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Date: 2011/8/13
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The Beginning of the Endgame
By John Mauldin | August 12, 2011
In this issue:
* The Big Bang Moment <#131c4eac026735a4_big>
Bang, Indeed! <#131c4eac026735a4_bang>
"It's the Economy, Dummkopf!" <#131c4eac026735a4_its>
The Long and Winding Road to Crisis <#131c4eac026735a4_long>
Are We Already in Recession? <#131c4eac026735a4_are>
So What Can We Do? <#131c4eac026735a4_what>
Home and then Ireland, London, and Geneva <#131c4eac026735a4_home> *
I came away from Maine, and meeting with some of the most astute economists
in the world, with a series of impressions that will be the core of this
week's letter. On Friday night, S&P downgraded US debt, and of course I need
to comment on that. But as we talked the next two days and into the nights,
I came increasingly to the opinion that this is indeed the Beginning of the
Endgame. I must admit it has come about faster than I thought. But that is
the nature of these things. And so, with no "but first," let's jump right
in.
The Big Bang Moment
I think it relevant to start off by quoting from my book *Endgame,* where I
quote in turn from what I think is the most important book of the last
decade, *This Time is Different: Eight Centuries of Financial Folly,* by Ken
Rogoff and Carmen Reinhart. I truly urge you to read it. The book is
consciously designed so you can read the first chapter and the last five and
get the thrust of the work. You can order it from
Amazon.com<http://www.amazon.com/exec/obidos/ASIN/0691142165/frontlinethou-20>.
(The Kindle edition is only $9.99 and makes a perfect companion to my book *
Endgame <http://ce.frontlinethoughts.com/CT00009004MjczMzA0.html>*[shameless
plug].) Quoting from my book:
"We are going to look at several quotes from *[This Time is Different],* as
well as an extensive interview [the authors] graciously granted. We have
also taken the great liberty of mixing paragraphs from various chapters that
we feel are important. Please note that all the emphasis is our editorial
license. Let's start by looking at part of their conclusion, which we think
eloquently sums up the problems we face:
"'The lesson of history, then, is that even as institutions and policy
makers improve, there will always be a temptation to stretch the limits. *Just
as an individual can go bankrupt no matter how rich she starts out, a
financial system can collapse under the pressure of greed, politics, and
profits no matter how well regulated it seems to be.* Technology has
changed, the height of humans has changed, and fashions have changed.
'Yet the ability of governments and investors to delude themselves, giving
rise to periodic bouts of euphoria that usually end in tears, seems to have
remained a constant. No careful reader of Friedman and Schwartz will be
surprised by this lesson about the ability of governments to mismanage
financial markets, a key theme of their analysis.
'As for financial markets, we have come full circle to the concept of
financial fragility in economies with massive indebtedness. All too often,
periods of heavy borrowing can take place
in a bubble and last for a surprisingly long time. *But highly leveraged
economies, particularly those in which continual rollover of short-term debt
is sustained only by confidence in relatively illiquid underlying assets,
seldom survive forever, particularly if leverage continues to grow
unchecked.*
'This time may seem different, but all too often a deeper look shows it is
not. Encouragingly, history does point to warning signs that policy makers
can look at to assess risk—if only they do not become too drunk with their
credit bubble–fueled success and say, as their predecessors have for
centuries, "This time is different."'
[Back to my voice] "*Sadly, the lesson is not a happy one. There are no good
endings once you start down a deleveraging path. As I have been writing for
several years, much of the entire developed world is now faced with choosing
from among several bad choices, some being worse than others."*
And this is key. Read it twice (at least!):
"'Perhaps more than anything else, failure to recognize the precariousness
and fickleness of confidence—especially in cases in which large short-term
debts need to be rolled over
continuously—is the key factor that gives rise to the this-time-is-different
syndrome. *Highly indebted governments, banks, or corporations can seem to
be merrily rolling along for an extended period, when bang! — confidence
collapses, lenders disappear, and a crisis hits.*
'Economic theory tells us that it is precisely the fickle nature of
confidence, including its dependence on the public's expectation of future
events, which makes it so difficult to predict the timing of debt crises.
High debt levels lead, in many mathematical economics models, to "multiple
equilibria" in which the debt level might be sustained—or might not be.
Economists do not have a terribly good idea of what kinds of events shift
confidence and of how to concretely assess confidence vulnerability. What
one does see, again and again, in the history of financial crises is that
when an accident is waiting to happen, it eventually does. When countries
become too deeply indebted, they are headed for trouble. When debt-fueled
asset price explosions seem too good to be true, they probably are. But the
exact timing can be very difficult to guess, and a crisis that seems
imminent can sometimes take years to ignite.'"
*Bang, Indeed!*
When the subprime crisis started, we were told by numerous authorities
(including Ben Bernanke) that the problems would be "contained." But by 2006
it was clear to anyone who studied the toxic instruments that the losses
would be in the hundreds of billions. I estimated $400 billion, which just
goes to show that I'm an optimist. That crisis spread to banks all over
Europe and then back to the US. Authorities used every bullet in their guns,
every legal means and –well let's be charitable, perhaps they pushed the
rules a bit – to try and stem the tide. And then we had a "Lehman moment"
and all at once the markets seemingly froze. It was *"Bang!"*
My sense is that the S&P downgrade is like that moment when we were told
things would be contained. In and of itself, the downgrade is not that
important. What did we learn that we did not already know? The US is headed
for a financial crisis if they do not get the deficit under control? This is
news?
But I think it forces S&P to take a very hard look at France, whose loss of
AAA would bring into doubt the whole EFSF mechanism. And Spain and Italy
must come under scrutiny if S&P's move in the US is not to be seen as
politically motivated. The main result of the downgrade may not be here in
the US but in Europe, where there are already issues. A series of downgrades
(which are warranted if the US one was) would be traumatic.
My London partner Niels Jensen penned this observation:
"If France is downgraded, a number of French banks will almost certainly be
downgraded, following which other European banks will face the same destiny.
Such a scenario has the potential to cause calamity across Europe. The 90
European banks which recently went through the (so-called) stress test
organized by the European Banking Authority need to roll a total of €5.4
trillion1 (!) of debt over the next 24 months. A massive amount even during
the best of times. Probably undoable during times of stress.
"As Ambrose Evans-Pritchard, in consultation with Willem Buiter of
Citigroup, pointed out in the Daily Telegraph over the weekend:
" '... the issue is not how long Italy and Spain can ride out the storm in
bond markets. There would be a banking and insurance crisis long before
sovereign defaults came into play, simply because the fall in bond prices on
the secondary market is causing carnage to bank books (among other
transmission mechanisms).'
"With its downgrade of U.S. sovereign debt, Standard and Poors has started a
chain of events which can only make things worse in an already crisis-hit
eurozone. For that reason, the decision to downgrade was not only badly
timed but also ill considered; that it was probably justified is of little
relevance at the moment."
My latest trip to Europe and discussions with friends in Maine, plus my
reading, simply reinforces my sense that we are seeing Europe unravel, or at
the very least come to a very important crossroads where they must make a
fateful decision. And let's make no mistake, this is a demon of a problem of
their own making. Monetary union without fiscal union will not work in a
world where there are so many cultures and different traditions. But how
does that work? How do you exorcise that demon?
Which leads me to a sidebar. Michael Lewis is one of the greatest writers of
our time. He is just brilliant. He has a piece in the latest *Vanity
Fair*on Germany and the crisis in Europe. It is rather long (about 15
pages in a
Word doc) and makes some rather interesting (if odd) scatological
references, trying to explain the German world view, so if you are of a
delicate mindset, perhaps you should confine yourself to the few paragraphs
I quote here. But I do suggest you set aside some time to read the entire
piece. (You can read the whole thing at
http://www.vanityfair.com/business/features/2011/09/europe-201109.) Here is
the editor's intro to the piece:
"It's the Economy, Dummkopf!"
"With Greece and Ireland in economic shreds, while Portugal, Spain, and
perhaps even Italy head south, only one nation can save Europe from
financial Armageddon: a highly reluctant Germany. The ironies—like the fact
that bankers from Düsseldorf were the ultimate patsies in Wall Street's con
game—pile up quickly as Michael Lewis investigates German attitudes toward
money, excrement, and the country's Nazi past, all of which help explain its
peculiar new status."
And from the middle of the piece, these insights:
"Greeks are still refusing to pay their taxes, in other words. But it is
only one of many Greek sins. 'They are also having a problem with the
structural reform. Their labor market is changing—but not as fast as it
needs to,' he continues. 'Due to the developments in the last 10 years, a
similar job in Germany pays 55,000 euros. In Greece it is 70,000.' To get
around pay restraints in the calendar year the Greek government simply paid
employees a 13th and even 14th monthly salary—months that didn't exist.
'There needs to be a change of the relationship between people and the
government,' he continues. 'It is not a task that can be done in three
months. You need time.' He couldn't put it more bluntly: if the Greeks and
the Germans are to coexist in a currency union, the Greeks need to change
who they are.
"This is unlikely to happen soon enough to matter. The Greeks not only have
massive debts but are still running big deficits. Trapped by an artificially
strong currency, they cannot turn these deficits into surpluses, even if
they do everything that outsiders ask them to do. Their exports, priced in
euros, remain expensive. The German government wants the Greeks to slash the
size of their government, but that will also slow economic growth and reduce
tax revenues. And so one of two things must happen. Either Germans must
agree to a new system in which they would be fiscally integrated with other
European countries as Indiana is integrated with Mississippi: the tax
dollars of ordinary Germans would go into a common coffer and be used to pay
for the lifestyle of ordinary Greeks. Or the Greeks (and probably,
eventually, every non-German) must introduce 'structural reform,' a
euphemism for magically and radically transforming themselves into a people
as efficient and productive as the Germans. The first solution is pleasant
for Greeks but painful for Germans. The second solution is pleasant for
Germans but painful, even suicidal, for Greeks.
"The only economically plausible scenario is that Germans, with a bit of
help from a rapidly shrinking population of solvent European countries, suck
it up, work harder, and pay for everyone else. But what is economically
plausible appears to be politically unacceptable. The German people all know
at least one fact about the euro: that before they agreed to trade in their
deutsche marks their leaders promised them, explicitly, they would never be
required to bail out other countries. That rule was created with the
founding of the European Central Bank (E.C.B.)--and was violated a year ago.
The German public is every day more upset by the violation--so upset that
Chancellor Angela Merkel, who has a reputation for reading the public mood,
hasn't even bothered to try to go before the German people to persuade them
that it might be in their interests to help the Greeks.
"That is why Europe's money problems feel not just problematic but
intractable. It's why Greeks are now mailing bombs to Merkel, and thugs in
Berlin are hurling stones through the window of the Greek consulate. And
it's why European leaders have done nothing but delay the inevitable
reckoning, by scrambling every few months to find cash to plug the ever
growing economic holes in Greece and Ireland and Portugal and praying that
even bigger and more alarming holes in Spain, Italy, and even France refrain
from revealing themselves.
Until now the European Central Bank, in Frankfurt, has been the main source
of this cash. The E.C.B. was designed to behave with the same discipline as
the German Bundesbank, but it has morphed into something very different.
Since the start of the financial crisis it has bought, outright, something
like $80 billion of Greek and Irish and Portuguese government bonds, and
lent another $450 billion or so to various European governments and European
banks, accepting virtually any collateral, including Greek government bonds.
"But the E.C.B. has a rule--and the Germans think the rule very
important--that they cannot accept as collateral bonds classified by the
U.S. ratings agencies as in default. Given that they once had a rule against
buying bonds outright in the open market, and another rule against
government bailouts, it's a little odd that they have gotten so hung up on
this technicality. But they have. *If Greece defaults on its debt, the
E.C.B. will not only lose a pile on its holdings of Greek bonds but must
return the bonds to the European banks, and the European banks must fork
over $450 billion in cash.* The E.C.B. itself might face insolvency, which
would mean turning for funds to its solvent member governments, led by
Germany. (The senior official at the Bundesbank told me they already have
thought about how to deal with the request. 'We have 3,400 tons of gold,' he
said. 'We are the only country that has not sold its original allotment from
the [late 1940s]. So we are covered to some extent.') The bigger problem
with a Greek default is that it might well force other European countries
and their banks into default. At the very least it would create panic and
confusion in the market for both sovereign and bank debt, at a time when a
lot of banks and at least two big European debt-ridden countries, Italy and
Spain, cannot afford panic and confusion.
"At the bottom of this unholy mess, from the point of view of the German
Finance Ministry, is the unwillingness, or inability, of the Greeks to
change their behavior.
"That was what the currency union always implied: entire peoples had to
change their ways of life. Conceived as a tool for integrating Germany into
Europe, and preventing Germans from dominating others, it has become the
opposite. For better or for worse, the Germans now own Europe. If the rest
of Europe is to continue to enjoy the benefits of what is essentially a
German currency, they need to become more German. And so, once again, all
sorts of people who would rather not think about what it means to be
'German' are compelled to do so."
The Long and Winding Road to Crisis
As I will show below, the US (indeed much of the world) is on the edge of
yet another recession. It will not take much to push us into one, just a
small shock, like say a banking crisis in Europe, alluded to by Lewis and
something I have been writing about for a year.
That being said, the apparent willingness of the Germans to come up with
creative ideas (and to get the French to go along) to fund the various
nations in crisis, in order to avoid technical defaults, is somewhat
amazing. And if there was an election today and the socialists and Greens
won in Germany, they would be even more open to the idea of a eurobond, to
be somehow guaranteed by member countries. The current EFSF can deal with
Greece, Ireland, and Portugal until maybe 2013, and the next version will be
large enough to deal with Spain, unless of course the Eurozone elites decide
to call it quits, which is something they have not shown the slightest hint
of doing. What is more likely is that we lurch from crisis to crisis, with
each crisis somehow being averted by throwing more money at it, until the
debt of the AAA guarantors like France (and to a lesser extent Italy) starts
to be called into question by the markets.
Remember, the demographics of Spain and Italy are horrendous, soon to be on
a level with Japan. The government portion of GDP in France is already 53%
(not a typo!) and is only going to get worse as aging Boomers have been
promised monster benefits that simply cannot be provided without Greek-level
austerities. Their future numbers are worse than those of the US.
This can go on for a long time, or it can end in a *Bang!* moment this year.
That is the nature of the lesson from Rogoff and Reinhart. Look at Japan.
They took what were functionally insolvent banks and kept them going for
decades. Where there is a political will there can be a way … but there will
be an Endgame. That is also the lesson we learn from history. Japan will not
be able to stave off a crisis of major proportions forever. Neither will
Europe, unless they all become Germans in their national accounting.
Are We Already in Recession?
My friend Barry Ritholtz posted the above question today, and wrote:
"Bloomberg reported today that " *Consumer Sentiment Plunged to Three-Decade
Low*<http://www.bloomberg.com/news/2011-08-12/u-s-consumer-sentiment-falls-more-than-expected-to-54-9-in-michigan-index.html>."
That sent me scurrying to find some charts, and I ended up liking the two
from UBS strategist Andy Lees, at bottom.
"The first one is an overlay the University of Michigan consumer confidence
index vs the Conference Board's data. The second chart shows the long term
history of the Conference Board data. At an implied level of 43.37 we would
be in recession now; not only that but a deep recession.
"As the charts show, the ABC index has diverged from the Conference Board
data for some time now. The correlation between consumer confidence and
recession might not hold this time - although that would be the first split
for 40 plus years. There is also an implication from this data series that
we are already in recession. Given yesterday's data showing both imports and
exports falling, we may have an implied Q2 GDP revised lower by 0.8% to 0.5%
annualized growth - putting Q2 into the negative category.
"Hence, it is not unfeasible that we could be the verge of recession."
And that brings me to a chart I asked Rich Yamarone (chief econ type at
Bloomberg) to update for me. Again, it is about the horrific consumer
confidence number that came in today, but this time it is correlated with
GDP. As you can see, there is a close correlation. With GDP growth of less
than 1% for the last six months, asking if we are close to or already in a
recession is not a question without merit. And either way, this does not
bode well for the long-term direction of stocks and corporate earnings.
Consumer confidence is really saying that a recession is in the cards. Maybe
it is just weariness with the political malaise (which would be
understandable), but we should pay attention.
And while I won't print the chart again, every time year-over-year GDP
growth falls below 2%, we end up in a recession. It is now 1.6%. Past
performance is not indicative of future recessions, but the trend is not in
our favor.
So What Can We Do?
The economy is getting weaker. What can we do? The short answer is, sadly,
not much. There were some in Maine who argued for more fiscal stimulus, but
I think there is little political will for another major stimulus program.
The last one got us up to 3% GDP growth before we fell back, and all we got
was a major debt bill and a higher level of government spending. I fully get
that lowering government spending will have negative short-term effects, but
we are at the point in the Endgame where we must bite the bullet.
And fiscal policy is becoming a drag on the entire Eurozone, as well as
Great Britain. Austerity may be warranted, but is has consequences.
What about QE3? Let's look at how that last move turned out. We ended up
with more money on the Fed's balance sheet and higher commodity prices. The
NFIB survey I cited last week showed there was no great demand on the part
of small business for loans. 91% had what they needed. What they want are
sales and customers! The trade data yesterday showed exports fell by over
$2.3 billion last month. That suggests a slowing world economy. Which is
borne out by numerous other indicators.
One has to applaud the Chinese for allowing their currency to rise by a
significant (for them) amount this week, as almost every other government
(including Switzerland) wants a weaker currency. Everyone can't devalue at
the same time, just as everyone cannot export their way out of this crisis.
Someone has to buy!
In short, there are no easy solutions. We have just about used up all our
"rabbits in the hat" as far as fiscal and monetary policy are concerned. We
now need to focus on what we can do to get out of the way of the private
sector, so it can find ways to create new businesses and jobs. And that
means figuring out how to get money to new businesses, because that is where
net new jobs come from. But that takes time – and is a subject for another
letter, as it is time to hit the send button.
Home and then Ireland, London, and Geneva
I am home for (can you believe it?) more than 40 days, which, even with the
Texas heat, I need. Then I'm off to Ireland, Geneva, and a few days in
London. I am sure I will be making at least one presentation in London.
Maine was more serious this time. I think more of us realize that things are
going to get harder and more volatile. While our group is not exactly
indigent, we do get what all this means. On Sunday night, Trey came to me.
He had been listening. "Dad, it is good for you that you wrote about all
this already and are right, but I don't think it's so good for the rest of
us." And he is right.
Book sales have been quite steady, as more and more people are realizing
that we truly are at the Endgame, and as we try to lay out how it plays out
for us all. There is a lot of data in the book, and we back up our
predictions with sources. As one reader wrote:
"John, I hope all is well. I just wanted to drop you a note and tell you how
much I am enjoying Endgame. As a guy with a degree in economics, I read a
lot of books trying to explain macroeconomics of the times, but I have to
tell you this is the single best book I have read explaining how
macroeconomics works to regular people like me. You have done a great
service to your readers, as you do every day. Best, Steve"
You can read reviews and buy it on
Amazon<http://ce.frontlinethoughts.com/CT00009004MjczMzA0.html>
.
It really is time to hit the send button and find something to eat. I am
starved – and maybe I'll catch a late movie. Have a great week.
Your glad God invented air conditioning analyst,
John Mauldin
John@xxxxxxxxxxxxxxxxxxxxx <johnmauldin@xxxxxxxxxxxxxxxxxxxxx>
Copyright 2011 John Mauldin. All Rights Reserved.
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IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE
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PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX
TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT
SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE
HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT
AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment
performance can be volatile. An investor could lose all or a substantial
amount of his or her investment. Often, alternative investment fund and
account managers have total trading authority over their funds or accounts;
the use of a single advisor applying generally similar trading programs
could mean lack of diversification and, consequently, higher risk. There is
often no secondary market for an investorâs interest in alternative
investments, and none is expected to develop.
All material presented herein is believed to be reliable but we cannot
attest to its accuracy. Opinions expressed in these reports may change
without prior notice. John Mauldin and/or the staffs may or may not have
investments in any funds cited above. John Mauldin can be reached at
800-829-7273.
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Carlos Contreras, presidente
Club Científico de Peñalolén, Santiago, CHILE
http://www.clubcientifico.cl
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