John Mauldin's Outside the Box : Inflation

Between a Rock and a Hard Place

John Mauldin — Mon, 24 Aug 2009 19:06:00 GMT

There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it "just right." The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week's Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.

Those who are absolutely positive about which of a variety of outcomes will emerge have a level of clairvoyance with which I am not familiar. It makes risk asset (like stocks) investing particularly tricky right now. This is a time to be nimble and avoid creating opportunities for large losses if you are wrong.

We will start this week's OTB with a few paragraphs from the Bank Credit Analyst about the Great Depression and then move on to a piece from the London office of Morgan Stanley on the problems facing central bankers.

And on a less ominous but more important note, the Muscular Dystrophy Association (MDA) has issued a warrant for my arrest which goes into effect on August 26th! I will be held at the PM Lounge in the Joule Hotel from 3-6. My bail is set at $2,400, which will benefit local families living with neuromuscular disease. No one person can set me free. It will take a little help from all of my friends, family, colleagues and enemies! Please use the link below to visit my Bail Page and help me post my bond by contributing in any way that you can. Thank you for having a big heart! And come see me in jail!

CLICK HERE TO HELP RAISE MY BAIL!!

And now, the thoughts from BCA.

John Mauldin, Editor
Outside the Box

"Prematurely exiting from an accommodative policy setting, derailed the recovery in the late 1930s and led to another leg of the depression.

"By mid-1936, the Federal Reserve lifted bank reserve requirements, in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces.

"Obviously the economic relapse in the 1930s is an extreme example. Nonetheless, it does highlight the risks of authorities exiting prematurely before the economy and banking system are ready (even after an extended period of healthy growth). Currently, U.S. and U.K. money multipliers are still impaired, although aggressive easing has allowed some liquidity to flow through to the real economy. A decline in U.S. M2 growth would be a major warning sign. U.K. broad money growth has plunged in recent months, presenting a significant threat to the economy.

"Bottom line: Policymakers will need to continue to curb investor expectations for an early exit in order to allow a sustainable recovery to materialize. It will likely be at least until the end of next year before growth conditions in the U.S. and U.K. are robust enough to withstand a reduction in stimulus." (www.bcaresearch.com)

Between a Rock and a Hard Place

By Manoj Pradhan & Spyros Andreopoulos | Morgan Stanley, London

Monetary policy usually finds traction in the real economy through different ‘channels of monetary transmission', working through falling interest rates, increasing asset prices and increased lending by banks. These translate into more consumer and business spending, which boosts economic growth. During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery. Turning away from the inflation-targeting (IT) regime that is now conventional wisdom to perhaps a price level-targeting (PT) regime or even explicitly accounting for asset prices may give central banks much-needed flexibility.

The Sequence of Events in Economic Recovery

In a garden-variety recession, policy rate cuts lead to declines in lending rates and slow traction in the form of a better outlook for consumer and business spending. Risky assets usually rally a quarter or two before the recession ends, whereas credit growth usually picks up only after recovery sets in (see "Credit Confusion", The Global Monetary Analyst, February 4, 2009). The Great Recession has not scrambled this sequence of events but it has changed the timing and response of some. Because of the freezing of credit markets, the interest rates that matter for borrowers fell much later than they would have during a more typical episode. Also, given the massive task of repairing balance sheets that confronts commercial banks and households in particular, spending and borrowing are likely to remain subdued. The risk is that credit growth could lag the end of the recession by more than usual. However, risky assets seem to have stuck to the script and rallied ahead of the bottom in economic growth by a familiar lead time.

Interest Rate Channel Less Effective So Far

When central banks cut policy rates, other interest rates respond quickest to the policy move. By providing cheaper borrowing rates to households and businesses, central banks aim to encourage spending and spur production. This is the ‘interest rate' channel for monetary transmission. This channel typically carries the bulk of the burden of resuscitating the economy. Untraditionally, during this current cycle, interest rates that matter to borrowers have fallen very slowly and much later than the cuts in policy rates. Even as they have fallen, however, they have met households who are reluctant to exploit these low rates, given the desire to save in the US and the UK and the conservative habits of German and Japanese households.

Credit Channel Likely to Be Subdued as Well

During a recession, credit flows to the private sector usually fall. Banks are less willing to lend and households and firms are less willing to borrow. Policy rate cuts normally provide commercial banks ‘carry' via a steeper yield curve, allowing them to borrow money at low rates and lend it at higher rates. In this cycle, central banks have had to resort to unconventional measures in addition to rate cuts to ensure that banks had the benefits of a steeper yield curve and an abundance of liquid funds to lend if they so desired. Surveys suggest that banks are becoming more receptive to lending but credit will likely grow with a lag (again see Credit Confusion) and quite slowly thanks to banks and households slowly rebuilding their balance sheets.

Asset Price Channel Leading the Charge...

Risky assets have outplayed the other channels by a margin over the last few months. This is an encouraging sign for central banks, who will undoubtedly welcome the economic traction that accompanies rising asset prices. A rise in equity prices should enhance the incentive to invest because the higher price of existing capital implied by higher share prices increases the relative attractiveness of investing in new capital (Tobin's q). Back in March, with the worst of the economic bad news likely already having been delivered and ultra-expansionary policy in place, risky assets rallied and rallied hard, which is a positive for investment. A possible bottoming in the housing market in the US and the UK would mean that Tobin's q could be applied to the housing sector as well. Households are more likely to buy new houses if house prices are rising, and this encourages homebuilding activity. Also, rising asset prices have supported the balance sheets of financial institutions.

...but Risky Asset Rallies Come at a Cost

One of the most important lessons from the Great Recession is the damage that asset bubbles can wreak. As the Fed and the ECB kept policy rates low for a very long time after the 2001 recession to ward off deflation concerns, they chose to allow an ultra-expansionary policy to inflate asset prices. Even though economic growth in the next couple of quarters could be very strong, the medium-term outlook for the major economies and therefore for global growth remains quite fragile. Policymakers therefore may end up having a repeat of the 2001-type dilemma on their hands.

Between a Rock and a Hard Place

If the imbalance between risky asset prices on one hand and interest rates and credit on the other persists for a significant period of time, the transition from über-expansionary policy to a neutral stance could be an extremely tricky balancing act for central banks. In the long run, asset prices cannot keep exceeding the growth potential of the economy. However, over shorter horizons, a loose policy regime with plentiful excess liquidity can lead to significant asset price inflation when markets see an improving economic outlook. If policymakers allow asset prices to surge because the other transmission channels have been weak, they risk inflating the type of bubble that got us here in the first place. If they decide to head off asset prices by tightening policy, they risk raising rates into a weak recovery! The transition to a neutral policy stance thus requires greater balance between the channels of monetary transmission - ideally from interest rates and credit growth gaining better traction in the economy as asset price inflation cools down. This balance is far from guaranteed. Worse, a revival in credit growth could further stoke asset price inflation. Not the best news for central banks.

Inflation Targeting Too Stringent

What could central banks do if they find themselves in such a situation? Using the interest rate tool to quell asset price inflation when the economy is yet to recover fully would risk sustained deviations from the inflation target on the downside. At the same time, it would expose central banks to criticism from politicians and the public since the policy might jeopardise the recovery. Central banks might try to counter the pressure by arguing that pricking asset price bubbles would foster price stability over a longer time horizon by preventing crises such as the current one. But this riposte would be problematic in the current policy framework. Deliberately using policy rates to pursue objectives other than inflation - especially in a way that is detrimental to achieving the inflation target - is incompatible with the inflation-targeting (IT) orthodoxy. More to the point, pursuing asset prices could deliver a fatal blow to the transparency of the monetary policy regime. If the public is unclear about what the objectives of monetary policy are, it could lose faith in the central banks' commitment to price stability and inflation expectations would become unanchored. One of the main advantages of IT - transparency - would then be rendered defunct.

A Way Out?

Assuming CBs want to ‘lean against the wind' of asset prices, is there a way for CBs to escape the strictures of orthodox IT without risking the loss of their holy grail, the credibility of monetary policy? Price level targeting (PT) may be the answer. Under PT, the central bank aims at a certain path for the price level, with the rate of increase in the price level given by the inflation target (see "From Inflation Targeting to Price Level Targeting", The Global Monetary Analyst, July 15). PT differs from IT in that past deviations from the inflation target have to be corrected. For example, with a price level target path consistent with 2% inflation, if inflation in one period is 1%, then it would have to be 3% in the next period. The undershoot in one period would have to be compensated for by an overshoot in the next period in order to return to the price level target path. In short, PT is essentially ‘average inflation' targeting.

How Would PT Help Central Banks?

By effectively increasing the time horizon over which the inflation target can be achieved, it would give monetary policy much-needed flexibility to, if necessary, pursue asset price inflation in the short term. At the same time, long-term inflation expectations would remain anchored since monetary policymakers would commit to achieving 2% inflation on average. Indeed, inflation expectations under PT would themselves have stabilising effects on the economy. While inflation undershoots the target temporarily in order to burst the bubble, the public would know that this would soon require a compensatory overshoot. Short-term inflation expectations would then rise, decreasing real interest rates. This would, in turn, increase spending and output.

In summary, the transition from ultra-expansionary policy to a neutral stance may be very tricky if the imbalance between different channels of monetary transmission persists. Central banks may find themselves hiking into a weak recovery to quell asset prices, or they might compensate for the weakness in the interest rate and credit channels and allow asset prices to rise but risk inflating another bubble. Central banks could gain some much-needed flexibility by thinking outside the IT box - but whether they will make a dramatic move and switch to a PT regime remains to be seen.

Slow Long-Term Growth, And Government's Response

John Mauldin — Mon, 10 Aug 2009 20:50:00 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. His web site is down being re-designed, but you can write for more information at insight@agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out until the end of the year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

John Mauldin, Editor
Outside the Box

Slow Long-Term Growth, And Government's Response

(excerpted from the August 2009 edition of A. Gary Shilling'sINSIGHT)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we've discussed in pastInsights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow -- so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in pastInsights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis -- U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids' education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices -- the vast majority of most Americans' net worth -- are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we're forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we've discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn't want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes aren't so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won't qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% won't qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We've already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore's huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won't stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It doesn't plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed's lending powers to require the Treasury Secretary's approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don't vote in domestic elections.

As noted earlier, initially this recession was in the financial arena -- the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it's not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country's financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps.

Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand wasn't caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We've consistently predicted the good deflation of excess supply, but we've also said clearly that the bad deflation of deficient demand could occur -- due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation. They've never seen anything but inflation in their business careers or lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we've cited in pastInsights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) -- the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall -- are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply overdemand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it's got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. Meanwhile, prices -- already down 32% from their second quarter 2006 peak -- are likely to fall to reach a total 37% decline we've forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by the unusually large slashing of consumer spending. It's hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That's a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7 ) to 2.1%.

So with the five other inhibitors to growth in coming years -- financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation -- our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We're also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s - mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same longrun phenomenon of past decades that was measured in different ways -- the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption's share of GDP, reflecting what consumers did with the money they didn't save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption's share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we're forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption's share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years -- the saving rate fell from 12% to zero, or 12 percentage points while consumption's share of real GDP rose from 67.5% to 71%.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption's share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation's share of national income falling while corporate profits' share leaped during those years.

In the years ahead, however, it's unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits' share was at its zenith, a big decline in corporate earnings' piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one's share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where's The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it's unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined -- and they hadn't on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future -- which means chronic declines with chronic deflation -- are shattering the scales that blinded homeowners. So they're beginning to separate places to live from investments. That means they'll want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we've run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead -- except for federal government stimuli that's spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California's latest budget stopgap will take, temporarily, $4 billion from local government funds.

We're forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there's no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s -- electrification of homes and factories and mass-produced automobiles -- was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June's 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we're right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising -- absent huge federal intervention. And that intervention is assured since no government -- left, right or center -- can withstand high and rising joblessness for long. And don't forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it won't be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what's left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment -- the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In futureInsights, we'll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, don't expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It's likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.

Make Sure You Get This One Right

John Mauldin — Mon, 06 Jul 2009 16:14:15 GMT

There are those who sweat over every decision, worrying about how it will affect their lives and investments. Then there is the school of thought that we should focus on the big decisions. I am of the latter school.

85% of investment returns are a result of asset class allocations and only 15% come from actually picking investment within the asset class. Getting the big picture right is critical. In this week's Outside the Box we look at a very well written essay about the biggest of all question in front of us today. Do we face deflation or inflation?

This OTB is by my good friends and business partners in London, Niels Jensen and his team at Absolute Return Partners. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box

Make Sure You Get This One Right

By Niels C. Jensen

"You can't beat deflation in a credit-based system."

Robert Prechter

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won't have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those 'make or break' decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or 'quantitative easing' as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don't understand the world of finance or you don't want to understand. Shame on those who fall for cheap tactics.

Let's begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that 'less bad' doesn't necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn't suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a 'buy and hold' market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people's problems than your own. A little bit like raising children, I suppose.

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won't rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?

Good question - counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn't go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest 'must have' amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry's leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. 'Get long and get loud' it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government's point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

Quarterly Review and Outlook - First Quarter 2009

John Mauldin — Mon, 20 Apr 2009 21:14:00 GMT

There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. And this week's letter does just that. I have made the comment more than once that is it unusual for two major bubbles to burst and for the conversation and our experience to be rising inflation and not a serious problem with deflation.

Van Hoisington and Dr. Lacy Hunt give us a seminar on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort.

Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter- intuitive to what we hear today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable.

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And their track record over the last 20 years suggests we should pay attention. And now let's jump right in to the essay.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook
First Quarter 2009

Inflation/Deflation

Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that "sooner or later" inflation will inevitably return, probably with great momentum. This inflationist view of the world seems to rely on two general propositions. First, the unprecedented increases in the Fed's balance sheet are, by definition, inflationary. The Fed has to print money to restore health to the economy, but ultimately this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity. This will serve to reinforce the reflationary efforts of the Fed and lead to inflation.

These propositions are intuitively attractive. However, they are beguiling and do not stand the test of history or economic theory. As a consequence, betting on inflation as a portfolio strategy will be as bad a bet in the next decade as it has been over the disinflationary period of the past twenty years when Treasury bonds produced a higher total return than common stocks. This is a reminder that both stock and Treasury bond returns are sensitive to inflation, albeit with inverse results.

Economic Theory

If inflation and interest rates were to rise in this recession, or in the early stages of a recovery, the expansion would be cut short and the economy would either remain in, or relapse into recession. In late stages of economic downturns, substantial amounts of unutilized labor and other resources exist. Thus, both factory utilization and unemployment rates lag other economic indicators. For instance, reflecting this severe recession, unused labor and other productive resources have increased sharply. The yearly percentage decline in household employment is the largest since current data series began in 1949. In March the unemployment rate stood at 8.5%, up from a cyclical low of 4.4%. This is the highest level since the early 1980s. The labor department's broader U6 unemployment rate includes those less active in the labor markets and working part time because full time work is not available. The U6 rate of 15.6% in March was the highest in the 15 year history of the series and up from its cyclical low of 7.9%. The operating rate for all industries and manufacturing both fell to their lowest levels on record in March. Manufacturing capacity was around 15% below the sixty year average (Chart 1). Given these conditions, let's assume for the moment that inflation rises immediately. With unemployment widespread, wages would seriously lag inflation. Thus, real household income would decline and truncate any potential gain in consumer spending.

A technically superior and more complete method of capturing the concept of excess labor and capacity is the Aggregate Supply and Demand Curve (Chart 2). Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity exists. Excess capacity causes firms to cut staff, wages and other costs. Since wage and benefit costs comprise about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD. Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve thus creating higher price levels. In our opinion such a process will take well over a decade.

Record Expansion of the Fed's Balance Sheet and M2

In the past year, the Fed's balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion, and potentially larger increases are indicated for the future. The increases already posted are far above the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts. They recall Milton Friedman's famous quote that "inflation is always and everywhere a monetary phenomenon."

These gigantic increases in the monetary base (or the Fed's balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public's preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank's needs for excess reserves. These factors, beyond the Fed's control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall (Chart 3). Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments. Not surprisingly, from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline.

If this all sounds complicated you are right, it is. The bottom line, however, is that it is totally incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.

What about the M2 Surge?

M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system. The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed.

The historical record indicates that V may be likened to a symbiotic relationship of two variables. One is financial innovation and the other is the degree of leverage in the economy. Financial innovation and greater leverage go hand in hand, and during those times velocity is generally above its long-term average of 1.67 (Chart 4). Velocity was generally below this average when there was a reversal of failed financial innovation and deleveraging occurred. When innovation and increased leveraging transpired early in the 20th century, velocity was generally above the long-term average. After 1928 velocity collapsed, and remained below the average until the early 1950s as the economy deleveraged. From the early 1950s through 1980 velocity was relatively stable and never far from 1.67 since leverage was generally stable in an environment of tight financial regulation. Since 1980, velocity was well above 1.67, reflecting rapid financial innovation and substantially greater leverage. With those innovations having failed miserably, and with the burdensome side of leverage (i.e. falling asset prices and income streams, but debt remaining) so apparent, velocity is likely to fall well below 1.67 in the years to come, compared with a still high 1.77 in the fourth quarter of 2008. Thus, as the shadow banking system continues to collapse, velocity should move well below its mean, greatly impairing the efficacy of monetary policy. This means that M2 growth will not necessarily be transferred into higher GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded by 15.7%. The same pattern appears likely in Q1 of this year.

The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.

Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.

Are Massive Budget Deficits Inflationary?

Based on the calculations of the Congressional Budget Office, U.S. Government Debt will jump to almost 72% of GDP in just four fiscal years. As such, this debt ratio would advance to the highest level since 1950 (Chart 5). The conventional wisdom is that this will restore prosperity and higher inflation will return. Contrarily, the historical record indicates that massive increases in government debt will weaken the private economy, thereby hindering rather than speeding an economic recovery. This does not mean that a recovery will not occur, but time rather than government action will be the curative factor.

By weakening the private economy, government borrowing is not an inflationary threat. Much light on this matter can be shed by examining Japan from 1988 to the 2008 and the U.S. from 1929 to 1941. In the case of Japan government debt to GDP ratio surged from 50% to almost 170%. So, if large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time. Instead, their economy is in shambles. After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5% (Chart 6). As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector (Chart 7). Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.

This recent Japanese experience mirrors U.S. history from 1929 to 1941 when the ratio of U.S. government debt to GDP almost tripled from 16% to near 50%. As the U.S. debt ratio rose, long Treasury yields moved lower, indicating that the private sector was hurt, not helped, by the government's efforts. The yearly low in long Treasury yields occurred at 1.95% in 1941, the last year before full WWII mobilization. In 1941, the S&P 500, despite some massive rallies in the 1930s, was 62% lower than in 1929, and had been falling since 1936. Thus, two distinct periods separated by country and considerable time indicate that stock prices respond unfavorably to massive government deficit spending and bond yields decline.

The U.S. economy finally recovered during WWII. Some attribute this recovery to a further increase in Federal debt which peaked at almost 109% of GDP. However, the dynamics during the War were much different than from those of 1929 through 1941 and today. The U.S. ran huge trade surpluses as we supplied military and other goods to allies, which served to lift the U.S. economy through a massive multiplier effect. Additionally, 10% of our population, or 12 million persons, were moved into military services. This is equivalent to 30 million people today. Also, mandatory rationing of goods was instituted and people were essentially forced to use an unprecedented portion of their income to buy U.S. bonds or other saving instruments. This unparalleled saving permitted the U.S. economy to recover from the massive debt acquired prior to 1929.

Bonds Still an Exceptional Value

Since the 1870s, three extended deflations have occurred--two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of "extreme over indebtedness," a term originally used by Irving Fisher in his famous 1933 article, "The Debt-Deflation Theory of Great Depressions." Fisher argued that debt deflation controlled all, or nearly all, other economic variables. Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per annum more than Treasury bonds, but in deflations the risk premium was negative. In the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9% and 7% per annum, respectively, more than common stocks. In Japan's recession from 1988-2008, Treasury bond returns exceeded those on common stocks by an even greater 8.4%. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond (Table 1).

This table also speaks to the impact of massive government deficit spending on stock and bond returns. In the U.S. from 1874-94, no significant fiscal policy response occurred. The negative consequences of the extreme over indebtedness were allowed to simply burn out over time. Discretionary monetary policy did not exist then since the U.S. was on the Gold Standard. The risk premium was not nearly as negative in the late 19th century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when the government debt to GDP ratio more than tripled in both cases. In the U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S. 1928-41 and in Japan in the past twenty years, stocks posted compound annual returns of negative 2.4% and 2.3%, respectively. Therefore on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows and slow growth.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Roadmap To Inflation And Sources Of Cheap Insurance

John Mauldin — Tue, 24 Mar 2009 14:35:31 GMT

What happens when inflation once again returns. As this week's Outside the Box writer, James Montier, writes, we may want to start thinking now about inflation insurance and he mentions a few ways to do so. But this letter is a must read for his bringing to light a speech by Fed chairman Ben Bernanke in 2000 given to the Japanese, where he suggest inflation targeting:

"In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%!"

I think you will find this week's OTB to be exceptionally thought provoking. Montier is one of my favorite economic thinkers (and a good friend). He works for Societe Generale in London in their Cross Asset Research group.

John Mauldin, Editor
Outside the Box

Roadmap To Inflation And Sources Of Cheap Insurance

by James Montier

As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher's "The debt-deflation theory of Great Depressions" published in 1933¹. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits "two dominant factors" in driving depressions "Namely over-indebtedness to start with and deflation following soon after... In short, the big bad actors are debt disturbances and price-level disturbances". He continues "Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed." That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: "It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors... I would emphasize... that great depressions are curable and preventable through reflation and stabilization". The irony of Fisher's route out of deflation is that, probably only the Fed - after helping lead us into this mess² - can now get us out of it.

Romer's lessons from the Great Depression

After reading Fisher's analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 1992³ arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn't large. As Romer notes "When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level... The deficit rose by about one and a half percent of GDP in 1934".

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes "The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936". Romer argues that this "Devaluation followed by rapid monetary expansion broke the deflationary spiral" - empirical evidence to support Fisher's hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes "The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937". She concludes "taking the wrong turn in 1937 effectively added two years to the Depression".

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren't really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at "fixing the financial system", witness Bernanke's recent comments "Recovery is not going to happen until the financial markets and the banks are stabilized". This appears to be a misperception, as, Romer notes "Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression".

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn't post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn't make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history - as represented by the balance sheet - cannot simply be ignored when it is inconvenient. As John Hussman noted "The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term "operating profit." Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet."

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, "Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery... across a wide range of countries in the 1930s... These actions worked to lower world [real] interest rates... rather than just to shift expansion from one country to another".

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it "Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American's fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries... would probably have been fully recovered before the outbreak of World War II" This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.

Bernanke and the policy options

The final source for signposts to watch comes from a speech given by Bernanke in 2000 to Japanese policy makers. As I wrote in Mind Matters 6 January 2009, in this speech Bernanke clearly acknowledged the greater threat that deflation poses in a highly leveraged economy, "Zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century."

Bernanke clearly believes that monetary policy is far from impotent at the zero interest rate bound. In essence his argument is an arbitrage based⁴ one as follows "Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero."

In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%!

Third on the list was money financed transfers. Essentially tax cuts financed by printing money. Obviously this requires co-ordination between the monetary and fiscal authorities, but this should be less of an issue in the US than it was in Japan. Finally, Bernanke argues that non-standard monetary policy should be deployed. Effectively, quantitative and qualitative easing. Bernanke has repeatedly mentioned the possibility of outright purchases of government bonds - as the UK is now doing.

This menu should provide us with a roadmap of policy options to watch for. If (and when) the deflationary pressure builds, we should expect to see more and more of these options wheeled out. Note that we aren't talking about trying to 'fix the system', to reflate the bubble (which would be the equivalent of giving crack cocaine to a heroin addict trying to deal with withdrawal). Rather, the suggestion from Fisher is that inflation erodes the real value of debt; it is the most painless way out of our current mess. Whether the authorities can create just a little inflation remains to be seen, as does their ability to actually create inflation in any way. Such imponderables are beyond my ken.

Investment implications – Cheap insurance

Howard Marks recently suggested that today's investment decisions must focus on "value, survivability and staying power". These factors lie at the heart of the three-pronged approach that I have been suggesting since the end of October last year.

The first prong is cash. This is a legacy from the lack of opportunities that characterised markets in the last few years. But it is also a hedge against outright deflation. The second prong is deep value opportunities in both debt and equity markets (as detailed for the equity markets most recently in Mind Matters, 4 March 2009). The third element is sources of cheap insurance. The idea behind this element of the portfolio is to prepare for a wide variety of outcomes by buying cheap insurance (which ideally, although not always, pays off in multiple states of the world). Of course, it should be noted that the purchase of cheap equities also contains an inflation hedge element.

Inflation/deflation insurance I – TIPS

The first and most obvious source of inflation/deflation protection when I first started thinking about this subject was US TIPS. These bonds have a deflation floor on the principal, so in the event of deflation I receive my cash back - representing a real rate of return equivalent to whatever the deflation rate is. In the event of inflation, I get whatever the yield is on the TIPS when I purchase them plus the inflation, of course (buying the new issue TIPS avoids the problem of accrued inflation).

When I started looking at TIPS, the yield was over 3.5%. This has dropped since then, resulting in the 10 year TIPS delivering a 9% return since the end of October. The 10 year TIP is currently yielding 2.1%, against the 10 year nominal bond yield of 3%. This implies that the market expects US inflation to be a mere 1% p.a. over the next decade - this strikes me as an exceptionally low rate.

Inflation/deflation insurance II – Gold

The second inflation/deflation hedge I suggested in late October was gold. Now, gold concerns me for a variety of reasons, not least of which is that it has no intrinsic worth: I can't really value gold - beyond extraction cost.

However, it has some attractive features from an insurance point of view. Most obviously, in a world of competitive devaluations, gold is the one currency that can't be debased. Thus it provides a useful hedge against the return of this sort of beggar-thy-neighbour policy. In the event of significant prolonged deflation, what is left of our financial system is likely to collapse, thus holding a money substitute isn't such a bad idea against this cataclysmic outcome.

Of course, recently everyone has been talking about gold (not hugely surprising given that it is up some 30% since late October) - something that makes me nervous. However, gold is institutionally massively under-owned, so whilst it may have been moving up the list of attractive assets of individual investors (if the EFTs are anything to go by) and sensible hedge funds (such as the likes of Greenlight, Paulson, Third Point, Eton Park and Hayman), the mainstream institutional appetite for it has remained depressed.

Inflation insurance I – Dividend swaps

As we noted in Mind Matters, 2 February 2009 the European and UK dividend swap markets are pricing in an outcome that implies greater dividend declines than witnessed in the US during the Great Depression. The pricing then implies that essentially the dividends won't recover, pretty much forever. This strikes me as excessively pessimistic.

In addition, dividends have a relatively close relationship with inflation (as detailed in the aforementioned Mind Matters). Thus dividend swaps look like a deeply distressed asset fire sale, with the added advantage of offering inflation insurance if I buy the longer dated swaps (up around 7% from my original note in February). The most common rebuttal to my fondness for dividend swaps is counterparty risk. However, the European dividend swaps have an exchange listed future, which obviously doesn't have any counterparty issues.

Inflation insurance II – Inflation swaps

The second of the pure inflation hedges comes via the inflation swap market. The charts below show the zero-coupon fixed rate necessary to build a swap against zero-coupon CPI appreciation over 10 years. When I first looked at the US version in January (see Mind Matters, 6 January 2009) the rate was a mere 1.5%. Today it has risen, although not dramatically, to 2.3%.

However, the cheapest inflation swaps in the world seem to be Japanese swaps. They are available for -2.5%! Both the US and Japanese inflation swaps strike me as cheap ways of buying inflation insurance at the moment. Although counterparty risk is obviously a significant factor in these long duration swap transactions.

Eurozone break-up insurance: Spanish and Portuguese CDS

The final element of the insurance policy concerns the risk of a euro break-up. In a world of competitive devaluation, it isn't clear that the Eurozone will be able to stand the pressure. The one area of the world which has anything like the gold standard in place is the Eurozone. As Albert opines during our meetings with clients, this is less a function of economic realities and more a function of political expediency (I'll leave a detailed exposition of this logic to Albert in a future note).

To protect against this risk (or even rising perceptions of this risk) the natural insurance is provided by the CDS market. If even one country was to publicly contemplate leaving the Eurozone then these CDS spreads would explode. I find it hard to believe that Portuguese and Spanish CDS are below those of the UK - where we have the ability (and have used it) to print our own money.

Footnotes:

¹Available from http://www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read!

²See Bill Flecksenstein's excellent book, Greenspan's Bubbles or John Taylor's insightful paper The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong, available from http://www.stanford.edu?~johntayl/FCPR.pdf, or any of Albert Edwards' myriad of rants on Greenspan.

³Romer (1992) What ended the Great Depression?, The Journal of Economic History, Vol 52

⁴As Stephen Ross once said, to turn a parrot into a learned financial economist it needs learn just one word: arbitrage. To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions. Indeed the second chapter of my first book, Behavioural Finance is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!).

Inflation Is Not The Problem

John Mauldin — Tue, 15 Jul 2008 01:34:58 GMT

This week we are going to do something unusual for Outside the Box. Normally I take an essay and send it to you to read. Today I am going to give you a link and strongly suggest you click to it. Long time readers are familiar with friend and comrade James Montier, who along with Albert Edwards, migrated to Societe Generale earlier this year. They are co-heads of Global Cross Asset Strategy and based in London.

Kate Welling does some of the best interviews anywhere in her Welling@Weeden letter, and this one of Montier and Edwards is typical of her immensely enjoyable style. She gave my good friend Prieur du Plessis permission to reprint the letter, and I provide you with a link to his blog and if you scroll down 6 short paragraphs you get the link to the letter, which includes the graphics and is much more fun than just me cutting and pasting. You can also subscribe to Prieur's blog if you wish. Once a week he provides a very useful review of what was written the previous week.

Montier and Edwards speak quite forcefully about the problems they see in the market today, and they are truly Outside the Box thinkers.

"They are, in a word, skeptics, and at this juncture most deeply skeptical of any and all notions that 'the worst is over.' The recession, which has barely begun, is more likely to be deep than shallow, market valuations are hideously expensive and the -flation policymakers should be worried about starts with de-, not in-. For their reasons, keep reading, if you dare."

The link is: http://www.investmentpostcards.com/2008/07/05/market-fundamentals-are-appalling/

And no, despite the picture, they are not twins separated at birth.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - Second Quarter 2008

John Mauldin — Tue, 08 Jul 2008 02:05:00 GMT

Van Hoisington and Dr. Lacy Hunt give us a seminar on why it will be deflation that will ultimately be the problem and not the current inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort. Remember our lesson from Economics 101. If you raise the supply of something, in normal markets the price goes down. And if you increase the price, suppliers will respond by producing more.

Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter-intuitive to what we see in the stores today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - Second Quarter 2008

Inflation

Widespread is the notion that inflation is back for good. Many assume that the relative price stability of the past two decades has been irrevocably shattered by "peak oil" and the surging demand by developing economies. Improvement of living standards in those developing countries has caused, and will continue to cause, increasing demand for calories, and final demand for food will outstrip supply. Additionally, the cost of basic materials is lifting production costs, and the cycle of higher food and fuel costs means that the prices of all imported goods to the United States will continue to rise. The fixed income investment conclusion is that inflation is endemic, and since the market does not currently reflect such dire inflation prospects, long dated Treasury securities should be sold. We would be among the first to move to the short dated part of the curve if the economic statistics supported the above view. Our conclusion is that deflation, not inflation, is, and will continue to be, the essential problem for the U.S. economy and that the optimum fixed income portfolio should consist of treasuries with the longest possible maturities.

Reality

Twelve months ago the annual increase in the CPI was 2.6%. Today it is at 4.1% and rising. The Reuters/Jefferies CRB Index fell 7.3% for the year ending last June. Today the 12 month change is 36% higher. Nevertheless, the 30 year bond yield fell to 4.5% on June 30 of this year, well down from 5.1% one year ago. This provided a remarkable 15% return for investors. How is it possible that bonds, which have the ultimate sensitivity to inflation, would decline in yield and rise in price in such an inflationary environment? The short answer is that in the broadest terms, insufficiency of demand has, and will continue, to overwhelm inflationary forces, creating deflation in many categories.

In the second quarter, current dollar gross domestic product totaled an estimated $14.3 trillion, about $572 billion greater than a year ago. Of this gain, $359 billion can be attributed to price increases and $213 to higher real output. There are times, however, when GDP is not the final arbiter of the economy's performance, and this is one. The seemingly large gain in GDP pales in comparison to the loss in wealth, which GDP does not capture. Over the past fiscal year, holdings in the stock market, as measured by the Wilshire 5000 Stock Index, lost more than $2.1 trillion. Simultaneously, the 15.3% contraction in the Case Shiller Home Price Index suggests the wealth loss in value of household residences was a staggering $3.1 trillion. Without including the negative wealth impact for declining prices of automobiles and other durables the total wealth loss was approximately $5.2 trillion. Obviously, the sum of dollars being erased from our economic system has overwhelmed the amount of dollars being increased by inflation by a factor of more than 14 to one. Thus, once again, the bond market had it right--deflation is in ascendancy. Treasury bond yields fell, and they will continue to trend lower, creating an even more profitable environment over the next four quarters for long-term Treasury bond holders.

A Basic Macroeconomic Model

A superior approach to evaluating the inflation/deflationary mix is to define inflation in terms of the aggregate supply (AS) and aggregate demand (AD) curves (Exhibit 1). This economy-wide model permits a structured framework to evaluate whether inflation or deflation is more likely. The model allows for the economy's price level and real GDP to be determined jointly. With the price level on the vertical axis and the real GDP on the horizontal axis, the AD curve slopes downward and the AS curve slopes upward. As such, AD and AS are both a function of price.

Exhibit 1

The AD curve is composed of plans to buy, which are dominated by consumers, and they buy less at higher prices. The premise of the AS curve is that sellers offer more at higher prices. Five major factors may shift the entire AD curve. They include: monetary conditions, fiscal policy, wealth, consumer expectations and global considerations. The aggregate supply curve may shift by three major factors: labor costs, raw material costs and rent. Presently, forces are shifting the aggregate demand curve downward while costs are holding the aggregate supply curve basically stable. This means that we are moving into a period of weak or insufficient demand, creating disinflation, if not outright deflation.

(In this very brief thumbnail sketch of the AD/AS model, we have cut at lot of corners. For those who want to know more about this thoroughly vetted and highly objective model, a more formal presentation is found in an Appendix of this letter which can be retrieved from our website at www.hoisingtonmgt.com, or by request.)

Factors Operating on the Aggregate Demand (AD) Curve

Four of the above mentioned factors - a massive wealth loss, a severe contraction of monetary conditions as measured by both money and velocity, deteriorating global demand and an enormous decline in consumer expectations - all point to a downward shift in aggregate demand, meaning lower inflation. However, we start this analysis with fiscal policy, which at first glance might appear to be supporting an outward shift in the AD curve, or an increase in planned final demand.

Fiscal Policy

Fiscal policy would seem to be undisputedly supportive for the economy with the Treasury's $110 billion in rebate checks and a Federal budget deficit that is approaching a record $500 billion. But that is not the case. The Treasury does not have $500 billion in its checking account to cover the deficit, nor even the lesser amount for the rebates. The Treasury has to raise the funds by selling debt securities to the private sector. Credit availability may be thought of as a pie. When the Federal sector, which is the economy's premier borrower, takes more of that pie, fewer dollars are left for the private sector. Thus, deficit financing crowds out funds that would have gone to private uses. With the exception of the Federal funds rate, in the first half of this year virtually all money and bond yields rose, a clear sign that the deficit usurped funds for the private sector. This has had the impact of slowing, rather than stimulating economic growth.

Historical experience has shown that deficits have a beneficial effect in the longer-term only under certain situations. Net gains can occur if the deficit is due to a reduction in the marginal tax rates, or if the expenditures are for projects such as power plants, roads and bridges that finance themselves in time and create large spending multipliers. Presidents Kennedy and Reagan cut marginal tax rates and this produced significant paybacks, but these positives took time because of pressures from financing the deficit over the short-run. Evidence indicates that transitory tax rebates produce no lasting benefit. Thus, another round of rebates, in view of the massive deficit already existing, would not be any more successful than the current round, or the previous one in 2001. The government merely usurps resources, which would have flowed into more productive private sector uses.

Monetary Conditions

The growth of M2 and changes in its velocity indicate monetary conditions are shifting the aggregate demand curve inward. M2 growth decelerated from 9.8% to 6% from the first to second quarter. Even more importantly, velocity continued to contract sharply, falling at an estimated 1.9 % annual rate. From its peak, velocity has declined from 1.932 to 1.866, an exceedingly sharp drop in just eight quarters. Other truly extraordinary symptoms of monetary contraction are also evident. In the past three months, commercial bank credit (loans and investments) plus commercial paper contracted at a 7.2% annual rate. A record decline for the nearly four decade history of this series (Chart 1). The latest survey of senior lending officers by the Fed indicates that bank lending standards are, in general, higher than ever, and that credit availability is harshly constrained. The economy cannot grow without credit expanding. Over the past four decades the credit elasticity of GDP (responsiveness of GDP to changes in debt) has been .86. If credit expansion fails, then GDP will definitely contract, shifting the AD curve downward to the left.

Chart 1

Wealth

From its peak in July 2006, home prices, as measured by the Case Shiller Index, have now fallen 17.8%. Stock prices have decreased 15% from their peak in 2007. The combined wealth loss from these two sectors is more than $5.2 trillion, an effect that, like the monetary contraction, shifts the AD leftward, lowering the price level.

Consumer Expectations

The deterioration in consumer expectations is another significant event. According to the University of Michigan, consumer expectations slumped to a 28 year low in June, while the Conference Board's measure fell to the lowest reading in the more than four decade history of the series (Chart 2). Since the aggregate demand curve is 70% supported by consumer spending plans, it implies that final demand will continue to weaken, causing the AD curve to shift downward and to the left, intensifying disinflationary forces.

Chart 2

Global Considerations

Numerous signs indicate that economic growth is decelerating worldwide, and that the trend is likely to continue. The OECD's World Leading Economic Index has declined 1.6% in the past 12 months (Chart 3). While there have been some false signals in this indicator, and it is not as reliable at the U.S. LEI (or ratio of the U.S. coincident to lagging indicators), the World Index has never fallen this sharply without a recession occurring. Thus, foreign factors are also a negative for buying plans.

Chart 3

Factors Currently Operating on the Aggregate Supply (AS) Curve

Cost push inflation reflects an inward or leftward shift in the AS, which is depicted in Exhibit 1, while an outward (rightward) shift would constitute cost push deflation. At present, the higher raw material costs, which would tend to shift the supply inward, are being neutralized by a moderation in compensation costs and rents. Thus, the aggregate supply appears to be relatively stable.

Compensation

In the past four quarters, unit labor costs in the nonfarm business sector have increased a very modest 0.7%, down from a peak of 4.3% registered in the four quarters ending in spring of 2007. Since wage costs comprise about 70% of the cost of production for the U.S. economy, this serves as a powerful disinflationary force.

Raw Material Costs

If energy and other commodities were the only major cost, the AS curve would shift inward and cause cost push inflation. But, raw material costs only constitute about 10% of U.S. production costs.

Rents

Rents account for about 10% of the cost of U.S. production, or approximately the same weight as raw materials. Rents for retail space are falling, and there are nascent signs that office and warehouse rents have begun to ease. All other costs also account for about 10% of the cost of U.S production, so any increases in this residual category would be neutralized by rents.

AD and AS Together

The divergent factors currently operating on economy-wide aggregate demand and supply are captured by Exhibit 2. The aggregate supply curve is stable, meaning that the risk of cost push deflation is equal to the risk of cost push inflation. Thus, the dominant force is the inward shift in the aggregate demand curve, which is also shown in Exhibit 2. Due to consumer expectations, wealth, monetary, global, and fiscal factors, the AD/AS model suggests that the direction of the aggregate prices and real GDP should both be downward. As such, the risk is greater for demand pull deflation than demand pull inflation.

Exhibit 2

Conclusion

Aggregate supply and demand analysis can be confirmed by three different indicators - the unemployment rate, the manufacturing capacity utilization rate, and the output gap. Presently, all indicate that the U.S. economy faces insufficient aggregate demand, and consequently disinflationary pressures.

The unemployment rate has risen to 5.5%, the highest level since October 2004, while the manufacturing capacity use rate has fallen to 77.5%, the lowest since November 2004. Since 1949, manufacturing capacity utilization has averaged 81.1%. As such, there is an additional 3.6 % of excess capacity. The output gap, which is real GDP less potential GDP as a percent of real GDP, was an estimated -2% in the second quarter, the largest amount of economy wide excess capacity in five years (Chart 4).

Chart 4

These measures also confirm our prognosis for aggregate prices. The higher unemployment rate points to downward pressure on wages and benefits. This is clearly happening since wage gains have fallen to 3.4%, down 0.9% from their cyclical peak. The low rate of manufacturing plant use indicates that firms do not have pricing power. As such they are unable to pass through higher fuel and raw material costs, thus squeezing their profit margins. The negative output gap confirms the excess supply in the labor and production markets and also points to lower inflation. In such a disinflationary environment, long term Treasury bond yields should continue to work lower.

Your feeling the stagflation pain analyst,

John Mauldin

The End of the Inflation Scare?

John Mauldin — Mon, 30 Jun 2008 17:34:00 GMT

I mentioned in last Saturday's letter a report by Louis Gave of GaveKal fame on whether inflation may be waning and its importance. Louis gave me permission to use it as this week's Outside the Box. It is typical of the thoughtful analytical work they do.

Louis and his partners and associates at GaveKal write some of the more thought-provoking material I read. They really challenge my position on numerous matters, causing me to look at many items from a different view. That of course, makes this particular piece good for Outside the Box. Whether you agree or disagree, you need to know why you hold a position. If you can't articulate the "against," how can you be sure you truly understand the "for"?

I think given the current debate on inflation, this week's Outside the Box is a must read. While it may look longer, there are a lot of very important graphs here. And thanks to Doug Harrison for helping with the tricky technical aspects of getting this letter out today. It was a lot more than a simple cut and paste, and way beyond my pay grade.

And congratulations to Louis and his wife Kelly who by this time may have a new child. She was due any minute on Friday. I trust you are enjoying your summer. I will be on Larry Kudlow's show tomorrow evening and then having dinner with he and Louis' father Charles (and Tiffani of course). And expect an announcement about a new survey in the next few days.

John Mauldin, Editor
Outside the Box

The End of the Inflation Scare?

by Louis-Vincent Gave

While most economists and strategists spend time worrying about growth, changes in inflation are usually a much greater driver of financial markets than changes in economic activity. This is because:

1- A surge in inflation usually increases volatility of economic growth--which in turn reduces P/Es and the willingness of the private sector to take risks.

2- As highlighted in The Myth of Reverting Margins, inflation typically takes a much meaner bite out of margins than a recession does. As we wrote back then concerning the US growth/margin relationship: "Margins bear little relationship to the level of GDP or consumption growth. In fact, as the economy accelerated from the mid-1960s to the early 1980s, margins plunged. Similarly, as the economy slowed from the early 1980s to the present, margins accelerated... It is inflation, not growth, which wreaks havoc on profit margins (ironically, if everyone has pricing power, no one makes money).

3- Finally, a surge in inflation typically means interest rates will be rising in the near future. Which means that investors get to lose money on both bonds and equities. For example, from 1966 to 1980 (i.e.: the last "inflationary surge" period), US bonds shed -2% per annum and US equities fell -4.9% per year.

Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat). And to be sure, growth almost everywhere around the world is slowing while inflation in almost every country is still accelerating.

Now everyone knows where the slowdown in growth comes from: de-leveraging in the financial sector, overextended consumers needing to tighten their belts, transfers of wealth from the private sector to the public sector through high oil prices, etc... And there are of course myriad opinions as to how long the slowdown will last. But meanwhile, on inflation, our clients seem to be much longer on questions than answers. Where does the current inflation spike come from? How long is it going to last? And can inflation abate without a "Paul Volcker" like monetary policy from the Fed?

In this ad hoc comment, we aim to review some of these questions and, as we always tend to do--answer these questions with yet more questions of our own!

1- Where Does the Inflation Come From?

Just like George Orwell's farm animals, all currencies are equal... though, of course, one is more equal than others. Indeed, the US$ remains the world's reserve currency and, thanks to this status, foreigners cannot impose a particular kind of monetary policy unto the US. As Treasury Secretary Connolly once said: "the US$ is our currency and your problem". And lately, there is little doubt that the US$ has indeed become the world's problem, with its fall in value associated with the spike in commodity prices, which in turn has triggered a sharp upturn in inflation rates all around the world, but especially in the emerging markets (where food and energy represent a much bigger piece of the average family's spending than in most OECD countries).

But of course, the surge in commodity prices cannot be the sole explanation for the recent surge in inflation numbers around the world. After all, an event like the spike in oil prices could also prove to be highly deflationary, since it takes money from the private sector and gives it to the public sector which will typically waste it (i.e.: Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah, etc...). For a commodity price spike to be inflationary, it needs to be accompanied by excess money creation. If it is not, all that we witness is a change in relative prices across the economy (i.e.: oil prices up, auto and house prices down). This is why Milton Friedman once said that "inflation is always and everywhere a monetary phenomenon" while, around the same time, Jacques Rueff made the observation that "inflation is subsidizing expenditures that give no returns with money that does not exist".

So given that we are now living through a surge in inflationary prices, the questions we should ask ourselves is a) where the excess liquidity creation of recent years has come from? and b) whether excess liquidity continues to be pushed into the system, hereby guaranteeing further increases in inflation in the coming quarters and years?

2- What Explains the Surge in the Amount of Money?

As highlighted above, the US$ is "more equal" than other currencies and, consequently, the Fed holds a "special place" in our current financial system. Undeniably, the Fed is the world's most important central bank and it is thus not that surprising that, as inflationary pressures accelerate around the world, most people are quick to blame the Fed for "falling asleep at the wheel" and allowing money supply in the US to grow unchecked. But is this a valid criticism?

After all, as the charts below highlight, narrow money supply growth in the US (i.e.: the aggregate mostly under the control of the Fed) has not seen much of a rise in recent years (incidentally, the same can be said about Japan and money growth is now decelerating fast in Europe):

While the Fed did print money aggressively between 2002 and 2005 (M1 annual growth was above +5% and sometimes close to +10%), in recent years, the pace of monetary creation has by and large been tame. So the ‘excess money' had to come from somewhere else.

Now as we never tire of pointing out, two sets of players can create money ex- nihilo in our system: central banks and commercial banks. So if the excess liquidity creation has not been the central banks, then the explanation must lie with the commercial banks.

And sure enough, in recent years, banks have ridden the 'financial revolution' as hard as they possibly could and we have witnessed an unprecedented expansion in credit (witness the growth in C&I loans at US banks, red line below):

And, as we now know, money creation off the banks' balance sheets was also, until recently, going strong. Witness, for example, the rapid expansion in corporate paper outstanding in the period between 2003 and 2007 (red line below):

To return to our old favorite, Irving Fisher's equation of MV=PQ, it seems obvious to us that the current increase in P (prices) has more to do with the past few years' extremely buoyant V (velocity) than excessive M (money) growth. A possibility which immediately raises the question of whether velocity will remain as buoyant over the next two years as it did in the 2003-2007 period.

3- Will Velocity Remain As Strong?

As the chart below suggests, the answer to the above question is a simple "No". With bank balance sheets under severe strain, and with bank shares almost everywhere around the world plumbing new depths, an increase in the willingness to take risk from private lenders would be very surprising. And sure enough, after its longest period ever in negative territory, our velocity indicator is once again negative after a brief respite:

This message of slowing private sector liquidity growth is also confirmed when adding the loans at commercial banks with the issuance of commercial paper (for a total private credit growth aggregate--blue line on following page). We have slumped from an annual growth rate of +13% in private credit one year ago to +2.8% today; a level not seen since 2003 (see chart).

So we are now in a situation where a) The Fed is not printing money and b) US financials are de-leveraging rapidly. Thus, if inflation is "always and everywhere a monetary phenomenon", one may conclude that what we are now seeing in the inflation numbers is the echo of the 2003-2007 credit boom, but that looking ahead, the inflation picture should start improving rather dramatically. But such a conclusion would miss out on the other big contributor to global liquidity growth, namely the US current account deficit.

4- The Importance of the US Current Account Deficit

Because the US$ is "more equal" than other currencies in our global system, the US current account deficit plays a specific, and very important, role in our global monetary systems. In essence, the US current account deficit provides the world with its working capital. After all, at any given point, the world needs US$. For example, Nokia needs US$ to pay for the chips it may buy in Taiwan. China needs US$ to pay for the iron ore it buys from Australia and Sweden needs US$ to pay for the oil it buys from neighboring Norway...

This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. Indeed, when the US exports a lot of dollars, then the rest of the worlds gets used to a "plentiful" liquidity situation... and when the US exports less money, then somebody gets cut off.

So in essence, the current account deficit has always been the mechanism through which the United States could reflate, or deflate, the global economy. When the US current account deficit improved, the US deflated other countries and vice versa.

Now today, the US current account deficit still stands at a rather large 6% of GDP. However, the composition of this deficit has changed dramatically: two years ago, around two-thirds of the US deficit went to non-oil producers and one third was for petroleum products. Today, that situation is inversed to the point where one could argue that, while the US is still reflating oil producing countries (which hardly need it), it is now deflating non-oil producing countries by around 2% of GDP. Moreover, should oil prices start pulling back, we would move extremely rapidly into a situation where the US current account deficit was deflating the whole world (below is a chart we borrowed from The Economist)!

The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies. Indeed, over the past few years, the prevalent belief amongst investors of all stripes has been: a) the US runs a large current account deficit, b) that US interest rates are low, and that, consequently c) the value of the US$ could only fall. And if the value of the US$ could only fall, then borrowing in US$ to finance whatever real estate project, factory, or financial market speculation made perfect sense. This is why, in a number of countries, we started to witness a growth in central bank reserves which far outpaced trade surpluses and foreign direct investment inflows; all of a sudden, a number of large countries started to save more than they earned!

But how can one save more than one earns? The answer, we have argued in the past (see The Surprisingly Strong Growth in Chinese Reserves) is simple: one borrows the difference. As mentioned above, if the perception is that the US$ can only fall against the RMB, INR, VND, MYR, etc... then why borrow in local currency to finance one's capital expenditures or investments? Much better to finance any spending in the ever falling, and cheap to borrow, US$!

So what happens when a Chinese property developer, or a Vietnamese industrialist, borrows US$ to finance his latest project? The first thing he does is that he changes the dollars he does not need for RMB, Rupee, Dong, etc... And, at this point, the foreign central bank has three choices:

1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years.

2- It can print money to prevent its currency from rising and then sterilize its FX intervention.

3- It can print money to prevent its currency from rising and just accept the consequences of fast money supply growth (usually higher inflation and asset prices).

And by and large, this is what most nations on the other side of the US current account deficit (i.e.: Asia and OPEC) have done. And unsurprisingly, these are the countries that are today dealing with the largest inflation threats.

We would thus argue that the US current account deficit has been a double inflationary force for the world at large. First, the US current account deficit has pushed a number of countries towards reflation, and secondly, the large US current account deficit has helped propagate the belief that the US$ could only fall, and thus encouraged large borrowings of US$ outside of the US.

And the US current account deficit, combined with the willingness to borrow US$, has been an inflationary force for more than just Asia and the Middle East. It may also explain the surge in money growth in Europe! Indeed, with central bank reserves growing very rapidly around the world (despite a high oil price which, at the very least, should have drained the reserves of Asian and European countries), central banks such as the PBoC or the RBI have likely spent the past few years diversifying their reserves, which for all intents and purposes means buying the Euro... And, as we argued in our book The End is Not Nigh, this "diversification" of reserves means buying European government bonds or, in other words, subsidizing the expenditures of foreign governments with domestically borrowed money.

Et voila! We are now back to Jacques Rueff's definition of inflation being "a policy which subsidizes expenditures that give no returns (i.e.: government spending in Europe or the US) being financed with money that does not exist (i.e.: central bank reserves that have been borrowed, not earned)!"

5- Will the US Deficit Continue to be an Inflationary Force?

Having established that one of the main factors of excess liquidity growth in the world (the willingness of the financial sector to lend very aggressively) had now disappeared, can we rely on the US current account deficit to continue providing excess liquidity to the world. Will an ever growing US trade deficit continue to force other countries to reflate and lead to an ever lower US$? We tend to believe that the answer to that question is a very firm "no". And, this for several reasons:

Reason #1: As reviewed on page 6, the US current account deficit is already improving. Moreover, since oil is now a bigger percentage of the US deficit, should oil prices roll over, we could witness the most rapid improvement in the US current account deficit ever seen. But even without oil rolling over, the recent weakness of the US$ argues for a continued improvement in the deficit:

As does the weakness in US housing:

Meanwhile, the prevalent belief of recent years that borrowing US$ to invest in local currencies was a "no-brainer" is now undergoing a significant test. For example, in recent months, the "long dong" strategy has undeniably failed (the black market now expects a devaluation of over 20% in the Vietnamese currency). The strategy is also failing in India where the Rupee, to many investors' surprise, has been amazingly weak in recent months....

In fact, an interesting development is occurring on the US$: fewer and fewer currencies have lately been rising against the US$ and this despite some pretty poor news from the US (MBIA downgrade, fears on Lehman, weak housing, weak growth, high oil, fears of war with Iran...). Now the typical pattern for an equity bull market is that, as it nears its peak, fewer and fewer shares make new highs even as indices keep on powering ahead. Major corrections are typically preceded by a narrowing breadth... And today, we are undeniably witnessing a deteriorating breath in the "anti-US$" bull market:

To cut a long story short, and with hindsight, the large US current account deficit and the weak US$ were another very potent inflationary force in our system. But, at least at the margin, these inflationary forces should abate, rather than acceler- ate, over the coming months.

6- Conclusion

There is little doubt that, right now, inflation is proving to be a massive headwind for financial markets. And part of that "inflation headwind" is the fear that the Fed, the ECB and other central banks will have little choice but to tighten monetary policy in the coming months. This is most likely true of some central banks, but maybe not all? After all, looking around the world, the inflationary threat is a sure thing in certain regions, and less of a threat in others:

In the US: In a recent paper (see The Dollar's Successful Devaluation), Charles argued that the Fed had just managed to engineer a "good devaluation" for the US$, whereby the currency is brought down without an explosion in monetary aggregates and a rapid acceleration in inflation. This makes the economy competitive and local assets attractive for foreigners. Since then, not much has happened to warrant a change in this view. In fact, since then, the main development has been the roll-over in velocity and renewed fears as to the health of the US financial sector. With velocity plummeting, we think that the bond market is broadly right to not anticipate an acceleration in US inflation.

In Euroland: Just like in the US, the bond market does not seem to really anticipate a massive surge in inflation. And given the very overvalued currency and the inverted yield curve, this makes sense to us.
In the Middle East: The one region of the world which is still experiencing reflation from the US current account deficit is the Middle-East (and to a lesser extent Russia). The unwillingness of policymakers to revalue their currencies (see The Arab Pegs) and the inability of local central banks to sterilize their FX intervention means that the local economies are condemned to continue experiencing inflation as long as they refuse to revalue their currency. More worryingly, a pursuit of the current fixed exchange rate, inflationary policies could lead local economies into the same kind of boom-bust cycle that Vietnam (and maybe India?) are now having to endure.
In India and Southeast Asia: If the US went through a ‘good devaluation' (i.e.: a lower currency without a spike in inflation, triggering an increase in foreign and domestic investments and productivity gains), then it increasingly looks as if India and Southeast Asia have just gone through a ‘bad devaluation' (i.e.: a lower currency which brings about fast money growth, higher inflation, deteriorating trade balances and foreign investor flight). As such, certain countries (India, Vietnam...) are now stuck in the unfortunate position of having to defend their currencies, which is rarely conducive to either economic, or asset price growth.
In China: Inflation is undeniably a problem but, thus far, it seems to be mostly contained to food and energy prices (see A Dummy's Guide to Chinese Inflation). Meanwhile, the only pressures on the RMB are still of a positive nature. Thus, if either the US$ rebounds or commodities roll over (two events that are likely to happen simultaneously), China's inflation problem could dissipate relatively quickly. Chinese and HK shares would then soar.
In Japan, Korea, and Taiwan: Japan, Korea and Taiwan have seen little "hot money" inflows in recent years and have also been better at letting their currencies rise against the US$ (this year, the NT$ is one of the world's best performing currencies with a +6.5% rise while the KRW was one of the best performing Asian currencies between 2004 and 2006). In general rule, these countries today have far less of an inflationary problem than the rest of Asia:

While the markets had started to rally in April and early May, the spike in oil prices fuelled fears of faster inflation and triggered a threat of coming rate hikes from the Fed and the ECB. In turn, all these events weighed down equity markets around the world. However, as we have tried to show in this paper:

The inflation threat is very different between countries. At most risk today are the Middle East, India and Southeast Asia. Meanwhile, inflation is far less of a threat in the US, Japan and North Asia.
Given the fact that the forces behind the recent pick-up in inflation are now turning around (strong willingness to take risk amongst financial firms, growing US current account deficits, overall weakness in the US$), inflation could well start abating in the coming quarters. Moreover, with the turnaround in velocity and the implosion in the banking systems, it seems increasingly likely that neither the Fed, nor the ECB will be willing/have to match their recent hawkishness with rate hikes.
As inflation rolls over in the OECD, the leadership of equity markets should go through a serious adjustment.

Your meditating on inflation analyst,

John Mauldin

A Kind Word for Inflation

John Mauldin — Mon, 23 Jun 2008 17:01:00 GMT

This week's Outside the Box will challenge a few of your base assumptions. Paul McCulley, the managing director at PIMCO, offers us a kind word for inflation and the reasons that the Fed will be on hold for a lot longer than the markets currently think. And part of that is to avoid a real recession or even a depression. Getting this debate right is important.

These are indeed interesting times we live in. I look forward to being with Paul at the end of July on our Maine fishing expedition, where he can defend his proposition to the group of economists and analysts gathered there. Have a great week.

John Mauldin, Editor
Outside the Box

A Kind Word for Inflation

by Paul McCulley

No, I have not lost my mind. I'm fully aware that inflation is not kind to bonds, so offering a kind word for inflation is de facto offering an unkind word about my own business. Investment managers don't tend to do that. But facts are facts. And the essential fact right now is that the American economy needs an inflation rate above the Fed's comfort zone. Needs, you ask?

Yes. Soaring commodity prices, particularly for petroleum and food, and especially in recent months, are an unambiguous negative real terms of trade shock to America. For those not familiar with the term, a nation's terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand the concept, at least for me, is to think of the number of hours of work necessary, at the average national hourly pay rate, to buy a barrel of oil – a real variable compared to another real variable. The chart below tells that simple story.

Misery Is as Misery Does
Americans are working more hours for the same barrel of oil. That is a negative real terms of trade shock. Put differently, we are less rich or more poor than we were before oil prices took off. There is no getting ‘round this. In turn, there is no escaping collateral adjustments of temporarily higher inflation and temporarily lower growth and employment. The question of the hour is how this pain should be apportioned. Last week, Fed Vice Chairman Don Kohn provided the right answer, presuming there is a right answer (my emphasis):

"... an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains."¹

Mr. Kohn was preaching the raw, honest truth: a surge in oil prices raises the Misery Index, temporarily lifting both inflation and the unemployment rate. In turn, those outcomes beget lower real wages and, presumably, lower real profits, too. We are less rich or more poor – period. Thus, those who holler and scream at the Fed for letting the inflation genie out of the bottle need to calm down. A negative terms of trade shock is a real shock, so it must be translated into lower real wages and profits. That simple and that painful. Logically, it also must be translated for a time into lower, even negative, real short-term interest rates, the rate of return on money.

Spiral Risk?
But, you retort, if the Fed surrenders to negative real interest rates, it will set off an inflationary spiral, as second and third round effects on prices and wages take hold: capital and labor will extrapolate what should be viewed as a transitorily higher inflation into permanently higher inflation. In a world of perfectly indexed prices and wages, this could well be the case. The 1970s resembled such a world, and nasty oil price shocks that should have been one-off adjustments in the price level via temporarily higher inflation morphed into a price-wage-price inflationary spiral.

In monetary policy terminology, inflation expectations in the 1970s were not firmly anchored at the pre-oil price shock level. This is true, I think, but more elementally, the highly unionized, closed-economy structure of the American economy price and wage setting process was inherently geared to transforming a one-off inflationary shock into an enduring inflationary shock.

We no longer live in such a world. Most importantly, wage inflation is now only loosely connected to price inflation, in the wake of a more globally competitive, less unionized labor force. As Vice Chairman Kohn hinted, the combination of somewhat higher inflation and higher unemployment is a prescription for diminished pricing power by labor, leading to lower real wages (than would be dictated by labor's productivity growth). Thus, unlike the 1970s, there is little wage fuel to generate over-heating aggregate demand and, thus, a sustained price-wage-price inflationary spiral.

This is good news indeed. Fed officials would make this argument through the lens of well-anchored inflationary expectations, and I have no quarrel with that interpretation, though I think it is but a veil over a more global, more competitive, less oligopolistic price and wage setting structure in the United States. Indeed, I believe the more nasty is the negative terms of trade shock, the fatter is the fat tail of asset price deflation rather than the fat tail of accelerating goods and services inflation.

Avoiding a Modern Day Depression
Deflating asset prices in a highly levered economy are a much more nefarious outcome than temporary increases in inflation in goods and services. This is particularly the case from a starting point of low inflation in goods and services (excluding those involved in the negative terms of trade shock). How so? Simple: a negative terms of trade shock and asset price deflation are a prescription for not just a recession, but a nasty one. More to the point, from a starting point of low goods and services inflation, the Fed is never far from the zero lower limit on nominal short-term interest rates, commonly known as a liquidity trap.

Therefore, the more flexible are wages in the face of a negative terms of trade shock, particularly if it coincides with asset price deflation, the greater is the risk of policy makers losing control of the economy on the downside. In turn, this reality argues for the Fed to tolerate higher headline inflation in the wake of a negative terms of trade shock.

To be sure, the Fed must be aware of the dreaded second and third round effects, constantly checking to make sure that real wages and real profits are being eroded by the aberrantly high headline inflation. But, assuming the evidence supports that thesis, as the following graph displays, it would be an absolute folly for the Fed – or any central bank in similar circumstances – to hike interest rates in an attempt to make the negative terms of trade shock go away. By definition, it can't. And if it tries, it will create an even bigger mess. In this case, the motto of a central bank should be the same as that of a physician: first, do no harm.

I think the Fed thoroughly understands these exigencies in the wake of a negative terms of trade shock. It doesn't mean that the Fed won't or shouldn't rhetorically sound tough at times, in the name of preventing inflationary expectations from becoming unmoored. But the bottom line is that as long as there is a huge gulf between the negative terms of trade cup and the wage inflation lip, the Fed should talk about the cup and focus on the lip.

Bottom Line
Which means, my friends, that low, even negative real short-term interest rates are here to stay for a considerable period. Yes, I know that many believe that it is somehow sinful or immoral for the Fed to hold nominal short rates so low as to render the real return on cash to be negative. I don't buy this proposition. Why should it be that those who only have labor to offer to the market should not be made whole for a negative terms of trade shock, while those with cash should be made whole?

In the wake of a negative terms of trade shock, all factors of production should absorb a negative hit to their real returns. If indexing to headline inflation is inappropriate for labor wages and capital's profits, why should cash yields be indexed by the Fed?

And what if holders of cash don't like it? Then they can step out on the risk spectrum. After all, a basic of capitalism is no risk, no reward. And temporarily higher inflation in the wake of a negative terms of trade shock is an efficient lubricant for the economy to make the necessary real adjustments.

Paul McCulley
Managing Director
June 16, 2008
mcculley@pimco.com

¹ http://www.federalreserve.gov/newsevents/speech/Kohn20080611a.htm

Your betting the Fed will be on hold a long time analyst,

John Mauldin

Fooling With Inflation

John Mauldin — Mon, 09 Jun 2008 17:15:12 GMT

This week in Outside the Box we look at Bill Gross's recent essay on measuring inflation. How you measure inflation makes a difference not only in social security payments but also in what your real returns on bonds are. As Bill notes, there is a significant difference in how the world measures inflation and how it is done in the US. He gives us some insights that are very thought-provoking.

In the last decade economists regularly argued the CPI over-stated inflation by 1%. Now Gross suggests that it may understate inflation by 1%. This week's OTB makes for very interesting reading. Bill Gross is managing director of PIMCO. (www.pimco.com)

John Mauldin, Editor
Outside the Box

Fooling With Inflation

By Bill Gross

You can fool some of the people all of the time,
and all of the people some of the time,
but you cannot fool all of the people all of the time.
- Abraham Lincoln

What this country needs is either a good 5¢ cigar or the reincarnation of an Illinois "rail-splitter" willing to tell the American people "what up" – "what really up." We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate's preacher – Democrat or Republican – should be a significant factor in how we vote. We care more about who's going to be eliminated from this week's American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher's seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have – we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.

It's Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome – better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America's wealth migrates into foreign hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on a geopolitical scale, that our allies are dropping like flies. "Yes we can?" Well, if so, then the "we" is the critical element, not the leader that will be chosen in November. Let's get off the couch and shape up – physically, intellectually, and institutionally – and begin to make some informed choices about our future. Lincoln didn't say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we've been doing a pretty good job of that for a long time now.

I'll tell you another area where we've been foolin' ourselves and that's the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, "Haute Con Job." I wasn't an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an "informed" American could make.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S. An observer's immediate take is that there are glaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.

This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity "miracle" may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized "one price fits all" commodity driven global economy? I suspect not. Somebody's been foolin', perhaps foolin' themselves – I don't know. This isn't a conspiracy blog and there are too many statisticians and analysts at the Bureau of Labor Statistics (BLS) and Treasury with rapid turnover to even think of it. I'm just concerned that some of the people are being fooled all of the time and that as an investor, an accurate measure of inflation makes a huge difference.

The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners' equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners' equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn't really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that "would have been" based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren't they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on "core" as opposed to "headline" inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation's mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO's Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether "headline" will ever drop below "core" for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian's recent Secular Outlook summary suggest otherwise.

The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress "real" as opposed to nominal inflation additive yields, today's acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be "entertained" with the notion of artificially low inflation than to be seriously "informed." But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today's world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market's assumption of low relative U.S. inflation in comparison to our global competitors.

Your watching gas go to $4 in Texas (!) analyst,

John Mauldin

Why We Must Fix It

John Mauldin — Mon, 05 May 2008 21:18:00 GMT

This week in Outside the Box we take up a topic that should be on the top of the agenda of every regulatory authority, executives at financial services firms of all types, and average investors: How do we fix the credit markets to make sure we do not have such a crisis again? Good friend Michael Lewitt of Hegemony Capital Management gives us his observations, some of which go further than I would personally like to see us go. But this is the conversation that must happen if we are to steer clear of future crises. It is clear to me now that a laissez faire approach to regulating certain financial instruments exposes the entire economy to risks much larger than the loss of a business here or there. While better disclosure is certainly appropriate, it is not enough.

I think that we should seriously consider having an exchange for credit default swaps and other similar OTC derivatives. If Bear Stearns is deemed too big to fail because of the extent of its CDS book, and taxpayers are put at risk in a bailout, which I agree was necessary, then rules must limit taxpayer exposure. Having futures and options trade on an exchange certainly hasn't limited commerce or restrained business, and with instantaneous execution and inexpensive transactions there is little friction from using an exchange.

Getting the rules right in the future is going to be difficult and contentious. But it is something we must begin to do as soon as possible. The footnotes that Michael uses are at the end.

John Mauldin, Editor
Outside the Box

Why We Must Fix It

By Michael Lewitt

"Society is indeed a contract. Subordinate contracts for objects of mere occasional interest may be dissolved at pleasure -- but the state ought not to be considered as nothing better than a partnership agreement in a trade of pepper and coffee, callico or tobacco, or some other such low concern, to be taken up for a little temporary interest, and to be dissolved by the fancy of the parties. It is to be looked on with other reverence; because it is not a partnership in things subservient only to the gross animal existence of a temporary and perishable nature. It is a partnership in all science; a partnership in all art; a partnership in every virtue, and in all perfection. As the ends of such a partnership cannot be obtained in many generations, it becomes a partnership not only between those who are living, but between those who are living, those who are dead, and those who are to be born. Each contract of each particular state is but a clause in the great primaeval contract of eternal society, linking the lower with the higher natures, connecting the visible and invisible world, according to a fixed compact sanctioned by the inviolable oath which holds all physical and moral natures, each in their appointed place."

Edmund Burke, Reflections on the Revolution in France (1790)

Last month's issue of this publication ("How To Fix It," March 1, 2008) attracted more reaction than usual. Like several previous issues, it was featured in John Mauldin's Outside the Box and Kate Welling's welling@weeden, and was also widely circulated on the Internet and elsewhere. While many readers agreed that drastic steps are needed to avoid continuing down the dangerous path that our economy and society are on, there were a few individuals who felt that HCM's proposals were too radical.¹ But in the face of the wholly inadequate plan that Treasury Secretary Hank Paulson offered up in response to the current crisis, it is painfully apparent that our suggestions were not radical enough. Mr. Paulson's recommendations do little to address the regulatory black holes that permitted some of the most powerful institutions in the world to make hundreds of billions of dollars of worthless loans.² Moreover, his plan fails to address the asymmetric compensation structures that allow financial industry executives to leverage their firms to the hilt and then walk away with pots of gold before their institutions all too predictably tumble into the abyss, inflicting damage on all parts of the financial system except the executives' own wallets.

Despite the fact that the financial markets have temporarily recovered their equilibrium, virtually none of the profound imbalances that led to the current crisis are being addressed. The markets, and those with the power to regulate them, continue to cling to the false ideologies that maintain that markets can correct themselves and that government regulation should be kept to a minimum. In fact, it has been the government that has had to bail out the markets each time they have nearly collapsed in recent years. George Soros makes this argument quite compellingly in a recent interview in The New York Review of Books ("The Financial Crisis: An Interview With George Soros," May 15, 2008).

"[T]he system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are selfcorrecting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long Term Capital Management in 1998, to name only three. Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them."

This time, the authorities were not only forced to bail out Bear Stearns but were also compelled to take a series of unprecedented steps to infuse massive amounts of liquidity into the banking system in order to fend off a collapse. Some of these steps broke new legal ground. Former Federal Reserve Chairman Paul Volcker, who is enjoying a resurgence in idolatry for his tough love policies of the early 1980s, castigated³ the current Federal Reserve for breaking new ground (and maybe the law): "The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long embedded Central Banking principles and practices." HCM imagines that Mr. Bernanke's response, faced with a potential collapse of the credit system, would be, "So sue me!" Over the past two decades, each successive crisis has required more draconian governmental action to ward off disaster, because the global financial system has grown exponentially larger and more complex. This growth is largely attributable to the uncontrolled and unregulated growth of derivatives and other financial products that have never been truly stress-tested. This is what HCM meant when we wrote last month that "n spite of claims to the contrary, the American economy has become increasingly unstable in recent decades." The only adjustment we would make to that statement would be to change the word "American" to "global" as the American economy has become increasingly linked to the global economy. The economic stability that former Federal Reserve Chairman Alan Greenspan used to brag about was just a veneer -- under the surface, forces of instability were building due to the fact that the system was becoming increasingly leveraged and unregulated. That is why we have to fix the system before it is too late (if if is not already too late). Mr. Soros points out in his interview, "[t]here are now, for example, complex forms of investment such as credit-default swaps that make it possible for investors to bet on the possibility that companies will default on repaying loans. Such bets on credit defaults now make up a $45 trillion market that is entirely unregulated. It amounts to more than five times the total of the US government bond market. The large potential risks of such investments are not being acknowledged." The CDS market, which is properly understood as an insurance market that is most likely under-reserved (not an insurance market without reserves, as some have incorrectly described it), now looms as everybody's candidate for the next accident waiting to happen. At the very least, it is somewhere between grossly and criminally irresponsible for the financial authorities to permit such a vast market to remain unregulated. The real question is whether there is anybody in our government who is even remotely qualified to regulate this market. Even the slightest tinkering with a market of this breadth without a proper understanding of the potential consequences could add a frightening new chapter to the law of unintended consequences. Doing nothing, however, is no longer an option. The failure to make the regulation of this market the top priority of government regulators is nothing less than a national disgrace. Let us hope it does not turn into a national tragedy.

We wish we could be as optimistic as Morgan Stanley's highly respected economist Richard Berner, who writes: "Re-regulation and a safer, better-capitalized financial system are coming. Intermediaries with little to no regulation will get new oversight, new disclosure responsibilities, and new capital requirements."⁴ Unfortunately, addressing the regulatory flaws that led to the current crisis won't be nearly as easy as Mr. Berner makes it sound. While HCM believes that more regulation is absolutely necessary, it is going to have to be implemented in a more enlightened and creative manner than in the past. The last time regulators took aggressive action to address flaws in the system, they badly missed the mark. They outlawed the type of off-balance-sheet investments done by industrial companies such as Enron Corp. but completely ignored the much larger and more highly leveraged shadow banking system (the Structured Investment Vehicles [SIVs]) until it collapsed under its own weight five years later. Federal prosecutors engaged in a series of high-profile show trials that featured far more abuses of prosecutorial power than findings of guilt against significant defendants. And the SEC stepped in too late, after billions of dollars were stolen from investors, to outlaw blatantly unethical but widely tolerated conduct such as lax underwriting standards verging on fraud, the participation of research analysts in the underwriting process, and after-hours trading in mutual funds. This time, we don't need political sound bites. We need independent parties with market experience who are not afraid to offend the powers-that-be to write and enforce the rules so our markets can function properly. Secretary Paulson is compromised, unfortunately, by his background as the former chairman of Goldman Sachs Group, Inc. His reaction to the crisis appears to be far too protective of the industry in which he made his fortune and does not go far enough to address the issues of leverage and asymmetric compensation structures that are ruining our markets and destroying our economy. The need to change how our markets are regulated is not merely a matter of law or economics; it is a matter that will affect the future of our country as it moves forward into a globalized world characterized by commodity shortages, religious conflicts that have economic overtones, and increasingly rapid technological change. The financial markets lie at the center of our way of life, and our obligation to insure that they operate fairly and efficiently extends beyond mere economic considerations. Nothing that has occurred in the past month dissuades HCM from the view that the long-term economic trends facing the United States are ominous and demand radical policy action. The continuing debasement of the U.S. dollar, the incessant (and only partially dollar-related) rise in the price of oil, and the unceasing flow of financial institution losses attributable to derivatives and structured products blunders convince HCM more than ever that the United States is set on a path that can only lead to a loss of its lead role in the global economy. The consequences of this will be deteriorating U.S. living standards on a relative and absolute basis, continued financial market volatility, further economic instability, and a long-term weakening of the United States' ability to influence world events in its favor. Americans, particularly the most advantaged, have sold their souls to the twin devils of immediate gratification and overconsumption. Unless we radically rethink our priorities and then put into action a drastic new policy regime, we will end up living in a world that is significantly more economically, culturally, and spiritually impoverished than today's before the current century has reached its midpoint.

Long-Term Threats

HCM sees several long-term threats that are being ignored by the markets as they struggle for some type of short-term stability. While we see many opportunities to invest profitably in the near term, we remain extremely concerned about long-term economic trends. We realize, with sadness, that there are very few long-term investors left in the world. Investors seem to have taken to heart, in a manner that borders between irony and self-delusion, John Maynard Keynes' famous statement that "in the long run, we are all dead." Since we are all not going to be dead tomorrow, however, HCM thought it would be useful to discuss some of the trends that are working against us as we live out our days. At the very least, these factors should be taken into account by investors as they fashion investment strategies for short- and intermediate-term time horizons.

Inflation: The first significant long-term threat is inflation -- both asset inflation and product inflation. The steps taken by the Federal Reserve to rescue the U.S. financial system from collapse have created the conditions for a long-term inflationary boom. Simply put, the authorities did what they always do in the face of a threatened systemic collapse: they reflated like crazy. Allowing the Federal Home Loan Banks and Freddie Mac and Fannie Mae to further swell their balance sheets with mortgage paper is hardly going to contribute to fiscal discipline. All it did was stick a finger in the dyke in the hope that other leaks wouldn't spring out right now. Second, the demographic and political pressures lifting the prices of both soft and hard commodities remain unrelenting. Oil is just the tip of the iceberg, though the best analogy is one that places the U.S. economy as the Titanic sailing straight at it. The long-term energy picture is nothing less than ruinous for the United States and other oil-dependent Western economies, as well as for the environment of our entire planet. The shift of wealth away from the U.S. and Western Europe toward countries that do not share our political values or interests is nothing less than potentially catastrophic for the future of world peace. That may sound like a terribly harsh statement to make now, but looking back on it in 50 years, it is likely to ring painfully prescient.

HCM's inflation view is somewhat different from that of Van R. Hoisington and Lacy H. Hunt of the highly regarded Van Hoisington Investment Management Company. We mention these gentlemen's views because their recent track record in economic forecasting has been second to none, and because we never believe we have cornered the market in knowing what's going to happen. In its most recent Quarterly Review and Outlook, Van Hoisington downplays the risks of a near-term inflation spiral. Conceding that CPI over the last twelve months has increased by 4.1 percent, much higher than the 2.8 percent average annual increase this decade, Van Hoisington points to four mitigating factors. First, inflation is a lagging rather than a leading indicator, and they believe that the historical pattern will persist of major reductions in inflation occurring in the early stages of the recovery from the current recession. Second, inflation gauges peaked well before the inception of the growth recession that began in mid-2007. Third, Van Hoisington believe that the upturn in headline inflation is transitory because higher food and fuel prices have not fed into wages (which is critical since labor costs comprise almost 70 percent of production costs in the U.S.). Finally, Van Hoisington believe that monetary policy is actually restrictive, not expansionary, pointing to the reversal of prior financial innovations (securitization) and absence of new ones, as well as the well-known refusal of banks to lend. HCM would never dismiss the views of Van Hoisington, which remains among the most accurate inflation and economic forecasters around. One question HCM would ask Van Hoisington about its forecast is whether tightness outside the Federal Reserve system (i.e. the collapse of the shadow banking system -- SIVs) will override the looseness being exercised by the Federal Reserve and other central banks themselves. In the near-term these two forces will struggle, but in the long-term HCM expects that it will be hard for the Federal Reserve and U.S. Treasury to put the Jack back in the box. But on a broader level, HCM is looking out much further in time than Van Hoisington. Van Hoisington's view is not intended to be a long-term (i.e. 5 to10 year) view of inflation (at least HCM does not read it that way). One cannot manage money very effectively these days based on such long-term views, although such forecasts should play some role in the process. The almost exclusive focus on the short term must be counted among the most profound flaws plaguing our markets and society today. And this is not merely a theoretical lament. This is one reason why so many investors end up losing years of returns in short periods of time through so-called "Black Swan" events. They invest in strategies that are sustainable in the short run, such as highly leveraged credit arbitrage strategies, but are susceptible to blowing up at some point in the future when conditions change. Such changes in conditions are always a certainty; the question is the timing of such changes, and the ability of investment managers to exit positions before the Black Swan drops a turd on their heads.

Dollar Debauchment: The second threat to U.S. economic hegemony is the demise of the U.S. dollar standard. There is no way to avoid the conclusion that wrong-headed economic and political leadership have all but completely debauched the American currency. Jason Rotenberg noted recently in Bridgewater Daily Observations⁵ that "we think we are now experiencing a breakdown in the US dollar system that is similar to the 1971 breakdown of the Bretton Woods system. Recent financial developments and the extreme provisions of liquidity that they have and will require are extremely bearish for the US dollar and are accelerating the process." HCM concurs with the view that the U.S. dollar breakdown is accelerating. With the Euro surpassing $1.60 for the first time (we take little long-term comfort in the recent "rally" to $1.55), the better play for investors concerned about the U.S. dollar continues to be South Asian currencies and the Chinese Yuan. But the fact that the dollar trades so poorly against the European currency, which represents an economic region that suffers from even more long-term structural deficiencies than the United States, raises serious concerns (however legitimate the view that the dollar is oversold in the short-term against the Euro).⁶ HCM remains squarely in the camp of those who believe that the dollar is a terminal short play absent radical changes in economic policy in the U.S. and around the world.

Corporate Earnings Weakness: The third threat is slower U.S. economic growth than in the rest of the world. This is a more complex question that deserves some discussion. Bridgewater Associates places the gap between U.S. and global GDP growth at 4 percent.⁷ Dr. Marc Faber warns that corporate profits are going to be far weaker than Wall Street analysts are projecting. Dr. Faber writes: "[m]y impression from talking to a large number of investors and from attending numerous investment conferences is this: yes, the mood among institutional investors is negative due to recent losses, but the urge to buy the dips is still far greater than the urge to sell on rebounds. Institutions perceive the current credit problems to be temporary and still expect S&P earnings to recover strongly in late 2008 and 2009."⁸ Dr. Faber cites a March 17, 2008 research report by Morgan Stanley economist Richard Berner entitled "Downside Risk for Corporate Profits," in which Mr. Berner writes: "I think the earnings outlook will disappoint. The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earning boom."⁹ Mr. Berner points to two areas of concern. First, the fact that operating leverage is currently far higher than in the 1990s, meaning that "a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze." Second, overseas earnings represent 31.5 percent of earnings today, compared with only 15 percent twenty years ago, so a non-U.S. slowdown would bode poorly for U.S. corporate profits. Mr. Berner already sees signs of the U.S. slowdown impacting foreign earnings (particularly in Europe): "Together with tighter financial conditions, I'm concerned that weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth. That would complete the circle, because it would also hurt US earnings abroad. About half of those overseas earnings originate in Europe." Morgan Stanley's European analysts recently projected a 16-percent drop in European corporate earnings this year, something that has not been carried through into U.S. analysts' earnings projections for U.S. companies with European exposure. U.S. stock market investors are still looking for a free lunch, and that lunch may be served cold (and stale). Weak corporate earnings are a particular concern in a recessionary environment in which the balance sheets of many companies have been larded with debt as a result of leveraged buyouts and similar speculative transactions. Retailers and airlines have already begun to default in packs, and more are of their brethren are certain to follow. Even as we appear to be well into the middle of the mortgage collapse, we are only in the very early innings of the corporate credit slowdown. There is a counterargument to the weak corporate earnings thesis, however. Many U.S. companies are continuing to post extremely strong results, particularly in the capital goods, energy infrastructure, commodities, and chemicals industries. Many U.S. companies retain unparalleled expertise in these industries and are exporting record amounts of products to the emerging markets around the world. One reason why the U.S. economy has not suffered as severely as some economists have expected from the housing industry collapse is that the global industrial economy has remained robust. HCM is working on a separate research report on the global industrial economy that explores this theme in detail, but our tentative conclusion is that many opportunities still exist to invest in the equity and debt of many U.S. companies providing goods and services to the global economy in the industries enumerated above. The question remains whether the strength in these sectors will be sufficient to counter the pronounced slowdown in the financial, housing, and consumer sectors that will continue to hang as an albatross around the neck of corporate profitability in the U.S. and Europe in coming quarters. On a long-term basis, the outlook for growth in these segments, and for the U.S. companies selling into them, remains very bullish. We hope to have our report completed sometime in June and will be making it available to readers of The HCM Market Letter at that time.

Relief Rally

Risk assets have rallied off their lows since JP Morgan Chase's acquisition of Bear Stearns in mid-March. The S&P 500 Index has jumped by 9 percent since that event, and the Merrill Lynch High Yield Bond Index has tightened sharply to a spread of 685 basis points over Treasuries from a high of 860 basis points. The prices of leveraged loans, which saw their worst drop in the history of that relatively new market in the first quarter of 2008, have also recovered sharply as dealers have managed to work down their backlog of unsold loans to under $100 billion from over $250 billion at year end. A key factor in the recovery in high-yield bonds and bank loans has been the continued low level of defaults, which have increased but remain confined thus far to the airline and retail industries. In the meantime, financial institutions such as Citigroup have had little trouble attracting additional debt and equity capital, and the markets are acting as though the worst of the crisis has passed. After all, compared to facing Armageddon, just waking up the next morning feels pretty good.

HCM is not surprised by this market recovery, particularly in the corporate credit markets. The bank loan market was bound to recover in the absence of any significant defaults, since its sell-off was entirely technically driven. The high-yield bond market, which remains a treacherous market for long-term investors, was also oversold in the absence of a rash of credit problems. At 680 basis points, however, it is again a poor value and should be avoided like the plague that it is (for everyone except the private equity firms who take advantage of its inability to price risk to purchase companies at exorbitant multiples). There is no question in HCM's mind that default rates will increase significantly in the second half of 2008 and 2009. When that occurs, the worst losses will be experienced by the holders of high-yield bonds in transactions that were completed in the 2005-2007 period, when acquisition multiples were mostly in the double digits. At anything less than 1000 basis points, high-yield bonds do not compensate investors for the risks they bring in today's economic environment.

Bank loans, on the other hand, continue to offer excellent value even after their recent rally. As floating-rate instruments that offer a senior position in the capital structure and collateral, bank loans offer extremely attractive risk-reward trade-offs. The market for Collateralized Loan Obligations (CLOs) remains moribund, but CLO liabilities remain an attractive way for investors to take advantage of the madness of crowds that have fled this asset class. Bank loans are not mortgages. One of the great lessons of the subprime debacle is that whatever fancy packages mortgages and other types of loans are wrapped up in, the only thing that matters in the end is whether borrowers can meet their obligations. Mortgage CDOs were flawed because the underlying borrowers couldn't make their mortgage payments, and all of the financial hocus-pocus in the world couldn't compensate for that. The same is true of CLOs. Either corporations will repay their loans or they won't. HCM believes that most will, and that most CLOs will end up repaying their liabilities and rewarding their equity investors handsomely. We are highly confident that those CLOs managed by our firm will do so.

The Road to Hell

As we said last month, the U.S. is being buried beneath the self-satisfied grins of investment bankers, hedge fund managers, and private equity tycoons who have figured out how to make personal fortunes without contributing commensurate amounts to the productive capacity of our economy. We can only join in Jeremy Grantham's recent lament:

"This has indeed not been our finest hour in the U.S. Times are bad enough, in fact, to make us mourn the American leadership skills of WWII and the generosity and foresight of the Marshall Plan. We can all wonder at the incredible vision, drive, organizational skill, and willingness to sacrifice resources that were required by the Manhattan Project and compare it to the rudderless or even deliberate avoidance of leadership of the greatest issues today: climate change and energy security. We can only wonder what a Manhattan Project aimed at alternative energy might have accomplished by now, had it been started 15 years ago. What we have had in lieu of vision, leadership, and backbone is a series of easy paths taken."¹⁰

It is a national tragedy that so much of the intellectual capital of this country is being directed at financial speculation rather than scientific and creative thinking. HCM believes that this is a problem of moral education. Our educational institutions need to teach the best and brightest students that there are rewards in this world other than pecuniary ones. Then it is up to the rest of society to insure that the financial rewards of doing good are commensurate with the benefits that such conduct confers on our communities.

PIMCO's Bill Gross is one of the few public figures in the market willing to speak out against the obscene compensation schemes that result from the asymmetric reward system that institutional investors have somehow been conned into believing align their interests with those responsible for generating the investment returns that will enable them to fund their future obligations. Jeremy Grantham's recent comments are consistent with Mr. Gross's and our own views:

"What's worse, those who took on unjustified risk live to prosper and reinforce the existing agency problems. These problems were big enough already: stock options, for example, that encouraged risks by rewarding upside success and punishing failure. If you win, you take some of the shareholders' company, and if you lose, you lose nothing. In fact, if you lose, you rewrite your options at depressed or crisis prices, just as some financial companies are doing as we write. Similarly some hedge funds and private equity firms can take a level of leverage that might guarantee failure in the long run but with asymmetrical returns they pocket gains and sidestep the worst impacts of a potential terminal loss. To maintain a healthy respect for risk taking, it is surely necessary to punish egregious over-reaching or spectacular misjudgment with the spectacular penalties they deserve and used to get but no longer."¹¹

Despite the performance of the occasional outliers, pension funds, endowments, and the like continue to experience shortfalls and other serious strains as professional money managers fail to provide sufficient returns to meet growing future spending needs. Moreover, outperformers continue to reap Brobdingnagian pay packages that sweep away a disproportionate amount of the upside from overall portfolio performance that never recycles back when conditions return to the mean. Some may think that we can simply continue on the road we are on. HCM believes otherwise. We believe that we must fix it.

Footnotes:

1 Most readers who disagreed with our approach took the high road, with the exception of one smug fund-of-funds executive who quoted a dead Nazi while accusing me of being a liberal fascist. He will no longer be receiving this publication from us. We are happy to listen to all types of criticism, however expressed, but we cannot stomach moral obliquity.

2 Estimates of total losses from the credit crisis keep mounting. Morgan Stanley is beginning to think that its current estimates of $400 million of total losses from mortgage lending and $750 million of overall credit losses may be too low. See Morgan Stanley Research North America, US Economics, "Funding Pressures, Adverse Feedback Loops and Monetary Policy," April 14, 2008. Some are estimating that the losses will exceed $1 trillion. However you measure it, there aren't enough guillotines to chop off the heads of all of the responsible parties.

3 "Castigation" may sound like an overstatement, but one has to understand Fedspeak to appreciate the harshness of Mr. Volcker's words.

4 Morgan Stanley Research North America, US Economics, "Fixing the Credit Crunch -- The Growing Case

for 'Unconventional' Tools," March 25, 2008.

5 Bridgewater Daily Observations, April 10, 2008.

6 Just to be clear, at this point HCM would not recommend shorting the dollar against the Euro but would recommend shorting the dollar against a basket of South Asian currencies and the Chinese Yuan.

7 Bridgewater Daily Observations, April 10, 2008.

8 Dr. Marc Faber, The Gloom, Boom & Doom Report, April 5, 2008, p. 5.

9 Morgan Stanley Research North America, US Economics, March 17, 2008.

10 GMO Quarterly Letter, April 2008, "Immoral Hazard."

11 GMO Quarterly Letter, April 2008, "Immoral Hazard."

On a lighter note, I am in South Africa after a 15-hour flight, landing to perfect weather. I watched the movie The Great Debaters, with Denzel Washington. It is a great movie. Rent it when you get a chance.

Your hoping that the authorities get it analyst,

John Mauldin

Two Essays on the Continuing Financial Crisis

John Mauldin — Mon, 28 Apr 2008 22:00:00 GMT

This week in Outside the Box we look at two brief essays which give us different perspective on the Continuing Crisis. The first is by Mohamed El-Erian, the co-chief executive and co-chief investment officer of Pimco. His book, 'When Markets Collide: Investment Strategies for the Age of Global Economic Change', will be published by McGraw Hill in June, and it will be on my summer reading list. El-Erian argues in the thought-provoking piece from the Financial Times that the crisis is still far from finished, and that those who think we are returning to more placid times may be surprised when volatility suddenly becomes even more pervasive.

The second is by good friend and Maine fishing buddy David Kotok, the chief investment officer of Cumberland Asset Managers (www.cumber.com). He was recently in Africa where he met with the head of the central bank of a small country with headline inflation of 10%. The problem is that "core inflation" is 5% and food inflation is 15%, yet accounts for 50% of the GDP. He asked a group of financial thinkers (including your humble analyst) to ponder what that central banker should do. Do you set high rates and target overall inflation or set lower rates and not worry about food inflation.

Why should we worry about inflation in a small African country? Because the principles are the same, and it makes a real difference where the Fed comes down at the end of the day on this very question.

This week's reading should be very helpful and thought-provoking. I hope you enjoy this read as much as I did.

John Mauldin, Editor
Outside the Box

Why This Crisis is Still Far From Finished

By Mohamed El-Erian

During the past few weeks we have seen a growing number of market participants predict an end to the dislocations that erupted last summer and claimed victims throughout the financial system and beyond. While their predictions are understandable, they are premature. The dynamics driving the disruptions are morphing and may again move ahead of both the market and policy responses.

The optimistic view is based on two distinct elements. First, that the deleveraging process is reaching its natural end as valuations stabilize and institutions come clean about their losses and raise capital; second, that a series of previously unthinkable policy responses have been effective in restoring liquidity to the financial system.

Both views have merit. Financial institutions, particularly in the US, have recognized the scale of the problem and are taking remedial steps. Just witness the recent round of capital raising by Citigroup, Merrill Lynch, JPMorgan and Wachovia. At the same time central banks in Europe and the US have opened up their financing windows, expanding the size of the financing, the range of institutions that can access it and the list of eligible collateral.

Yet, consistent with what we have seen since last summer, the dislocations are entering a new phase. As such, bold reactions on the part of policymakers may, once again, prove to be too little and too late.

Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.

Economic data in the US have taken a notable turn for the worse. Most importantly, the already weakening employment outlook is being further undermined by a widely diffused build-up in inventory and falling profitability. History suggests that the latter two factors lead to significant employment losses.

Pity the US consumers. Their ability to sustain spending is already challenged by the declining availability of credit, a negative wealth effect triggered by declining house values, and a lower standard of living as the result of higher energy and food prices and a depreciating dollar. Job losses will accentuate the pressures on consumers, leading to income declines and a further loss of confidence.

While the financial system has taken steps to enhance balance sheets, they speak essentially to addressing the consequences of excessive leveraging and imprudent financial alchemy. As such, the nasty turn in the real economy may fuel another wave of disruptions that, this time around, would also have an impact on mid-size and smaller banks.

It is thus too early to declare the end of the turmoil that started last summer. Instead, during the next few months we may witness a new phase of dislocations, led this time by the real economy. The blame game will intensify; political pressure will continue to mount; momentum will build for greater and broader regulation of financial activities within the banking system and beyond.

The focus will also be on the reaction of policymakers. Here the outlook is mixed. The good news is that the crisis is now moving to an area where traditional policy tools are more effective. This is in sharp contrast to the situation of the past few months, where central banks were forced to use instruments that were too blunt for the purpose at hand.

But there is also bad news. The sharp slowdown in the US real economy will occur in the context of continued global inflationary pressures. As such, the Federal Reserve's dual objectives - maintaining price stability and solid economic growth - will become increasingly inconsistent and difficult to reconcile. Indeed, if the Fed is again forced to carry the bulk of the burden of the US policy response, it will find itself in the unpleasant and undesirable situation of potentially undermining its inflation-fighting credibility in order to prevent an already bad situation from becoming even worse.

It is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.

And our next essay:

Food Price Inflation, Monetary Policy & Financial Markets

By David Kotok

Suddenly food price inflation has become the premier hot topic. The media is now attuned to food issues including emerging market country riots.

In the US, the politicians are gearing up to castigate the speculators and blame everyone but themselves. They conveniently forget that they are the ones who passed the ethanol subsidy and they are the ones who appropriate taxpayer money to pay farmers not to grow crops. And so the political circus begins.

Notice how the three presidential candidates are silent on how the US ethanol subsidy has caused a food price explosion in grains. They avoid the issue of US policy starving many in the world. 1 billion very poor people sustain themselves on $1 or less a day. We have doubled the cost of their food.

Ethanol directly impacted corn which, in turn, also drove up maize. In addition, the substitution of wheat and rice are not easily occurring because of crop issues and concomitant price inflation in those items.

Well Cumberland is in the financial market and money management business. We eat food. We don't grow it and we don't process it. So let's try to inject some serious monetary policy issues into this media hysteria and political cacophony.

In the mature countries, food is a minor portion of the price index. And some of the food costs originate from eating out and some come from food processing. Processed food cost is heavily dependent on the inputs which are non-food items. Labor, machinery, transportation and distribution all come in to play. So in the mature countries we see that the food price inflation may be topical and attention getting but it is not a crisis.

Also, the major mature countries are mostly in food surplus. In the US we are very efficient in running our agriculture enterprise. We actually pay farmers not to till their soil. This is dumb. It occurs only because of our sorrowful Congress who has learned how to bribe the farm belt for votes at the expense of the rest of us.

In the US food has a 14% weight in the consumer price index. Compare that with Canada at 17%, the Euro zone at 16%, England at 11% and Japan at 25%. Only Japan lacks the fullness of food self sufficiency. Sure, food price inflation is important. But it is not the most important issue in these major economies.

The reverse is true for the emerging markets. In some of them the food price component is as much as half the price index. In a few it is above half. Since many of these economies are open to some degree, the importation of food price inflation is hitting them particularly hard. Some are responding with tariff adjustments. Others have actually embargoed food exports. Of course they ultimately make matters worse when they restrict world trade and in the end all suffer because of this protectionism.

What about monetary policy?

Here is where it gets difficult. We will admittedly simplify now and we acknowledge to our critics that we know there are second order effects and are ignoring them to make our point. In our view, monetary policy cannot easily and directly address food price inflation when the source of the inflation is in the raw food commodity. This is also true for energy costs when the source is in the oil or natural gas. The whole concept of "core" inflation vs. total inflation originates in this notion that monetary policy should be directed at the price level changes it can affect.

Let's get to the inflation problem in an emerging economy. Our example is imaginary for simplicity's sake. But it reflects characteristics that are very similar to many countries and regions in the emerging markets of the world.

We developed this simple and theoretical case study and then sent it to a number of economist friends. We suggested that following facts: the economy in question is a small and open emerging market. The food price component is 50% of the price index and is inflating at 15%. The non-food component is inflating at 5%. Thus the overall index is inflating at 10%. In this small and open economy, the main items in the food component are based on maize; therefore, the US ethanol policy which has raised the corn priced has also pressured an increase in the maize price.

Suppose you are the governor of the central bank. You have to set your policy interest rate. Do you base that decision on overall inflation rate of 10% or on the core inflation rate of 5%? Or are you going to confront the food inflation rate of 15%. Let's further assume that your economy is growing at a trend rate of 5% and all other aspects are in trend or neutral position. You have no negative output gap and no above trend pressures. Your only direct problem is what to do about inflation.

My economist friends who answered offered a suggested policy rate as low as 6% and as high as 13.5%. The answers were about equally divided and the respondents sample size is over 20. The distribution of answers was distinctly bi-modal. About half the answers were bunched in the lower range of 6%-8%; the other half were in the double digit area between 11% and 13.5%.

The divided views centered on whether or not to target food, ignore food, or blend policy. No one wanted to set the interest rate above the 15% food price inflation. Nearly all acknowledged that this central bank would have difficulty in communicating whatever it decided. Most respondents worried about changes in inflation expectations because of the complexity of this issue. Most believed the citizens in the country would not understand the monetary policy dynamics that led to the decision.

Some worried that setting the policy interest rate in double digits would impose a very high financing cost on the non-food portion of the economy and cause it to go into recession. They argued that the real (inflation-adjusted) rate of interest for that non-food half of the economy would be 7% or so. That would set the threshold of finance too high.

Others argued that the monetary policy expectation effect would cause the rate of inflation to accelerate if the policy rate was not set in double digits. They were willing to take the recession in the non-food area in order to keep inflation expectations under control. No one mentioned substitution effects. Perhaps that was overlooked. Or it may be because rice and wheat are not easy cultural substitutes and those grains are each experiencing their own price pressures.

In sum, almost two dozen folks with some monetary economics expertise were equally divided on this technical question. It is a question that impacts billions of citizens in this world and many countries, their governments, their currencies and, possibly, their political stability.

We do not know the correct answer. Our view would support the lower interest rate and we would focus on the non-food portion of the economy but we can argue the other side with equal vigor. For us a lot would depend on how the food price inflation spreads into wages and if it could trigger a broader wage/price spiral.

In many respects this question is now being asked of the major and mature economy central banks as well. It appears that the European Central Bank (ECB) favors the higher mode while the US Federal Reserve is positioned in the lower one. For the emerging markets it appears that there is quite a mix of policy and that it is made more complicated by the management of each currency's foreign exchange rate. In sum, our simple case study is actually quite complex when applied in the real world.

David R. Kotok, Chairman and Chief Investment Officer

I trust you enjoyed this week's Outside the Box. And for the record, I thought rates in our hypothetical African country should be at the lower end. Targeting food inflation with high interest rates would hammer the productive, job creating portion of the economy. I have been to 15 countries in Africa and they are in desperate need of jobs. Better to target inflation through control of the money supply and encourage capital formation and foreign direct investment. But it is a tough question.

Your glad I don't have to be a African central banker analyst,

John Mauldin

Quarterly Review and Outlook - First Quarter 2008

John Mauldin — Tue, 22 Apr 2008 02:08:00 GMT

This week's Outside the Box is from my friends at Hoisington Management. While somewhat technical, they make the case that a slowdown in consumer spending is inevitable. This is worth taking some time and thinking about. Quoting: "This means that consumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction."

If they are right, and the evidence of their research is compelling, then we are in for a much tougher time than the recent stock market rallies suggest. The stock market is not always a leading indicator. This week's letter suggests that businesses that depend on the US consumer for growth may be in trouble.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - First Quarter 2008

Semantics

Nominal GDP in the first quarter totaled an estimated $14.2 trillion, a 3% annual rate of increase from the final quarter of 2007, which also registered a 3% gain. This two quarter growth rate in nominal GDP is typically associated with recessionary periods (Chart 1). The various price deflators applied to this nominal gain will now determine whether real GDP will be negative or positive, possibly clarifying the debate of whether an actual recession is in place. For financial participants, however, this argument is moot since the U.S. economy, at best, has been in a growth recession since mid-2007.

Solomon Fabricant, the NYU professor and NBER committee member who first identified this particular characteristic of the business cycle, stated that a growth recession occurs when economic conditions are sufficiently poor that unemployment rises and industrial capacity falls. From the cyclical low in March 2007 to March 2008, the unemployment rate jumped from 4.4% to 5.1%. In February, the manufacturing capacity use rate was 78.7, down 1.4% from its peak in July. Both signify a deteriorating economy. Growth recessions, like full scale recessions, produce falling inflation, a margin squeeze on corporate profits, eroding stock prices, and declining interest rates. Thus, the difference is really one of semantics. The point for investors is not what type of recession we are experiencing, but rather how long the downturn will last. Our conclusion is that our present economic difficulties will persist for at least two years.

An Extended Slump

Going forward, the main problem for the U.S. economy is likely to be a protracted period of restrained consumer spending. In the expansion from 2002 to 2007, real Personal Consumer Expenditures (PCE), which comprised 71.5% of GDP at the end of last year, posted a 3.1% per annum increase, down from 3.5% and 4.2%, respectively, in the expansions of the 1990s and 1980s (Chart 2). The subdued gain in spending would have been even less had consumers lived within their means, as real personal income (2.5%) expanded less than the spending rate. With spending outpacing income, the personal saving rate dropped from 2.4% in 2002 to 0.4% in 2007.

A disparity of 0.7% per annum between the growth of income and spending might seem insignificant until you consider that income must also support all the other demands on consumers -- investment in housing and other real assets, financial investment, and gifts to charitable and other causes.

The main cause of the weaker trend in personal income in this decade was lackluster real wage and salary income that rose just 1.8%, or one-half the rate of gain in the expansion of the 1990s. This meager gain was caused by the sluggish .8% payroll employment growth rate that was the smallest of any expansion since World War II. With this key determinant of consumer spending restrained, consumers lived well beyond their means, only because their paper worth was boosted by surging home prices.

Consumption And The Wealth Effect

One of the most studied issues is the consumption function - the factors that determine the way in which consumers are motivated to spend. For example, in Macroeconomics by Andrew Abel of Wharton and Ben Bernanke (now of the Federal Reserve and formerly of Princeton University) have a lengthy section entitled "the effects of changes in income and wealth on consumption and saving". This analysis like many others of a similar nature conclude that both income, expected future income, wealth as well as other considerations are causally related to spending. Using econometric models, economists are able to assign different numeric weights to those elements in the consumption function. These studies indicate, as a general rule, that expected or permanent income is more important that current income and that income considerations are more important than wealth. However, something known as initial conditions (the current starting point in the business cycle) may serve to over-ride the general rule. We, for example, believe that there are notable difficulties facing the U.S. economy that were typically not present in the past.

Wages, salaries, interest, dividends and rent generate funds that are available for spending. When wealth rises, however, funds are not typically generated that, in turn, can be translated into spending. Thus, understanding the mechanism of how wealth translates into spending may involve additional steps.

Consumers could turn wealth into spending funds by selling appreciating assets. However, if all consumers decided to do this at roughly the same time, the prices of those assets would fall, reversing the rise in wealth that had seemingly occurred. Thus, the main mechanism that increased wealth leads to rising consumption is for consumers to borrow against those assets. This, therefore, avoids the necessity of selling the appreciating asset and avoiding or at least postponing the decline of the appreciating assets.

Our research suggests that the mechanism of choice from 2002 to 2007 to convert rising wealth into spendable funds was borrowing against what consumers and their lenders apparently believed to be was a permanent rise in housing wealth - i.e. something that we have come to know as equity cash take outs.

The Home Equity Connection

From 2002 to 2007, home equity extraction, as determined by Freddie Mac, averaged $51.5 billion per quarter, up from $5.8 billion in the 1990s expansion (Chart 3). If we convert these cash outs into real dollars (using the PCE deflator), we see that they represented 2.4% of real PCE from 2002 to 2007, compared with a miniscule .4% of PCE in the 1990s. Thus, for spending, the shortfall in jobs and income was substituted by the famous home ATM machine. However, the connection between equity withdrawal and wealth is a complex matter. A great deal of econometric research has demonstrated that for every dollar change in real wealth, real spending shifts by 7.5 cents over the ensuing three years. If the massive real wealth gains derived from both homes and the equity markets in the 2002 to 2007 period are adjusted by the $1 to 7.5 cent relationship, the real wealth gains amounted to 2.5% per annum, expressed as a percent of real PCE. For all practical purposes, this is equal to the 2.4% per annum rise in mortgage cash outs. Consumers borrowed against the value of their homes in virtual direct proportion to their wealth gains.

The problem going forward is that real wealth is now declining, with the bottom yet to be found. Assuming home prices fall only 30% from their peak (some estimate a 50% decline), while stock prices rise 10% from the first quarter level and inflation is 2% per annum, the real wealth loss is about $7 trillion (Chart 4). Using the $1 to 7.5 cent ratio, this will constitute a drag on real PCE of 1.8% per annum from 2008 to 2010. Considering that the 3.1% rate of increase was the last expansion's average, a 1.8% drag will be a 60% reduction in consumer spending growth over the next three years just from the cash out/wealth effect alone.

However, there are other constraints. During the postwar recessions, real personal income's average growth was only 1.9%, but it has risen only 1.1% over the past 12 months. If real personal income moves back up to 1.9%, in itself a highly optimistic assumption, it would, nevertheless, be completely offset by the negative wealth impact of 1.8% mentioned above. This means that consumer spending increases should be approximately zero for the next three years. Further exacerbating the problem is the personal saving rate which declined from 5.2% in the decade of the 1990s to average 1.3% in the last seven years, and now stands at 0.3%. Should declining wealth, rising unemployment and poor economic conditions cause consumers to begin to save and lift the rate back to the 1.3% average of the past seven years, real consumer spending would experience a multi-year contraction. It is not a stretch to predict an extended quasi-recessionary period.

Is Inflation Accelerating?

In the last twelve months, the CPI increased by 4.1%, well above the 2.8% average annual increase this decade. Do these readings mean that the inflationary spiral has started? Other factors that contribute to inflation fears are the acceleration in M2 growth to a 13% rate of increase in the past three months, $100 plus per barrel oil, elevated prices for food, a wide variety of other commodity prices, and a weak dollar. A related question is whether the higher CPI readings, combined with poor economic growth, will result in stagflation, a condition last witnessed nearly three decades ago. Four considerations suggest that these fears are not likely to be realized.

First, inflation is a lagging indicator. This is true of all major broad based inflation barometers -- the CPI, the core CPI, the more reliable core PCE deflator and the Employment Cost Index (ECI). Over the past five cyclical downturns, the year over year increases in these four series did not peak until the economy was in recession (Chart 5). In all these situations, major reductions in inflation occurred in the early stages of the ensuing recovery. This historical pattern is due to the fact that productivity surges rapidly in early stage expansion, causing unit labor costs to rise much more slowly than wage costs.

Second, in this particular episode all these inflation gauges have peaked well before the start of the growth recession in mid-2007. The year over year increases peaked as follows: 4.7% for the headline CPI in September 2005; 2.9% for the core CPI in September 2006; 2.5% for the core PCE in February 2007, and 4% for the ECI all the way back in the fourth quarter of 2003. The year over year change in the fourth quarter was a substantially lower 3%.

Third, the unprecedented deceleration in the increase in the ECI of one full percent during the past three years of economic expansion strongly documents the impact of globalization on the United States inflation rate. Even with the recent increases, the unemployment rate is still 1.2% lower than in June 2003. Despite this tighter job market, wage cost increases decelerated, a clear reflection that employers have global options, and wages are increasingly set in the global marketplace. This is strong confirmation that the upturn in headline inflation is transitory. Higher food and fuel costs have not fed into wages, a critical element since wage, salary and benefit costs comprise almost 70% of the cost of production in the United States. Persistent inflation episodes have all exhibited a price/wage spiral.

Fourth, in spite of the 13% rate of growth in M2 in the past three months, and the striking new creations in Federal Reserve lending and financial support activities, we actually judge the thrust of monetary polity to be somewhat restrictive, not expansionary. This is based on the consideration of both the stock of money (M) and its velocity (V). For example, the first quarter surge in M2 growth has been more than entirely neutralized by a dramatic decline in M2 velocity (Chart 6).

Moreover, velocity is likely to continue to decline. Velocity falls when financial innovations are not forthcoming and declines sharply when previous financial innovations are reversed. In the midst of the current massive credit crunch, this cycle's innovations in mortgage finance, collateralized debt obligations, and structured investment vehicles are all being reversed. In the first quarter, nominal GDP grew around a 3% annual rate, meaning that velocity dropped to 1.85 from 1.9 in the fourth quarter, remaining well above the post 1900 average of 1.67.

More striking, perhaps, has been the impact of velocity over the past seven quarters. M2 growth has accelerated to 6.8% versus 4.4% in the seven quarters ended in the second quarter of 2006 when velocity peaked. Based on M2 alone, the economy should have been accelerating, not falling into the current slump. However, in the past seven quarters V2 (the velocity of M2) declined 2.3% per annum, causing GDP growth to decelerate from 6.5% to 4.4% (Table 1). This declining velocity will mean the Federal Reserve's best efforts are likely to be thwarted, and nominal GDP will slow coincident with inflation and output.

Interest Rate Possibilities

Treasury yields have dropped to near record lows, but the historical record suggests the ultimate bottom in cyclical rates is considerably in the future. On average, thirty year Treasury bond yields are a lagging economic indicator. This is not surprising since inflation is a lagging indicator and inflation is the main long run determinant of bond yields. Since the end of World War II, the thirty year Treasury yields reached their cyclical lows, on average, 14.9 months after the end of the business cycle troughs (Table 2).

Thus, if this growth, or outright recession, ends in 2008, the low in bond yields will be some time in 2010. However, if we are in an extended growth recession that lasts into 2009 or 2010, as we suspect, and if rates are at record low levels, similar to the 1940s and 1950s, then the low in rates is likely to coincide with the end of the recessionary period.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Your doing my bit to keep up consumer spending analyst,

John Mauldin

Let's Get Real About Bear

John Mauldin — Mon, 17 Mar 2008 20:48:05 GMT

This week's Outside the Box is going to be a little different. I am going to write about the extraordinary action by the NY Fed to foster the Bear Stearns deal with JP Morgan, and give you three brief notes from Michael Lewitt of Harch Capital Management...(read more)

What Do They Know?

John Mauldin — Mon, 01 Oct 2007 16:42:00 GMT

Introduction We are in a world far different than the one I learned about in economic text books. As I have written, the shadow banking system of hedge funds and CDOs, CLOs, PIPES, etc. have created a new financing economic reality far different than...(read more)

John Mauldin's Outside the Box : Inflation

Between a Rock and a Hard Place

Between a Rock and a Hard Place

Slow Long-Term Growth, And Government's Response

Slow Long-Term Growth, And Government's Response

Six Causes of Slow Long-Term Growth

Slow And Weak Recovery

2.0% GDP Growth

Consumer Spending Growth

Consumption vs. GDP

Where's The Growth?

Capital Spending

Imports and Exports

State and Local Government Spending

Rescued By Slow Productivity

Big Federal Spending

Savers To The Rescue

Debt Reduction

Future Insights

Make Sure You Get This One Right

Make Sure You Get This One Right

Quarterly Review and Outlook - First Quarter 2009

Quarterly Review and Outlook First Quarter 2009

Inflation/Deflation

Economic Theory

Record Expansion of the Fed's Balance Sheet and M2

What about the M2 Surge?

Are Massive Budget Deficits Inflationary?

Bonds Still an Exceptional Value

Roadmap To Inflation And Sources Of Cheap Insurance

Roadmap To Inflation And Sources Of Cheap Insurance

Fisher and the debt-deflation theory of depressions

Romer's lessons from the Great Depression

Bernanke and the policy options

Investment implications – Cheap insurance

Inflation Is Not The Problem

Quarterly Review and Outlook - Second Quarter 2008

Quarterly Review and Outlook - Second Quarter 2008

Inflation

Reality

A Basic Macroeconomic Model

Factors Operating on the Aggregate Demand (AD) Curve

Factors Currently Operating on the Aggregate Supply (AS) Curve

AD and AS Together

Conclusion

The End of the Inflation Scare?

The End of the Inflation Scare?

1- Where Does the Inflation Come From?

2- What Explains the Surge in the Amount of Money?

3- Will Velocity Remain As Strong?

4- The Importance of the US Current Account Deficit

5- Will the US Deficit Continue to be an Inflationary Force?

6- Conclusion

A Kind Word for Inflation

A Kind Word for Inflation

Fooling With Inflation

Fooling With Inflation

Why We Must Fix It

Why We Must Fix It

Long-Term Threats

Relief Rally

The Road to Hell

Two Essays on the Continuing Financial Crisis

Why This Crisis is Still Far From Finished

Food Price Inflation, Monetary Policy & Financial Markets

Quarterly Review and Outlook - First Quarter 2008

Quarterly Review and Outlook - First Quarter 2008

Semantics

An Extended Slump

Consumption And The Wealth Effect

The Home Equity Connection

Is Inflation Accelerating?

Interest Rate Possibilities

Let's Get Real About Bear

What Do They Know?

Quarterly Review and Outlook
First Quarter 2009