Greenspan: Fight Deflation Now

John Mauldin | Thoughts from the Frontline
November 1, 2002

Today we examine the deluge of month end data, which continues to confirm we are in the Muddle Through Economy. I politely respond to George Gilder (even after he called me a Keynesian and an economist) and look at the very long term implications of tax policy. There is a lot of very interesting ground to cover, so let's get started.

As long time readers know, I am in the process of writing a book called Absolute Returns . The basic premise is that we are in a long term secular bear market cycle, which is likely to last for at least the rest of this decade. Therefore, investors will be wise to look for investment strategies that yield absolute returns. History and economic data suggest traditional mutual fund and index fund investors are likely to be disappointed over the rest of this decade, and perhaps longer.

Writing a book is a lot like birthing a child. It is a lot of fun at the beginning. It becomes increasingly burdensome as the project develops, and ends with a lot of screaming and panic as the deadline approaches. The entire process is messy, and what you thought you were going to get when you started is not what you end up with.

At the beginning of the process, I thought about 25% of the book would be about the economic forces which produce a secular bear market, and the rest about what we as investors should do in response. Now, at least half of the book will be about why stock market returns are likely to be subdued for at least the rest of this decade, if not longer. (You can go to www.johnmauldin.com and find the link to the book website, where I post chapters as I finish them, as well as links to my free letter Accredited Investor E-letter.)

If you understand what the pressures are on the market, it becomes easier to choose investments which have the opportunity to do well. It is like making sure the wind is behind you if you want to sail. We will deal with themes familiar to readers, like deflation, historical trends, valuations, earnings, currency values, global trade pressures and sentiment, all of which point to a continuing long term secular bear market.

But as I think through the above, I realize that they are all taking place within a broader social context. There are larger forces which influence these themes, in both good and bad ways. It is more important to know why something is happening than simply what is happening.

Specifically, there are three areas of social conflict which have a major bearing on how our themes play out. The first is tax policy which sets the "rich" against the "poor"; the second is the coming generational conflict as baby boomers find out they cannot retire on time and younger generations are asked to bear an increasing load to support their elders; and, third, the dislocations stemming from increased globalization.

Over the next month or so, I will deal with each of these in this space. I am particularly looking forward to writing about the retirement issues, as I have been studying a privately circulated research paper by the always insightful and creative thinker, Rob Arnott. His theme is that there is no social security crisis as we presently think of it, as the real problem presents itself far earlier than 2030. This paper will soon be published in a major financial journal, and I predict it will be one of the most explosive research papers to come down the pike in some time. I have Rob's permission to share the basic thoughts, and am studying the paper diligently to present his ideas in a shorter form, yet as cogently as he does. Stay tuned.

Tax That Man Behind the Tree

Today, before we look at the current economic data, I want to begin to address the very long term implications of tax policy on the economy which in turn will affect jobs and earnings, which directly influence stocks and bonds. While there are direct effects, which we will address briefly, it is the unintended consequences in which I am more interested. I am not arguing for or against a particular tax policy here, but am particularly interested in the influence upon stocks.

Dennis Gartman reminded me this week of Governor Huey Long's famous line, "I'll not tax thee, I'll not tax me; We'll tax that fellow behind the tree."

Let's look at the following distribution of taxes paid by various wage earners in the US, as reported by the IRS, for the tax year 2000 (the latest year for which the figures are available):

The top 1% paid 37.4% of all federal income taxes; The top 5% paid 56.7%..... The top 10% paid 67.3%..... The top 25% paid 84.0%..... The top 50% paid 96.1%.....

That means that 50% of the country paid less than 4% of all incomes taxes. The proportion of taxes paid by the top half increases with each year, and will continue to do so. As Gartman points out, we will soon be in the situation where 50% of the voters pay no income tax, yet can vote for higher taxes to be paid by the top half.

Even were we to adopt the idea of a less graduated, more flat tax, the above would still be true, with some adjustment within the various brackets, for the simple reason that the rich make more money and thus pay higher taxes. No flat tax proponent puts forth the idea of adding lower income (bottom 50%) families to the tax rolls. Tax policy and political rhetoric revolves around shifting the burden within the top 50%.

No serious economist would say that high tax rates are not a drag on the economy. Tax cuts have always been and will always be a stimulus to the economy. To that extent, the Bush tax cuts have helped cushion the recession and will help do so in the future.

The problem is that between the tax cuts, a weak economy and 9/11 related spending, the budget surpluses have not only vanished, we are back into deficit territory. Current deficit levels are not a crisis, nor an impending crisis, but it is not current levels that concern me.

Let me state clearly that I am a proponent of lower taxes, less government spending and balanced budgets. But that is not what I see on the horizon. And thus my concern. (Please note- this letter is not about political philosophy, but about our investments.)

Current projections show a modest budget surplus over the next ten years, but only when you assume the Bush tax cuts go away at the end of the period, don't assume we eventually get some kind of prescription drug program and that we don't have two recessions within the next ten years, which is likely, as I have demonstrated elsewhere.

Others will argue that projections should take into account the positive effect of tax cuts, and I readily admit the cuts will produce positive affects, softening other negative economic problems.

But whatever system you use to analyze future deficits, the direction is not good. The concern I have is that there are political forces developing which will demand more government services and more money over time, and thus make deficits and/or taxes increase.

This year, the average cost of living increase of Social Security was 1.4% or $13 a month while Medicare contribution costs went up $4.70. This means that those on social security will see less than a 1% rise in incomes. Let us assume what will happen in a low inflation/deflation environment for the next decade or so. Social Security, which is indexed to inflation, will not rise much. Let's assume a net of a 2% rise over the next two decades.

But the deflation which and others talk about is in the overall economy. On average, we are seeing low inflation, and could see outright deflation within a year or so (see more on that later). The goods and services which retirees want to buy are not, unfortunately, on the low inflation part of the balance sheet.

Specifically, health care costs, local taxes, utility services, property insurance are all sky-rocketing, with no end in sight.

Let's look at some facts.

* The average person in this economy has very little, if any, retirement savings. Less than 5% will retire comfortably. Most will retire with little more than social security.

* The average social security check will be $895 starting in January.

HCFA projects that national health spending will rise from $1.23 trillion in 1999 to $2.18 trillion by 2008. Let's assume health care costs continue to rise at 6% a year. That means health care costs are doubling every 12 years. Clearly, this cannot continue forever, as at some point it overwhelms society; but it can, and will, grow for a long time.

Therefore health care costs will be an increasing proportion of retirement costs, as retirement income is slated to grow far less than health care costs. One of the reasons health care costs are growing is that we keep developing more gee whiz drugs and medical procedures. We can treat more diseases and problems. Sure, we waste money, medical malpractice costs are too high due to an out of control legal system and so on. There are a lot of things, like Medical Savings Accounts, that could hold down costs.

But they will keep rising, as we demand more services. If health care costs rise 5% per year more than income, it is not long before health care is out of reach for many citizens/voters.

Question: if you can treat your health problem with a 5 year old technology or a brand new drug or device which will make life better, do you choose the least costly or the better life? Absent a cost constraint, everyone wants the better product or service. If it is a matter of life or death, there is not even a cost objection. We choose life.

Medical science will offer more and more people the opportunity of living longer, beating cancer, heart disease, creaking bones and the other effects of aging. As the Boomer Generation gets older, they will want more and more of these services.

However, on average, they will not be able to afford them. And therein lays the problem. The 50% of the voters who pay little or no taxes will also be the 50% who cannot afford medical services. And as time goes on, it will be the 60% who cannot afford health care, and so on.

The pressure on the government to offer more health care to those who cannot afford it is going to be huge. But what part of the budget could be diverted into health care?

Everyone will want their benefits continued. Farmers will want to keep their subsidies. Every constituency argues that their part of the budget is necessary.

Defense spending is likely to continue to grow, especially if we get another significant attack. Warren Buffett, in this week's Fortune, argues that it is likely we will see another attack of some kind, and even puts some probabilities on a nuclear attack. In essence, he argues that increased protection costs are necessary.

There will be two choices if we decide to subsidize more medical services for the elderly and less wealthy among us: we will either run deficits which will make those we see today look small, or we will raise taxes, or a combination of both.

The political rhetoric will make this into a rich man-poor man debate. It will be the politics of envy coupled with the quite serious problem how to take care of the sick. Forget the philosophical arguments from both the libertarian and socialist sides. This political battle will be fought in the philosophical middle.

Today, the median household income is $42,000. Above that is the top 50%. If you make more than $42,000, you will be the target in coming decades for tax increases to subsidize increased health care costs. I think most people would agree that $42,000 is not rich.

Given that the goal of politicians is to stay in power, there will be pandering to get enough voters in the middle to move one direction or the other. Pandering always means more government expenditures. In times of rising tax revenues, this is easy. We can spend more and still cut deficits.

But unless we figure out a way to hold down health care cost increases, or the self-evident need for defense spending goes away, it is not likely we will have budget surpluses any time soon. Given my Muddle Through economic view of this decade, it is not likely revenues will rise fast enough to get us back to a balanced budget, without a serious effort to cut back the rise in expenditures, though we could come close.

The problem seems to be that any effort to cut back spending upsets enough voters that Republicans fear they will lose what tenuous grasp they have on power now, and thus they simply do not have the will to cut spending. The recent farm subsidies were a disgraceful display of pandering to a small but powerful constituency which simply blows the budget apart.

Even if we get close to a balanced budget later this decade, a dramatic rise in political pressure for increased health care services will begin as Boomers approach retirement. I do not think it matters which party is in power. If I am right, the party in power will be the one which can carve out a coalition in the middle. If it is the Republicans, it will be those who want to hold down spending allied with those who will tolerate merely small increases in health care subsidies and thus a modest rise in taxes. If it is the Democrats, it will be those who want far more health care benefits allied with those who want more taxes on the upper brackets to fund more government services.

I am reminded of this quote attributed to Walter Mondale as he called for increases taxes at the Democrat Convention 1984:

"Dan Rostenkowski, standing next to the candidate in front of the cameras and the cheering crowd at the convention after the fateful speech, whispered to Mondale, "You've got a lot of balls, pal." According to Rostenkowski, Mondale whispered back, "Look at 'em, we're going tax their ass off." (From Showdown at Gucci Gulch, Jeffrey H. Birnbaum and Alan S. Murray)

In a slow growth economy, we need less taxes, not more. Unfortunately, it is not likely to happen, in my opinion. In the future, it is more likely we will find ourselves with higher taxes. There will be no Gipper to ride to the rescue of the economy. This does not even take into account the pressure for higher state and local taxes.

Rising taxes will be a drag on the nation and the economy, pure and simple. Clearly, if you raise taxes on the lower part of the top 50%, you cut back on consumer spending. If you raise taxes on the top tier, you cut back the primary source for investment spending and entrepreneurial activity.

What do you get at the end of the process? You get Europe. I am not arguing for some Malthusian end of the world scenario. It will simply be higher taxes, but higher taxes have economic costs.

There are those who will argue that would be a good outcome. That is not the debate I am focused on here. We are looking at stock market valuations.

European stocks, because they are seen as part of a slower growing economy, are given lower valuations by investors. That same process will happen here if taxes are raised at the end of the decade.

Just at the time when we should be getting through a secular bear market and ready for the bull, a new set of pressures will develop to hold down stock market valuations. The very act of increasing taxes will contribute to lower stock market growth, just as Boomers are wanting to sell their stocks to retire.

Is this scenario a lock to happen? No, as there will be a large constituency who will not want taxes raised. Further, I could be wrong, and we could grow at 4% a year for another 10 years, rather than the 2% I think likely, and grow our way out of the deficit problem.

If either side can get a more energized electorate, then that side will prevail. But looking at voter trends, and factoring in the enormous self-interest of a significant portion of voters to vote for more health care which they will not be able to afford without subsidies, it is hard to see how taxes will not rise next decade, and thus be a drag on stocks.

Will the Real Economy Please Stand up?

OK, the above section admittedly deals with issues a long time from now. What about today's economy? Bulls will point out that the economy grew at 3.1%, which is a nice rate if it can be sustained. In my opinion, it can't. But we are also not falling off the table.

First, the economy is clearly slowing, and has done so significantly in October. The US unemployment rate rose to 5.7%, and is likely to rise as more lay-offs are constantly being announced. Manufacturing is still showing marked job loss, which is not surprising as today's ISM numbers still s show manufacturing nationwide to be in a contraction. Foreign competition and a high dollar are hurting our manufacturing base.

Industrial production is way down, as is consumer confidence, which is at a 9 year low. Consumer spending is down, and retail store sales are off. Projections for the coming Christmas season are not rosy, but still show hopes for small gains.

It is likely that the 3.1% GDP number will be revised downward, as firmer numbers for September are put into the equation. Right now, they are using estimates, and if the numbers which came from independent economists are any indication, these estimates are going to have been high.

I project this quarter will have us back below 2% growth. Already Ford is telling us auto sales are down by 34% for October. Chrysler says they are off 31%. Housing is slowing slightly, although still at decent levels. With consumer spending down, it is easy to think we are in for a repeat of the second quarter's 1.1% anemic growth rate.

The ECRI index of leading economic indicators are flashing warnings of a recession, although much of that is because the market is down so much. The stock market is part of their index, and has been the primary component pulling the index down. The rest of the index is not pretty, but is not indicating a near recession.

On the plus side, even though a lot of indicators are down, they are not "out." Secretary of Labor Chao noted that last year 52 million people changed jobs. That is a sign of an economy that is resilient, and still has plenty of strength. I continue to note that a free market economy can withstand a lot more than most bears would think.

Thus, we should end the year somewhere near a 2.5% growth in GDP for 2002, but slowing. Given all the pressures upon the US economy, that is excellent. There will be a time when we look back fondly on 2.5%, probably in the last half of 2003.

But that gives the Fed all the more reason to cut rates now.

Greenspan Must Cut Rates

I argued last year that Greenspan had raised interest rates for the last time in his career. That was not the consensus view, by any stretch. Early this year, I argued that it would be more likely he would cut rates this year than raise them.

In my opinion, the primary reason to lower rates is not to stimulate the economy. While it will have some small effect, and may help lower mortgage rates somewhat, which is beneficial, it will not stimulate a new round of corporate spending. Rates are low enough today that if you have an economic reason to borrow money, you already have. Loan demand is soft, there is too much capacity everywhere, and no incentive to increase capacity when final consumer and business demand is weak.

Further, consumers are showing signs of weariness. This will translate into less willingness to take on more debt.

The Dollar Needs to Drop

The primary reason to lower rates is that it will help push the dollar lower. It makes holding dollars less attractive. I think that is why the dollar is dropping modestly ahead of next week's Federal Reserve meeting.

A falling dollar is our best weapon in the battle against deflation.

The Fed has dramatically slowed the pace of monetary growth in the last year. The growth rate of M-1, the most basic measure of money supply, is in actual contraction, especially if you take into account the large amount of currency that has gone permanently overseas.

Whether it is 50 basis points now, or 25 this meeting and another 25 basis points in December, the Fed needs to act. One of the reasons I think they will is that the market has already priced in the rate cuts. Greenspan has been behind the market curve for much of this entire rate cutting binge.

George Gilder

I have always enjoyed reading George Gilder's analysis of technology. He writes the Gilder Technology Report and numerous articles and books. As a student of technology, he gives me a lot to think about.

In the recent issue of the Gilder Technology Report, he took me to task for last week's e-letter. I have never been so delightfully skewered in my life. Let me quote a few sentences:

"I find myself helplessly clicking through to the weekly commentary of John Mauldin (http://www.2000wave.com). ...Thus I join some million morbid folk avidly consuming his casual doom laden prose. ...Mauldin is a conventional accountant economist, deeply alarmed by budget deficits and trade gaps and social security liabilities and other tedious trivia like quarterly reports....no one knows less about the US economy than accountant-economists and Keynesians. Mauldin mostly follows in their trail."

He does go on later to say, "But the reason I read Mauldin is that he can surprise you every issue or so with a penetrating analysis. He had the most acute explanation of the deflation crises published by an investment advisor."

But let's get to the heart of his critique. In my last letter, I pointed out that in my opinion pension costs and expensing options are going to be a glass ceiling on stock market prices. Gilder argues that these do not matter. They are so much "trivia."

Essentially, he believes investors will ignore them. In the 1990's they certainly did. There are now a few investors who wish they had paid attention to some of these trivial details.

My major point in last week's letter is that we are in a new era, where investors will not be willing to overlook these details. They will matter more and more as we progress into a secular bear market. Operating earnings will be seen as more and more suspect, and investors will focus on real earnings. The new accounting standards are going to force companies to be more conservative, and expensing options is just one of the several items which will hold down earnings growth.

Investors have been burned, and now they are twice shy. They will not be willing, in my opinion, to overlook options expense or pension liabilities as trivial. They will not automatically ignore them.

In secular bear markets, value becomes the rule of the day, and conservative accounting standards will be seen as the way to measure them. Any company which tries to "push the envelope" and gets caught will find their stock hammered.

They may have been meaningless trivia in the 90's, but they are important tedious trivia in this decade. Welcome to the real new era.

On the Road Again

Tomorrow I leave for Santa Monica and the National Endowments and Foundations Symposium. I am somewhat nervous, as I speak following a debate between the bearish Jeremy Grantham, one of this country's greatest investment minds, and the bullish Wharton Professor Jeremy Siegel. I am supposed to talk about current economic trends and projections after them, which is somewhat like talking about investing after Warren Buffett speaks. Then off to New Orleans on Thursday for the New Orleans Investment Conference and back to San Francisco on Sunday for the Public Pension Funds Conference. I will be glad to return on Monday to get back home.

I will do further damage to my body by going to my Rice University 30th class reunion the next weekend in Houston and then a quick trip to New York. When I get home on November 18, I intend to avoid airports for a long time.

November is always a good month. Any month with a day set aside to give thanks and be with family just has to be loved. We all have plenty to be thankful for, and it is not too soon to be thinking grateful thoughts.

Your rushing to the nearest early voting site analyst,

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