Greenspan Fiddles and the French Dance

John Mauldin | Thoughts from the Frontline
February 14, 2003

Sometimes it is the small things that lead to big changes. Today we briefly look at one paragraph in Greenspan's latest speech, then move on to Europe and Iraq. I want to suggest some small things that could lead to changes in global politics and the world economy just as significant as the fall of the Berlin Wall. My theme for 2003 was Surprise and Transition." I think we are getting ready for our first true surprise. Again, there is a lot to go over, so let's get started.

Greenspan Fiddles as the Economy Burns

First, carefully read the following quote from Alan Greenspan's recent Senate testimony (my bold for emphasis):

"The intensification of geopolitical risks makes discerning the economic path ahead especially difficult. If these uncertainties diminish considerably in the near term, we should be able to tell far better whether we are dealing with a business sector and an economy poised to grow more rapidly -- our more probable expectation -- or one that is still laboring under persisting strains and imbalances that have been misidentified as transitory.... If instead, contrary to our expectations, we find that, despite the removal of the Iraq-related uncertainties, constraints to expansion remain, various initiatives for conventional monetary and fiscal stimulus will doubtless move higher on the policy agenda. "

Throughout his testimony, Greenspan blamed the current "soft spot" on the uncertainty surrounding Iraq. He (along with nearly every mainstream economist) still predicts an economic upturn this year.

The economy grew at 0.7% in the 4th quarter, but as Andrew Kashdan of Apogee points out, that number is misleading. Government spending contributed 0.86% of the growth, or more than the actual growth. Even that may be misleading.

The real problem he reveals is the "strength" in nonresidential fixed investment is tenuous, at best. Much of the transportation increase is composed of planes which were contracted for years ago. This part of the economy is not going to stay strong. Light truck sales were strong, but because of significant incentives. "In sum, the strength in fourth quarter business equipment spending appears to be a one-off event."

He goes on: "How about technology, then -- is the boom back? Well, we're not partying like it's 1999 just yet. If we look at the subcategory that includes "information processing equipment and software," we see that, in real terms, IT spending increased at an annualized rate of 3.95%. This is a volatile number, but even so the growth is significantly slower than it's been the last few quarters (e.g., the annualized rate of growth was nearly 13% in Q3). On a nominal basis [actual dollars spent], the slowdown is even more severe -- fourth-quarter growth was only 0.9%.

"How to explain the discrepancy? Prices in the equipment and software category (as well as in the technology subcategory) have been declining, on average, which would make real sales increase slightly even without a rise in nominal sales. But the rest of the increase, we must presume, is due to tinkering to account for quality improvements, i.e., so-called hedonic price adjustments. The result: a nominal increase of $407 billion in equipment and software spending is magically transformed into a $581 billion increase (again, these numbers are annualized). The $174 billion difference is rather significant when overall nonresidential fixed investment increased by a mere $4.5 billion. (We have not yet figured out how to adjust our personal incomes for quality enhancements, but we've got our best people working on it.)"

In short, the economy is probably growing, but not by much. Without the growth provided by an increase in government spending, we would have been in recession. In my opinion, laying the problems in our economy to concerns about Iraq is over-stating the case. I do not doubt for a moment they are having a large effect, but this economy was soft before those concerns became so large.

Thus, I find it strange that Greenspan is suggesting a policy of "wait and see" before "various initiatives for conventional monetary and fiscal stimulus will doubtless move higher on the policy agenda. "

Jim Bunning was a major league pitcher who was known for his rather aggressive pitching style. Today he is a senator from Kentucky. He threw Greenspan a high inside pitch at the hearing, chastising him for his comments on fiscal policy, saying he waited too late to begin to lower rates on 2001 as the economy approached recession, and later suggesting he resign.

This was a somewhat less adulatory hearing than when Senator Gramm called Greenspan "The greatest central banker in history."

"Wait and see" did not work in 2001. As I wrote at the time, he should have begun cutting rates when the 90 day average of the yield curve went negative in September of 2000, which has always been followed by a recession 4 quarters later. The seminal paper on this phenomenon was done by the Federal Reserve in 1996. Only a few weeks ago, I wrote about the Fed strangely sitting on their hands in regard to monetary policy. I was right to notice such a problem. Greenspan as much as said this week that waiting is their current policy.

I quite often get emails or read articles suggesting Greenspan and the Bush administration are working together to orchestrate Bush's re-election. I hope that after this week, I get no more of these. Greenspan trashed the Bush stimulus plan, tax cuts and budget deficits. This is not cooperation. This is, as Bunning said "...undermining [Bush] and Congress on fiscal policy."

(For the moment, let's put aside the libertarian debate over whether we should have a Fed or whether they can really, at the end of the day, do anything. The reality is we have a Fed and what it does affects our economy and our investments.)

My Muddle Through Economic scenario depends upon aggressive Fed monetary policy and strong fiscal stimulus from government deficit spending. At the beginning of the year, especially after the Bernanke speech, I expected to get an aggressive Fed. (Again, I am not arguing for or against these policies - I am simply trying to discern the short-term economic implications.) If we get those policies, I think the best we get is Muddle Through, but we put off a recession for another time and another year.

Greenspan's testimony suggests my "optimism" may be misplaced.

Bush is betting that Iraq can be resolved quickly, that after we are there it will become apparent that Saddam has serious weapons potential and that tensions will ease. He will then have the political capital to push through his economic stimulus.

I believe the war with Iraq will be shorter than most people think. The sighs of relief will be audible throughout the business and investment communities. There is no doubt there is pent-spending waiting on the outcome. That will provide a boost to the economy.

We need that boost to maintain Muddle Through. It will probably not take us to the 3% plus annual growth that is predicted, but it will keep us out of recession, IF... the Fed does more than wait and see.

Bush also needs cooperation from Greenspan and the Fed. For whatever reason, they seem reluctant to act. Wait and see, he says, and if we find out we are in a soft patch, then we can do something. That is NOT what a Bush administration that understands "It's the economy, stupid" wants to hear.

We will have to wait and see as well, but this bears watching closely. If the Fed surprises by waiting to long, we will not like the transition we will see.

Now, we are going to shift gears. I am reminded of the story about the Baptist preacher in Tennessee who began to wax eloquent about sin. He was against it, and the congregation was with him. He began to talk about how dancing was corrupting the kids, tobacco was fouling the lungs of the saints and how gossip was destroying the unity of the church. With each new sin he got an increasing chorus of "Amen's." He then started to preach about moonshine, at which point 4 of the men in the congregation got up to walk out.

"What is the problem?" he asked. On his way out the door, one of the men turned and replied, "Pastor, you just went from preaching to meddling."

This is a letter about economics and investing. Any time I write about something political I get lots of letters, because to many people, that is the point I cross from preaching to meddling. But when politics has an effect upon the economic world, I think it is a legitimate point of inquiry. As I now have readers from countries all over the world, I recognize that many will have a different point of view, and I welcome comments, especially from European readers.

For The Want Of A Nail

For the want of a nail, the shoe was lost; For the want of the shoe, the horse was lost; For the want of the horse, the rider was lost; For the want of a rider, the battle was lost; For the want of the battle, the kingdom was lost; All for the want of a nail.

A small event can change things far beyond the seeming initial circumstance. The stirrup, the cotton gin and the steam engine all changed economies in ways that the inventors and those who first observed them could not imagine. A cow kicking over a lantern burned a city. The assassination of a minor Austrian Duke led to World War One. Chamberlain's trust of Hitler led to catastrophe rather than "peace in our time."

I have given a great deal of thought these past few weeks to the behavior of Chirac and the French. It may be that trying to make rhyme or reason out of French diplomacy is a fool's errand, but I think there is something much deeper going on than mere antagonism to war.

I believe we have seen a series of small events in the past few weeks and months that portend a change in the global political and economic structure that historians will look back upon as one of the major events of this century. It is not Iraq. Follow this trail with me of seemingly random events and let's see if we can detect a pattern.

Europe is Sliding Into Recession

Last year, as the economy of Germany was getting softer, Gerhardt Schroeder was running for re-election. By all rights, he should have been losing, except that his opponents were running a campaign almost as inept as Bush and the Republicans did in 1992. But he still needed an extra push. He found it by bashing America, and with that anti-American rhetoric, he managed to narrowly win.

German production slipped 2.5% in January, industrial orders declined 4.1% and unemployment approached 10%. Economists said the data were consistent with continued stagnation, if not slight contraction, in the German economy and warned that the stronger euro could make matters worse. There are constant calls for the European Central Bank to cut rates, but so far they resist, even though they cut their growth rate to 1.6% for the year for the eurozone. Most economists oddly enough think growth will be less than 1%, and the outlook for Germany is outright recession.

In the face of this, Schroeder is calling for tax increases, an almost guaranteed prescription to worsen any recession.

David DeRosa, a finance professor at Yale School of Management writes:

"Now as Schroeder's popularity disintegrates before his eyes - - the economy is a disappointment; he is being second-guessed about his foreign policy; people don't like his idea about raising taxes -- his opponents, the Christian Democrats, smell blood. Last week's local elections in Saxony and Hesse were a disaster for his Social Democrats.

"And there is a conservative star on the horizon, Angela Merkel. Merkel is now the head of the Christian Democrats. When she is not blasting Schroeder on the economy she is hitting him on foreign policy.

"What does she think of the eight European governments that signed the Iraq letter? Merkel says if her party had been in office Germany would have been the ninth signer."

The Union of European Socialist Republics

This week Valery Giscard d'Estaing, former president of France, presented a document that is the basis for a new European constitution. It is a blatant attempt to force French and German socialist policies on the rest of Europe. The same policies that produce 10% unemployment in France and Germany.

The Financial Times writes "Europe will soon have a new constitution. But if the draft presented by Valery Giscard d'Estaing last week is anything to go by, it will be imbued with old ideology. The document ignores the free-market economy. There is not a word about the protection of property and no commitment to free enterprise and the division of labour. Instead, it contains dubious secondary objectives such as "sustainability" and "balanced economic growth", as if a constitution could ensure that such concepts become reality."

It is a document only a socialist could love. Much of Europe is moving in the opposite direction.

France and Germany hope to force this document through, which will put them in the driver's seat of the new Europe. However, they view the current European budget rules which they developed and forced the rest of Europe to go along with as mere points for negotiation when it threatens their economies. Germany was in violation of the 3% budget deficit rule last year and will do so as well this year. You can bet the French will do the same when it suits them.

This does not sit well with some of the other members of the central bank. Gertrude Tumpel-Gugerell, Austria's probable candidate for a seat on the European Central Bank's executive board, said she sees no reason to loosen Europe's budget rules even if there is a war in Iraq. "The rule limiting budget deficits to 3% of gross domestic product shouldn't be relaxed." (Bloomberg)

Now, think through with me on this. Chirac and Schroeder know they will need something to unite Europe if they are going to get this new constitution through. As we are taught in marketing, you need the Big Idea -- the Unique Selling Proposition -- the Sizzle. They need to be able to demonstrate what political power a United Europe could have, and with that carrot hopefully get the rest of Europe to go along with what will not be an easy sale.

Chirac especially, with the special love of diplomatic games that the French have, sees this as a way to lead Europe into a new era. A union that in the French mind will be the equal of, or superior to, the US on the world stage. Oh, and can we ask, "Who might want to run for president of this new union?"

The Economist wrote this week: "Now [Chirac] is free to release his pent-up energy and fulfil his re-election promises to "make a united Europe our horizon" and to "do everything to resolve international conflicts" - free, of course, to fulfill those promises on his own terms as the EU's senior leader."

To demonstrate the potential world-wide political clout of the European Union, they need some cause to stand up to the US and project European power. They need something around which to rally a feeling of European unity: us against them. Specifically, Chirac also wants to assert French leadership of this new union.

Schroeder's narrow win gave Chirac his opportunity to stand up to the US. Schroeder is publicly committed to opposing the war. It was a central part of his election campaign. If a Christian Democrat had won the recent German election, I do not think Chirac would have stood alone in Europe against the war. You can't lead if the troops don't follow. If you are wanting to get the rest of Europe to go along with a new constitution of your creation, you don't start out by antagonizing your neighbors.

I do not believe the driving factor is, as many suggest, the fact that Germany and France do very large amounts of business with Iraq, nor that Saddam offered Germany $2 billion as a gift for their anti-war stance. Normally, I suggest to follow the money, and the money clearly goes to France and Germany. If it was only money, they could simply negotiate assurances they get the business, and Bush would go along. The US would lose nothing in that case. But the opportunity to create a cause which they felt would unite Europe was too tempting for primarily Chirac and secondarily Schroeder to resist.

Chirac assumed that the rest of Europe would go along as they usually do if the French and Germans take the lead. Besides, he has polls in most of the other major countries which shows enough popular support for an anti-American (or perhaps anti-Bush) war stance that he believes the rest of his fellow European leaders would go along.

So, Chirac and Schroeder began a public campaign to actively oppose US intervention in Iraq.

And now we come to the small event: Donald Rumsfeld makes an off-the-cuff remark about "That's just Old Europe." Chirac and Schroeder respond vehemently, talking about American arrogance, the power of the European Union, and the need for world-wide consensus (which for them means their consensus and recognition of their importance, which they need so they can push their constitution). They draw a line in the sand. Stay with me, as the line will become more important than the issue.

At the same time this is going on, a European Wall Street Journal editor is calling a few other leaders of European countries asking them if they would like to speak out about their support of the US.

Those of us who live in Texas know what it is to watch Dallas Cowboy pulling guard Larry Allen open a hole for running back Emmitt Smith. It happens so quickly that if you blink you miss it.

Donald Rumsfeld opened a hole a mile wide for the rest of Europe to assert itself against French and German domination, and they drove a truck through that hole. In just a few days, 8 countries had an editorial asserting their support of US policy. Later, 15 more countries which all want to be a part of the European Union signed a separate letter of support.

I can fully believe that France and Germany (Chirac and Schroeder) are opposed to a war, and believe that those countries which signed the letter support the US, all for principled reasons. Support for or against the war is not the important issue in this analysis. The line in the sand has become more important than the war, as far as the future of Europe is concerned.

I also believe that Chirac was caught totally by surprise by the Wall Street Journal letter. He broke the first two rules of politics: "#1. Never ask a question if you don't know the answer. #2. Never call a vote until you know what the result will be." He did not consult with his fellow European leaders to see if they would go along with him.

I should note that I make a difference between Chirac and Schroeder. Chirac is the ring-leader in this operation. Schroeder is political history, and everyone knows it. He will lose the next elections, and Merkel or her compatriots will say, "Don't blame us. It was that other guy. We were really with you all along."

In an odd way, Germany gets a pass on this one. They are not the one with the UN veto, so when Germany changes their leadership (or if Bush loses in 2004), everyone will talk about a new era of cooperation. Right now, Schroeder must feel like he is watching a train wreck in slow motion.

In for a Dime, In for a Dollar

The rest of Europe is using this opportunity to tell Chirac that their opinions matter: in a nation of states, you are just another state. Further, the majority of the population of Europe resides in the states that are opposed to France and Germany.

Make no mistake about it. This is a defining moment for Europe and the direction of world politics. The Iraq's of the world will come and go, but Europe is a major economic and political power. A truly united Europe changes the global political equation (and no one knows yet exactly how that equation will change). How they organize, and what philosophical economic guidelines they use, will be of far greater economic importance in the long run than a short war with Iraq.

Betting the Whole French Ranch

As we say in Texas, Bush us betting the north 40 on his policy (for the non-Texans that means the north 40 acres or just part of the farm). If he is wrong, he will lose the next election and the US will survive as a major economic player and world power for the rest of this century, even as China and India grow in power. The balances will change, but they will change slowly.

Chirac, however, is betting the whole French ranch on Iraq. He should have chosen another issue around which to unite Europe. This will go down as one of the all-time worst diplomatic moves in history.

He is betting the ability of the French to really lead in a united Europe. He has bet whatever influence the French have in the NATO alliance. And if he puts the UN in a position of being seen as impotent, he will be betting France's permanent veto on the Security Council.

There is precedent. Taiwan was replaced by China on the UN Security Council. The rest of the world will be asking, "Why does France get a veto?" There are clear reasons for China and Russia. But why is France more important than India, the second largest nation in population, an up and coming economic powerhouse, a nuclear and growing military power? For that matter, why should France have a permanent veto if there is a true European Union?

I have nothing against the French. I love the country, the French people, the food and the wines. There is a great history in the nation, and justifiable reasons to be proud of being French.

I don't know whether France will listen to Hans Blix's testimony tomorrow (I write this on Thursday) and "see the light." Will diplomats be able to paper over the differences such that France can save face and go along?

My feeling is that Chirac will not back down. He has pushed all his chips onto the table in the world power poker game, and has nothing to win by changing his mind.

It really makes no difference. Bush is going to see that Saddam goes, with or without France. He has no choice. Russia will come along, as will most of the rest of the world. Has anyone noticed how much support for the US is brewing among Arab countries, with a few notable exceptions?

Chirac has made the bet, and he has lost. The rest of Europe will now feel quite able to begin crafting the future of a united Europe themselves, along guidelines with which they feel comfortable. France will have a significant say, of course, as they are an important part of Europe. But now they will just be a part.

I believe we are watching the changing of an era. 50 years from now, historians will be talking about the seismic shift that occurred because of an off-the-cuff remark by someone called Donald Rumsfeld.

We will not know the full implications of this new order in Europe for some time. The leaders in Europe will have to work that out for themselves. I hope it is along free market lines.

Austin, Del Ray Beach and New York

I will be speaking at the Texas Association of Public Employee Retirement Systems in Austin, Texas on March 24. I will be in Delray Beach, Florida next month at the Oxford Club Investment University conference. The conference is March 5-9. You can find out more by going to http://www.agora-inc.com/reports/300SCONF/F300D312.

I will also once again be speaking at the 10th Annual Hedge Fund Forum in New York June 23-25. I will be available at each of these meetings for meetings.

Many readers have been writing and asking about my specific investment recommendations. Bluntly, most of what I do involves private offerings and alternative investments, about which I can say nothing. If you are an accredited investor (at least $1,000,000 net worth), you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds and private offerings. Please read all the material on the site so you can understand the process, especially the part about risk. For those who have signed up already, I apologize that you have not had an issue this year. Those letters must first go through the attorneys, and we have one almost ready. I have a new assistant that is going to help with the research and writing schedule, and so hope to get back on track.

I am also working on a small list of investment advisors with interesting (and regulated) programs that I can recommend for investors who are not "accredited." I hope to have that within a month. Please note that it is not my idea to divide investors into groups, or to suggest I think net worth makes you less valuable or intelligent. Each one of you is important. It is just the way that Congress writes the rules. (The SEC simply enforces them.)

I know I am supposed to be against cloning, but if offered the chance to have three of me, I think I would take it, at least until this book is finished. Have a great week.

Your off to spend a long weekend with his kids analyst,

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