing the Obama White House. Why? The explanation partly lies in a crisis of intellectual competence. Scholars trained in “macroeconomics” are as poor in discussing Olson’s dilemmas of collective action as oncologists are in discussing dentistry. The fact that the macroeconomists in question are “brilliant” is irrelevant. Being smart is not enough.

The abject moral failure of the new team to identify much less to propose a solution to the End Game is extremely disturbing to the present author. Despite his initial support of President Obama, he increasingly wonders whether we have the right team in place. And he is alarmed that time to rebuild credibility is running out.

© 2009 Strategic Economic Decisions, Inc.


1 We stressed that this hike in real rates does not occur in the case of normal-sized fiscal deficits caused by normal G-7 recessions. It only occurs when the deficits are exceptionally large, as they are turning out to be this time around. Accordingly, our analysis cannot be supported by the data of G-7 recessions during the past half century for the simple reason that we have rarely before experienced deficits of the magnitude confronting the US today. Nonetheless, our analysis can be supported by the experience of many emerging market economies that became overly indebted.

2 US federal debt is often stated to be $5.5T. This is because some $4.5T of debt is held by the Social Security Administration trust funds and other entities. But what matters for the purposes of our analysis is the total debt of some $10T.

3 This forecast growth of debt excludes the growth of liabilities of the balance sheet of the Federal Reserve Bank, as well as some off-balance sheet operations by the Treasury. But much of the costs of bailing out the financial system should properly be viewed as asset exchanges, and not as increases in the fiscal deficit per se. The story is highly complicated, and mistaken interpretations are commonplace.

4 In one of the grandest achievements in the history of social thought, Hurwicz demonstrated mathematically that the incentive structure of “true capitalism” alone is compatible with the societal goals of efficiency, privacy, freedom, equity, and stability. In our view, this result gave a more compelling and concrete interpretation of Aristotle’s concept of “The Good Life” than any theory before or since has done.

Don’t Ever Mix Hallucinogens and CNBC

If you ever wondered how a CNBC financial commentator acted while on drugs, watch this clip. What in the world!?


clsid:D27CDB6E-AE6D-11cf-96B8-444553540000" codebase="http://download.macromedia.com/pub/shockwave/cabs/flash/swflash.cab#version=9,0,0,0" height="380" width="400">

Wednesday Articles

David Kotok of Cumberland Advisors sounds confident that March 9th is the low – he also discuss some decoupling of various asset classes in the recent market upswing in excerpts from this article:

Some bullets on different asset classes follow.

US Stocks

It appears that the March 9 low is seriously established. Since then, the market has powered higher with broadened participation. The market has confirmed a determined upward bias. We can see evidence of this broadening by examining the S&P 500 Index and its component parts four different ways. Let’s look at four ETFs to support this view.

RSP is the stellar performer among them; it is the equal-weighted version of the S&P 500 stocks. From March 9 through May 18 it delivered a total return of 50%. Compare this with RWL, the revenue-weighted version of the same S&P 500 index; it delivered a total return of 43.5% for the same period. SPY is the ETF that tracks the cap-weighted S&P 500 index; it was up 35%. OEF is the cap-weighted largest 100 stocks within the S&P 500 index; it was up 32.7%. Conclusion: market leadership has been broadening, which is why the specially designed ETFs are outperforming the standard cap-weighted ETF. Disclosure: RSP is Cumberland’s largest ETF position and a current core holding in US ETF portfolios.

Contrast the above with the performance of these same four ETFs during the period of January 1, 2009 through March 9. Then the market was in steep decline. Selling was uniform and impacted all four ETFs nearly equally. RSP declined 28.4%, RWL was off 29.3%, SPY fell 26.7%, and OEF declined 26.8%. Conclusion: during the sell-off nearly all stocks fell; after the bottom was formed on March 9 the market leadership changed, which is why the highly correlated performance during the decline morphed into the diverse and less-correlated outcome of the recovery.

International Stocks

Emerging markets have been the stellar performers in the rally since March. Brazil and China have been leaders among them. Many believe that China’s stimulus response to the global financial crisis has been and remains more effective than that in the US. Cumberland has been overweight China and overweight the emerging markets in international ETF accounts. Bill Witherell will be writing about the details. Cumberland continues to overweight this sector.

Tax-Free Bonds

It is safe to say that the Muni market has caught fire. Interest rates in Muniland are falling rapidly from extremely priced levels. The 7% high-grade tax-free Muni at the peak quickly gave way to 6% and then to 5%. Accounts that were funded were rapidly invested and have been able to participate in this rally. This tax-free bond sector is still cheap. The ratio of taxable fixed-income to tax-free suggests that the fall in Muni yields (rise in bond prices) is only partially over. John Mousseau will have more details to offer about this sector and about the demise of the bond insurers. Cumberland’s tax-free accounts are nearly fully invested and favor longer durations and a selective focus on refunding candidates. This asset class is still very attractive.

Taxable Municipal Bonds

With the introduction of the Build America Bonds (BAB), this asset class has taken on a life of its own. BAB issuance is replacing traditional tax-free new issues in many jurisdictions. Nearly all new municipal bonds are constructed and priced on both a traditional tax-free and a BAB structure. The issuer is then able to choose which is more economical. The effect has been to compress the spread to the tax-free new-issue yield and also orient the spread between taxable and tax-free so that it approaches the tax arbitrage of 35%. We expect that to continue. Peter Demirali will have more details on this exciting new issue. Cumberland has been active in taxable municipal bonds for years and is able to apply that experience to this new and rapidly expanding asset class.

Certificates of Deposit

The temporary FDIC insurance limit of $250,000 is scheduled to expire on December 31, 2009. Pricing in the CD market reflects the risk that it may revert to $100,000. Some CD investors are altering their behavior when they consider CDs with maturities into 2010 and beyond. Congress knows this. The Senate version of the FDIC limit bill extends the insurance to 2013. The House version makes the insurance limit of $250,000 permanent. We expect that the $250,000 limit will be extended beyond December 31. Fast Congressional action would relieve fearful investors in the CD sector. Getting it from Congress is problematic. Because there is some political risk, albeit small, we are limiting longer-term CDs to $100,000 until Congress actually passes the extension.


This second article is a must read for anyone who considers themselves a trader OR an investor. It is from Brett Steenbarger who among other things runs the excellent TraderFeed blog. The title of this article speaks for itself, “Mixing Investing and Trading Mindsets Can Be Hazardous to Your Wealth”:

Several traders that I interacted with Monday were not able to participate on the long side despite the fact that the stock market was strong throughout the day. When they explained their selling bias, they said things like, “I just don’t believe we should be trading up here” and “There’s no way we are going higher; the economy is in terrible shape.”

Mixing the mindset of trader and investor is hazardous to your wealth. As an investor, I can tell you that I remain very conservatively positioned with my retirement assets. I believe that we entered a secular bear market in 2000, and I believe that the bear market has years–not months–to run. Just as we hit bottom in 1932 and did not see a full fledged bull market until the late 1940s, and just as we hit bottom in 1974 and did not see a fresh bull until 1982, we could muddle around for a considerable period in a long-term bottoming process.

And that’s generously assuming that we made a price low for the secular bear in March!

All of that, however, is irrelevant to what I think about the stock market *today*. If I see that there is no bearish bias over the next several days and that indicators are strengthening over a three-day period, I am going to look for reasons to buy in today’s session if I detect signs of strength. Trading is about exploiting supply and demand during short-term intervals; it is not investing.

You could tell me that President Obama is saddling this country with outrageous debt; you could decry the greed of banks; you could question the ability of the consumer to sustain a durable economic recovery; you could question the fundamentals of the U.S. dollar: for the most part, I would agree with you. But those have nothing to do with whether institutional participants, right here and right now, are purchasing, selling, or avoiding equities.

There’s a time for politics, and there’s a time for economics. Just not when you’re trading the day timeframe.

Richard Shaw: The Role of Moving Averages in Risk Management

For those of you interested in using some simple, easy to understand and implement strategies in your portfolio, moving averages are a good place to start. Richard Shaw of QVM Group has a nice summary in a Seeking Alpha article, which I have pasted below.

Personally, I am a fan of using moving averages in making investment decisions and the empirical evidence of other researchers (Mebane Faber for one) seem to validate that it works well as a risk management strategy. Over the next few days I am going to feature some additional research articles discussing moving averages. The article below:

Some investors use the 200-day simple moving average (alternatively the 40-week or 10-month average) as a primary trend line indicating an upward or downward moving market. Some also use it as a reference line around which the price or other moving averages oscillate.

It is easier to be motivated to be in a risk asset when the primary trend line is moving up than when it is moving down. Conversely, it is probably prudent to limit risk commitments when the primary trend line is moving down, even when other fundamental or technical factors suggest opportunity.

There is no magic to 200-days, but it is probably most widely used, making it likely that large numbers of investors will be responsive to it. Other longer or shorter periods may “fit” better with different securities which have different cycle characteristics.

Keep in mind that longer averages are slower to recognize changes in the trend, but present fewer false positives; while shorter averages are quicker to recognize change in the trend, but present more false positives. Each investor must choose his or her balance between trend recognition lag time and the whipsaw effect of false positive signals.

Some Multi-Year Examples:

These seven examples use the 40-week moving average of the price as the primary trend reference line, and the 20-week moving average as a signal line.

The idea is that when the signal line is above the reference line, there is strong upward pressure on the primary trend. If the primary trend is sloping up, it is likely to continue to move up. If the primary trend is down, there is a reasonable probability that a trend reversal has occurred or is about to occur.

If the signal line crosses below the reference line, there is strong downward pressure on the primary trend. If the primary trend is sloping up, it is subject to reduction in upward slope or possible reversal. If the primary trend is down, the downward slope is likely to become steeper.

It would be helpful when interpreting the risks to see the price confirming the superior or inferior position of the 20-week relative to the 40-week average.

Please do take note of the words “probability”, “likely”, and “possible”. No indicator is perfect. All indicators give some level of false positives. The key is to select indicators that have the lowest false positive rate consistent with your investment time frame, risk tolerance and degree of active management.

The 40-week/20-week approach is fairly conservative and results in a low frequency of buying and selling in the US stock market, and in some others as well.

Here are multi-year views of the 40-week/20-week approach for seven important indexes:

US Stocks (S&P 500)



MSCI Emerging Markets Stocks

AMEX Japan Stocks

DJ-AIG Commodities

US Aggregate Bonds (Vanguard Fund)

(Some securities related to the charts: SPY, IVV, VFINX, IYR, VNQ, EFA, VEA, EEM, VWO, EWJ, DJP, DBC, AGG, BND, VBMFX.)

For all of the indexes reviewed, except for bonds, the 20-week average is below the 40-week moving average, suggesting that they remain in primary down trends. Bonds appear to be in a primary uptrend.

You can judge for yourself how useful this method may or may not be for your purposes. At a minimum, it may be useful as general information to factor into your overall risk and opportunity evaluation process.

Andrew Horowitz on Inflation

Andrew Horowitz author of The Discliplined Investor blog and partner in Horowitz & Company discusses in this entry his expectation for inflation and rising commodity prices. He also recommends some investing opportunities, MOO and DBA. As an aside, his podcast is one of the better finance/investing related podcasts available:

size:100%;">This is what inflation looks like….

May 18, 2009

I thought it would be interesting to post some of the recent levels on items that could be the industrial indication that inflation continues its slow but persistent creep onward. Yes, I know that Mr. Bernanke has scoffed at the idea, but javascript:urchinTracker ('/outbound/article/www.bloomberg.com');">Mr. Taylor is starting to believe that the stimulus hose is pumping out too much green water.

The Federal Reserve may soon need to raise interest rates, said John Taylor, the former Treasury official who devised the “Taylor Rule,” a formula for rate- setting based on the outlook for inflation and growth.

“My calculation implies we may not have as much time before the Fed has to remove excess reserves and raise the rate,” Taylor, a Treasury undersecretary under President George W. Bush from 2001 to 2005, said yesterday at an Atlanta Fed conference in Jekyll Island, Georgia.

Unless we are able to thread a very small hole in a very small needle, prices are going to continue to move higher as a combination demand and quantitative easing take hold. There is virtually no way that an easy take off after such a sever move by the Fed that includes printing record levels of money and providing massive and perhaps reckless levels of stimulus. (Picture the Fed as a living and breathing animal which now has stimulus shooting shooting of every orifice.)


China may be is hoarding, but no matter what it is called, the process still makes prices run up – simple supply and demand. Oil demand is up, but consumption is down. How? Think of speculation entering in again as many of the same players (Morgan Stanley, Goldman Sachs and JP Morgan) are filling up ships with crude and floating throughout the world’s oceans until such time as they must deliver or sell at a higher price. The Contango trade at its best…

We are also watching the javascript:urchinTracker ('/outbound/article/www.dubaimerc.com');">Dubai Mercantile Exchange as the next breeding ground for the oil price battle. Last year’s speculation loopholes have finally closed and not players are looking for alternative exchanges to ramp up pricing without the pesky need to expose their positions. Last year, javascript:urchinTracker ('/outbound/article/www.dubaimerc.com');">Goldman Sachs, Morgan Stanley and others bought a significant stake in the DME and the time is just about right for oil prices to begin to start seeing a speculative run, right before the summer driving season begins.

Copper on the other hand is clearly being bought up and stockpiled for use by China and other nations that are in the process of massive infrastructure development. (Listen to Dennis Gartman on The Disciplined Investor Podcast discuss Copper –javascript:urchinTracker ('/outbound/article/phobos.apple.com');">via iTunes)


Then there is the question as to whether or not food commodities will see another run-up in prices as we experienced last summer. Corn may be headed higher as the soggy planting season has pushed the crop cycle back. This and the additional strain due to ethanol use should push prices higher through the summer. As for wheat, we have heard several reports that India’s javascript:urchinTracker ('/outbound/article/in.news.yahoo.com');">trading ban have been difficult on wheat and now massive/surplus levels are laying, tarp-covered, in parking lots, schools and fields. After the recent election, the ban may be lifted and could push a nice supply onto the markets, thereby moderate and eventually helping to stabilize prices.


Still, it appears that even if we are not in a domestic or global recovery just yet, commodities, especially food based ETFS – MOO and DBA) may be good investment ideas to help diversify a portfolio during difficult market conditions.

(javascript:urchinTracker ('/outbound/article/www.horowitzandcompany.com');">Horowitz & Company clients are LONG positions mentioned as of the publish date)

John Hussman: The Destructive Implications of the Bailout – Understanding Equilibrium

In what has become a weekly routine, I’d like to point you toward John Hussman’s Weekly Market Comment. It is always a must read for those interested in the ‘big picture’. This week he focuses on the destructive economic impact of the bailout money in crowding out gross domestic investment. He also focuses on the mis-characterization by many in the mass media regarding the ‘cash on the sidelines’ and the notion that higher personal savings rates are detrimental for the overall economy. I’ve decide to just paste his entire article into my blog entries, rather then summarizing them. Here is this week’s comment, please-Please-read, you won’t regret it:

May 18, 2009
The Destructive Implications of the Bailout – Understanding Equilibrium

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Reprint Policy

One of the features that has enabled the bureaucratic abuse of the public during the past year has been the frantic, if temporary, flight-to-safety by investors. The Treasury has issued an enormous volume of debt into the frightened hands of investors seeking default-free securities. This has allowed the Treasury to finance a massive and largely needless transfer of wealth to bank bondholders so easily over the short-term that the longer-term cost has been almost completely obscured. But by transferring wealth from those who did not finance reckless loans to those who did – providing monetary compensation without economic production – the bureaucrats at the Treasury and Federal Reserve have crowded out more than a trillion dollars of gross investment that would have otherwise have been made by responsible people in the coming years, shifted assets to the control of those who have proven themselves to be irresponsible destroyers of capital, and have planted the seeds of inflation that will cut short any emerging recovery.

In order to understand the impact of these interventions, you have to think in terms of equilibrium – recognizing that all securities that are issued must also be held by someone – and then follow the money. Initially, suppose you have a banking system with $12 trillion in assets, financed with about $7 trillion in deposits and other liabilities to customers, about $4 trillion in debt to the bondholders of the banks, and about $1 trillion in shareholder equity as a buffer against insolvency.
Now, suppose that the value of the assets deteriorates by $1 trillion, effectively wiping out the shareholder equity and putting much of the banking system in an insolvent position. Suppose also that government bureaucrats refuse to properly take receivership of insolvent banks, to impose haircuts on the debt to bondholders or to require them to swap debt for equity. Instead, suppose these bureaucrats prefer to defend the private bondholders who funded the bad loans from experiencing any loss whatsoever, and are willing to use public funds to do it.
In order to do this, the Treasury issues $1 trillion in government debt, with a preference toward shorter “money market” maturities (since it doesn’t want to drive up long-term interest rates at the same time the Fed hopes to invigorate the housing market). It may seem like this means that there is $1 trillion of new “liquidity” in the economy, but you have to think carefully.
If you look at various individuals in the economy, including yourself, notice that except for cold, hard currency in your wallet, whatever savings you have accumulated in the past have been allocated to finance investments that have already occurred. You may think that your stocks and bonds and bank CDs and money market securities represent your “savings,” but they are actually securities that exist as evidence of money that has already been spent by some borrower, and on which you have some claim to future income or repayment. And this is crucial: the securities that represent those claims – the stocks, the bonds, the CDs – will all continue to exist until and those securities are retired. If you sell your stocks, or bonds, or money market securities, you have to sell them to someone who presently holds cash. In other words, in order for you to get cash that you can spend, you have to sell your securities to someone whose savings have not already been allocated to something.
So where does the money come from to buy these new Treasury securities? Clearly, the sale of those securities must absorb the savings of someone in the economy whose savings have not already been claimed. Alternatively, the Fed can directly purchase those Treasury securities and literally print money. In practice, we have a third option. The Fed can acquire $1 trillion of commercial mortgage-backed securities and other assets from banks and create an equivalent amount of “reserves” (which is essentially printing money) at the same time that the Treasury issues the $1 trillion in new Treasury securities. In this case, which is in fact exactly what has happened, the banks that previously held $1 trillion in commercial debt securities can now use their newly acquired reserves to buy the $1 trillion in newly issued Treasuries. Having done this, they have no more money to lend than they had before. There is no more “liquidity” in the system than there was previously, except that the “quality” of the bank balance sheets has improved.
The Fed has turned its balance sheet into a garbage dump, in order to accommodate all of the additional Treasury issuance required to finance the rescue of bank bondholders.


Incidentally, what we’ve observed in bank balance sheets (dumping mortgage related securities off on central banks and accumulating newly issued Treasury securities) is mirrored in the activity of foreign holders (year over year change in holdings depicted below):

Treasury Securities vs. Agency Securities

In order to get these Treasury securities off the bank books so that the banks again have capital to lend, one of two things must happen:
1) Somebody other than the government would have to buy those Treasuries from the hands of the banks with new private savings that have not yet been allocated or spent. This means that in order to finance this bailout, the money that has been provided to make bank bondholders whole will have to come at the expense of crowding out more than $1 trillion of private investment that would otherwise have occurred, or;
2) The Federal Reserve would have to buy those Treasuries, in addition to the commercial securities it already holds, and create reserves to pay for them, which would add yet another $1 trillion to a base money supply that a year ago was less than $850 billion, and has already exploded to $1.8 trillion.
In both cases, the bailout ensures that any incipient recovery will be cut short, because the only reason that our economy is able to absorb the present supply of government liabilities is extreme risk aversion that creates a demand for default-free instruments. If that risk aversion abates, it will quickly be replaced by higher short term interest rates, higher monetary velocity, and inflation that can be expected to be quite difficult to control. At that point all the Fed will be able to do is to swap one government liability (monetary base) for another (Treasury securities). The genie will not easily go back into the bottle.
The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I’ve noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.
As Nobel economist Joseph Stiglitz recently noted, the bureaucrats that designed this bailout are “either in the pocket of the banks or they’re incompetent. It’s a real redistribution and a tax on all American savers. This is a strategy trying to recreate the bubble. That’s not likely to provide a long-run solution. It’s a solution that says let’s kick the can down the road a little bit. They haven’t thought enough about the determinants of the flow of credit and lending.”
Not that anyone is listening, unfortunately.
The second fact is that as a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).
If you sell your stocks or bonds or money market securities, they don’t cease to exist. Somebody else has to purchase them. Somebody else has to hold them. As I’ve said numerous times, if Ricky wants to sell his money market funds and buy stocks, then his money market fund has to sell money market securities to Nicky, whose cash goes to Ricky, who uses the cash to buy stocks from Mickey. In the end, the cash that was held by Nicky is now held by Mickey. The money market securities that were previously held by Ricky are now held by Nicky. And the stocks that were once held by Mickey are now held by Ricky. There is exactly as much “money on the sidelines” after these transactions as there was before. Money doesn’t go into or out of the stock market – it goes through it. Prices don’t move because supply exceeds demand or demand exceeds supply. In equilibrium, the two are identical because that’s exactly what a trade is. Prices move because the buyer is more eager than the seller, or vice versa.

A note on savings and investment

In recent months, we’ve increasingly heard analysts bemoaning the fact that the personal savings rate has increased, as if greater savings are inherently bad for the economy. Aside from the fact that the U.S. government has been running deficits (negative savings) that swamp any positive effect of personal savings, the larger issue is that analysts appear not to understand the importance of savings, or the link between savings and investment. Since the subject of this comment is equilibrium, a few notes about the savings-investment identity are appropriate.
Let’s begin with several basic premises (actually accounting definitions)
Income that is not consumed represents “savings.”
Output that is not consumed represents “investment,” even if it is unintentional “inventory investment.”
GDP can be defined as the total value of income or, equivalently, as the total value of output. These numbers are the same (aside from a purely statistical discrepancy). The total income in the economy is either consumed or it ends up financing “investment.” The total output of the economy is either consumed or it represents “investment.”
Given these facts, total savings – by definition – are equal to total investment. In any economy, money flows from savers to investors will have occurred in a manner that makes this savings-investment identity true. If the money did not flow, then either the income was not earned, or the production and consumption did not happen. Whatever happens in the economy, and however it happens, we can be certain that when we add it all up at the end, total savings will have been equal to total investment. This is not a theory. It is algebra. It is an accounting identity.
When people think of saving as something that depresses the economy, they are thinking of the Keynesian setup, where Keynes specifically and explicitly assumed that investment was constant. In that sort of setup, it is impossible for the economy as a whole to save more, since by definition, holding investment constant must also hold total savings constant. So the attempt to save a greater amount must fail. Let total savings S be equal to some percentage “s” of total income Y. Then S = sY. In Keynes’ setup, the attempt to save a greater proportion of income as savings must result in a reduction in total income Y (or GDP). For example, suppose that total savings are $10 and GDP is $100, so that s = 10%. If you try to boost up s to 20% of income, but you’re restraining total savings to $10, then GDP must fall to $50 (that is, $10 = 20% of $50).
At present, it is not valid to say that the economy is weak because people are saving too much, because if gross savings were up, gross investment would also be up. One might say that the economy is weak because people are unsuccessfully attempting to save more, but it is far more accurate to say that the economy is weak because gross investment is collapsing despite a greater willingness of individuals to save. If we don’t get those distinctions right, we’ll end up with policies aimed at discouraging savings, which by their very nature will end up discouraging investment and will make the economy suffer interminably. Growth-oriented policies encourage new investment, and require an economy with the capacity to save in order to finance that investment. As long as we have a set of economic policies aimed at running massive government deficits at the same time individuals are encouraged not to save, we will risk driving this economy into the ground for a very, very long time.
Market Climate
As of last week, the Market Climate for stocks remained characterized by mixed valuations – modestly overvalued on the basis of most fundamental measures except those that assume a sustained return to the record profit margins of 2007, and slightly undervalued if one assumes that a return to those profit margins is a given. Market action was also mixed – volume continues to show fairly tepid sponsorship relative to durable market advances. Meanwhile, price action has been very favorable on the basis of breadth, but with the strongest leadership from industry groups with the least favorable balance sheets and financial stability. It is not typical for the industries that suffer worst in a bear market to be the ones that lead the subsequent bull market. That sort of “leadership by losers” however, is very characteristic of bear market rallies. That’s not to say that we can immediately conclude that stocks are in a bear market advance as opposed to a new bull market, but as usual, we don’t spend much of our energy making assumptions about things that aren’t observable. At present, the observable evidence is that stocks are priced to deliver modestly sub-par long-term returns, but still in the range of about 8% annually over the coming decade, while market action is favorable enough for us to carry an index call option position in the range of 1-2% of assets here, in order to soften our hedge in the event that the market experiences a more sustained advance, without strongly compromising our defense against fresh weakness. Aside from that 1-2% in index calls, the Strategic Growth Fund continues to hold a strong hedge against the market risk of the stocks in the portfolio.
In bonds, the Market Climate last week was characterized by modestly favorable yield levels and modestly unfavorable market action. From an investment standpoint, the prevailing yields on Treasury securities beyond about 5 years in duration are probably not sufficient to offset eventual inflation pressures, so longer maturities will function primarily as speculative as opposed to investment vehicles for a while. The Strategic Total Return Fund continues to emphasis TIPS, where real yields are still reasonable. Though there will probably not be much need for inflation compensation at short maturities, it will probably be important for longer maturities. The Fund also holds about 20% of assets divided between precious metals shares, foreign currencies and utility shares. The valuation of precious metals stocks remains generally favorable, particularly relative to gold prices, but the strongest returns are typically in environments where Treasury yields are falling and the rate of inflation is flat or rising (i.e. the combined environment features downward pressure on real yields and the U.S. dollar). Those pressures haven’t been strong recently, so while we continue to hold precious metals shares here, the strongest returns are likely to emerge once downward pressure on the U.S. dollar picks up again.

Prospectuses for the Hussman Strategic Growth Fund and the Hussman Strategic Total Return Fund, as well as Fund reports and other information, are available by clicking “The Funds” menu button from any page of this website.

If you are interested in finding out more about high interest savings check out Meridian