It is not normal to think you can spend your way out of debt...
HERE is a speech given in Las Vegas last Saturday, edited and improved, writes Bill Bonner in his Daily Reckoning...
On my recent trip to India, the financial press was very eager to hear what I had to say.
They invited me on to their television shows. They interviewed me for magazines and newspapers. The local paper ran a full-page interview and sent out an artist to do a sketch of me.
I thought they might have had me mixed up with someone else. I'm not used to people taking me so seriously.
"Noted Western Economist Gloomy on World Recovery," was the headline in the paper.
In all these interviews I had more or less the same message. I told them that there was no recovery...none at all...and that very soon it would be obvious that we were in a period of correction – the Great Correction, I called it.
Stock prices would fall, I said. The property market in the US and the UK would sink further. There would be some spectacular bankruptcies...including some bankruptcies by whole nations.
Whether the next move to the downside has begun or not, I don't know. The Dow fell 158 points on Friday, after taking a jolt earlier in the week. Gold rose over 1,180.
The one thing that Indian investors seemed most interested in...and I assume you are interested in too...was my Trade of the Decade. But I'm not going to give you a typical investment analysis or a target for GDP growth or for the Dow this year. Instead, I'm going to talk to you about history and philosophy. I hope that's okay.
I had great luck with my last trade of the decade. Ten years ago I suggested selling US stocks and Buying Gold. It worked out very well on both sides. So people wanted to know what my trade would be for the next decade. I gave it some thought and came up with something. I think this one will work out too...but I'll give you an even better Trade of the Decade.
But first, let me explain how it works. Behind the Trade of the Decade is just a simple observation: that things that are very out-of-whack tend to get back into whack. Over a 10-year period you have a fair chance that they'll return to normal.
This is another way of describing the phenomenon known as regression to the mean. One of the surest phenomena in the natural world is that things that are extraordinary will eventually become less extraordinary. And over a 10-year period, you have a decent chance that that's what will happen.
So, what's my Trade of the Decade now?
Right now, the US Treasury market is out of whack. It's been going up since 1983. And now investors lend money to the world's biggest debtor at what are historically very low interest rates. And they do this at a time when that debtor has begun the biggest borrowing and spending spree in history. This is not normal. It's downright weird.
Sometime within the next 10 years, I figure that the Treasury market will get whacked hard. So on one side of the trade...I'm short US Treasuries.
On the other side of the trade I had more trouble. Because I was looking for something to buy. And nothing is really cheap. Buying gold? Well, it seems to be in a bull market...and I expect it to go up much higher...but gold not cheap. As near as I can tell, an ounce of gold buys about as much – in terms of consumer products – as it did 700 years ago...and maybe even as much as it bought 2,000 years ago.
Gold has already reverted to the mean, after being seriously undervalued in 1999. Now, most likely, it will become over-valued when the current monetary system begins to break up...but that's a different phenomenon. It's not reversion to the mean, at least, not for gold. It's a reversion to the mean of the monetary system...I'll get to that in a moment.
What I needed for the buy side of the trade was something that was historically undervalued. And the best I could come up with was Japanese small cap stocks, which have been going down since 1989. There are some that sell for less than the amount of net cash and current assets that they have in their own company accounts. That is extraordinary. Of course, it could become even more extraordinary. But that's the risk we take. And over 10 years, we hope that that risk – such as it is – comes and goes.
So, that's the new Trade of the Decade?
Sell US Treasuries. Buy Japanese small caps.
But I'm going to give you an even better Trade of the Decade. The problem for non-Japanese investors is that the small caps may actually go up...but if the Yen goes down you might lose your gains.
So, how about this? Instead of selling US Treasury bonds, sell Japanese government bonds. Japanese bonds are probably even more over-valued than US bonds. And with the Japanese borrowing more than ever...while the Japanese savings rate declines...it seems a fair bet that Japanese government debt will go down at least as much as US debt. Maybe more.
By buying Japanese small caps while selling Japanese bonds you take out the currency risk. You have an even better Trade of the Decade. The Japanese small caps stocks are extraordinarily under-appreciated. The Japanese government debt, on the other hand, is extraordinarily over- appreciated.
But the first point I want to make is that this is just an idea. It's not a substitute for a serious investment strategy.
The second point I want to make is that you can only have a serious investment strategy if you're willing and able to think deeply about ideas. And if you do think about them enough, you'll have a decent chance of doing well...simply because most people – including most serious investment professionals – don't think about them very much. That's what I mean about philosophy...you have to think long and hard about how the world actually works. And history is about the only tool we have to work with.
I'm going to give you 2 examples of what I mean right away.
First, we celebrated an important anniversary in April. It was 2 years ago, in April 2008, that Countrywide Financial went broke. Countrywide was the second biggest subprime lender in the US. When it went down it set in motion a whole series of domino-like bankruptcies that eventually wiped out half the world's capital.
But when Countrywide collapsed, reporters asked Henry Paulson what would happen next. Paulson would seem to be a good person to ask. He was Secretary of the Treasury and formerly the top man at Goldman Sachs. Nobody had more or better information than Paulson. So what did Paulson say?
He said that he could imagine 'no scenario' in which the taxpayer would be called upon to bail out the financial industry.
That was 2008. By the end of 2009, according to Bloomberg's calculation, the federal government had committed more than $8 trillion in taxpayer support, supposedly to prevent the end of the world.
It must have worked. Here we are 2 years later, and the world still exists.
But there's a gap of 8,000 billion numbers between Paulson's estimate and the eventual federal commitment. Which, at the very least, makes you wonder about the people at the top of America's financial intelligentsia...and the methods they use to figure out what is going on.
What does it mean when the best informed, most sophisticated, most knowledgeable financial authorities in the country are completely wrong about what is going on? It means they've got the wrong idea about the way things work...and probably no incentive to have the right one.
Goldman Sachs had 21 billion reasons to think it was a good idea to bail out AIG. The bankers who hold Greek debt have 146 billion reasons to like the bailout announced yesterday. And the US government has about 2 trillion reasons to believe the economy is growing.
There were 8,000 billion numbers between Hank Paulson's estimate of how much taxpayers' money would be put at risk rescuing Wall Street and the actual fact. But Hank Paulson is by no means the only major authority or financial celebrity to be wrong. The folks running money for Harvard and Yale – the crème de la crème of financial managers – were spectacularly wrong too.
And so were the people running major banks. But today I will mention just one of them...someone who had already settled up when the financial crisis of '07-09 arrived. Walter Wriston was the Chairman of Citibank...the bank that eventually got taken over the federal government in the general panic of 2008...he remarked that:
"Governments can't go broke."
And here I'll do a little speculation – I bet that Citibank would NOT have had to seek government support if it had been run by a historian.
Financial history is full of government bankruptcies. The first modern nation to go broke was Spain – which did so 4 times in the 16th century.
The book by Ken Rogoff and Carmen Reinhardt has a nice list of these state bankruptcies. You'll see there are dozens of them. Some countries seem to be bankrupt all the time. Greece, for example. According to Rogoff and Reinhardt, Greece has been in default about every other year since it gained its independence in the 1820s.
And I'll offer you a prediction, before this decade is over...or perhaps the next one...dozens of countries will go broke, including the United States of America.
I don't mean they will close down and go out of business. But they will default on their debts – either by ceasing payment, by forced restructuring, or by intentional inflation.
How do I know that? Well, I don't. It's just a guess. And it's a guess that comes from reading history...not from doing mathematics.
Generally, as I told an audience in India, we seem to be at some major inflation point. I call this period the Great Correction, because it appears that there are several things that are in the process...or perhaps only the very beginning...of being corrected.
There is the 50-year credit expansion – centered in the US...largely a product of the modern, numbers-oriented way of looking at economics
There is the bull market in stocks, begun in 1982...correction began in 2000 and still is not fully realized. That bull market too owed a lot to modern financial thinking
There is the 28-year-old bull market in bonds, which apparently came to an end in the fall of 2008...but has not yet been completed. Again, this was made possible and sustained by the financial ideas of the mid- 20th century
There is even a 400-year boom in Anglo-Saxon culture – backed by military and economic force – which may be beginning a correction too. And it wouldn't surprise you to know that these new, modern financial theories are almost entirely the product of Anglo-Saxon academics...
All of these things are connected. The common thread is the 5th thing that needs to be corrected...and the thing I'm going to focus on here today. It's the rise of a body of thought concerning the way the world works – at least the world of money – which began in England and then was developed in the United States...
Let's call it "Fab Finance" after the Frenchman who got charged with fraud by the SEC. The idea is to put together slimy packages of debt and sell them to people who don't know what's in them. "Lumps for Chumps," you might call it.
Poor Fabulous Fab got stuck in the hot seat, but he was only following the logical development of a whole body of thinking that dates back almost 100 years...and which now seems to be leading the world to something much bigger and much more dangerous than just blowing up a few hedge funds and German banks.
Now, practically all the world's countries are using Fab Finance. They're gradually absorbing all the world's financial risks and putting them on the public accounts...ultimately backed by the full faith and credit of the United States of America.
This year, governments around the globe will issue $4.5 trillion in debt – three times the average over the last 5 years. About $2 trillion of that will be issued by the US.
What's more, there is NO EXIT from this debt build up. Only about 10% of these deficits is really caused by the financial downturn. Most of it is structural. That is, it is the result of programs that have been in place for years.
These programs just grow and grow...year after year...until they become unsupportable. And most of these programs are sold as Fab Finance...they transfer small, individual risks onto the balance sheet of the whole country.
In fact, if you had to sum up the entire effect of Fab Finance – the whole body of ideas and theories of modern, anglo-saxon economics in the 20th century – you could say that they took small problems and turned them into big ones.
Instead of running the risk that a few people will retire without sufficient funds, we now face the risk that the whole country will run out of money.
Instead of taking the risk that some people will not be able to afford health care, we now run the risk that the whole nation will be bankrupted by public health care costs.
Instead of allowing a few badly managed financial institutions to go under, the feds have put the entire credit of the United States of America at risk.
And in Europe, we see the same thing. Instead of allowing tiny little Greece to go bust, the Europeans are spreading the risks out all over the Eurozone.
I'm sure other speakers will talk about this, so I won't go into details. It's the most important economic event of our time. After a huge run up in debt in the private sector, now the public sector is having a go at it...and rolling it up into bigger and heavier balls.
And what happens when the government spends too much and borrows too much? History tells us what happened in the past. Philosophy tells us what should happen. Governments go broke. Always have. Always will.
But I'd like to share with you a headline from The Washington Post on Wednesday. The Post is the paper the politicians and bureaucrats read. So you can imagine how penetrating its insights are.
Well, the headline that made me laugh was this:
"Task force to tackle National Debt."
Not many things are certain in this life. But I can guarantee you that the bipartisan task force will not get close enough to the National Debt to read the number on its jersey, let alone tackle it.
The Great Depression convinced economists that they needed to be more activist. Now, our economy is responding to economic activism. And it will be destroyed by these modern ideas...and then, and only then, will new ideas arise.
We're going to see a correction...a regression to the mean of a number of things...including the way people think.
It is not normal to think you can spend your way out of debt.
It's not normal to think you can consume capital and get richer.
It's not normal to believe that central economic planning will make the world a better place. The Soviets proved that central planning doesn't work. We got to see that experiment. But instead of learning from it...we seem destined to repeat it.
The problem with trying to engineer a 'recovery' is the same problem with all central planning – it substitutes the honest signals from the marketplace with imposters. For example, instead of getting the message that they need to conduct their business in a different way, the banks get the idea that the feds will always bail them out...and automakers – thanks to the Cash for Clunkers program – may get the idea that there is more demand than there really is...and everyone could get the idea that the economy is healthier than it really is, thanks to the feds $1.5 trillion deficits.
The authorities are trying to force the economy back into the shape it was in before the crash. They're preventing it from taking a new, better shape....and preventing the correction from doing its work. A correction is supposed to cleanse out the mistakes from the 50-year credit expansion. But it's hard to do so when you don't know what is really going on. Markets – when they are allowed to do their work – are always in the process of discovering what assets are worth. They were doing a good job of it in the fall of 2008. They were discovering that the US had too many houses, and too many shopping malls, (the US has 10 times as much retail space per person as France...) We also had too many derivatives backed by real estate, and too many private equity deals based on too many optimistic assumptions about the future.
Anyway you look at it, the US has, as Paul Volcker puts it, a "long period of economic adjustment" ahead of us. The feds are just getting in the way...and making it even longer.
The market was in the process of discovering what assets were worth when the feds stepped in. They stopped the process of discovery. Instead, they forced the market into a process of Price Hiding.
Probably the most dramatic example of price hiding has been in the financial sector itself. There, the feds took away the risks of bad debt from the bankers and put it on the general public. The Fed bought the toxic loans, transferring hundreds of billions of losses from the banks' balance sheets onto the balance sheet of the Fed.
The Fed also lent the banks money at near zero percent...and then the federal government borrowed it back. The banks were able to make profits without doing any work or taking any risks. No wonder they didn't lend money to private businesses or consumers. It was too much trouble. And they didn't have to.
If you look at the latest figures from the Fed you will see that private credit is still falling. Commercial and industrial loans in March fell 16%. Asset backed commercial paper fell 20%. This correction, by the way, marks the first major reversal of commercial and consumer credit since WWII.
And now the Treasury has the gall to tell the public that it made money from its 'investments' in the banking sector. If so, those were the most expensive profits in the history of finance. They cost the nation about $4 trillion in fiscal stimulus deficits – added to the national debt. And another $1.8 trillion worth of dodgy debt on the FED balance sheet. And about $6 trillion more worth of financial guarantees of various sorts.
If the SEC wants to redeem itself, it should forget about the small fry. It should get off Fabulous Fab's case and go after the real frauds in this case...Ben Bernanke and Tim Geithner.
That won't happen. But everything regresses to the mean. That's the work of a correction – to bring things back to normal, back in balance. First, the private sector is corrected. And then, the public sector.
When something is out of balance on one end, you can be sure it's out of balance on the other side too. Americans consumed too much during the Bubble Epoch. Now, they need to save and produce more. But who was on the other side of this trade...?
Let's begin by going back to the 1920s. Back then, the USA was the industrial powerhouse of the world and its number one exporter. In those boom years, America had the largest trade SURPLUS on the planet. At the time, trade balances were settled in gold. So, the US built up the world's largest reserves – in gold. It still has them.
But that pile of gold didn't keep the US from financial trouble. The stock market crashed in '29 and the following two years cut the US GDP in half.
It took the stock market 27 years to recover.
In the 1980s, Japan had the biggest trade surplus in the world. You remember Japan, Inc? It was such an export success story that people worried that the Japanese would take over the world. But in 1989, Japan, Inc. peaked out. Its stocks have been going down ever since – 20 years already.
Now, it's China's turn. China has the world's largest trade surplus and its largest pile of reserves. (Unfortunately for China, after 1971, treasuries switched to using paper Dollars for reserves. So China has one enormous pile of paper...not gold.)
Thomas Friedman wrote that he wouldn't bet against a country with more than $2 trillion in reserves. But does this pile of paper money guarantee that China cannot fail? To the contrary, history tells us that China is most likely to fail – spectacularly – even though, over the longer run, like the US after the '30s, China may turn out to be a great success story.
Everything regresses to the mean. Everything tends to go back to normal. Corrections are normal. They help things get back in balance.
Now, here's the interesting thing. While Japan's government tried to prevent it, the Japanese private sector de-leveraged. Over a long period of adjustment – 20 years – the household, business and financial debt went down by about 40%, in GDP terms.
And now, in the US, even though the government tries to hide prices and delay the correction, the private economy is still de-leveraging. The latest figures suggest that households took a little pause in the first quarter of this year. Savings actually went down as consumption went up. But if we continue to follow the Japanese example the de-leveraging should resume soon.
We know from the Japanese history too – if we had any doubt about it – that price hiding doesn't work. First, they tried fiscal stimulus. That didn't do anything. The banks took the monetary stimulus and held onto it, just as US banks are doing now.
Then, they tried fiscal stimulus. Now, this deserves a little discussion. Because Richard Koo among others argues that the fiscal stimulus did work in Japan. He points out that Japanese GDP did not drop significantly – thanks to massive doses of fiscal stimulus. And now, Paul Krugman and others are saying that fiscal stimulus has worked in the US too...because our GDP only went down less than 3% in what they call the Great Recession.
Here is where we see the claptrap theories at work. Fab Finance turned the economic profession from historians and philosophers into mathematicians and engineers. Dozens of these fellows won Nobel Prizes for elaborate mathematical proof of what were essentially bogus or inconsequential ideas.
And now they turn to GDP as proof that fiscal stimulus works, without bothering to think about what is really going on. GDP measures economic activity. Like everything else in modern finance, it is sensitive to quantity and completely ignorant about quality. To borrow from Oscar Wilde, it knows the price of everything but the value of nothing.
Yet, here again, as the Soviet Union showed us, you can summon up all the GDP you want. Just divide the country at the Mississippi. Get half the population to dig a big hole in Tennessee...and get the other half of the population to fill it up. Imagine the trucks...the fuel...the machinery...the labor...the housing you'd need...GDP would go up. You'd have full employment. Modern economists would be content with themselves. They'd sit by the phone, waiting for the Nobel committee to call.
But what would you really have?
You'd have Japan! That's what the Japanese did. Well, not quite like that...They put people to work building roads and bridges...pouring concrete on a massive scale. Until then, Japan had the healthiest government finances in the world. Now, it has more government debt/GDP than any other nation – approaching 200%.
And think about what really happened. Japan's population is getting older. These are people who lent the government money so that it would be safe. They wanted to be sure they'd have the money they needed when they retired.
But where is that money? It has literally been poured into a hole in the ground. The savings of an entire generation have been turned into bridge abutments and canals – most of them unnecessary and many of them unwanted.
That is what is happening in the US too. Except we don't have enough savings to finance our own holes in the ground. We're more like Greece.
And like Greece, we will pay a high price when the final correction comes.