The Last Half

John Mauldin | Thoughts from the Frontline
September 10, 2010

There are a number of economic forces in play in today's world, not all of them working in the same direction, which makes choosing policies particularly difficult. Today we finish what we started last week, the last half of the last chapter I have to write to get a rough draft of my forthcoming book, The End Game. (Right now, though, it appears this will actually be the third chapter.) We will start with a few paragraphs to help you remember where we were (or you can click here to read the first part of the chapter).

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The Last Half

A $1.5-trillion-dollar yearly increase in the national debt means that someone has to invest that much in Treasury bonds. Let's look at where the $1.5 trillion might come from. Let's assume that all of our trade deficit comes back to the US and is invested in US government bonds. That could be as much as $500 billion, although over time that number has been falling. That still leaves $1 trillion that needs to be found to be invested in US government debt (forget about the financing needs for business and consumer loans and mortgages).

$1 trillion is roughly 7% of total US GDP. That is a staggering amount of money to find each and every year. And again, that assumes that foreigners continue to put 100% of their fresh reserves into dollar-denominated assets. That is not a safe assumption, given the recent news stories about how governments are thinking about creating an alternative to the dollar as a reserve currency. (And if we were watching the US run $1.5-trillion deficits, with no realistic plans to cut back, we would be having private talks, too.)

There are only three sources for the needed funds: either an increase in taxes or people increasing savings and putting them into government bonds or the Fed monetizing the debt, or some combination of all three.

Leaving aside the monetization of debt (for a later chapter on inflation), using taxes or savings to handle a large fiscal deficit reduces the amount of money available to private investment and therefore curtails the creation of new businesses and limits much-needed increases in productivity. That is the goose we will kill if we don't deal with our deficit.

But It's More Than the Deficit

We talked earlier about how increasing government debt crowds out the necessary savings for private investment, which is the real factor in increasing productivity. But there is another part of that equation, and that is the percentage of government spending in relationship to the overall economy. Let's look at some recent analysis by Charles Gave of GaveKal Research.

It seems that bigger government leads to slower growth. The chart below is for France, but the general principle holds across countries. It shows the ratio of the private sector to the public sector and relates it to growth. The correlation is high. (In the book we will show the same graph for other countries.)

That is not to say that the best environment for growth is a 0% government. There is clearly a role for government, but government does cost and that takes money from the productive private sector.

Charles next shows us the ratio of the public sector to the private sector when compared to unemployment (again in France). While there are clearly some periods where there are clear divergences (and those would be even more clear in a US chart), there is a clear correlation over time.

And that makes sense, given our argument that it is the private sector that increases productivity. Government transfer payments do not. You need a vibrant private sector and dynamic small businesses to really see growth in jobs.

And at some point, government spending becomes an anchor on the economy. In an environment where assets (stocks and housing) have shrunk over the last decade and consumers in the US and elsewhere are increasing their savings and reducing debt as retirement looms for an aging Boomer generation, the current policies of stimulus make less and less sense. As Charles argues:

"This is the law of unintended consequences at work: if an individual receives US$100 from the government, and at the same time the value of his portfolio/house falls by US$500, what is the individual likely to do? Spend the US$100 or save it to compensate for the capital loss he has just had to endure and perhaps reduce his consumption even further?

"The only way that one can expect Keynesian policies to break the 'paradox of thrift' is to make the bet that people are foolish, and that they will disregard the deterioration in their balance sheets and simply look at the improvements in their income statements.

"This seems unlikely. Worse yet, even if individuals are foolish enough to disregard their balance sheets, banks surely won't; policies that push asset prices lower are bound to lead to further contractions in bank lending. This is why 'stimulating consumption' in the middle of a balance sheet recession (as Japan has tried to do for two decades) is worse than useless, it is detrimental to a recovery.

"With fragile balance sheets the main issue in most markets today, the last thing OECD governments should want to do is to boost income statements at the expense of balance sheets. This probably explains why, the more the US administration talks about a second stimulus bill, the weaker US retail sales, US housing and the US$ are likely to be. It probably also helps explain why US retail investor confidence today stands at a record low."

This is the fundamental mistake that so many analysts and economists make about today's economic landscape. They assume that the recent recession and aftermath are like all past recessions since WWII. A little Keynesian stimulus and the consumer and business sectors will get back on track. But this is a very different environment. It is the end of the Debt Supercycle. It is Mohammed El-Erian's New Normal.

As we will see in a few chapters, the periods following credit and financial crises are substantially different. They play out over years (if not decades) and are structural in nature and not merely cyclical recessions. And the policies needed by the government are different than in other cyclical recessions. We will go into those later in the book, as they differ from country to country. But business as normal is not the medicine we need, even though that is what many countries are going to attempt.

Not Everyone Can Run a Surplus

The desire of every country is to somehow grow its way out of the current mess. And indeed that is the time-honored way for a country to heal itself. But let's look at yet another equation to show why that might not be possible this time. It is yet another case of people wanting to believe six impossible things before breakfast.

Let's divide a country's economy into three sections: private, government, and exports. If you play with the variables a little bit you find that you get the following equation. Keep in mind that this is an accounting identity, not a theory. If it is wrong, then five centuries of double-entry bookkeeping must also be wrong.

Domestic Private Sector Financial Balance + Governmental Fiscal Balance - the Current Account Balance (or Trade Deficit/Surplus) = 0

By Domestic Private Sector Financial Balance we mean the net balance of businesses and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.

The implications are simple. The three items have to add up to zero. That means you cannot have surpluses in both the private and government sectors and run a trade deficit. You have to have a trade surplus.

Let's make this simple. Let's say that the private sector runs a $100 surplus (they pay down debt), as does the government. Now, we subtract the trade balance. To make the equation come to zero there must be a $200 trade surplus:

$100 (private debt reduction) + $100 (government debt reduction) - $200 (trade surplus) = 0.

But what if the country wanted to run a $100 trade deficit? Then either private or public debt would have to increase by $100. The numbers have to add up to zero. One way for that to happen would be:

$50 (private debt reduction) + (-$150) (government deficit) - (-$100) (trade deficit) = 0. (Note that we are adding a negative number and subtracting a negative number.)

Bottom line: you can run a trade deficit, reduce government debt, and reduce private debt, but not all three at the same time. Choose two. Choose carefully.

We are going to quote from a paper by Rob Parenteau, the editor of The Richebacher Letter, to help us understand why this simple equation is so important. Rob was writing about the problems in Europe, but the principles are the same everywhere.

"The question of fiscal sustainability looms large at the moment - not just in the peripheral nations of the eurozone, but also in the UK, the US, and Japan. More restrictive fiscal paths are being proposed in order to avoid rapidly rising government debt-to-GDP ratios and the financing challenges they may entail, including the possibility of default for nations without sovereign currencies.

"However, most of the analysis and negotiation regarding the appropriate fiscal trajectory from here is occurring in something of a vacuum. The financial balance approach reveals that this way of proceeding may introduce new instabilities. Intended changes to the financial balance of one sector can only be accomplished if the remaining sectors also adjust in a complementary fashion. Pursuing fiscal sustainability along currently proposed lines is likely to increase the odds of destabilizing the private sectors in the eurozone and elsewhere - unless an offsetting increase in current account balances can be accomplished in tandem.

"...The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus. More specific to the current predicament, we remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe's tradable products. Countries currently running large trade surpluses view these as hard-won and well-deserved gains. They are unlikely to give up global market shares without a fight, especially since they are running export-led growth strategies. Then again, it is also said that necessity is the mother of all invention (and desperation its father?), so perhaps current-account-deficit nations will find the product innovations or the labor productivity gains that can lead to growing the market for their tradable products. In the meantime, for the sake of the citizens in the peripheral eurozone nations now facing fiscal retrenchment, pray there is life on Mars that exclusively consumes olives, red wine, and Guinness beer." - Rob Parenteau, CFA [1]

This has profound implications for those countries struggling to deal with large government deficits, large trade deficits, and a desire on the part of individuals and businesses to reduce their debt, while wanting the government to curtail its spending. Something in that quest has to take a back seat.

The time-honored (and preferred) way a country digs itself out from a debt or financial crisis is to grow its way out. And that is what Martin Wolf, the highly regarded columnist for the Financial Times in London, suggests that Great Britain should do. Wolf argues, rather cogently, that the answer is to increase exports and aim for a further weakening of the pound. Quoting:

"Weak sterling, far from being the problem, is a big part of the solution. But it will not be enough. Attention must also be paid to nurturing a more dynamic manufacturing sector. With the decline in energy production under way, this is now surely inescapable."

When Martin Wolf writes, he reflects what the cognoscenti of Britain are thinking. The pound is already down by 25% against the dollar as we write. We think it could go down even further. John has long been on record that the pound could reach parity with the dollar (and was saying so when the pound was much stronger).

How can Britain accomplish this? By printing money to help the current deficit crisis even as the government institutes austerity measures. We see a hand waving in the back. The question is, "Wouldn't that be inflationary?"

Of course it would. That's the plan. A little inflation along with decreasing deficits will result in a weaker currency and therefore (hopefully) more exports, and you "grow" your way out of the crisis. Of course, inflation means you can buy less with your currency, especially from foreign markets. And those on fixed incomes get hurt, and maybe even savagely hurt, depending on the level of inflation. But of course the hope is that it will be "mild" inflation and spread out over time, which is better for people who owe debt (as in governments).

Here is their dilemma. In order to reduce the government's fiscal deficit, either private business must increase their deficits or the trade balance has to shift, or some combination of the two. Lucky for them, they can in fact allow the pound to drift lower by monetizing some of their debt. Lucky, in that they can at least find a path out of their morass. Of course, that means that pound-denominated assets drop by another third against the dollar. It means that the buying power of British citizens for foreign goods is crushed. British citizens on pensions in foreign countries could see their locally denominated incomes drop by half from their peak (well, not against the euro, which is also in freefall).

What's the alternative? Keep running those massive deficits until ever-increasing borrowing costs blow a hole in your economy, reducing your currency valuation anyway. And remember, if you reduce government spending, in the short run that is a drag on the economy, so you are guaranteeing slower growth in the short run. As I have been pointing out for a long time, countries around the world are down to no good choices.

Britain's is a much slower economy (maybe in another recession), with much lower buying power for the pound and lower real incomes for its workers, yet they have a path that they can get them back on track in a few years. Because they have control of their currency and their debt, which is mostly in their own currency, they can devalue their way to a solution.

Pity the Greeks

Some of my fondest memories were made in Greece. I like the country and the people. But they have made some bad choices and now must deal with the consequences.

We all know that Greek government deficits are somewhere around 14%. But their trade deficit is running north of 10%. (By comparison, the US trade deficit is now about 4%.) Going back to the equation, if Greece wants to reduce its fiscal deficit by 11% over the next three years, then either private debt must increase or the trade deficit must drop sharply. That's the accounting rules.

But here's the problem. Greece cannot devalue its currency. It is (for now) stuck with the euro. So, how can they make their products more competitive? How do they grow their way out of their problems? How do they become more productive relative to the rest of Europe and the world?

Barring some new productivity boost in olive oil and other agricultural produce, there is no easy way. Since the creation of the euro in1999, Germany has become some 30% more productive than Greece. Very roughly, that means it costs 30% more in Greece to produce the same amount of goods. That is why Greece imports $64 billion and exports $21 billion.

What needs to happen for Greece to become more competitive? Labor costs must fall by a lot. And not by just 10 or 15%. But if labor costs drop (deflation) then that means that taxes also drop. The government takes in less and GDP drops. The perverse situation is that the debt-to-GDP ratio gets worse, even as they enact their austerity measures.

In short, Greek lifestyles are on the line. They are going to fall. They have no choice. They are going to have to willingly put themselves into a severe recession or, more realistically, a depression.

Just as British incomes relative to their competitors will fall, Greek labor costs must fall as well. But the problem for Greeks is that the costs they bear are still in euros.

It becomes a most vicious spiral. The more cuts they make, the less income there is to tax, which means less government revenue, which means more cuts, which mean, etc.

And the solution is to borrow more money they cannot at the end of the day hope to repay. All that is happening is that the day of reckoning is being delayed in the hope of some miracle.

What are their choices? They can simply default on the debt. Stop making any payments. That means they cannot borrow any more money for a minimum of a few years (Argentina seemed to be able to come back fairly quickly after default), but it would go a long way toward balancing the government budget. Government employees would need to take large pay cuts, and there would be other large cuts in services. It would be a depression, but you work your way out of it. You are still in the euro and need to figure out how to become more competitive.

Or, you could take the austerity, downsize your labor costs, and borrow more money, which would mean even larger debt service in a few years. Private citizens can go into more debt. (Remember, we have to have our balance!) This is also a depression.

Finally, you could leave the euro and devalue, as Britain is going to do. Very ugly scenario, as contracts are in euros. The legal bills would go on forever.

There are no good choices for the Greeks. No easy way. And then you wonder why people worry about contagion to Portugal and Spain?

I see that hand asking another question. Since the euro is falling, won't that make Greece more competitive? The answer is yes, and no. Yes, relative to the dollar and a lot of emerging-market currencies. No to the rest of Europe, which are their main trade partners. A falling euro just makes economic-export power Germany and the other northern countries even more competitive.

Europe as a whole has a small trade surplus. But the bulk of it comes from a few countries. For Greece to reduce its trade deficit means a very large lifestyle change.

Germany is basically saying, you should be like us. And everyone wants to be. But not everyone can.

Every country cannot run a trade surplus. Someone has to buy. But the prescription that politicians want is for fiscal austerity and trade surpluses, at least for European countries. That is the import of Martin Wolfe's editorial we mentioned above. He is as wired in as you get in Britain. And in a few short sentences he has laid out the formula Britain will pursue. Devalue and put your goods and services on sale. Figure out how to get to that surplus.

Germany has been thriving because much of Europe has been buying its goods. If they are forced by circumstances to buy less, that will not be good for Germany. It's all connected.

Yet politicians want to believe that somehow we can all run surpluses - at least in their own countries. We can balance the budgets. We can reduce our private debts. We all want to believe in that mythical Lake Woebegone, where all the kids are above average. Sadly, it just isn't possible for everyone to have a happy ending.

Before we leave this part of the chapter, a few thoughts about the situation in the US. The mood in the country, if not in Washington (at least before the elections last November), is that the deficit needs to be brought down. And consumers are clearly increasing savings and cutting back on debt. But those accounts must balance. If we want to reduce the deficits AND reduce our personal debt, we must then find a way to reduce the trade deficit, which is running about $500 billion a year as we write, or about $1 trillion less than the deficit.

If the US is going to really attempt to balance the budget over time, reduce our personal leverage, and save more, then we have to address the glaring fact that we import $300 billion in oil (give or take, depending on the price of oil).

This can only partially be done by offshore drilling. The real key is to reduce the need for oil. Nuclear power, renewables, and a shift to electric cars will be most helpful. Let us suggest something a little more radical. When the price of oil approached $4 a few years ago, Americans changed their driving and car-buying habits.

Perhaps we need to see the price of oil rise. What if we increased the price of oil with an increase in gas taxes by 2 cents a gallon each and every month until the demand for oil dropped to the point where we did not need foreign oil? If we had European gas-mileage standards, that would be the case now.

And take that 2 cents a month and dedicate it to fixing our infrastructure, which is badly in need of repair. In fact, the US Infrastructure Report Card ( www.infrastructurereportcard.org), by the American Society of Civil Engineers, which grades the US on a variety of factors (the link has a very informative short video), gave our infrastructure the following grades in 2009: Aviation (D), Bridges (C), Dams (D), Drinking Water (D-), Energy (D+), Hazardous Waste (D), Inland Waterways (D-), Levees (D-), Public Parks and Recreation (C-), Rail (C-), Roads (D-), Schools (D), Solid Waste (C+), Transit (D), and Wastewater (D-).

Overall, America's Infrastructure GPA was graded a "D." To get to an "A" would requires a 5-year infrastructure investment of 2.2 trillion dollars.

That infrastructure has to be paid for. And we need to buy less oil. And we know price makes a difference. The majority of that 2 cents would need to stay in the states where it was taxed, and forbidden to be used on anything other than infrastructure.

(And while we are at it, why not build 50 thorium nuclear plants now? No fissionable material, no waste-storage problem, and an unlimited supply (at least for the next 1,000 years) of thorium in the US. The reason we chose uranium was to be able to produce nuclear bombs, among other reasons.) We'll get into this and more when we get to the chapter on the way back for the US.

The Competitive Currency Devaluation Raceway

Greg Weldon likened the competitive currency devaluations in Asia in the middle of the last decade to that a NASCAR race. Each country tried to get in the "draft" of the other ones, keeping its currency and selling power more or less in line as it tried to market its products to the US and Europe. This is a form of mercantilism, where countries encourage exports and, by reducing the value of their currencies, discourage imports. It also helps explain the massive current-account surpluses building up in emerging-market countries, especially in Asia.

There is the real potential for this race to become far more "competitive." Indeed, Martin Wolf's few sentences are the equivalent of the NASCAR announcer saying,

"Gentlemen, start your engines."

We touched on Britain. But there are structural weaknesses in the euro as well (again, in later chapters). In the early part of the last decade, when the euro was at $.88, John wrote that the euro would rise to $1.50 (seemingly unattainable at the time) and then fall back to parity with the dollar by the middle of this decade. He was overly optimistic, as the euro went to $1.60 but is now retracing that rise.

The title for our chapter on Japan is "A Bug in Search of a Windshield." While the currency of the Land of the Rising Sun is very strong as we write, there are again real structural reasons, as well as political ones, why we predict the yen will begin to weaken. At first, its fall will be gradual. But without real reform in government expenditures, the yen could weaken substantially. A fall of 50% or more against the dollar by the middle of the decade (if not sooner) is quite thinkable.

The euro at parity. The pound at parity. The value of the yen in half. What will be the response of other countries around the world? Do they sit by and allow their currencies to rise, making it more difficult to compete with Europe and Japan? The Swiss are clearly not happy with the rise of the Swiss Franc. The Scandinavian countries? The rest of Asia?

And what of China? Europe is an extremely important market to them. Do they sit by and let their currency rise (a lot!) against the euro and hurt their exports? But if they react, that makes the US unhappy and starts another competitive devaluation throughout Asia.

What does the US do? US senators are mad enough about the valuation of the Chinese yuan. Do Schumer, Graham, et al. start talking about tariffs on European goods? On Japanese goods?

The US and the world went into a deep recession in the early 1930s, but it took the protectionist Taft-Hartley bill to stretch it out into a prolonged depression. It was a beggar-thy-neighbor policy that swept the world. It was disastrous and sowed the seeds of World War II. There was an unintended consequence on every page of that bill.

In a few years, the world will be at significant risk of protectionist policies damaging world trade. Let us hope that cool heads will be in the lead and avoid the policies that so clearly would hurt us all.

This chapter has been a kind of introduction to the macroeconomic forces that are at play in the world in which we find ourselves. While much of the developed world has no good choices, we (each country on its own) still must decide on a path forward. We can choose between bad choices and what would be disastrous choices. We can make the best of what we have created and move on. If we make the correct choices to solve the structural problems, we can emerge into a brighter future for ourselves and our children. If we choose to avoid the problems, we will hit the wall in spectacular and dramatic fashion.

As Ollie said to Stan (Laurel and Hardy), "Here's another fine mess you've gotten me into!" A fine mess indeed.

Amsterdam, Malta, Zurich, Mallorca, Denmark, and London

I leave for Europe tomorrow evening, and will be flitting here and there, packing a lot into a few days. I will be meeting with Jonathan Tepper, and we will finalize the rough draft of The End Game and send it out to a few friends for comments. There is a lot of editing, going back to findi that missing piece of data, adding footnotes, etc. The plan is to be done with it by the end of September. I am so ready to move on.

John Grisham (who knows a thing or two about writing) recently had this to say about his first book:

"I had never worked so hard in my life, nor imagined that writing could be such an effort. It was more difficult than laying asphalt, and at times more frustrating than selling underwear. But it paid off. Eventually, I was able to leave the law and quit politics. Writing's still the most difficult job I've ever had - but it's worth it." ( http://www.nytimes.com/2010/09/06/opinion/06Grisham.html?_r=2)

It is time to hit the send button. I look forward to the next few weeks, as I will be with old friends and meet new ones in interesting places. But I will be remembering another 9/11 just nine years ago as I get on an American Airlines flight to London. And take a moment to remember those who did not make it home.

Your reflective analyst,

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