Q1 ’12:   Contrary (Positive) Thoughts

I have been writing about the inevitable consequences of our fiscal and political insanity since 2001, when those inevitable consequences were almost universally ignored. Since then, much of what I warned about has come to pass, the balance is looming on the horizon, and it has become de rigueur to be pessimistic about the future of the U.S. and the world. (See the recent Mauldin Outside the Box newsletter “I’m Worried”).

Given the litany of problems we are facing and the epic scale corruption of our economic and political elites, it is hard not to be pessimistic these days. As a commenter on Naked Capitalism recently put it, “You can’t expect good long term outcomes from a culture whose elites are as openly corrupt as ours are.”

However, being a contrarian by nature, I have recently found my attention drawn to a variety of inputs that give pause to my pessimism. I have been reminded that despite the poor quality of our leadership and the damage they have inflicted on us, America’s culture of creativity and capacity for reinvention are something special in the world. Warren Buffet put it this way in a recent CNBC interview…“It’s a terrible mistake to get pessimistic on America…It has not worked since 1776 and it’s not going to work now.”

I am also reminded that the bottom always comes when things look the worst. Our “leaders” have kicked the can down the road about as far as they can, and are fast coming to the day when they will have no choice but to bite the bullet and deal. This will present a rare opportunity for resolution of longstanding imbalances, and for national renewal. There are huge opportunities for new growth and prosperity just waiting for the toxic sludge of past mistakes to be cleared.

I have recently come across several inspiring books and articles that offer ideas and insights into developing trends.

1) Ken Fisher has published an excellent and perfectly timed book on the election cycle, the nature of markets and the impact of politics on markets, entitled “Markets Never Forget (But People Do).” My recommendation is to run, not walk, to your nearest bookstore, or to your Kindle, Nook or smartphone to download this book. (Don’t overlook Ken’s brief history of the Wizard of Oz in the Appendix!)

Ken reminds us, and provides ample documentation, that worry over such things as the dreaded “double dip” recession, which almost never happens, and the “jobless recovery” are staples of market commentary and public perception during every recovery from recession. The job market is slowly reviving, lagging the general recovery as it always does, but the jobs being generated are not nearly equivalent to those that have been lost, and this is also typical.

The bottom line is, while anything can happen, probabilities are strongly in favor of solid economic growth and stock market gains for at least the next year or so. Ken Fisher is a “glass half full” kind of guy, and we can all benefit from his clear thinking and optimism.

2) From John Mauldin’s endlessly informative Outside the Box newsletter, is a gem from GaveKal on major developing trends entitled “Weeks When Decades Happen.”

GaveKal points out that technology, in particular, robotics, is undermining the advantage of cheap labor countries, sending manufacturing back to the U.S. and other consuming countries. This trend, combined with the trend to energy independence (and much cheaper energy) in the U.S., resulting in much smaller U.S. trade and fiscal deficits going forward, will promote greater balance in the global financial system and strengthen the dollar (or boost dollar denominated assets). GaveKal also highlights the recent birth of the RMB bond market as a historical development mostly overlooked by the press, and predicts the inevitable internationalization of the RMB.

3) Last but not least, Kirk Spano, proprieter of Bluemound Asset Management, recently penned a very insightful and upbeat series for Marketwatch on the dollar and opportunity in America, here, here, and here.

Kirk points out that the vast money creation from the Fed has since 2008 has for the most been replacement of the money previously created by the big banks and subsequently vaporized in 2008. That’s one major reason we have not had big inflation along with the Fed’s money creation…so far.

Kirk echoes GaveKal in pointing out the huge opportunity and future growth from the inevitable trend to energy independence in the U.S. He sums up his argument thusly:

“…America, and the dollar, will be fine long-term as long as the United States bends its spending curve down and continues on a path of becoming energy independent, as well as increases exports of food, high-end manufactured goods, technology and medicine over time.”

Taken together, these publications create a hopeful sense that something new is happening; that maybe, just maybe, the destructive trends of recent years have nearly spent themselves, and positive trends have begun. Perhaps that is that way it always is at the turning points…the attention is held by the spectacle and madness of wide scale destruction, even as new growth is quietly taking place.


It’s a presidential election year, and the stock market has been doing what it usually does in presidential election years…going up! Those who managed to remember this tendency last October when the sky was falling have been rewarded. Stocks (correcting at publication time) have been steadily “climbing the wall of worry,” creeping up on their all-time highs, while ignoring the tepid recovery, the meltdown in Europe, war drums in the Middle East, and the looming Taxmageddon.

The Obama Treasury and the Fed will be working full time to make sure that the trend continues into the election. Barring unexpected developments, that effort should be successful.

Precious metals are consolidating after an 11 year bull market that peaked in September of last year. No-one can say how long this consolidation will last or how deeply the metals will correct, but in the long run the dollar is going to continue to lose purchasing power and gold in dollar terms will find its way higher.

As the Fed continues to maintain negative real interest rates, many investors, desperate for yield, are buying junk bonds, others, treasuries for “safety.” Bond holders of all types need to be reminded that regardless of what the Fed does, or for how long, the upside for bonds is very limited, and the potential downside is very large. In the long run, rates are going to go up, and once they get going they will probably go much higher than anyone imagines possible at this time.

The Fed is clearly stuck between a rock and a hard place. More QE will spike inflation, less and the economy sinks back into recession. Last year the Fed bought over 60% of U.S. debt issuance. Yes, that’s right…60%. If ever there was an unsustainable trend, this is it. What’s a Fed chairman to do? “Helicopter Ben” Bernanke has long since made clear what he thinks. Political considerations may prompt a temporary halt to QE, but any signs of deflation will bring its swift return.


We are, in reality, in a controlled depression. The official unemployment rate is 8.1%. Shadowstats, a more reliable source, shows real unemployment running at about 22%…Great Depression levels of unemployment.

The problems in the Eurozone, slowing growth in China, the continuing technology revolution, globalization and looming “fiscal Armageddon” in the U.S. will continue to challenge job growth until there is some paradigm shifting development. That development could be something good, like the rise of enlightened leadership and global co-operation, or it could be something really painful like a global pandemic or financial collapse.

At present, as Ken Fisher points out, the recovery is following the normal path of all recoveries. This one is just proceeding from a much deeper trough than any since the Great Depression.


The ongoing sovereign debt crisis is like a simmering pot that threatens to boil over at any moment. The German-driven austerity guiding the policy response to the crisis to date is not going to last. Recent elections in France and Greece dealt a blow to austerity policies in those countries, and an upcoming referendum in Ireland is sure to do the same.

Austerity is Germany is waging war on its neighbors, as it has done for centuries. The outcome is most likely going to be as it has been in the past. After Germany lays waste to its neighbors, it in turn will be laid to waste. In this case, after Europe has had all it can take of German imposed austerity, German banks are going to take a massive hit as the rest of Europe defaults on its debts to Germany.

We could say that this is progress of a sort…at least this war is being waged with debt instead of bullets and bombs, but the underlying pattern continues. Can Germany be enticed to join with its neighbors without insisting on subjugating them? See “Europe’s Future is Not Up to the Bundesbank,” by George Soros.


“You can always count on Americans to do the right thing…after they’ve tried everything else.” Winston Churchill

It’s time. We have certainly tried everything else.

It’s possible that politicians have always been such as ours are. Perhaps in this information age it is more difficult for them to hide their nature. That is a hopeful thought (sort of), and unfortunately about the best thing I have to say about the state of our politics.

I will say this about the upcoming election. It is terribly important for our collective future. There are many hard choices and actions that will need to be taken, or that will be forced on us of they are not taken, after this election. I hope that the American electorate will be able to see through the rhetorical fog being generated by the big money, scorched earth, “win at any cost” super PAC ad campaigns to choose those who most likely will be willing and able to serve the nation rather than themselves, their parties or their financiers.

As far as the presidential candidates are concerned, anyone who thinks there is any substantive difference between Barack Obama and Mitt Romney, other than the color of their skin and the size of their bank accounts, has been listening to the spin instead of paying attention to what they actually do. On the political spectrum they both stand shoulder to shoulder in the space traditionally known as “moderate Republican.” Obamacare is in fact Romneycare gone national. That should tell you something.

Given the reality that Obama and Romney are indistinguishable in their personal political inclinations, the question is, who would better serve the nation over the next four critical years. I see three primary considerations:

  1. Political Dynamics: If Romney is elected, it will be much more difficult for him to make the hard decisions that need to be made. With Romney, we will most likely get four more years of posturing and positioning for re-election, as we have for the past four years, instead of decisive leadership. Obama will not have this motivation. There is no guarantee that Obama will deliver, but the probabilities are more in his favor. Political dynamics favor Obama.
  2. Supreme Court: If Romney is elected, despite his generally moderate tendencies, he will face intense, scorched earth pressure from his “base” to appoint right wing ideologues to the Supreme Court. The current right leaning court has already given us the egregious Citizens United decision, and “strip searches for all.” What other violations of our core values will we see with another right wing ideologue or two on the Court? America needs better justices. Obama has done well in his appointments. The future of the Court also favors Obama.
  3. The Team: A President does not govern alone. Despite the fact that Romney is a moderate himself, he will be under heavy pressure to include the extreme elements of the party that helped him get elected. With so many unresolved problems remaining from the last bout of extremist Republican policy, I don’t think America can take another round. Balance and moderation, not extremism, are what we need in these perilous times. The team also favors Obama.

Despite that fact that Obama has been such a big disappointment on so many fronts, he still offers us better odds of a favorable outcome over the next four years. Romney personally is no more or less offensive than any of the current crop of national politicians, but considering the pressures he will be under from the extreme elements of his party, the odds are stacked against him–and us–if he wins.


The geopolitical scene is dominated these days by the Iranian nuclear program drama. War hawks, led by Israeli Prime Minister Benjamin Netanyahu have been lobbying hard for military action against Iran. Just as they were building the chorus to a fever pitch, they finally began to get serious pushback.

President Obama chose the annual AIPAC meeting on March 4th to take the hawks to task, publicly lambasting them for “too much loose talk of war.” This speech was closely followed by Meir Dagan, a former leader of Mossad, making the case on 60 Minutes that an attack on Iran is not in Israel’s best interest, and an op-ed in the Financial Times by Walt and Mearshimer entitled “Mr Obama must take a stand against Israel over Iran.”

Most recently, in a rising tide of opposition to war, Elie Wiesel, the widely respected Holocaust survivor, rejected Netanyahu’s comparison of Iran’s threat to the Holocaust, Yuval Diskin, former head of Shin Bet, Israel’s internal security service, called out Netanyahu and his Defense Minister as “not fit to stand at the helm of government,” and finally former Israeli Prime Minister Ehud Olmert condemned Netanyahu’s Iran policies.

The net impact of all this pushback has been a blunting (if temporary) of the building juggernaut for war. Noteworthy: at this writing, Intrade places the odds of a U.S./Israeli attack on Iran this year at 25%, down from its high of 62% in February.

In the background, China continues its own juggernaut to extend its global reach and position the yuan as a competitor to the dollar. Currency swap arrangements with trading partners are being steadily expanded, as well as investments in raw materials and mining operations globally.

The first ever use of the SWIFT global financial telecommunications system as a weapon against Iran by the U.S. has accelerated the move away from the dollar as the preferred reserve currency. In response, the BRICS nations have set up a BRICS bank to compete with the U.S. dominated World Bank and IMF. It is noteworthy that India has rejected U.S. pressure to cut off Iran and has agreed to pay Iran for its oil with gold.

A very insightful and frank article by an influential Chinese policy analyst outlines China’s perspective on future relations and competition with the U.S. In short, they view it as a zero sum game, with the U.S. in decline, and China winning the future. My own thought: We’ll see about that. Maybe this is the challenge that the U.S. needs to get its act together.

For those wishing a clear perspective on the current state of the global financial system, and the history and prospects for currency war, James Rickard’s “Currency Wars: The Making of the Next Global Crisis” is a must read.


Hard assets and stocks are the most obvious opportunities at this time, given the ongoing debasement of the dollar and the strong indications of the Presidential cycle. See the articles referenced at the beginning of this newsletter for specific sectors and companies likely to benefit from developing trends in automation and energy development. Another opportunity for bond holders is to get out of the line of fire. In the long run, any bonds have only one way to go, and that is down.


I find myself feeling strangely optimistic. Maybe this is a passing thing, or possibly a sign that I should short the market. In any case I do think that we have either reached a nadir in public life, and things are going to start improving, or else we will soon go into a rapid and sustained decline. I hope that Warren Buffet is right. There are certainly major opportunities for new growth just waiting for the detritus of past excesses to be cleared away.

All hands are on deck to maintain calm going into the election. Presently, it appears that this effort will be successful and the Presidential cycle will follow its normal course. This effort requires sweeping a huge number of unresolved imbalances and dislocations under the rug, where they will not stay for long. The mega crisis marking the end of the debt super-cycle that began in 1998 is not over. Each sub-crisis since 1998 has been worse than the previous and the next will be worse than the last, until finally the global financial structure is reorganized or ruined.

We can only hope that behind the façade of happy talk about recovery there are real plans being made for a restructuring that can be implemented when the inevitable can no longer be delayed.


Q4 ’11:   Real Change is Coming

The reality of the economic catastrophe that has been created by 30 years of debt creation, laissez-faire globalization and upward redistribution of wealth, is gradually and steadily asserting itself. Our leaders have been doing everything they can think of to first deny, and then delay, delay, delay the inevitable, but big changes are beginning to take shape on every front, and these changes are ultimately going to impact virtually everything.

Domestically, Occupy Wall Street is a gathering storm that is not going to go away. In Europe, the slow moving sovereign debt meltdown is presenting a new drama every day and roiling markets globally. Our own slow moving political meltdown was again demonstrated by the failure of the Super Committee to agree on anything. Geopolitically, the U.S. continues to lose influence around the globe, even as we commit to expand our military “footprint” everywhere, and the pace of realignment is quickening. And in the “from out of left field” category, scientists at CERN have confirmed the measurement of particles traveling faster than light, a development equivalent to the recognition that the world is not flat, or that the Earth is not the center of the universe. What changes in human civilization this might usher in are hard to imagine.

Our chronic economic problems are all being politically driven at this point. There is a desperate need for a reality-based public debate and policy response to the metastasizing crisis. However, any efforts in that direction continue to be stonewalled by Republicans, who are convinced that they will gain in the upcoming election by preventing any improvement in the situation, and who continue to deny any responsibility for the disaster that their policies have created (in fact they continue to promote the very same policies). Feckless Democrats either don’t understand what is happening, or are too cowardly to speak up.


Markets across the board have been gyrating viciously for months, driven by the Greek (and Spanish, and Italian, and Portuguese, and Irish, and French) sovereign debt crisis, and the indecisiveness of Eurozone policy makers in crafting a solution to the problem.

In the U.S. we are looking at diametrically opposed policy “solutions” to the current economic malaise yielding dramatically different market outcomes. Given the polarized debate and policy options, we are either going to have a Republican sponsored all-out depression, or a Fed sponsored inflationary spiral that could morph into hyperinflation. Obama, as usual, has been trying to split the difference, but as usual that effort has not been working. Instability is increasing. Market participants have no confidence in their positions, and are quick to jump out, and slow to get back in. Price action is even more volatile and unpredictable than usual. I wish I could say otherwise, but I can’t find any reason to think the situation is going to improve any time soon.


Eurozone policy makers keep trying to buy time with short term fixes, but the banks are broke and need to be recapitalized, or they will go under and take the Euro with them.

When the architects of unified Europe created the Euro, they did not include a mechanism for adjusting the price of debt issued by the various member states according their creditworthiness. For some strange reason, instead of penalizing Germany for affiliating with Greece and other less credit worthy nations, global bond investors have given Greece and the other less credit worthy members a free ride on Germany’s pristine credit rating. As a result, Greece (and others) have been borrowing money for years at the same rate as Germany. It doesn’t take a Ph.D. in economics to figure out that this arrangement will probably not end well.

To simplify a rather complex situation, European banks have bought all of this debt at super low rates (high prices), and now that the bond market is pricing that debt at much higher rates (lower prices), the banks are seriously under water. So the banks need to be bailed out. But the Bundesbank and German taxpayers, who will have to pick up the lion’s share of any bailout and who still retain a vivid national memory of the Weimar era hyperinflation, don’t want any part of it. In fact, the Germans originally went along with the Euro because they were explicitly promised that they would not have to do this very thing. Things have gotten so bad that even Germany was unable to sell out a recent bond offering.

As usual, John Mauldin is a good source of timely information. He has been publishing a series of in-depth articles on the unfolding Euro-disaster in his Outside the Box newsletter. Mauldin also published an especially insightful piece entitled “An Irish Haircut” in his Thoughts From the Frontline newsletter, which delves into how the Irish view their situation.

The bottom line for the Irish is this: if investors are taking a haircut on Greek debt, thus relieving Greek taxpayers, the Irish will demand the same. The Irish are not presently in the streets, but their patience should not be taken for lack of resolve. They will demand it. Extrapolating to the rest of Europe, if the Greeks and the Irish get a haircut, then what of Italy, Spain and Portugal, even France? The situation is simply not resolvable with the half measures that are currently being deployed.

Yves Smith has also been providing extensive coverage of the European crisis and other economic issues on her excellent blog Naked Capitalism. For those intrepid enough to dig into the minutia of this very complex situation, see “Europe’s Plan to End the Debt Crisis – Putting the ‘Con’ in Confidence,” Part I and Part II, by Satyajit Das.


The Republican Party has been captured by the lunatic fringe of American politics and has become, in the words of Paul Craig Roberts (former Assistant Secretary of the Treasury under Ronald Reagan) “the greatest threat America has ever faced.” I encourage my readers to review Roberts’ 2008 essay at Counterpunch, “The Mother of All Messes,” just as true today if not more so, and my own 2010 op-ed at the Denver Post on the consequences of sending Republicans to Washington, entitled “The Republicans’ Wrecking Ball.”

The Republican “base” is composed of people who cheer for executions and letting the uninsured die, and who hope that our President’s policies fail. Their representatives in Washington are doing everything they can to make sure that the President fails, regardless of the cost to the nation. It hardly needs to be said, but these are profoundly disloyal and un-American sentiments.

The nature of the modern Republican Party is captured by this quote from John Judis, courtesy of Josh Marshall at TPM.

“Over the last four decades, the Republican Party has transformed from a loyal opposition into an insurrectionary party that flouts the law when it is in the majority and threatens disorder when it is the minority.”

The 2012 election season has already begun (heaven help us!). Given his performance and the chronic economic malaise, Obama wouldn’t have a prayer of being re-elected if the Republican Party presidential nomination process had not turned into a freak show. At this point the Republican field gives Obama a pretty good chance. Mitt Romney appears to be the likely nominee. Romney is a political chameleon who changes his position on issues so frequently that it is hard to know what he stands for. Real conservatives hate him and have been offering up a series of lunatic true believers – Michele Bachmann, Rick Perry, Herman Cain, and the latest, Newt Gingrich — in hopes of displacing Romney.

Occupy Wall Street

Occupy Wall Street is the first manifestation of a popular uprising that will eventually sweep away the existing economic paradigm. The 99% have been remarkably indulgent of the fraud (supply side economics, otherwise known as Reaganomics or “voodoo economics”) perpetrated on them for the past 30 years. It appears that we have finally reached the breaking point. Unlike the Tea Party, which from the beginning was the creation of well financed Republican political operators, Occupy Wall Street is a genuine grass roots phenomenon. It’s interesting to note that one of the main criticisms of OWS is that it doesn’t have a political agenda…it’s simply a protest. Critics don’t seem to understand the significance of that reality. A political agenda will inevitably rise out of this protest…in fact it will be more than an agenda, it will be a movement based on the principles of economic justice, commonwealth, and public service. It is not going to be friendly to the status quo or to those who try to hold on to it.

No-one likes to pay taxes. That’s a given. However, any and all efforts to increase taxes, even modestly, on the upper tier (which benefitted so massively from the run-up of debt over the past 30 years), has been assailed by Republicans as class war. Reflecting the growing anger at the intransigence and the fundamental dishonesty of this position, the Economist posted this item on 9/21 entitled “Class War”:

“There is a class war in this country, a war between the subsidy barons, the regulatory arbitrageurs, the patent monopolists and the rest of us. Mr Obama is a class warrior. The trouble is he’s on the wrong side.

During Mr Obama’s reign, the revolving door between Washington and Wall Street has been replaced with an open garage door you can drive a hybrid truck through.”

When the Economist — a very traditional and balanced conservative publication — posts something like this, then you know the ground has shifted. Ironically, Republican intransigence on this matter will go a long way towards generating a real class war.

While the debt-financed party was ongoing the vast majority were only gradually losing purchasing power. Like the frog put in the pot of cold water and then slowly cooked, the majority didn’t realize what was happening to them. Meanwhile, the vastly inflating riches of the upper tier were being financed entirely by debt that would eventually have to be shouldered by the 99%, who are finally beginning to wake up. The so-called conservatives who have been painting Obama as a socialist are going to have to find a new term for the real socialism that is coming.

The following chart illustrates the central issue that is driving Occupy Wall Street. No commentary needed.

And the next chart represents the issue that pushes people over the indignation edge and out to the streets. In 2009 alone, the five highest paid financial executives at bailed out firms received just shy of $100 million in combined compensation, even as their companies were laying off 110,000 people and absorbing over $130 billion in taxpayer subsidies.

Source: Economic Populist

Egregious as it is, however, this chart represents just the tip of the iceberg of what can only be called corporate looting. It doesn’t include the “golden parachute” payments to failed CEO’s such as the $161 million paid to Stanley O’Neil in 2008 after he destroyed Merrill Lynch, or the $100 million paid to Chuck Prince who nearly brought down Citicorp (saved by the taxpayers). And of course none of this touches the billions of dollars paid out in bonuses during the lead up to the meltdown, as the banksters were busy heaping up fuel for the bonfire that would consume our economy for at least a generation. A recent Bloomberg article documents over $7 trillion in Fed loans (read: taxpayer subsidies) to the banks in 2008.

William Cohan posted an excellent article on Bloomberg that identifies the central problem on Wall Street entitled “Ending the Moral Rot on Wall Street.” The following quote sums it up:

“Human beings are pretty simple. They do what they are rewarded to do. On Wall Street, people are rewarded when they take big, short-term risks with other people’s money. Trouble is, they are rewarded not only when the bets pay off, but also when they don’t. There’s probably no practical way to return to the private partnerships that required people to put their net worth on the line, but a way must be found to require bankers, traders and executives to have skin in the game.”

Meanwhile, 46 million Americans are living in poverty, the biggest number ever, over 15% of our people, even as the median corporate CEO has bounced back to pre-2008 levels, and is getting paid 343 times the average wage of their employees, up from 42 times in 1980.


The global political temperature is rising and the pace of realignment is quickening. Obama is putting the screws to the Pakistanis on their double dealing with the Taliban. This has created political chaos in nuclear Pakistan, and our relentless drone attacks inside Pakistan are feeding the fire. Every incident of civilian casualties from our drone attacks is broadcast far and wide, further inflaming anti-American sentiment throughout the Muslim world. These repeated incidents are destroying what is left of America’s moral authority globally.

The “Arab spring” has created openings for Islamists throughout the Middle East. Israel is now more isolated than ever as Egypt and Turkey have backed away from long term alliances. Iran stubbornly persists in its nuclear program in the face of crippling economic sanctions, while neo-cons lobby for military action against Iran.

At the same time, we are pledging an increased military “footprint” in the Far East to counter China’s growing influence, and in the Middle East to counter Iran. Folks, we simply cannot afford to continue to project military force around the world, unless the world wants to pay us to be the global policeman, which seems highly unlikely. Our fiscal situation is dire, and the entire Western debt based economic model is growing unstable. We have big problems at home and we need to withdraw from empire.

The military industrial complex is about to meet its Waterloo, in the form of the American people, who are increasingly going to start saying “no more foreign military adventures…bring home the troops.” Readers might want to check out Ron Paul’s sensible foreign policy positions. Paul is generally known for his Austrian economic philosophy and more specifically for his opposition to the Fed. Depending on how quickly the metastasizing global financial crisis unravels, however, it is Paul’s foreign policy positions that are most likely to make him a real contender for the Republican nomination. See David Sirota’s piece “Why Young Voters Love Ron Paul.”


See the Economist’s 10/15 cover article “Nowhere to hide: Investing during a crisis.” The lede pretty much covers it…”Investors have had a dreadful time in the recent past. The immediate future looks pretty rotten, too.”


I still expect that an “all hands on deck” effort to maintain stability going into the election will be successful despite Republicans’ best efforts to create chaos. The wild card is the looming breakdown in Europe. After the election I think we will see the end game, and which way it goes will in large part depend on who wins the election.

Our market risk these days is being driven almost entirely by political developments. As with bear markets, destructive social phenomena often reach their nadir when things are looking hopeless. Several recent developments have given me some hope that the destructive downward spiral in our political process may be starting to bottom out.

The Citizens United decision is becoming a battle ground and focal point around which good government forces can galvanize. Common Cause, Public Citizen and Move to Amend among others have been gaining traction with efforts to overturn this decision. Senator Tom Udall is leading the effort to overturn Citizens United in the Senate, and several Congressmen have offered language for a Constitutional Amendment to overturn this egregious decision.

In another hopeful development, former Colorado Senate Majority Leader Ken Gordon (termed out) has launched a website dedicated to publicizing and supporting candidates who refuse to take special interest money — CleanSlateNow.org. This is a worthy effort that will hopefully gain traction nationally. I encourage my readers to give their support to any and all efforts to eliminate the corrupting influence of big money on our politics.


Q2 ’11:   Government is Losing Legitimacy

Washington can be an ugly place even in the best of times, but the recent debt ceiling debacle was downright obscene. House Republicans, loud and proud in their ignorance and extremism, successfully took the nation hostage over the national debt ceiling. All their demands were met by our Compromiser-in-Chief. I am certainly not unsympathetic to the demand for fiscal responsibility, nor to the goal of a minimal tax burden, but these tactics are disgraceful and have been extremely destructive.


The marketplace has cast its verdict on the debt ceiling deal – a resounding vote of no confidence, and the first ever downgrade of U.S. debt by S&P. Panic hit the stock market, which registered both its sixth and ninth largest one day point losses in one week (635 and 520) and its worst ever advance/decline ratio (67 decliners for every advancer). The previous worst advance/decline ratio (66 -1) was in 1940 when German tanks broke through French army lines. The Black Monday crash in October, 1987 was 38 to 1.

Long bonds are approaching their all-time highs (low yields) and the 10 years have made all-time highs, although why anyone would buy them is beyond me. Gold has continued its relentless uptrend, trading above $1800 at press time, more than double the previous all-time high of $887.50 in 1980. The White House has assured us that there is no possibility of a double dip recession. The marketplace begs to differ.


The Wall Street Journal reports that “across a wide range of measures — employment growth, unemployment levels, bank lending, economic output, income growth, home prices and household expectations for financial well-being — the economy’s improvement since the recession’s end in June 2009 has been the worst, or one of the worst, since the government started tracking these trends after World War II.”

The last several stimulus driven recoveries have each been weaker than the previous one, so this is not a big surprise. The current recovery is by far the most anemic since the Great Depression. Worse, according to a new report by the Center for Labor Market Studies at Northeastern University, corporations captured 88% of the economic gains from the current recovery. It seems almost too obvious to mention, but this is a very unhealthy trend in a consumer economy. If consumers are to consume they must have the financial ability to do so. Increasingly they do not.

The following chart demonstrates the fruit of three decades of Voodoo Economics for American workers.

Meanwhile, our debt to GNP ratio is approaching 90%. The previous all-time high after WWII was 109%. Even now, this debt could be managed and worked off over time in the traditional manner, not without pain, but it could be done. But Republicans are pushing for maximum pain while Obama is in office, insisting that the deficits be addressed solely by austerity measures.

As Bill Clinton recently noted….”Republicans, who control the House and now have greater control of the Senate, have now decided — having tripled the debt in the 12 years before I took office and doubled it since I left — that it’s all of a sudden the biggest problem in the world.”

Martin Wolfe explains “Why Austerity Alone Risks Disaster.” We are currently in a controlled depression when every sector except government is trying to improve its balance sheet at the same time. It follows that if government also tries to improve its balance sheet at the same time then we will have un-controlled depression.

“The BIS insists…highly leveraged countries are running structural fiscal deficits, which must be eliminated as soon as possible. Fair enough, but where are the offsetting adjustments to occur?…If you believe a sharp monetary and fiscal tightening would result in an investment boom, I have a bridge to sell you. If the more plausible adjustment is via shrinking profits, that surely implies a fall in output. If so, this would preclude lowering the debt overhang via higher real incomes. That then leaves default. This would work, but via a slump and destruction of financial assets.”

Our press has utterly failed in its mission by not bringing the truth of this matter to the American people. It’s notable that Elliot Spitzer, one of the few commentators willing to point out that Republican economic talking points are not reality based, has been let go by CNN.

Meanwhile, policymakers in Europe are tiptoeing around the herd of sleeping sovereign debt elephants, hoping not to wake them into a stampede of defaults. A new loan to Greece has put off default there for a few more months, and the ECB has since had to step in to buy Italian and Spanish bonds in order to keep those markets from melting down. The European landscape is littered with bad debt, which will continue to demand attention. Take your pick as to which European country will kick off the next crisis. You may want to start an office pool.

We are in the midst of a major shift in the economic and political structure of the global economy. Efforts to manage a recovery in the same fashion as past recoveries, by monetary re-flation, have been a failure. The current recovery is so anemic as to hardly warrant the term. Job prospects for the millions of consumers who are un or under-employed don’t look much better going forward than they have since 2008.

The entire globalization agenda is in jeopardy as the advanced nations gradually sink under the weight of their debt. China, India and the rest of the emerging sector are in pretty good shape debt-wise, but they are largely dependent on exports. Who will they export to if the Western financial structure collapses? This next recession will probably mark the end of the current paradigm.


The hostage situation over the debt ceiling has overshadowed everything else lately, except of course the terribly important Casey Anthony trial.

Behind the headlines, the extremism of House Republicans is being driven by threats of primary contests for anyone not hewing to the Tea Party line. The Republican Party made a deal with the devil and now the devil is calling the shots. On the Democrat side, craven subservience to the oligarchy prevails, resulting in no effective opposition to the Republican mob.

As one clever commentator put it, “the oligarchs own the Republican Party and have rented the Democrats.” Democrats may have to choose soon between their voters and their financiers.

Obama is in trouble with his base. After getting elected as a relative unknown by tapping into the deep desire of the American people for a real change in the way things are done in Washington, he pivoted 180 degrees from day one and has seriously alienated his base of support. David Sirota sums it up in a recent Salon piece entitled “If Obama Cuts Social Security…

“Indeed, when a political candidate promises to try to pass a public option to compete with private insurers, attempt to crack down on Wall Street abuse, do what he can to stop unfair trade deals, oppose extending his predecessors tax cuts and avoid initiating initiate costly new wars sans congressional approval, and then once in office works to kill a public option, refuses to prosecute Wall Street crimes, presses the rigged trade deals he opposed, supports the extension of his predecessor’s tax cuts and starts a new war in Libya with no congressional authorization — whose fault is it that he ends up in reelection trouble?”

It’s going to be very difficult for us to find our way out of the problems we have created with our current leadership. Like bad money that drives out good, partisans have replaced public servants and the resulting public “debate” is an ongoing food fight that has little do with truth and even less to do with reality. And the successful hostage taking in the debt ceiling fiasco will only embolden the mob to employ the same tactics with every dispute going forward.

I feel some vague concern that the debt ceiling fiasco represents some kind of symbolic Rubicon, and that in having crossed it we are going to end up with a complete meltdown of government function and the end of the great American experiment. The resulting corporate sponsored propaganda wars will be so far removed from reality that it will be impossible for ordinary people to understand what has happened, why, or who is responsible.

Government is losing its legitimacy.

Government failure is of course high on the Republican agenda. The objective is not to make government more responsive or efficient or less burdensome, but to prove that government doesn’t work by doing everything possible to undermine and obstruct government from doing anything successfully. Unfortunately, corrupted and disorganized Democrats have been unable or unwilling to counter this agenda.

Stanley Greenberg published a very insightful commentary in the 7/31 New York Times entitled “Why Voters Tune Out Democrats.” Even though the people consistently favor Democrat positions on the issues, they don’t bother to support the Democrats because they don’t trust them to actually implement their stated policies.

Even the Supreme Court is losing respect. In the midst of the cacophony that is our public “debate” and the political devolution of our major parties, there has been one refuge of honor and integrity that has given Americans hope that reason and justice would ultimately prevail…the Supreme Court. Now, even that bastion of integrity is crumbling under the right wing assault. The appointment of George Bush in 2000 was a black mark on the court, but it was a one-off violation. Recently however, the Court has gone out of its way to implement the so-called “conservative” agenda.

At Chief Justice John Roberts’ confirmation hearings he pledged to respect precedent, to “call balls and strikes” rather than use his position to legislate from the bench. Since then, making a mockery of his promises, he has engineered a series of partisan 5-4 rulings, most notably the Citizens United decision overturning 100 years of precedent and affirming a commitment to a nation of, by and for the corporation. The distorted reasoning behind many of these rulings is shameful.

Ronald Dworkin, a prominent and widely respected legal scholar, dissects the intellectual dishonesty of the Supreme Court in its recent partisan rulings in an article in the New York Review of Books entitled “The Court’s Embarrassingly Bad Decisions.”

In addition to the blatantly partisan rulings, Clarence Thomas’s casual attitude toward judicial ethics has brought discredit to the Court. Joy-Ann Reid has been documenting the growing array of scandals surrounding Clarence Thomas on her blog, The Reid Report.

This is the beginning of chaos. If our politicians are liars and cons, well, they are members of the world’s second oldest profession. It’s not acceptable but not entirely unexpected. But when the Supreme Court is increasingly seen as just another partisan group shaping the law for the benefit of their buddies, telling the convenient lie and ignoring ethical constraints, then how can we expect the people to have any respect for the law?

The people may be easily manipulated but they are not blind. When they watch our “leaders” consistently saying one thing and doing exactly the opposite — ignoring the general welfare, gaming the system for their own benefit and that of their financiers and violating the law with impunity — why should they bother to be truthful, or honorable in their dealings, or feel constrained by the law? Why shouldn’t they just do whatever they please?


Pax Americana has been in a topping phase since Vietnam and we have clearly entered into the markdown phase. The debt ceiling debacle has done serious damage to America’s already tarnished image abroad and has accelerated the trend.

Realignment proceeds at an ever faster pace. Afghanistan is just another neo-con disaster and our alliance with Pakistan is unraveling. Our relentless drone attacks and deadly night raids rightly or wrongly are seen as immoral, and are cementing anti-American sentiment in the Muslim world. Regional trade agreements with local currency swaps are proliferating, diminishing the role of the dollar. The widespread uprising in the Arab world has left the U.S. with sharply reduced influence in the Middle East. We still have the most and biggest guns of course, but the Taliban has demonstrated to the world that our big guns don’t guarantee victory. We are losing ground militarily, economically and morally. Even China has taken to lamenting that U.S. behavior is not a good advertisement for democracy. Vladimir Putin, of all people, has called the U.S. a “parasite” on the world economy.


The geometric expansion of computing power is enabling future paradigm shifting technologies in every sector. There are going to continue to be big changes, which means big winners and big losers going forward. We essentially have a casino economy bestowing vast wealth on a few fortunate winners while the vast majority languish with marginal gains at best. There will continue to be big winners in the casino, but for most they will be out of reach. These opportunities in the near future will be in paradigm shifting long shots (see Vinod Khosla’s Scientific American interview) that are hugely expensive to ramp up.

Our technological ascendance will eventually yield a new economy, but in order to generate a robust broad based economy and not a neo-feudal dystopia, it will require a parallel shift in the way we allocate the fruit of economy. That change is not going to come easily, or quickly.

Our increasingly virtual economy is isolating and this is not healthy. Humans are social animals. Doing business with a website is not socially rewarding. We will inevitably find our way back to humans doing business with humans. The opportunity is to position for and serve that transition.

In this vein, there is a growing trend toward community and local economy. This is seen in the burgeoning local agriculture movement, alternative health care and the recent growth of co-op and worker owned businesses. See “The New Economy Movement” by Gar Alperovitz in the May 25th edition of The Nation.


I find myself fantasizing that the debt limit saga and all the extreme rhetoric emanating from Washington has been an elaborately staged theatrical production and they didn’t really mean any of it. But even if that were true, in politics perception trumps reality. And the widespread perception now is that the Republicans are insane and the President is weak, and either unwilling or unable to control the Republican mob.

Perhaps Republicans will wake up and realize that they are taking themselves down along with the country. Extreme partisanship and rampant demagoguery amplified by a credulous, tabloid style corporate press threatens to turn a very difficult situation into a disaster. A rational policy response to the ongoing economic distress is critical to an acceptable outcome. Given the imbalances created by decades of mismanagement, any real solution will not yield fruit overnight, and any credible policy response will necessarily involve compromises and components not acceptable to the so-called conservatives. Unfortunately, in the absence of any coherent opposition, these conservatives are dominating the debate and dictating policy.

In the current environment, government is the only economic player with the wherewithal to sustain any semblance of growth while the imbalances from the Bush era are gradually normalized. Unfortunately, Republicans are determined to cut this source of economy off at the knees and Democrats are offering little resistance. There are no ideal solutions after decades of fiscal mismanagement, but there are less bad solutions. We remain vulnerable to debt deflation and/or hyperinflation if the economic illiterates driving the public debate are successful. Investors need to be aware and as much as possible prepared for a wide range of possible outcomes.


Q1 ’11:   The Deficit Dilemma

Only four months into 2011 and we’ve already had a decade’s worth of drama. The year began with the Arab uprising that continues to reshape the Middle East, followed by the earthquake and tsunami that devastated Japan, another war in Libya, and finally the killing of Osama bin Laden. Given that the global financial system is being held together with duct tape and baling wire and the virtual certainty of a sovereign default by Greece (see “Beware of Greeks Bearing Bonds” by Michael Lewis), along with Republican determination to deny positive resolution to any problem as long as Obama is in office, we are pretty much guaranteed more drama soon. Maybe there is something to the Mayan calendar after all.

Domestically the big issue of the day is the deficits. Sadly, Washington has decided that the deficits are a big problem precisely 10 years and $8 trillion too late. The concern about the deficits is certainly not wrong — we are way beyond sustainability on this front. I have been writing about the inevitable consequences of our debt addiction for years, but I find it rather galling that many of the very same people who are responsible for our fiscal problems are now posturing as fiscal conservatives. Worse yet, Republicans are using the deficits as a bludgeon to try to dismantle (not improve or fix) Social Security and Medicare and send America back to the 19th century. We may be headed there anyway, but to deliberately try to make it happen is perverse. This destructive politics vastly complicates a complex and difficult problem and reduces the odds that we will manage our way to an acceptable outcome.

As usual with important issues these days, there is a great deal of contradictory information in the media about the deficits, making it difficult for most people to know the truth of the matter.

As a public service I offer the following presentation on the deficits by David M. Walker, Former Comptroller General of the United States (1998-2008) and Founder and CEO of the Comeback America Initiative. Mr. Walker is also a co-founder of No Labels, a non-partisan group attempting to provide balanced input into public issues. Mr. Walker has given his permission for Risk & Opportunity to reprint his presentation.

Mr. Walker leans moderately conservative on the matter of deficits. In fiscal affairs conservatism is a good thing and Mr. Walker’s presentation is an honest, comprehensive, non-partisan overview of the deficits — most importantly the range of issues that must be addressed in order to bring them back under control. I should note that I am not in agreement with him on every point. But the purpose of this letter is not to debate the fine points, rather to provide a comprehensive understanding of the issue. Thanks to John Mauldin’s Outside the Box newsletter for bringing this presentation to my attention.

Restoring Fiscal Sanity in the United States: A Way Forward
by David M. Walker

Two hundred and twenty two years ago, the American Republic was founded. The United States had defeated the world’s most powerful military force to win independence, and over a several year period, went about creating a federal government based on certain key principles, including limited government, individual liberty, and fiscal responsibility. That government was established by what is arguably the world’s greatest political document – the United States Constitution.

Our nation’s founders understood the difference between opportunity and entitlement. They believed in certain key values including the prudence of thrift, savings and limited debt. They took seriously their stewardship obligation to the country and future generations of Americans.

The truth is, we have strayed from these key, time-tested principles and values in recent decades. We must return to them if we want to keep America great and help to ensure that our future is better than our past.

Believe it or not, to win our independence and achieve ratification of the U.S. Constitution, the U.S. only had to go into total federal and state debt equal to 40 percent of the size of its then fledgling economy. Fast forward to today, when the U.S. is the largest economy on earth and a global superpower – but total federal debt alone is almost 100 percent of the economy and growing rapidly. Add in state and local debt, and the total number is about three times as much as the total debt we held at the beginning of our Republic – and it is headed up rapidly. As the below graphic shows, our total federal debt has more than doubled in just the past ten and a half years.

Federal Debt Burdens

America has gone from the world’s leading creditor nation to the world’s largest debtor nation. We have also become unduly dependent on foreign nations to finance our excess consumption. Many of these foreign investors have shunned our long-term debt due to concerns over future interest rates and the longer-term value of the dollar. And PIMCO, the largest Treasury bond manager in the U.S., also recently sold their Treasury security holdings due to a lack of adequate return for the related interest rate risk.

And who is now the largest holder of Treasury securities? It’s the Federal Reserve. I call that self-dealing. The Fed may be able to hold down interest rates for a period of time; however, they cannot hold them down forever. The Fed’s debt purchase actions are just another example of how Washington policymakers take steps to provide short-term gain while failing to take steps to avoid the longer-term pain that will surely come if we fail to put our nation’s fiscal and monetary policies in order.

The Fiscal Fitness Index

In March 2011 the Comeback America Initiative (CAI) and Stanford University released a new Sovereign Fiscal Responsibility Index (SFRI) – or as my wife Mary refers to it, a Fiscal Fitness Index. We calculated each country’s SFRI based on three factors – fiscal space, fiscal path, and fiscal governance.

Fiscal space represents the amount of additional debt a country could theoretically issue before a fiscal crisis is imminent. Fiscal path is an estimate of the number of years before a country will hit its theoretical maximum debt capacity. (The U.S. will hit its maximum within16 years, but will enter a “fiscal danger zone” within 2-3 years). Fiscal governance is a value based on the strength of a government’s institutions, as well as its transparency and accountability to its citizens. Unfortunately, the U.S. ranks far below the average in all three of these categories – in particular, the fiscal governance category.

The overall SFRI index showed that the U.S. ranked 28 out of 34 nations in the area of fiscal responsibility and sustainability. And when you see which countries rank around us, it’s clear that we’re in a bad neighborhood. We’re only a few notches above countries like Greece, Ireland, and Portugal, all of which have recently suffered severe debt crises. That report also showed that the U.S. could face a debt crisis as soon as two to three years from now, given our present path and interest rate risk. Below is the full list of rankings.

Fiscal Fitness Index

On the positive side, the CAI and Stanford report showed that if Congress and the President were able to work together to pass fiscal reforms that were the “bottom line” fiscal equivalent of those recommended by the National Fiscal Responsibility and Reform Commission last year, our nation’s ranking would improve dramatically, to number 8 out of 34 nations. In addition, we would achieve fiscal sustainability for over 40 years!

So what are our elected officials waiting for? Do they want a debt crisis to force them to make very sudden and possibly draconian changes? If not, they need to wake up and work together to make tough choices. That’s what New Zealand did in the early 1990s, when that country faced a currency crisis. Due to tough choices then and persistence over time, New Zealand now ranks number 2 in the SFRI – second only to Australia, which the Kiwis are not happy about! If New Zealand can do it, America can too!

In order for us to begin to restore fiscal sanity to this country, President Obama has to discharge his leadership responsibilities as CEO of the United States Government. He got into the game with his fiscal speech on April 13, in which he largely embraced the work of his National Fiscal Responsibility and Reform Commission, although with a longer timeframe for implementation and less specifics on entitlement reforms. The President also endorsed the debt/GDP trigger and automatic enforcement concept that CAI had been advocating. Under this concept, Congress could agree on a set of statutory budget controls that would come into effect in fiscal 2013. Such controls should include specific annual debt/GDP targets with automatic spending cuts and temporary revenue increases in the event the annual target is not met. In my view, a ratio of three parts spending cuts, excluding interest savings, to one part revenue would make sense.

House Budget Committee Chairman Paul Ryan recently demonstrated the political courage to lead in connection with our nation’s huge deficit and debt challenges. His budget proposal recognizes that restoring fiscal sustainability will require tough transformational changes in many areas, including spending programs and tax policies. Chairman Ryan’s proposal includes several major reform proposals, especially in the area of health care. For example, he proposes to convert Medicare to a premium support model that will provide more individual choice, limit the government’s long-term financial commitment and focus government support more on those who truly need it. He also proposed to employ a block grant approach to Medicaid in order to provide more flexibility to the states and limit the governments’ financial exposure. These concepts have varying degrees of merit; however, how they are designed and implemented involve key questions of social equity that need to be carefully explored. And contrary to Chairman Ryan’s proposal, additional defense and other security cuts that do not compromise national security and comprehensive tax reform that raises more revenue as compared to historical levels of GDP also need to be on the table in order to help ensure bipartisan support for any comprehensive fiscal reform proposal.

The President and Congressional leaders should be commended for reaching an agreement that averted a partial shutdown of the federal government and resolved funding levels for fiscal 2011. While it took way too much time and effort, this compromise involved real concessions from both sides and represents a small yet positive step towards restoring fiscal responsibility. But this action is far from the most important fiscal challenge facing both the Congress and the President. After all, Washington policymakers took about 88 percent of federal spending, along with much-needed federal tax reforms, “off the table” during the recent debate over the 2011 budget. In essence, they have been arguing over the bar tab on the Titanic when we can see the huge iceberg that lies ahead. The ice that is below the surface is comprised of tens of trillions of dollars in unfunded Medicare, Social Security and other off-balance sheet obligations along with other commitments and contingencies that could sink our “Ship of State”. It is, therefore, critically important that we change course before we experience a collision that could have catastrophic consequences. As you can see in the series of pie charts below, mandatory programs like Social Security and Medicare already take up the largest share of the federal budget and, absent a change in course, will continue to do so in increasing amounts in the next several decades.

More on Autopilot

The Federal Debt Ceiling Limit

Now that the level of federal funding for the 2011 fiscal year has been resolved, there has been an increasing amount of attention on Congress’ upcoming vote to increase the federal debt ceiling limit. As is evident by the chart below detailing the debt ceiling limit per capita adjusted for inflation since 1940, the U.S. started losing its way in the early 1980s. Fiscal responsibility was temporarily restored during the 1990s, when statutory budget controls were in place, but things went out of control again in 2003, the year after those budget controls expired.

Social Security Cash Flow

In essence, raising the debt ceiling is simply recognizing the federal government’s past fiscally irresponsible practices. But while federal law provides for the continuation of essential government operations even if the government has not decided on a budget or funding levels for a fiscal year, such a provision does not exist in connection with the debt ceiling. Therefore, if the federal government hits the debt ceiling during a time of large deficits, which is the case today, dramatic and draconian actions will have to be taken to ensure that additional debt is not incurred. This would likely include a suspension of payments to government contractors, delays in tax refunds, and massive furloughs of government employees. In addition, since Social Security is now paying out more in benefits than it receives in taxes, the monthly payments may not go out on time if we hit the debt ceiling limit. That would clearly get the attention of tens of millions of Americans, including elected officials.

However, although failure to raise the debt ceiling is not a viable option given our current fiscal state, we must take concrete steps to address the government’s lack of fiscal responsibility. We must also do so in a manner that avoids triggering a massive disruption and a possible loss of confidence by investors in the ability of the federal government to manage its own finances. Such a loss of confidence could spur a dramatic rise in interest rates that would further increase our nation’s fiscal, economic, unemployment and other challenges.

In order to begin to restore fiscal sanity, Congress could increase the debt ceiling limit in exchange for one or more specific steps designed to send a signal to the markets, and the American people, that a new day in federal finance is dawning. To be credible, any such action must go beyond short-term spending cuts for the 2012 fiscal year. The debt/GDP trigger and automatic enforcement concepts I advocate above are one specific step Congress could take.

The S&P’s revised outlook on the long-term rating for U.S. sovereign debt should be yet another wake-up call for elected officials and other policymakers in Washington. S&P’s action serves as a market-based signal that independent ratings agencies believe the U.S. is on an imprudent and unsustainable fiscal path and that action is needed in order to maintain investor confidence. In my view, this action should have been taken place some time ago; however, it is now likely that other rating agencies will reconsider their ratings positions on U.S. Sovereign debt.

Moving Past Partisan Politics

The American people need to understand that doing nothing to address our deteriorating financial condition and huge structural deficits is simply not an option. Failure to act will serve to threaten America’s future position in the world and our standard of living at home. Therefore, both major political parties must come to the table and put aside their sacred cows and unrealistic expectations. As John F. Kennedy said, “The great enemy of the truth is very often not the lie — deliberate, contrived and dishonest — but the myth — persistent, persuasive, and unrealistic.”

Given President Kennedy’s admonition, liberals need to acknowledge that we need to renegotiate the current social insurance contract. For example, contrary to assertions by some, Social Security is now adding to the federal deficit and is underfunded by about $8 trillion. As you can see below, it will face escalating annual deficits beginning in 2015.

Description: http://www.johnmauldin.com/images/uploads/charts/050211-05.jpg

There is no debate that last year’s health care reform legislation will result in higher federal health care costs as a percentage of the economy. (See the chart below). In addition, according to Medicare’s independent Chief Actuary, based on reasonable and sustainable assumptions, last year’s health care reform legislation will end up exacerbating our deficit and debt challenges rather than helping to lessen them. He estimated that the cost of the health care law to the Medicare program could be over $12 trillion in current dollars more than advertised.

Description: http://www.johnmauldin.com/images/uploads/charts/050211-06.jpg

Conservatives need to acknowledge that we can’t just grow our way out of our fiscal hole. They need to admit that all tax cuts are not equal and there is plenty of room to cut defense and other security spending without compromising our national security. And while conservatives are correct to say that our nation’s fiscal challenge is primarily a spending problem, they must recognize that some additional revenues will be needed to restore fiscal sanity. The math just doesn’t work otherwise.

All parties must acknowledge that we can’t inflate our way out of our problem and that we must take steps to improve our nation’s competitive posture. This means that some properly targeted and effectively implemented critical infrastructure and other investments may be both needed and appropriate even if they exacerbate our short-term fiscal challenge.

Washington policymakers need to understand that the same four factors that caused the recent financial crisis exist for the federal government’s own finances. And what are those factors?

First, a disconnect between those who benefit from prevailing policies and practices and those who will pay the price and bear the burden if and when the bubble bursts. Second, a lack of adequate transparency and accountability in connection with the true financial risks that we face. Third, too much debt, not enough focus on cash flow, and an over-reliance on narrow and myopic credit ratings. Finally, a failure of responsible parties to act until a crisis was at the doorstep.

There is growing agreement that the greatest threat to our nation’s future is our own fiscal irresponsibility. In fact, as I noted in 2007 and Joint Chiefs Chairman Admiral Mullin stated last year, our fiscal irresponsibility and resulting debt is a national security issue. After all, if you don’t keep your economy strong for both today and tomorrow, America’s standing in the world and standard of living at home will both suffer over time – and waiting for a crisis before we act could also undermine our domestic tranquility.

So where should Washington go from here?

First, Congress and the President should reach a compromise agreement on an appropriate level of spending cuts in 2012 while also providing for some additional properly designed and effectively implemented critical infrastructure investments. Second, they should agree to re-impose tough statutory budget controls that will force much tougher choices on both the spending and tax side of the ledger beginning no later than 2013. Third, they should authorize and fund a national citizen education and engagement effort to help prepare the American people for the needed actions and to facilitate elected officials taking them without losing their jobs. Fourth, they should create a credible and independent process that will provide for a baseline review of major federal organizational structures, operational practices, policies and programs in order to make a range a transformational recommendations that will make the federal government more future focused, results oriented, successful and sustainable.

Spending levels certainly need to be cut. After all, the base levels of federal discretionary spending increased by over 30 percent between 2007 and 2010 during a time of low inflation. At the same time, all parties must be realistic regarding how much should be cut and how quickly it can be achieved. In my view, we should be targeting greater cuts than have been recently considered, but over a longer period of time: for example, real spending cuts of $125-$150 billion over several years. If we did so, the related savings would be significant and would compound over time.

As the National Fiscal Responsibility and Reform Commission, CAI, The No Labels political movement (of which I am a co-founder), and others have noted, everything must be on the table – and all political leaders need to be at the table – in order to put our nation on a more prudent and sustainable fiscal path. This includes a range of social insurance program reforms, defense and other spending cuts, and comprehensive tax reform that generates additional revenues, including both individual and corporate tax reform. We must keep in mind that the private sector is the engine of innovation, growth, and jobs. In addition, many businesses are taxed at the individual, rather than the corporate, level.

Realistically, it will take us a number of years to get back into fiscal shape. And while it would be great if we could do a “grand bargain” and enact a broad range of transformational reforms in one step, that just isn’t realistic in today’s world. Therefore, what is a reasonable order of battle to win the war for our fiscal future?

First and foremost we need to enact budget process reforms, re-impose the type of budget controls and engage in the fact-based citizen education and engagement effort referred to previously. The next order of battle items should be corporate tax reform and Social Security reform. Why corporate tax reform? Because it can help to improve our competitiveness, enhance economic growth and generate jobs.

And why Social Security reform? Because we have a chance to make this important social insurance program solvent, sustainable and secure for both current and future generations. We can also exceed the expectations of all generations and demonstrate to both the markets and the American people that Washington can act before a crisis forces it too.

The above efforts should be followed by broader tax reform and Medicare/Medicaid reforms. We will then need to rationalize our health care promises and focus more on reducing health care costs in another round of health care legislation. We must also begin a multi-year effort to re-baseline the federal government’s organizations, operations, programs and policies to make them more future focused, results oriented, affordable and sustainable.

In summary, the truth is that the government has grown too big, promised too much and waited too long to restructure. Our fiscal clock is ticking and time is not working in our favor. The Moment of Truth is rapidly approaching. As it does, let us hope that our elected officials must keep the words of Theodore Roosevelt in mind: “In any moment of decision the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.” And “We the People” must do our part by insisting on action and by making the price of doing nothing greater than the price of doing something We must insist that our legislators offer specific solutions to defuse our ticking debt bomb in a manner that is economically sensible, socially equitable, culturally acceptable, and politically feasible We need to recognize that improving our fiscal health, just like our physical health, will require some short-term pain for greater long-term gain. The same is true for state and local governments.

We’ll soon know whether Washington policymakers are up to the challenge and whether they will start focusing more of doing their job than keeping their job. They need to focus first on their country rather than their party. And yes, the President and Congressional leaders from both political parties need to be at the table and everything must be on the table in order to achieve sustainable success. Let’s hope they make the right choice this time!

All of us who are involved with the Comeback America Initiative (CAI) will do our part. All that we ask is that you do yours. The future of our country, communities and families depends on it.

For more information about the Comeback America Initiative and No Labels, check out www.tcaii.org and www.nolabels.org.


Q4 ’10:   On the Brink

Egypt and Libya have been the most visible parts of a wave of popular revolt sweeping through the Arab world. Whether this is a miracle or a catastrophe only time will tell. Who will actually end up wielding power in these countries is the critical “unknown unknown” at this time. The one clear outcome of this upheaval is that U.S. influence in the region will be substantially reduced.

The nature of the other uprising, the one in Washington, is not in doubt. House Republicans have loaded up their budget with politically targeted spending cuts that they know are unacceptable to the Senate and the White House. In so doing they are deliberately driving towards a government shutdown and a default by the U.S. government on a wide array of obligations. There is always the possibility that disaster will be averted at the last moment, but if the default happens, it could unleash a cascade of unpredictable and uncontrollable consequences. See Tim Geithner’s warning to congressional leaders on the consequences of default.


The stock market continues to push steadily higher. The DJIA and S&P500 have regained approximately 70% of their losses from the 2008 meltdown. The Russell 2000 and the Dow Transports are both approaching their all-time highs and one index, the S&P Mid-Cap 400, actually made new all-time highs this month. The tech heavy NASDAQ has bettered its 2007 highs but is still only 1/3rd of the way back to the 2000 dot-com highs.

If the quantitative easing (QE) continues, it will eventually push stocks to new all-time highs regardless of the underlying merits of owning stocks. At the moment, however, complacency is pretty high in the face of major turbulence in the Middle East and the prospect of chaos looming in Washington. I would expect to see increased volatility soon.

The bond market is another matter. Bonds have sold off sharply since the announcement of QEII in November, which ironically was intended to keep rates down. This is a clear sign that the era of artificially low rates is coming to an end. Technically bonds have completed a 60 year cycle. All indications are that the top is in (bottom in rates) and we will see a trend to higher rates for many years to come.

Precious metals have been big winners from QE, and will likely continue to be so over time. However, gold has been higher 10 years in a row, and nothing goes straight up forever. The upheaval in the Middle East has given the metals another (final?) surge to the upside, with silver leading the way to new highs. The looming government shutdown and default in Washington could provide yet another surge, or on the other hand it could kick off a deflationary scare, which would provide the overdue opportunity for a major correction in gold. If all this sounds indecisive, that’s because it is. The nature of our present situation is uncertain and unstable.


The economy is gradually recovering from the devastation of the financial meltdown of 2008, but the recovery is slow and shallow, and jobs are not a big part of it. In reality we are experiencing a controlled depression that will not be over until the imbalances created by 30 years of fiscal insanity and trickle-down economics are resolved. This would not be an easy task under any circumstances, and given the general quality of our political leadership, I don’t see resolution any time soon.

I have written previously that the only opportunity I see on the horizon to re-invigorate our economy is a national commitment to energy independence. This would at once free us from all the degrading economic and environmental influences of our addiction to oil, and simultaneously unleash a wave of entrepreneurial activity that would produce real, organic economic growth. Bobby Kennedy Jr. presents an inspiring vision of the consequences of a genuine national commitment to energy independence.

President Obama acknowledged the importance of this issue to our global competitiveness in his State of the Union speech. Subsequent events in the Middle East are providing some perspective on the insane economic and national security risks we have been taking with our dependence on foreign oil, and could provide political cover and catalyst for action. Let’s hope that Obama seizes this opportunity.

Meanwhile, our economy is vulnerable to further setbacks. The enormous stimulus that has been thrown at the financial meltdown is having its effect. Absent any unexpected shocks, which might be asking for a lot, things should hold up until 2013, the next expected downturn in the Presidential Cycle. It’s always difficult to predict the future of the stock market, but the Presidential Cycle would indicate sideways to higher markets into the first quarter of 2013. This cycle performed badly in 2008, but it has historically been a reliable indicator, and I would not expect it to fail twice in a row.

The assumption has been that QE will continue for as long as it is needed, until the economy is self-sustaining again. However, dissent is starting to manifest from within the Fed as well as in Congress. Richard Fisher, President of the Federal Reserve bank in Dallas, recently gave a speech focused on the consequences of continued money printing.


It appears that President Obama has begun to emerge from a two year period of on-the-job training. His first two years were marked by caution, premature compromises and often outright capitulation to Republicans that left many of his supporters demoralized. But recently Obama has begun to look downright Presidential.

After the “shellacking” at the polls in November, Obama unexpectedly used the clout of his office to push through a series of priorities during the lame duck session, most importantly ratification of the START treaty with Russia, ending the Don’t Ask, Don’t Tell policy in the military, and an extension of unemployment benefits and tax cuts.

Republicans, shocked at the sudden change in character and tactics by the White House, felt like they had been rolled, and came back to Washington determined to regain their momentum from the election victory. They were pushing the envelope on the extreme rhetoric and demagoguery that had prevailed during the election. But sometimes it’s the totally unexpected event that becomes the game changer.

A political firestorm erupted in the aftermath of the shootings in Arizona. Republicans were put on the defensive trying to deflect charges that they had contributed to the massacre with their relentless extreme rhetoric. And it was Obama who seized the opportunity with an elegant non-partisan speech, eulogizing the fallen, and speaking to the collective spirit of the American people, noting “we can do better than this.” Shortly thereafter, Obama once again seized the day in an upbeat State of the Union speech that was at once inspiring, comforting and politically savvy.

While Obama’s filling of the leadership vacuum is a welcome development in and of itself, the unfortunate thing about his “coming out” as a leader is his agenda. Obama is most definitely not a socialist, or even a liberal, although Republicans insist on painting him as a “far leftie” in order to mask their extremism. He is, in fact, what 20 or 30 years ago would have been thought of as a moderate Republican. And he isn’t even a very moderate. Only in contrast to the far right lunatic fringe that has taken over the Republican Party does he appear moderate. In the most important elements of policy, economy and national security, with a few notable exceptions, he has fully embraced the Republican agenda.

Donald Rumsfeld summed up the dismal reality of Obama’s national security policies while receiving the Defender of the Constitution award at the Conservative Political Action Conference (no-one can say that conservatives don’t go in for irony). Citing the administration’s many reversals on national security policy issues such as Guantanamo, military commissions and CIA drone strikes, Rumsfeld said “it makes me wonder if Dick (Cheney) has had more influence on President Obama than the people that got him elected.”

At the same time the Obama DOJ has been aggressive in claiming national security to prevent lawsuits and stonewall investigations into abuses of power, turning Obama’s campaign call for more transparency in government on its head, as well as continuing and expanding the warrantless wiretaps and vacuuming of electronic communications begun under the Bush administration. Glenn Greenwald has been tireless in documenting this trend.

Regarding economic policy, William Greider recently published an insightful commentary entitled “The Death of New Deal Liberalism.” Greider’s message is summed up thus,

“Government has been disabled or captured by the formidable powers of private enterprise and concentrated wealth. Self-governing rights that representative democracy conferred on citizens are now usurped by the overbearing demands of corporate and financial interests. Collectively, the corporate sector has its arms around both political parties, the financing of political careers, the production of the policy agendas and propaganda of influential think tanks, and control of most major media.”

Republicans and so-called “moderate” Democrats have been the champions of this neo-Feudal agenda, which would not be acceptable to the American people if they recognized it for what it really is. Republicans have been successful for decades at distracting attention from their true agenda by exploiting “wedge” issues such as abortion and gay rights, and more recently by creating endless distractions (Obama’s birth certificate, “victory” mosques, “death panels,” etc) and tearing down and creating distrust of government, science, and anyone or anything not part of the so-called “conservative” movement.

The price for not standing up to this agenda is getting steeper every day. Eventually the American people will wake up and the backlash will be severe, but I am not holding my breath. That day is most likely years, if not decades away.


The big story at press time is the upheaval in the Middle East. But there are many other important stories unfolding across the globe.

Developments in Pakistan top the list. The recent assassination of Punjab Governor Salman Taseer by his bodyguard, a member of an elite police force, is an ominous development, demonstrating how deeply radical Islam has penetrated Pakistan. Even more shocking is the groundswell of support for the killer by young Pakistani lawyers, who had previously been thought to be a bulwark against radical Islam.

The guard has admitted that he killed Governor Taseer due to Taseer’s opposition to anti-blasphemy laws, which call for execution for impugning Islam or the Prophet Muhammad. Mass rallies in support of the killer and blasphemy laws have continued and anti-Americanism is a pervasive theme of this movement. Our relentless drone attacks and the inevitable civilian casualties from them are stoking the fire of radical Islam in Pakistan, and the case of the American “diplomat” who shot and killed two Pakistanis on the street in Lahore has added fuel to the fire. The thought of radical Islamists in control of Pakistan’s nuclear arsenal is chilling.

Meanwhile, China is extending its gains and influence. The state dinner extended to Chinese President Hu Jintao during his recent visit to Washington demonstrated just how much so. Great care was taken to put a positive spin on Chinese-American relations, glossing over contentious human rights and currency issues.

There was a noteworthy event during a recent visit to China by Defense Secretary Gates, which demonstrated that Chinese leadership is not monolithic and raises questions about the extent of Hu’s real power. Hu was taken by surprise when he learned that the Chinese version of the stealth fighter was rolled out for an unusually public test flight on the very day Secretary Gates arrived in China.

China’s military buildup has been going on for years and has recently been getting a lot of press. If internal problems (and there are many) should ever threaten the Communist Party’s grip on power, there will be an almost irresistible urge to project its newly muscular military outward in order to rally the people to the flag, and the Party.

Food prices are putting serious stress on the world’s poorest. This will trend will exacerbate and maybe even exceed all other causes of global instability. Large numbers of hungry people will be looking for someone to blame for their suffering. Meanwhile, almost 40% of U.S. corn production goes to ethanol, undoubtedly one of the worst public policy decisions in history.


Major change is sweeping the globe and where there is change, there is opportunity. Unfortunately where the opportunity lies in the near term is not clear to me. What is clear is that risk is very high in all sectors. It may be that the best opportunity right now is in trying not to lose anything.

Precious metals will probably continue to benefit from global turmoil, but the metals rally is pretty long in the tooth and difficult to embrace if you aren’t already in from much lower. Complacent gold bugs could be severely tested at any time.

The situation in the Middle East is highlighting the need to embrace energy independence. Imagine $300 oil. The “plus” here is that $300 oil would probably be the catalyst for finally making a serious national commitment to energy independence, which would be wildly bullish for America. Sooner or later – inevitably — alternative energy will be big in America.

A development that looks like it could be as disruptive as the transistor or the steam engine is featured in the 2/12 cover article of the Economist entitled “Print Me a Stradivarius.” 3D Printing, “the manufacturing technology that will change the world.”


Our situation remains delicate. Continuing to print money creates the illusion of “growth,” but inflation is creeping upward and at some point it will take off. Serious inflation is already being felt in food and energy, putting severe pressure on ordinary people globally, especially the very poorest. This is probably the underlying catalyst to the upheaval in the Middle East.

The damage to our economy and financial system was done years ago, and much of it was done deliberately by Republicans following their “starve the beast” strategy. These same people now profess to be deeply concerned about deficits and are driving the push to cut social spending, even as they continue to push tax cuts that add to the deficits. This situation speaks volumes about the quality of our public debate and in the integrity of our “leadership” in Washington.

The reality is that QE, despite its negative consequences, is at this point the only way to manage the adjustment to stability, short of allowing a full blown depression to take hold. There is no guarantee that the clever people from Goldman Sachs who run the Fed and Treasury will be able to finesse this transition successfully. Despite the fact that in a truly just universe these people would all be in jail, one can only hope that they can serve the useful purpose of managing the transition to a stable economy. We can also hope that current efforts to force a cold turkey withdrawal from deficit spending are not successful. Our condition is far too delicate for that right now. The patient might not survive the cure.


Q3 ’10:   2010 Election Issue: The Rise of the Mob

America is in trouble. Around the country, the nominations of Tea Party Republicans like Senate candidates Christine O’Donnell in Delaware, Sharon Angle in Nevada, Joe Miller in Alaska, Rand Paul in Kentucky and Ken Buck in Colorado are the canaries in the coal mine. A group of Rand Paul supporters assaulted and stomped a woman from MoveOn at a campaign event in Kentucky. Joe Miller’s security arrested and handcuffed a reporter at public event in Alaska. Tea Party Republican House candidate Stephen Broden says violent overthrow of the government is “on the table,” a sentiment previously suggested by Sharon Angle.

Tea Party Republicans talk endlessly about “protecting the constitution” even as they work to undermine the separation of church and state. They rally their supporters with cries of “freedom,” apparently unaware that the freedom they are advocating is the freedom of huge corporations to grind the American people into serfdom. They don’t understand that the economic calamity they are railing about was created by the very policies they are promoting at the behest of their corporate financiers, and that the massive deficits are the direct and deliberate result of the Republican “starve the beast” strategy. These candidates are woefully unqualified to hold high office. The fact that approximately half the American people support them suggests that America is no longer worthy of democracy. Mob rule is the new order.

The rise of the Tea Party mob is the direct result of decades of Republican “divide and conquer” tactics, featuring a relentless propaganda machine attacking anything Democrat or “liberal,” characterizing our government as the enemy, and promoting conspiracy theories and outright lies about “death panels,” “government takeovers” and such. The Grand Ole Party is now the party of Karl Rove, Rush Limbaugh, Sarah Palin, Glenn Beck and the Tea Party…demagogues and lunatics. Principled conservatives are no longer welcome. What remains of the Republican Party has become an entirely destructive force and is a cancer on America.

Our sound-bite media doesn’t seem to have the ability to place anything in context. Stepping back from the cacophony of the 24-hour news cycle and taking in the long view, one can see clearly how much damage the Republican Party has done, and continues to do, to our country. See my op-ed, “The Republican Wrecking Ball” in the Denver Post.

Free lunch and magic cake

The entire Republican agenda is a fraud, as is their politics. Their economic agenda is the same utopian free market fundamentalism, anchored in “supply side economics,” that created our current problems. Supply side economics was properly labeled as “voodoo economics” by George Bush Sr. when it was first introduced to the public by Ronald Reagan. I call it the “free lunch and magic cake” theory. The rich get free lunch, and everyone else gets magic cake. Supply side economics, also known as trickle-down economics, was never anything other than a scam intended to shift the national wealth from the hands of the many to the hands of the few, and it has been quite successful in this mission. See Martin Wolfe’s blog post “The Political Genius of Supply Side Economics.”

In their politics Republicans have totally embraced the anti-ethic that “the end justifies the means.” Their end is to gain power for its own sake. And their means are depraved. They have taught the impressionable that the truth matters not at all. What matters is what plays; what gives an advantage; what undermines the opposition, even if it’s an outright lie. Principles? None. What was touted as good policy or practice in the Bush years is now condemned as a threat to the republic and a crime against humanity in the Obama years. Any damage to the country from their scorched earth politics is “collateral damage.”

Republicans have deliberately sabotaged our nation and our future in their blind pursuit of power.

Those interested in some perspective from a couple of old fashioned Republicans might take a look at John Danforth’s book, Faith and Politics. Also recommended is a visit to the National Endowment for the Humanities website to check out a series of speeches given recently by Jim Leach on the importance of civility in public discourse, and the historical consequences of the kind of incivility we are seeing from so-called conservatives today.

Obama’s Failure

Obama inspired the nation by promising a big change from the tawdry record and mean-spirited hubris of Republican rule. He made a terrible strategic error by retreating from his promise for change into a deal-making posture that made him look weak, emboldened his opposition and left his supporters completely disillusioned.

The architect of this strategy, Rahm Emmanuel, is now gone. The other bad influence, Lawrence Summers, will also be gone at the end of the year. (Unfortunately Tim Geithner remains at Treasury.) Whether these personnel changes signal that Obama is going to finally take a stand for something remains to be seen. Democrats are too cowed by the right wing propaganda machine and the thinly veiled threats of violence from the Tea Party types. They won’t stand and fight unless Obama steps up first. If he doesn’t start to lead politically, the Republican mob will overrun Washington, and the country will come apart at the seams. See Frank Rich’s column, What Happened to Change We Can Believe In?


The dollar is the driver of all markets right now….down, down, down. Everything else….up, up, up. The Fed is going to keep pumping until real estate floats. The dollar will be worth a nickel…oh, wait…it’s already worth a nickel! Gold is telling the story of the value of the dollar…$1,340 at press time. Ten years ago it was $250.

Currently we are in an intermediate term disinflationary cycle, driven by still deflating real estate prices and consumer retrenchment. When this cycle has run its course, inflation is going to go bonkers. (That’s a technical term.) Even now, despite the disinflationary pressure and official inflation of 1.5%, real inflation is running closer to 8% according to John Williams’ Shadow Government Statistics. That number better reflects my personal experience with the cost of necessities like food, gasoline and insurance.

Commodity prices across the board have had a big move up recently. That move will be felt in increased consumer prices in the coming months. Coming soon: a big rise in rates. The authorities have been playing a manipulation game for 30 years, and they have lost control. Even the Fed can’t hold back the ocean forever. When the dike bursts, we will see dramatically higher rates, and everything else will go into freefall. Then we will have a new dollar, worth a fraction of the old dollar at conversion time. Maybe we’ll have two dollars; one for international dealings, backed partially by gold, and another domestic dollar that the politicians will immediately start devaluing with new debt.


China is on the rise, growing steadily stronger and more confident, with India not far behind. The entire Far East is forming into its own economic sphere. If they can avoid falling into old rivalries and warfare, they are in for a long run of expansion and growing prosperity. We, on the other hand, are in decline, and our lack of leadership and general political decay ensures that we will remain so for a long time. Soon there will be a battle royal over military spending vs. Social Security and Medicare. The military is going to lose this battle and we will finally start closing down our global network of military installations. Maybe we can put our downsized military to work eradicating the Mexican drug cartels, which have risen to power courtesy of the price support from our War on Drugs.

Unless Iran collapses inward from the growing pressure of global sanctions, war is inevitable in the Middle East. In fact, the war is already underway. Stuxnet was the opening volley. For those who are unaware, Stuxnet is the computer worm that has mysteriously appeared in Iranian industrial computers, most specifically those related to the nuclear industry. Reports are sketchy but apparently it has done extensive damage. Stuxnet is the first weaponized computer virus, specifically designed to take control of industrial computers and to destroy equipment and facilities. The general consensus is that Stuxnet is so sophisticated and complex that it could only have been created by governments, namely Israel and/or the United States.

Also, Debka reports that Iranian bunkers housing ballistic rocket launchers earmarked for attacks on Israel and U.S. ships have been destroyed by drone attacks. Iran will no doubt be looking for its opportunity to strike back.


The economy is not going to get much better any time soon. If Republicans make the election gains predicted and follow through on their promise to bring government to a halt, things are certain to start deteriorating again, quickly.

As Warren Buffett put it not long ago, we’re on our way to becoming a “sharecropper society.” He was referring to our increasing indebtedness to foreigners. But the analogy applies in another way as well. The wealth of a nation is like the blood in a body. It needs to circulate. Thirty years of Republican economic policies have concentrated America’s wealth increasingly in the upper tier, devastating our once thriving middle class and gradually impoverishing an ever greater segment of the population. On our current track most of us will soon be sharecroppers, if we aren’t already, in a neo-feudal state where most assets are controlled by a small oligarchy.


The election of Barack Obama in 2008 presented an opportunity for America, and a choice. We could undertake the hard task of cleaning up the wreckage left by the Bush regime together, or we could continue the partisan warfare and make everything worse.

It seemed that Obama was genuine in his desire to work in a bi-partisan way, and he certainly did make the effort, to a fault in my opinion. The destructive behavior of the Republican Party has ensured that we are going to go through this the hard way. Ultimately, though, it is we the people who are responsible. If Republicans didn’t have the support of approximately half the people, they wouldn’t do these things. Unless there is a miraculous national awakening at the final moment, it appears that we have made our choice, and we are going to suffer for it.


Q2 ’10:   Sliding Gradually Down the Slippery Slope

There has been a lot of water under the dam since my last letter. Not much change of real substance; just gradual erosion across the board. The economy is still in a funk, markets have been gyrating in broad trading ranges, our political devolution proceeds unabated, and the global scene, especially the Middle East, is just as fragile as ever.

The grip of corporate money over our political establishment has been demonstrated repeatedly as scores of lobbyists descend on Washington to spread their millions and our Senators dance to their tunes as each new “reform” is considered. As if the corruption were not bad enough, the Supremes, in Citizens United v. Federal Election Commission, decided that corporations should be freed of all constraints regarding their political “donations.” We have now made government of the corporation, by the corporation, for the corporation the law of the land.


The bear took another bite out of stocks in May and again in late June, erasing the gains for the year. The mood was so black at the June lows that, in retrospect, the lows should have been obvious. Of course stocks began to rally the next day, climbing back to even for the year and gyrating around the even mark since. At this writing stocks have been selling off again but sentiment is again so negative that I think we must be nearer to a bottom than a top. The 8/21 Sunday NY Times featured a front page article about small investors fleeing the stock market. Anything can happen, but this is not what one would expect to see at the beginning of a big move down.

Bonds have been rallying strongly. Rates on long bonds are approaching their all-time lows. The Fed recently announced that it is “reinvesting” its mortgage income in long bonds, and bond traders are convinced that the deflation trade is the place to be. For the time being it would be expensive to bet against them. Longer term, however, I disagree. Yes, the economic numbers have been horrible, and we are in a deflationary cycle, but the policy response to deflation is going to be even more aggressive quantitative easing, which is economic-ese for printing dollars. The Fed bond purchases are only the first step. It’s only a matter of time before bonds begin to discount the inevitable dollar devaluation and the ever growing risk of default. As Warren Buffet recently put it in a NY Times Op-ed piece entitled “The Greenback Effect,”

“The United States is spewing a potentially damaging substance into our economy — greenback emissions. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt.”

The Euro zone is under tremendous stress. John Taylor, Chief Investment Officer at FX Concepts, one of the largest currency hedge funds, places the value of a German euro at six times the value of a Greek euro. Of course there is only one euro, and therein lies the problem. The Euro zone does not have any internal mechanism for adjusting the relative values of the various countries’ euro-denominated debt. This obviously cannot last. Ultimately the resolution is going to be up to Germany, which will have to pick up the majority of the tab for Greece, Spain, Portugal, Ireland and several other euro-laggards. Politically this will be very unpopular, but in the end it may be in Germany’s best interest to do so as German banks own large chunks of bonds issued by Greece, Spain, etc. Big bets are being placed for and against the survival of the euro, and the relative position of the dollar will swing widely as perception of ongoing euro viability waxes and wanes.


The Bank for International Settlements (BIS) put out a paper recently entitled “The Future of Public Debt” that has received a lot of attention. The short of it is that the current trajectory of public debt in Western nations is “unsustainable.” This is not really news, but an official report like this gives politicians an opportunity to pretend that something new has happened. Not that they needed an excuse, but Republicans have focused their impressive propaganda machine lately on deficits. The deficits are indeed troublesome. Since 2002 I have been writing about the inevitable consequences of irresponsible fiscal policy, and we are witnessing those consequences every day. But the truth of the matter is that the damage has already been done, and most of it was done when Republicans were in power. If Republicans were serious about deficits they would have done something about them when they were in power. Instead, when they had the chance to put our fiscal house in order they went on the biggest deficit spending spree in history.

Several Republican leaders have recently gone on record that any spending for social benefits, for example unemployment benefits, must be balanced by spending cuts elsewhere. However, they say, tax cuts for the wealthiest Americans do not need to be balanced by cuts elsewhere, even though the latter will add to the deficit just as surely as the former. So clearly the issue for them is not the deficits.

What is really happening, for those who are not aware, is that Republicans are deploying the second half of their “starve the beast” strategy, which is designed to defund and weaken government functions across the board, and especially to undermine entitlement programs such as Social Security and Medicare.

The deficit reduction theme has Democrats (as usual) cowering before the latest Republican onslaught. Regarding the sincerity of Republican concern over deficits, I refer the reader to Martin Wolf’s recent post, “The Political Genius of Supply Side Economics.” Martin Wolf is the chief economics commentator for the Financial Times. His opinions are highly regarded and sought after by senior policy makers, economists and money managers around the world.


Republicans continue to wage their war of attrition on all things Obama and all things Democrat. No consideration is given, nor is there any thought at all apparently, to the damage this doing to the country. What’s most troubling about all of this is that we really could use some loyal opposition; some Republicans who actually believe in something and have something constructive to add to the national debate.

Unfortunately, they have been quite successful with their strategy of obstruction and distraction, if the polls are to be believed. Americans generally seem to have forgotten completely who implemented the policies that led to the awful deficits, the failed wars in Iraq and Afghanistan, and the financial meltdown and recession through which we are still suffering. All is forgotten. A majority of Americans, apparently, are more concerned that Obama might be a closet Muslim, a Socialist, or maybe a Fascist, than with understanding the array of bad choices he has before him.

The reality is that Obama is a somewhat right of center moderate. His profile is much closer to that of Richard Nixon than Lyndon Johnson. As such he continues to disappoint his supporters, who are generally much more progressive than he is. He is certainly not the bold, visionary leader that was promised in his campaign. Gail Collins has an interesting take on Obama’s uninspiring style, entitled “The Boring Speech Policy.” So there may be hidden benefits to Obama’s process oriented leadership. Let’s hope so. Also, Eric Alterman has an in-depth piece at The Nation entitled “Kabuki Democracy; Why a Progressive Presidency is Impossible, For Now.”

One area where there is great concern among Obama’s supporters has been in his embrace of pretty much the entire Bush agenda for the war on terror. Also, after all the talk during the campaign about bringing transparency to government, the Obama Justice Dept has been especially aggressive in pursuing whistle blowers, even reviving cases dropped by Bush. And in the “can you believe it” category, White House aides have taken to meeting lobbyists at a coffee house across the street so the meetings don’t have to be disclosed in White House visitor logs.

Obama apologists are willing to overlook these matters, insisting that because Obama is a good guy, honorable and well-intentioned; we can trust that he is doing the right thing. Well, that may or may not be true. But here is the problem, especially regarding the war on terror issues. By “looking forward, not back”; by refusing to make amends for the abuses of the Bush era, and refusing to hold accountable the blatant lawbreaking of the Bush crowd, and then embracing the full range of positions and actions of the Bush arsenal for the war on terror (with the exception of waterboarding), Obama is sanctioning these violations and making the unambiguous declaration that the powerful who violate the law will not be held accountable.

As Jeb Koogler at Foreign Policy Watch recently put it in a piece entitle “On Executive Power, Obama as Frodo”:

“One has to wonder: what happened to the Obama that we saw on the campaign trail and in the Senate — the Obama who so vigorously advocated for the closing of Guantanamo, an end to rendition, and the restoration of habeas corpus? That man is no longer to be found.”

Glen Greenwald has also posted some in-depth commentary on this issue, here and here.

This has also been the case in the financial arena. The case against AIG executive Joseph Cassano, who took advantage of AIG’s AAA rating to issue hundreds of billions of dollars of “insurance” in the form of credit default swaps without the collateral to back them, has been dropped. Not one of the dozens of top Wall Street executives who knowingly participated in the biggest Ponzi scheme in history while counting on the “Greenspan put” to bail them out when things went south will be prosecuted. Nor will anyone in the CIA, Defense Department, or Executive who enabled and engaged in torture and even murder of “enemy combatants” while in custody be prosecuted, other than perhaps a few low level grunts who foolishly followed orders or encouragement to do such things.

All of this means that when the folks who so egregiously abused their power when they were last in power, when it was unclear whether they would be prosecuted for doing so and thus had some constraints on their actions, the next time they come into power they will know with certainty that there will be no accountability for their actions. If they violated the law with impunity when they were unsure of accountability, what will they do when they know there won’t be any? I don’t want to find out.

Also, if you want to read an excellent in-depth piece on the sorry state of the Senate, then “The Empty Chamber” by George Packer in the recent New Yorker is for you.


On the global scene there is good news and bad news. The good news is that China recently inked a major trade deal with Taiwan. Apparently the Chinese Communists have been satisfied with the progress of integrating Hong Kong through engagement, so they have decided to try the same tack with Taiwan. This moves the possibility of armed conflict to the back burner. Perhaps as China grows more confident in its regional dominance it will start to lean on North Korea to open up and join the family of nations. If that happens there will be little justification for continued U.S. military presence in the area. Realignment continues at a solid pace.

In the Mideast things are not going so well. The Obama administration has been trying to convince Iran to let go of its nuclear ambition, relying first on engagement and then on sanctions. Neither strategy has had much effect. Russia has been ramping up their trade with Iran to minimize the impact of the sanctions, and China is not co-operating either. Iran is in turn providing Hezbollah, Hamas and Syria with advanced weaponry and upgraded rockets, and ratcheting up the bellicose rhetoric against Israel. The entire Middle East is on a war footing. The next war is almost certain to be regional and we will be in the midst of it.

Jonah Goldberg presents the “war is imminent” argument in a recent Atlantic article entitled “The Point of No Return.” Robin Wright, also in Atlantic, rebuts Goldberg in a piece entitled “A Long Way From the Point of No Return With Iran.” And here is piece from an Israeli blog, The Promised Land, which takes issue with Goldberg’s conclusions.


There is not a lot to look to regarding opportunity right now. However, readers should take note that it is during such difficult times that new ventures get started that often grow into great companies. John Mauldin reminds us that Microsoft, Apple, Intel, cell phones and the Internet came to us courtesy of the recessionary ‘70’s. So this may be the time for experiments and startups. Also, I believe we are in an interest rate bubble, so to the extent that you need to borrow money (prudently), this is as good as you are going to get, ever. You might want to take advantage of these super low rates for as long a term as you can get.


There is a general sense of deterioration across the board, hence the title of this letter. Deflation is the dominant theme in the marketplace and Republicans are pushing hard to exacerbate the deflation. This could easily get out of hand, and I expect it to create a scare which will in turn cause an inflationary policy response. This is the long term scenario I have been expecting for some years and I believe we are getting fairly close to the end game. The damage has been done and there are no good solutions at this point. The hyper-polarized political insanity that has consumed the nation is making it virtually impossible to deal with a very difficult situation.

We seem to be unable to come together to deal with our problems and in fact are drifting farther apart. Those agitating for chaos are in the ascendant. There is no power on earth that can defeat the United States, but we are doing it for them. This is how empires cease being empires. As Pogo said, “I have met the enemy and he is us.”


Q4 ’09:   Real Estate Reality

I have been fortunate in obtaining an excellent set of notes from the November Urban Land Conference, which make up the bulk of this letter. The comments are wide ranging and very informative.

First a few comments on markets and the political scene.

There are signs that the see-saw battle between inflationary and deflationary forces is tipping in favor of deflation. Despite the massive and relentless “quantitative easing” by the world’s central banks over the past year, inflation has remained quite subdued. The consensus is that the jobless rate will remain high for years. Also, there are concerns over possible default of sovereign debt by several European nations, and at the same time China is pulling in the reins on bank lending over concerns of developing asset bubbles. Markets across the board have been selling off sharply. Even gold has seen persistent selling pressure.

Most significant, however, at this juncture is the political chaos that has been unleashed in Washington by the victory of Republican Scott Brown in the Massachusetts special election for Ted Kennedy’s Senate seat. Democrats are now in panic mode and could do something seriously damaging. Our financial system is still in a very delicate state. Republicans have been successful in selling deficit hysteria to the media and making the feckless Democrats pay the price for salvaging their mess, thus executing the second half of their despicable “starve the beast” strategy. If Republicans had been concerned about the deficit when they were in the majority we wouldn’t be in this situation today. Cowardly Democrats are now moving toward cutting back on the spending, which would be the right thing under normal circumstances, but if they do so now we will find ourselves quickly in phase two of the market meltdown, and very likely into a real depression that could linger for many years. The New York Times has an excellent editorial on this matter in the February 7th issue entitled “The Truth About the Deficit.”

Of course the odds of a managing a successful “soft landing” from the epic abuses of the Republican era were pretty slim to begin with, but things could get much worse, and fast. Be aware and take precautions if you can. If deflation takes over, cash is the place to be. Any long term assets should be hedged if possible.

We have a SERIOUS lack of leadership in Washington. The health care fiasco was, and continues to be, a demoralizing affair for anyone who has been paying attention. Many are still holding out hope that Obama will step up and be the visionary leader we need, but so far he has been a big disappointment in the leadership department. Democrat leadership in general has been pathetic, especially in the Senate, and Republicans have been downright nihilistic. Judging from their actions, they seem intent on provoking as much chaos and pain as possible while Democrats are in the majority, regardless of the long term consequences. If Democrats were doing what the Republicans are doing, Republicans would be loudly accusing them of treason. Democrats, however, are too timid to call out Republicans for their outrageous behavior. See the Economist article “The Party of No.”

As if we don’t already have enough problems to deal with, Debkafile is reporting that Israel is finally getting ready to bomb Iran’s nuclear facilities. Iran, in preparation, has been training 5,000 Hezbollah troops for a planned invasion of Northern Israel with the intent of occupying several towns and taking the residents hostage. Iran has also reportedly recruited Hamas and Syria to open additional fronts against Israel once hostilities begin. Stratfor has published a rather alarming assessment of the situation entitled “Defensive Buildup in the Gulf.”

Moving on to the Urban Land Conference notes. Given the new developments visited above, the perspective reflected in these notes may be somewhat optimistic. Anything can happen, better or worse than the perspective at that time, but the trend in the short time since has been distinctly worse. The key here is that increased political turmoil has added a destabilizing element to an already unstable economy. Readers may want to contact their representatives in Washington to make this point and encourage them to focus on creating stability.

Urban Land Conference Notes

  1. Not one expert was willing to predict what things will look like in three years other than they think it will be better.
  2. One top economist said if you are a developer find another career for the next three years. There is nothing to do and it may be five years.
  3. Recovery will be slow. Unemployment will not drop back to more normal levels until 2014. First they will bring back people on four day weeks to five days. Then they will increase hours from the average 33 hours now, then part timers will become more full time, then they will start to hire.
  4. Real estate values are down generally 40% and there is a huge need for value reset to occur.
  5. Nobody knows what debt will look like when it returns other than it will be far more conservative. Nobody knows what securitization will be when it does return.
  6. The rating agencies will operate differently. There is a discussion among some of us that there needs to be an agency probably of Treasury that collects fees of some sort from issuers each time there is an issuance of debt to be rated and that agency will then hire a rating agency to be an analyst firm to determine the quality of the issue. There will definitely not be a continuation of investment bankers hiring the raters and paying them directly. There needs to be a rule that the bankers cannot talk to the raters. There was far too much threats of withholding fees and other inducements to the raters before making ratings about as accurate as appraisals which were also paid for by the bankers who needed high appraisals to justify the over leveraging.
  7. Housing in some bad markets is still bad and the first time buyer credit is making it a somewhat phony market. Phoenix has 45,000 housing lots so there is a literal lifetime supply of lots. Land prices in Phoenix, SoCal and other markets are 50% of the cost of the infrastructure installed on finished lots. The land has zero or negative value. In most areas it will be at least five years before any of this land will get built out in any quantity.
  8. There are still 2-3 million too many houses in the U.S.
  9. This time is really different than any recession in the past.
  10. The U.S. is no longer the world economic leader and will not lead the world out of this mess.
  11. Real estate will once again be an investment and not the trading vehicle it became, which is what led to this crisis.
  12. We will go back to financing real estate with long term debt, and not the short term floating rate debt used to allow a quick flip.
  13. The Internet completely changed unemployment trends. Instead of just pumping up the U.S. economy and bringing back production jobs, the Internet has caused the entire world to be competitors for many jobs in the U.S. It ranges from call centers to research, financial analysis, medical research, and on and on. This may be one of the most historic changes in history and one everyone needs to be aware of. It likely means wages in the U.S. will be reduced below where they might have been were it not for this competition.
    As several economists put it, the young in China and India and other Asian countries are hungry to get ahead and enjoy the good life, while U.S. kids feel entitled and poorly educated. Those of us who built businesses were very hungry. Today there are still some like us, but many are too comfortable and unwilling to really sacrifice to make it like we were. The Asians want to learn. Our young people think they already know it, whatever it happens to be.
  14. Third quarter GDP number is inflated by clunkers, home buyer subsidy, etc.
  15. Growth next year (2010) will be more like 1-2% in the first part of the year.
  16. Inflation will return in 3-4 years.
  17. U.S. corporations are sitting on record cash balances way beyond any they ever had. They will be doing more acquisitions.
  18. The best market in the U.S. is Washington D.C., for obvious reasons.
  19. Investors fled real estate completely in the early 90’s. This time they see the long term opportunity to create wealth and will be back as soon as the opportunity to buy appears.
  20. There is an enormous amount of cash on the sidelines.
  21. The Fed is intentionally holding rates at zero to try to force investors to invest in longer term riskier assets instead of collecting nothing on money market or CD’s.
  22. The banks are still weak.
  23. All values are still dropping and we have only gotten to 80% of the drop so far. Office and retail are only 80% there, industrial is only 60% and will be hurt by further inventory liquidation and lower levels carried going forward. Rents are only 75% of the way to the bottom.
  24. In the 90’s it was easier to fix the problem because the damage was much more confined to a small number of large new buildings which were revalued and then re-rented. Now the damage is widespread and covers a lot of older buildings so it will take a lot longer to solve. Quality really matters now. The best buildings will return; a lot of others will struggle.
  25. Office vacancy will hit 18.6% nationally, retail 23%, and multifamily 8%.
  26. The unwind of the massive Fed stimulus is critical to how it goes. Everyone thinks Bernanke is great but nobody ever did this before. It is truly uncharted waters. Then there is the politics and what will the rest of the world do.
  27. As you will read below there will not be the massive foreclosure and asset disposal we all expected. The lenders are going to hold on. When assets do come to market prices will be higher than they should be due to very few deals being chased by massive dollars. There is already evidence of this in the multifamily market.
  28. Mobile phones and other devices are now becoming all sorts of tools and multiple use devices. Social networking is growing faster than anything anyone can imagine. The growth rates are beyond comprehension. This is everything in the world is going from ordering food or reserving a car on Zip Car, to reading the news or anything. If you are over 30 you can’t grasp what is happening and how fast. The growth in usage is by tens of millions in months, and it is worldwide. You can’t get your mind around this. There has never been anything in modern times that is even remotely like this. The growth rate makes the growth in TV usage look like it was glacial. This is the biggest transformation in how the world functions in maybe hundreds of years. You need to learn all about this or get run over.
  29. Here is the real stunner. A senior person at Treasury said to a small group of us that it is now official Treasury policy to extend and pretend on real estate loans. In other words, the policy statement from last week says that if you can make an analysis that says even if the current value is less than the loan, if you can do a spreadsheet that shows if you extend for 3-5 years, and if the economy gets better, and if the loan can be amortized down to where the loan is no longer more than the value, then the lender does not have to take an impairment/write down. Loans are to be modified by rate reductions, deferral of reserves, deferral of amortization or whatever. Just not principal reduction. This is just like they are doing in housing.Giant make believe. The free market seeking an equilibrium price is no longer economic policy. In short, the working of the free market is suspended. She went on to say that it was administration policy that they will create new employment and by doing so they will boost the economy, and so then real estate values will return to old levels. There were 50 of the most senior and smartest real estate people in the room. They ripped her to pieces. It looked like one of the town hall meetings of August, except everyone there was a very senior, polished professional. At one point everyone was calling out or moaning at her. It was clear to all that she had been given a few talking points and she was told to stick to them no matter how foolish she looked. The group told her in no uncertain terms that this is terrible public policy. They said for jobs to be created you need to lower rents so the cost of occupancy was at a level to encourage more hiring. If the loan is kept at old levels and building values not reduced, then landlords can’t reduce rents to where they need to be to make taking space by tenants economically viable. Retailer’s costs remain higher than they should be by making it harder to lower prices to induce sales. So there is a massive make believe going on. When I pressed the issue of political interference she said, “what do you want us to do, bankrupt all the banks?”

That is the choice.

What does this tell you?

  • The problem is going to take much longer to solve than it should.
  • The banks are still very weak, so lending will not return any time soon.
  • A massive refi problem is being deferred to 2013-2015.
  • The administration is playing politics with the economy to a degree that is dangerous. There has to be a massive value reset for real estate. We are deferring the inevitable.



Q3 ’09:   Mauldin on Economic Policy Options

Due to the flu I have been unable to complete this quarter’s newsletter.  It so happens that this week’s Thoughts From the Frontline, The Glide Path Option, by John Mauldin is the perfect substitute, summarizing the various economic policy options that remain open to us going forward and consequences of those various options. Mauldin’s letter follows:

Mauldin on Economic Policy Options

The Present Contains All Possible Futures
The Ugly Unemployment Numbers
Argentinian Disease
The Austrian Solution
The Eastern European Solution
Japanese Disease
The Glide Path Option
Philadelphia, Orlando, and Phoenix

By John Mauldin

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we’re headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.2000wave.com and search for terms I am writing about. And I will start out by briefly touching on today’s ugly unemployment numbers, with data you did not get in the mainstream media.

But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.2000wave.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don’t know, I write a brief monthly column for them.

The Ugly Unemployment Numbers

The headlines said unemployment, as measured by the “establishment survey,” was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month’s. It is an improvement that we are not falling as fast.

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

Let’s look at the real number in the establishment survey. If you don’t seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the socalled birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg:

“Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual ‘change’ in the underlying labor market situation … in which case, October’s figure of 817,000 represents the fourth LARGEST yet, behind last month’s (September’s) second largest figure of 1,021,000 … for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer ‘in’ the Labor Force …

“… the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

“Bottom line … basis this measure AND the ‘Total Unemployment Rate,’ we could conclude that not only is there NO ‘improvement’ in the labor market, butmoreover, that it continues to DETERIORATE, intently.”

There are plenty more implications in the data, but let’s turn to the topic of the day.

The Present Contains All Possible Futures

Like teenagers, we as a US polity have made a number of bad choices over the past decade. We allowed banks to overleverage and, in the case of AIG (and others), sell what were essentially naked call options of credit default swaps, based on their firm balance sheets, far in excess of their net worth; and that put our entire financial system at risk. We gave mortgages to people who could not pay them, and did so in such large amounts that we again brought down the entire world financial system to the point that only with staggering amounts of taxpayer money was it brought back from the brink of Armageddon. We assumed that home prices were not in a bubble but were a permanent fixture of ever-rising value, and we borrowed against our homes to finance what seemed like the perfect lifestyle. We did not regulate the mortgage markets. We ran large and growing government deficits. We did not save enough. We allowed rating agencies to degrade their ratings to a point where they no longer meant anything. The list is much longer, but you get the idea.

Now, we are faced with a continuing crisis and the aftermath of multiple bubbles bursting. We are left with a massive government deficit and growing public debt, record unemployment, and consumers who are desperately trying to repair their balance sheets.

If present trends are left unchecked, we will need to find $15 trillion in the next ten years, just to pay for US government debt, let alone state, county, and city debt. And perhaps some loans for business will be needed? Where can all this money come from?

The answer is that it can’t be found. Long before we get to 2019 there will be an upheaval in the market, forcing what could be unpleasant changes.

We are left with no good choices, only bad ones. We have created a situation that is going to cause a lot of pain. It is not a question of pain or no pain, it is just when and how we decide (or are forced) to take it. There are no easy paths, but some bad choices are less bad than others. So, let’s review some of the choices we can make. (Again, I am being very general here. You can go to the archives for more specifics. This is a summary letter.)

Argentinian Disease

One way to deal with the deficit is to do what Argentina and other countries have done: simply print the money needed to cover the deficits. Of course, that eventually means hyperinflation and the collapse of the currency and all debt. There are writers who think this is an inevitable outcome. How else, they ask, can we deal with the debt? Where is the political willpower?

One large hedge-fund manager in Brazil humorously remarked that Argentina is a binomial country. When faced with two choices (hence binomial) they always made the bad choice. Could it happen here?

Hyperinflation is not an economic event; it is a political choice. I think last Tuesday’s election is a sign that the voter population is beginning to pay attention to the need for something more than talk of change. There is growing discomfort with the size of the deficits. Further, the Fed would have to cooperate in order for there to be hyperinflation, and I think there is only a very slight (as in almost zero) chance of that happening. Could Congress change the rules and take over the Fed? Anything’s possible, but I seriously doubt there is any appetite in saner Democratic circles for such a thing to happen.

I think the chances of hyperinflation in the US are quite low. It would be the worst of all possible bad choices.

The Austrian Solution

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to the new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

The Eastern European Solution

As it turned out, Niall Ferguson (last week I wrote about his brilliant book, The
Ascent of Money) was in Dallas last night, and I was graciously invited to hear him. He gave a great speech and signed books, and then we went to a local bar and proceeded to solve the world’s problems over Scotch (Niall) and tequila (me), and went farther into the night than we originally intended. He’s a very fun and knowledgeable guy.

As we were talking about possible paths, he brought one to mind that I hadn’t thought of. He reminded me of the period after the fall of the Berlin Wall, as the nations of Eastern Europe broke from the former Soviet Union. They started with very weak economies and simply overhauled their entire governments and economies in a rather short period of time, though not in lockstep with one another. Privatization, lowered taxes, etc. were the order of the day.

We here in the US are always talking about the need for reform. We need to reform health care or education or energy. In Eastern Europe they did not reform in the sense that we use the word. In many cases they simply started from scratch and built new systems. They had the advantage that there was general agreement that things did not work the way they had been, so there was more room for change.

Today in the US there are large constituencies that resist change. We only get to tinker around the edges, when real structural change is needed. Sadly, we agreed that here there is not much chance of major change. We can’t even get the obvious changes needed in the financial regulatory world.

Sidebar: I am outraged at the paltry proposed financial “reforms.” Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don’t care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

Japanese Disease

I have written a lot over the past year about the problems facing Japan. Their population is shrinking, as is their work force. They are running massive fiscal deficits and have done so for almost 20 years. Government debt-to-GDP is now up to 178% and projected to rise to over 200% within a few years. They started their “lost decades” with a savings rate of almost 16%, and are now down to 2% as their aging population spends its savings in retirement. They have had no new job creation for 20 years, and nominal GDP is where it was 17 years ago.

As bad as our problems are here in the US, their bubble was far more massive. Values of commercial property fell 87%! Their stock market is still down 70%. They had twice as much bank leverage to GDP as the US. (Think about how bad off we would be if bank lending was twice as large and had even worse defaults and capital shortfalls!) And yet, they Muddle Through. Productivity has kept their standard of living reasonable. Up until recently their exports were strong. The trading floors of the world are littered with the bodies of traders who have shorted Japanese government debt in the belief that it simply must implode. While I believe that it eventually will, if they stay on the path they are on, Japan is a very clear demonstration that things that don’t make sense can go on longer than we think.

Richard Koo (chief economist of Nomura Securities, in Tokyo) argues passionately that Japan had a balance-sheet recession, and that the only way for Japan to fight it was to run massive deficits. Banks were not lending and businesses were not borrowing, as both groups were trying to repair their balance sheets, which were savaged by the bursting of the bubble. It is said that at one time the value of the land on which the Emperor’s Palace sits in Tokyo was worth more than all of California. Clearly this was a bubble that puts our housing bubble to shame.

So, I understand the point that there are differences between Japan and the US . But there are also similarities. We too have had a balance sheet recession, although here it was mostly individuals and financial institutions that have had to retrench and repair their balance sheets.

Japan elected to run large deficits and raise taxes. As I wrote in the October 16th letter (http://www.2000wave.com/article.asp?id=mwo101609), “Savings equal Investments:

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus
Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

I don’t want to go on at length again, but basically, the literature I quoted suggests that government stimulus and deficits have no long-run positive effect on GDP. In fact, the work done by Christina Romer, Obama’s chairman of the Council of Economic
Advisors, shows that tax cuts have a three-times-greater positive effect on GDP, and tax increases have the same level of negative effect.

In the equation above, if you increase government spending it will have a positive effect in the short run on GDP, but not in the long run. In essence, the increase in “G” must be made up by savings from consumers and businesses and foreigners.

But “G” does not enhance overall productivity. Government spending may be necessary but it is not especially productive. You increase productivity when private businesses invest and create jobs and products. But if government soaks up the investment capital, there is less for private business.

And that is Japanese disease. You run large deficits, sucking the air out of the room, and you raise taxes, taking the money from productive businesses and reducing the ability of consumers to save. Then you go for 20 years with little or no economic or job growth.

This is the path we currently seem to be on. The Japanese experience says that it could last a lot longer than people think before we hit the wall; because if savings rise in the US, and if banks, instead of lending, put that money on deposit with the Fed, as they are now doing (in order to repair their balance sheets), the US could run large deficits forlonger than most observers currently believe.

We will need 15-18 million new jobs in the next five years, just to get back to where we were only a few years ago. Without the creation of whole new industries, that is not going to happen. Nearly 20% of Americans are not paying anywhere close to the amount of taxes they paid a few years ago, and at least ten million are now collecting some kind of unemployment benefits or welfare.

Choosing large deficits does not reduce the amount of pain we will experience, it just seemingly reduces it in the short term and creates the potential for a serious economic upheaval when the bond market finally decides to opt for higher rates. This path is a bad choice, but sadly, in reality it is one we could take.

The Glide Path Option

A glide path is the final path followed by an aircraft as it is landing. We need to establish a glide path to sustainable deficits (could we dream of surpluses?). That is because at some point there will be recognition, either proactively or forced upon us by the bond market, that large deficits are unsustainable in the long term.

If Congress and the president decided to lay out a real (and credible) plan to reduce the deficit over time, say 5-6 years, to where it was less than nominal GDP, the bond market would (I think) behave. Reducing deficits by $150 billion a year through a combination of cuts in growth and spending would get us there in five years.

The problem is that there is real pain associated with this option. Remember that equation above. Absent a growing private sector, if you reduce “G” (government spending) you also reduce GDP in the short run. You have to take some pain today in order to do that. But you avoid worse pain down the road: a bubble of massive federal debt that has to be serviced will be very painful when it blows up, as all bubbles do.

The Glide Path Option means that structural unemployment is going to be higher than we like (which is actually the case with all the options). And the large tax increases that come with this option will by their very nature be a drag on growth (and cause a double-dip recession in 2011). We can debate tax increases all we want, but I sadly think we will soon have a VAT tax. There are no good options. I just hope that we cut corporate taxes enough when we do create a VAT, that it will make our corporations more competitive, which will be a boost for jobs.

That’s pretty much it. This is not a problem we can grow ourselves out of in the next few years. We have simply dug ourselves into a huge hole. This is not a normal recession. There is not a “V” ending to this recession. We are going to have deal with the pain. It will be the pain of reduced returns on traditional stock market investments, a lower dollar, low returns on bonds, European-like unemployment, lower corporate profits over the long term, and a very slow-growth environment. But if we choose this path, we will get through it in the fullness of time.

And of course, then we will eventually have to deal with the $70 trillion in our off-balance-sheet liabilities in Medicare and Social Security and pensions. Sigh. But that’s for another time.

Philadelphia, Orlando, and Phoenix

I really am more optimistic than this letter makes me seem. But if you ignore reality, then you have no chance to figure out how to make the best of your situation. It is the efforts of hundreds of millions of individuals trying to make their own lot a little better than will get us back to a robust economy.

Monday I fly to Philadelphia and then the next day to Orlando for two speeches, and then the following week a quick trip to Phoenix, then home to start to plan for Thanksgiving. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org/). Interestingly, they hold it every year at a “Texas” barbecue joint. Look me up if you are there.

Tiffani has been out the last two days of this week. She is due in seven weeks or less, and her hips are expanding. The pain is too much right now for her to walk up the stairs to the office, so she is working from home. The doctor says this is the one time that her pain is not a sign of something bad. She is being a trooper and not taking any pain meds.

It has been 30 years since I was around a pregnant lady for more than a few hours, and it does bring back some memories. Watching her grow and change has brought back the sense of awe over how our bodies are designed.

Ryan and Tiffani have decided on the name Lively for my first granddaughter, to add to the two new grandsons this year. From zero to three grandkids in just six months! Kind of makes me dizzy.

I really enjoyed my time in South America. Rio is quite beautiful and I want to go back and spend some time.

Have a great week. There will be enough good friends and family that I know I will. And tomorrow night I finally get to go to a Dallas Mavericks game. We may have a real team this year.

Your always optimistic at the beginning of the season analyst,

John Mauldin

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore


Q2 ’09:   The Financial Crisis is Not Over

The massive intervention by our government to shore up the financial system has stabilized the situation, for now. Recent reports have shown a distinct lessening in the pace of destruction. The contraction in economic activity (GDP) was only 1% in the second quarter, compared to -6.4% in the first quarter. Stocks have put on an impressive rally, so far retracing approximately one-third of the big move down from October ‘07. Even house prices inked a modest uptick this month, the first in three years. This is all welcome news, but it is a long way from a lessening in the pace of destruction to a real economic recovery. If we are indeed in the early stage of a recovery, and it appears that we are, it will be a recovery that only an economist could love.

Jobs of course, or rather the lack of them, is the number one economic issue “on the ground” as they say, but underlying the lack of jobs is a still fragile financial system and a banking industry that is desperate to avoid acknowledging the losses it has already incurred — bad loans which are hiding behind the industry’s government sanctioned creative accounting standards. This reticence to take their medicine and properly recapitalize has rendered the nation’s bankers reluctant to lend, and lending is the life-blood of our debt driven economy.

David Einhorn, CEO of hedge fund Greenlight Capital recently addressed this issue in a lecture given at the at the Ira W. Sohn Investment Research Conference entitled “The Curse of the Triple A.” I found this lecture compelling and brilliant. It explains in plain language the dilemma we face, what must be done to resolve it, and why it will not be resolved until certain things are done. I have obtained permission from Mr. Einhorn to include the lecture in full as my offering for the Q2 ‘09 Risk & Opportunity newsletter.

You can access the latest of Mr. Einhorn’s lectures here, where you can also order his book, “Fooling Some of the People All of the Time,” a fascinating chronicle of his battle with Allied Capital and the SEC, highlighting the pervasive criminality and corruption in corporate America and Washington that is destroying our economy. Without further introduction, I present Mr. Einhorn.

The Curse of the Triple A

The views expressed in this speech reflect our opinions about certain companies or industries in which Greenlight Capital has a position or may take a position in the future.

The actor Michael J. Fox recently published an excellent book subtitled The Adventures of an Incurable Optimist. In it, he writes that “the only unavailable choice was whether or not to have Parkinson’s. Everything else was up to me.”

I would like to apply that thought to why I spoke up about Lehman Brothers last year, what has happened since, and what I believe is preventing the economic recovery we would all like.

Over a year ago Lehman was in serious trouble. It had taken on a tremendous number of questionable assets, using a great deal of borrowed money, with only a sliver of equity. We had taken a short position in the stock. When I first spoke out about Lehman, the shares were more than $60, and though Lehman’s troubles were evident, its fate was not sealed.

When I saw Lehman’s predicament and how it had effectively doubled down into the economic downturn, adding still more assets, repurchasing stock, trying to “squeeze” and intimidate short-sellers, I doubted whether Lehman would do the right thing on its own. So last May 21st, at this conference, I said, “My hope is that Mr. Cox and Mr. Paulson and Mr. Bernanke will pay heed to the risks in the financial system that Lehman is creating and that they will guide Lehman toward a recapitalization and recognition of its losses.” That, of course, did not happen.

Putting aside the question of whether Lehman should have been saved, the real question is, why wasn’t more done between the Bear Stearns bailout and Lehman’s demise to protect the system from the risk that Lehman obviously posed?

We all lost when the authorities failed to insist that Lehman recognize its losses and de-lever. In the midst of a crisis, our leaders hoped Lehman would make sensible decisions and also hoped for a market recovery so that Lehman could earn its way out of trouble. The authorities did not want to be held responsible for intervening and causing losses to Lehman equity holders. Instead they waited and hoped. Hope is a nice human emotion, but does not make for good public policy.

Now we have the Obama administration, which disappointingly seems to be following the same path as the Bush administration. The basic strategy appears to be to try to bring us back to 2006 by propping up asset prices and reflating the popped credit bubble, subsidizing bank creditors and shareholders, and delaying needed bank recapitalizations, while hoping for an economic recovery.

The official attitude appears to be that what is good for the banks is good for the economy. I question this view because the best interest of the banks is to buy time so that future earnings can outrun embedded losses, while the best hope for a rapid economic recovery rests on insolvent borrowers resolving bad debts as quickly as possible. A corporation, homeowner or consumer that has more than a manageable amount of debt is not going to hire people, invest or spend. For the economy to recover, underwater entities need to restructure their debts. Banks must be able to negotiate with their borrowers, but they can only do so after they have written down the loans as aggressively as possible. What is good for the economy is, in this sense, bad for the banks.

I know a company that was capitalized in better times and need to renegotiate its bank debt or else turn the keys over to the bank – which in turn might cause a lot of people to lose their jobs. The owners have offered to improve the situation with an infusion of new money if the banks convert some of the debt into equity. There are ten banks in the syndicate, and some of them have marked the loans at 50 cents or less and the rest have them marked at 90 cents or more. Not surpringly, the banks that have marked down the loans would support the new funding plan, but the other would prefer a program of temporary forbearance, likely due to the accounting implications of a recapitalization. The willingness for banks to negotiate depends on where they have the loans marked.

Consider the homeowner who bought a house for $350,000 and has a $300,000 mortgage. The house is now worth $200,000. The bank should restructure the mortgage to $175,000 and figure out how to share the upside with the borrower. Otherwise, the homeowner is likely to rent the house down the street, and leave the bank with a house it must sell.

Geithner & Company prefer a policy of loan modifications. Mark Hanson of Fieldcheck Group has observed that, “In a nutshell, the modifications are meant to keep the principal balance in place so the banks don’t have to take losses, stretching the foreclosure problem out over a longer period of time. The modifications have ultra-low teaser rates and loan to value ratios that were unheard of even during the worst period of bubble lending.” It is no wonder that the re-default rates are very high.

The modifications lack the one change that is most needed – principal reductions. Recently, Congress made a stab at giving judges the power to enforce principal reductions of bankrupt homeowners. The banks, of course, opposed the legislation because it would force them to recognize the losses. Even after the legislation was watered down to the point where it probably wouldn’t have helped much, the banking lobby was sufficiently strong to defeat it.

We need banks to be willing to write down the bad loans and negotiate with homeowners. In order to do that, they need to be massively better capitalized or even overcapitalized so they can absorb the losses. Everyone must recognize that these losses have already occurred and it is time to own up to them, which is the clearest way to a recovery path for the economy.

The Obama team has posed the issue of bank solvency as a choice between nationalizing the banks versus supporting them with lots of taxpayer money. I believe this is a false choice – there really is a third alternative. Bill Ackman has observed that the financial institutions have plenty of capital; they just don’t have the right type of capital. Too much of the capital is debt or hybrid equity and not enough is common equity. For most of the large banks there are lots of non-depositor liabilities that can be converted into equity, as needed, to enable the banks to be properly capitalized without requiring the taxpayers to put in any more money.

The main opponents to debt for equity conversions are, of course, bank shareholders who don’t want to be diluted, and bank bondholders who would prefer to be bailed out by colossal government subsidies. These shareholders and bondholders threaten Armageddon if they are asked to shoulder the losses on the risks that they have voluntarily taken. I have posed the question of bondholders sharing the pain to many people including a Nobel Prize winning economist and a former Treasury Secretary. Invariably, they respond with something overwrought like, “without the banks, we have no economy.” On the other hand, among investors that I speak with, there is broad consensus that debt for equity exchanges are needed.

Three years ago everyone understood that if a bank failed, the order of loss would be common equity, preferred equity, subordinated bonds, senior bonds and finally the FDIC. Non-insured lenders to the banks knew that they weren’t buying Treasuries and they demanded compensation for the additional risk. Now, the government has arbitrarily flipped the order at enormous cost, so that the taxpayer assumes all the risk above the common equity.

A better solution than government injections into troubled financial institutions is to figure out how to induce debt for equity conversions without forcing a disorderly liquidation. This is what should have been done with Lehman. There was a price where conversions, rather than bankruptcy and liquidation, would have been in everyone’s interest. Legislation to create conservatorships for holding companies to enable this to be conducted promptly, but not necessarily over a weekend, is a good idea.

I believe that the banks are not materially more solvent now than they were two months ago. What has changed is that a couple of months ago investors worried that the government might seized the banks. But the authorities, again, don’t want to be held responsible for intervening and causing losses to equity holders; they are instead hoping for an economic recovery which allows the banks to outrun their problems with future earnings. This regulatory forbearance explains much of the rally in bank stocks.

If Saturday Night Live could figure out that the bank stress test was a sham, it’s unlikely anyone else was fooled either. The test was designed for banks to “pass” and the regulators renegotiated the grades in a way that my eleventh grade English teacher wouldn’t consider. Telling everyone that the banks are sound is not as good as actually recapitalizing the banks.

Even if the banks that have not recognized the losses can argue that they don’t “need” more capital on technical regulatory grounds, overcapitalizing the banks would be very bullish. The rally over the last few weeks shows just how eager the market is to see the end of this crisis. If we overcapitalize the banks and direct them to resolve the insolvent borrowers, I believe that the market would react even more bullishly, and more importantly, the economy would truly begin to recover.

Once a bubble pops, it can’t be reflated. Attempts to do so only end up creating the next bubble. Thus, the Internet bubble gave way to the credit bubble, which gave way to a bubble in U.S. Treasuries in a rush to safety. The Federal Reserve has commenced a program of “quantitative easing,” a fancy term for printing money to prop-up the government bond market as a way to help cushion the credit bubble; this is on the heels of a 25 year bull run in Treasuries.

If we learned anything from the credit bubble, it is that giving unlimited cheap funds to AAA rated entities can be a bad idea, particularly when the entities are prone to taking full advantage of their perceived safety. Could the U.S. Government, or for that matter any of the indebted industrialized sovereigns, fall victim to the curse of the AAA rating by overindulging in the cheap financing thrust at it, to everyone’s ultimate dismay?

The U.S. fiscal position is problematic. It wasn’t great during the Bush years, but now we have overt stimulus, while the tax base is shrinking. AS a result, this year the deficit will be about 13% of GDP. Incrementally, the government has issued trillions of sneaky guarantees. Sneaky because they don’t show up in the government accounting at the moment they are made, but only later, when they are paid. Not every guarantee will create a loss, but many will and the bills will come due over the next few years, creating a real headwind against reducing the deficit. Demographics are working against us and one investment theme to watch over the coming years is how industrialized nations with large debts and large social commitments to aging populations allocate the sacrifice.

In the long-term we need to manage our debt through taxation, inflation or default. Some take comfort that since we can print as much money as we want – the Fed can become the purchaser of government debt as a matter of first and last resort – default is out of the question. However, from a bondholder’s perspective, there isn’t any difference between default and being paid in wampum. And, if we don’t have a credible plan that avoids ultimate payments in funny money, the authorities can lose control. Eventually, we could be forced into an uncomfortable choice of fiscal austerity versus inflationary collapse.

President Obama’s handling of the Chrysler bankruptcy has added additional uncertainty into the credit markets. He has introduced a quixotic idea: that creditor recoveries in troubled situations can be determined by an arbitrary sense of shared sacrifice rather than legal agreements and long established prior practice. One government official noted in the Wall Street Journal, “You don’t need banks and bondholders to make cars.” Well, after the money has been lent, who needs the lender? But where do you draw the line? Should a politically driven shared sacrifice theory apply to lenders of other troubled entities? When teachers and firefighters are losing jobs and benefits, will municipal bondholders be asked to share in the collective sacrifice? Might the shared sacrifice theory eventually extend into the U.S. Treasury market during a crisis?

Already the long-end of the bond market is sensing a problem with the long-term implications of all the short-term fixes.

I’d like to spend a minute discussing AIG. I believe most of the discussion about compensation at financial institutions is a populist diversion. IF the goal is to avoid excessive risk in the system, the proper response is to reduce it directly by enforcing much greater capital requirements. The lower leverage will also have the side effect of reducing the future peak earnings, which will mean less egregious compensation.

Both President Obama and Chairman Bernanke have said that the problem with AIG was that greedy people put a hedge fund on top of an insurance company. As I see it, AIG failed precisely because it was not a hedge fund, but a highly regulated, AAA rated insurance company. Call it the Curse of the Triple A. The market incorrectly believed that regulators and rating agencies carefully its risk profile and activities. As a result, AIG was able to abuse its access to unlimited cheap financing without its counterparties performing any additional credit analysis or demanding any collateral. Hedge funds can’t abuse the system in the same way, particularly in the aftermath of Long Term Capital Management, as lenders pay much more attention to hedge fund counterparty risk and collateral requirements. Had AIG been a hedge fund as President Obama and Chairman Bernanke claim, none of this could have happened.

Come to think of it, many of the spectacular failures during this crisis bore AAA ratings. The Government Sponsored Enterprises, the monocline insurers, AIG and General Electric, whose slow moving train-wreck is ongoing, suffered the Curse of the Triple A and damaged their companies with sizable harm to the economy at large. The only AAA rated (or at least until recently AAA) financial institution I can think of that didn’t abuse its status is Berkshire Hathaway.

Investors who bought AAA rated structured products thought they were buying safety, but instead bought disaster. They can forgive themselves by blaming the rating agencies. But if the credit markets improve to the point where newly issued AAA rated bonds price with tight spreads only to later widen or ultimately fail, investors will have no one but themselves to blame. Fool me once…

Investors have figured this out and many deny that they buy bonds based on ratings unless they are forced to by law. Even Moody’s largest shareholder, Warren Buffett, has said that he doesn’t believe in using ratings.

We are short Moody’s Investor Service. If your product is a stamp of approval where your highest rating is a curse to those that receive it, and is shunned by those who are supposed to use it, you have problems.

Moody’s says that it has enormous incentive to do a good job with the ratings because the ratings are the brand. Imagine yourself the head of Moody’s a decade ago. If your goal was to destroy the brand, would you have done anything differently?

The truth is that nobody I know buys or uses Moody’s credit ratings because they believe in the brand. They use it because it is part of a government created oligopoly and, often, because they are required to by law. As a classic oligopolist, Moody’s earns exceedingly high margins while paying only the needed lip service to product quality. The real value of Moody’s lies in its ability to cow the authorities into preserving its status.

The rating agencies’ lobby is pushing “reform” through modest changes to the ratings process. Why reform them when we can get rid of them? Are we waiting for them to blow up the Lunar economy as well? Some wonder what would happen without government sanctioned ratings. It is hard to imagine how things would be any worse.

Even if the ratings were free of conflict, the unfixable issue is that the rating system is inherently pro-cyclical and economically destabilizing. When times are good, rating upgrades reduce borrowing costs and contribute to credit bubbles. The more debt they rate, the more profit they earn. When times are bad, rating downgrades accelerate a negative feedback loop and can be catastrophic for entities that rely so much on their credit rating that a rating downgrade jeopardizes their existence. The monocline insurers and AIG suffered this fate. This empowers the rating agencies to decide whether a company lives or dies. The rating agencies are sensitive to this responsibility. As a result, they fail to use the downgrade as a warning signal to investors, and when they do finally act, it is often the coup de grace.

Regulators can improve the stability of the financial markets by eliminating the formal credit rating system.

Credit analysts don’t believe in credit ratings; equity analysts do. Moody’s shares trade at 19x estimated earnings that, wink-wink, they are supposed to beat. Ironically, for a firm that evaluates credit, its balance sheet is upside down, with a negative net worth of $900 million.

That is a lot to pay for a franchise with a socially undesirable product and a shattered brand that exists at a time when the government is considering broad reform in its mission to fix some of the systemic regulatory issues that got our economy into trouble in the first place.


AIG, GE and even the U.S. Government all have the problem of relying on the easy financing and false confidence brought upon by the myth of AAA credit ratings. JFK said, “Belief in myths allows the comfort of opinion without the discomfort of thought.”

As a society we need to de-lever and President Obama and the policy makers are not stepping up to the plate, bur are instead trying to stretch things out in the hope that time will solve the problems. Forbearance has not stopped people from losing their jobs or preventing asset prices from falling; it is delaying the recovery.

I believe President Obama ran for our highest office because he had a broad vision for the country on issues like healthcare, energy, and America’s role in the world. As Michael J. Fox might put it, the only unavailable choice for President Obama was whether or not we have a financial crisis. Everything else is up to him.

I am optimistic because even though I believe that Secretary Geithner is leading us down the wrong path, President Obama has demonstrated an ability to change is mind in other areas. To me this reflects the work of an intelligent pragmatist acting upon fresh understanding. I am optimistic that President Obama is capable of making similar reassessments of the economic rescue plan, and change direction there as well.

I have one final area that I’d like to cover. Seven years ago, I first spoke at this conference and, as you all know, discussed our short thesis on Allied Capital. The staff of Greenlight pledged half its share of any profits on that position to the Tomorrows Children’s Fund. In 2005, when the investment took longer than we imagined, we donated $1 million, as we felt that the children who benefit from this charity should not have to wait.

When I published Fooling Some of the People All of the Time last year, we promised the other half of any profits to two other worthy organizations: The Project On Government Oversight (POGO) which is an independent nonprofit that investigates and exposes corruptiona and other misconduct to achieve a more effective, accountable, open and ethical federal government, and the Center for Public Integrity (CPI) which produces original investigative journalism about significant public issues to make institutional power more transparent and accountable.

Now our short has finally paid off. Allied would no doubt argue that it took an enormous collapse in the credit market for that to happen. I would respond that it took a historic credit bubble to prop-up Allied all those years.

At the end of my book I tried to explain why, even though I was embroiled in a ridiculously unpleasant controversy, I felt optimistic that it would end well. With the collapse of Allied’s balance sheet and stock price, the matter is now finally resolved. I am honored on behalf of every member of Greenlight, each of whom is a part of this contribution, to donate an additional $6 million, to make a total of $7 million to these three organizations to help each of them carry out their important mission. The good work they do gives all a reason to be optimists.