John Mauldin is a well known economics commentator and forecaster. I recommend subscribing to his email newsletter "Thoughts from the Frontline", which you can do here.
In this week's newsletter he provides a concise description of what ails Europe and that the banking system's debt is a creation of government policy (allowing banks to buy sovereign debt at a 30:1 leverage ratio) and the inexorable effects of having to borrow more to pay back previous debt.
The root cause, of course, is paying for the increasingly large promises of the social welfare state. Not that today's left can understand that basic fact.
When the Labor government won power in Australia in 2007 it inherited probably the strongest economy on the planet, which included near zero government debt. In only a few years it has managed to grow that debt to $230 billion. The tragedy is not only that the country has nothing to show for all that spending but also that we are not able to learn from the disaster in Europe.
One of the interesting things about being in Hong Kong is that I get to see the weekend edition of the Financial Times 12 hours early. And the headlines were not all that pleasant. As I promised last week, we will cast our eyes to Europe and ponder what is in store for Europe for the year and the next five years. And what do we read on page 2? The "ECB raps revisions to draft a fiscal pact." Seems they feel there are too many loopholes, which will make the document meaningless … somewhat like the treaty they have now. And we further learn that "Greek default threat grows as talks falter." Seems there is a lack of agreement on how much of a haircut the investors ought to take, and the Greeks don't want to guarantee any future debt, just in case they need to default some more in the future. But they do want the €15 billion they need to keep the debt machine running for a few more months.
And on page 1, in big type, we are surprised (but not very) by the headline, "France and Austria face debt blow." Seems those sharp-eyed accountants over at S&P have decided to downgrade French debt from AAA. Which of course leads to another headline on page 2, suggesting "Firepower of bail-out fund cast into doubt." The currency markets were shocked – shocked I tell you – that S&P would do such a thing and promptly took back the euro rally and cast the euro down to recent cycle lows. Who knew, other than the entire free world not watching reality TV, that S&P was planning to do such a thing? And we read elsewhere that the European Commission is dismayed that S&P would do something so clearly not right, at least according to the way they keep their own books. Even here in amazing Hong Kong, with the growth of China driving a wave of prosperity, eyes are fixed on Europe. How will they deal with the crisis? We read that US exports to Europe were down 7% last quarter, and Europe has not yet really entered into recession, which is almost guaranteed this year. And if US exports are down, then so are Asian and Latin American exports. Global growth appears to be threatened.
Solving the Mayan Code
There are so many pieces of data to go through in order to augur Europe's future – I want readers to know I have left no stone unturned! In fact, I went to some very old stones to get help with this week's letter. I began to scrutinize the Mayan Code from ancient Central America, which so many feel predicts the end of the world on December 21 of this year, bringing my fresh eyes to an old mystery. After much deliberation, I have come to this astounding insight: The Mayan academics who created the code were not in fact astronomers or even astrologers. No, it is clear they were another breed of even more dubious forecasters, called economists. Once you approach the glyphs with that understanding, it becomes clear they are not predicting the end of the world, merely the end of Europe. One symbol clearly shows the Greek flag dipping to the ground. Another depicts the Italian flag with its wheels coming off. Oh, and you don't even want to know what they have prognosticated for the French. This is a family e-letter and I can't squeeze such language past the censors. But now that I have provided the basic insight, I leave it to you, fellow scholars, to decipher the rest of code.
And we will spend our time together here this week trying to discern what it means, in fact, for Europe to come to the place in its journey where it must make extremely difficult and often painful choices. As I wrote last week, as I started this voyage of discovery with you, the choices the various countries in the developed world are now making will put us on a path that does not allow us to turn back without severe consequences. (If you missed last week's letter, here it is.) We are left with debt that must be dealt with, with imbalances that must be balanced, and with deficits that must be brought under control. No matter what we choose, there will be pain for all of us. You cannot make debt go away without paying it back or defaulting, one way or the other, which means someone loses. And as we will see, paying it back can be very difficult, indeed, once it has grown this large.
To Solve the Crisis You Must Solve Three Problems
There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are going to have trouble paying that debt. If the banks have to mark down the debt to what its real value is – or to what it will soon be – they will be bankrupt on a scale that makes 2008 look like a waltz in the park.
Countries simply cannot function in a manner that can be called normal without viable banking systems, which is why the authorities spend so much time worrying about them. If banks can't make loans, then businesses must cut back, which means fewer jobs, products, and services, which quickly becomes an ugly spiral. Losses in the private sector mount up. This obliges the treasury secretary to get on one knee and beg some elected official who has no understanding of how business and economics work to save the world as he knows it.
But if countries must step in and save their banks, then they have to assume some of the losses. (I am assuming that this time shareholders get completely wiped out, as do most bondholders. Taxpayers – read voters –are actually paying attention this time. They are in no mood to bail out bankers.) But most of the countries in Europe with the worst banks simply do not have the money to invest. They already have too much debt. Where do they get the capital? (More on that later.)
For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: "If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved." They have now arrived at the understanding that it this not a short-term problem. Rather, it's a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.
But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.
Greece runs a trade deficit of about 10% of GDP. Until they can stop that bleeding, they cannot get their government and private budgets under control. It is not simply a matter of cutting budgets or raising taxes. Indeed, their economy will continue to shrink, making it more difficult buy foreign goods without increasing their own production of goods and services. It is a vicious spiral. And that same spiral will spin up to take in all of Europe. Again, more on that later, as we consider what their choices are.
But for now, let's start with my contention that if you do not solve all three problems you do not solve the real problem. Greece cannot "stand on its own" without a change in its cost of production relative to Northern Europe. Neither can Portugal, et al., unless Germany either changes how it exports and consumes more, or Germany is willing to fund Greek (and Portuguese and Italian and…) debt, so those countries can continue to run large deficits. Let's resort to something I have done in the past, and that is to create a simple model to help us understand the issues involved. As always, when we make simple assumptions we are ignoring the real complexities. I know things are vastly more complicated than the following simple analogies, but the underlying truths are basically the same.
Getting Simple About Europe
Let's assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public's benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.
But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP.
That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country's economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy.
But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows. And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP. (Yes, I know that debt must change as a percentage over time and nothing is stagnant, but work with me here.)
Now debt-to-GDP is rising by about 5% a year. Not a large number in the grand scheme of things, and everyone knows that the recession will soon be over and the deficits will come down. Sovereign governments never default on their debts – our government leaders assure us of that. They can always raise taxes or cut spending, can't they?
And things rock along just fine, and the bond market continues to buy the debt, until one day you look up and the debt is 120% of GDP. Then the bond market gets nervous and says that instead of 4% it wants 7%. Now the interest payments are over 8% of GDP and 16% of government spending, which means the government must either cut back on services or salaries or benefits, or raise taxes, or borrow more money. But cutting spending and raising taxes have consequences. They reduce GDP growth over the following 4-5 quarters as the economy adjusts.
What if that interest rate cost rose to 10%? Then the interest cost to the government would become 20% of its expenses and be rising faster than the country could grow, even in the best of times. And if they continued to borrow at 7% and the country did not grow, those interest expenses would rise at least 7% a year – as long as interest rates didn't go up.
And what if the other countries who had been buying the government's debt looked at the basic math and realized that, another step or two down the current path of government spending, there was no way they would be able to get their money back?
How Much Risk Do You Want in a Government Bond?
Now, government bond investors are a curious breed. They invest in government bonds because they actually think there is not supposed to be any risk. They want their money to be safe. If they wanted risk, there are lots of opportunities to invest with the potential for more reward.
The moment that government bond investors begin to think they might be at risk, they leave. And history suggests they tend to leave seemingly all at once. It is the Bang! moment. Someone fires the starting gun, and they all head for the exits. They start selling their bonds to speculators at discounts, which makes the effective interest rates in the market rise, sometimes by a lot. That means that if a country wants to borrow more money, it will have to pay the effective price in the market, or maybe as much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which of course makes it even more difficult to pay their debt as interest costs rise.
Now, let's add a twist. The other countries that have bought those bonds are not actually countries, but banks in other countries. And because the regulators of those banks knew it was impossible – inconceivable – that a sovereign country might default, they allowed their banks to buy 30 times as much sovereign debt as they had capital in their banks. They did not have to reserve against any losses, so these were "free" profits for the banks. You pay 2% on deposits or short term commercial paper and buy bonds paying at 4%. You make a 2% spread, which you then do 30 times. Now you are making 60% profits on your capital and deposits. It is a very nice business – as long as everyone pays the interest. And because it is such a good business, you just roll over the debt every time the bond comes due, because you want more easy profits.
Let's say that banks bought up to 10% of their total government sovereign-debt holdings in our problem country. If the country gets into trouble and says, we will only pay 50% of our debt (we will discuss why below), then that means the banks lose 5% of their total assets. But they only have about 3% capital, because they were allowed to leverage. That means they are functionally bankrupt.
Without a functioning banking system, other countries now have to step in and take the losses (and perhaps wipe out the shareholders and owners of their banks). That would be bad for the other countries, as that much spare cash is not just lying around in government coffers. They are ALL borrowing money already and have their own deficits to worry about.
So everyone gets together and they tell the bankrupt country (because that is what it really is), we will lend you more money to keep you alive, but you must agree to balance your budget. And since that is the only way the problem country can get more money, they initially say, "Sure. We can do that. Just give us some money now so we can get it figured out and get everything under control." In the world of government, living within your means is called austerity. And it's an uphill slog. Let's say your deficit started out at 15% of GDP (somewhat like Greece's). If you agree to cut that deficit by 4% a year for four years running, if everything stays the same, you could be back in balance. But the other counties would have to agree to lend you the difference between what you budgeted to spend and what you took in as tax revenues. Just to keep things going. Otherwise you'd have to default on your debt. If the countries simply have to guarantee the loans and not actually spend the money, it is a lot easier than having to find real money to save their banks, so they agree.
But the cuts you have to make are not as easy as everyone hoped. It seems that employees don't like having their pay cut, and unions don't want pensions cut, and retirees certainly expect the government to fulfill its promises; and don't even get started on cutting healthcare, which is a God-given right.
So you raise taxes and cut spending by about 4% the first year. But a funny thing happens. That reduces the private economy by about 4%, so the base on which taxes are collected is reduced, which means less revenue is raised, which means that the deficit is much worse than projected. And then the following year you have to make another 4% in cuts, plus the last shortfall, just to make your plan and get to the agreed-upon deficit, in order to get more loan money. It becomes a very vicious circle.
And let's look at the endgame. That debt-to-GDP ratio will rise to at least 150%, while the economy is actually shrinking. If interest rates settle to a mere 7% (hardly likely), it means the people of the country are going to have to pay over 10% of their total production to foreign banks each and every year for decades, never mind paying down the principle.
Let's throw in one more twist. The country has been buying about 10% of GDP more from other countries than it sells to them. That is because the relative wages in the problem country are about 30% higher than in the "good" countries. The good countries get the money from what they sell and have a nice surplus. The problem country soon runs through its savings, trying to buy the goods and service it wants; and the private sector, as well as the government, must cut back.
What happens is that you are locking in what feels like a depression initially, and then you have a slow- or no-growth economy for many years, as so much of your work goes just to pay back that debt to the banks of other countries.
Understand, your government has freely obligated itself to pay that debt. But it means that its citizens in effect become debt slaves for a generation or two to foreign banks. Not a very popular platform for a politician to run on for re-election.
Long-time readers know I think the neo-Keynesians do not have a proper view of the world. They live in a theoretical world divorced from what really happens. But in this respect they are deadly right. Austerity on the scale needed by many countries will only reduce potential GDP. The Keynesian prescription is to therefore run deficits and borrow money until you get growth again; but when you have already exhausted your ability to borrow money, it just doesn't work.
More debt makes if far more difficult to grow your way out of the problem. If you are already drunk, you can't get sober by drinking more whiskey. If Greece cuts its deficit by 15% of GDP, the reality is that GDP over time will be reduced by about 20%, and the debt will grow, both in real terms and as a percentage of GDP. A 20% decline in GDP is by any standard a depression and makes it even harder to grow, as so much of what you do make has to go to basic expenses and not productive capital. And if you have the burden of massive debt it becomes damn near impossible.
That is why individuals can file for personal bankruptcy. We no longer force people into slavery or debtor's prison to pay their debts, at least in most places.
So our problem country goes to its lenders and says, "We think you should share our pain. We are only going to pay you back 50% of what we owe you, and you must let us pay a 4% interest rate and pay you over a longer period. We think we can do that. Oh, and give us some more money in the meantime. And if you refuse, we won't pay you anything and you will all have a banking crisis. Thanks for everything."
The difficult is that if our problem country A gets to cut its debt by 50%, what about problem countries B, C, and D? Do they get the same deal? Why would voters in one country expect any less, if you agree to such terms for the first country? So now let's return to the real world of Europe. Greece cannot pay its debt without a major depression. So its wants to pay only 50%, but it doesn't even want to guarantee that in any meaningful way; so bondholders scream, "We get nothing in return for agreeing to take a 50% haircut?!" Which is today's headline.
Greece cannot print its own money, so unless it leaves the Eurozone, it's stuck. They can default on their debt, but that means they are shut out of the bond market for some period of time. That would force them to make the spending cuts they are now resisting, as they would simply not have enough money to pay their bills. Even with a 100% haircut they're looking at a shorter but very real depression. And because no one will sell them products they need, like energy and food and medicine, unless they can sell or trade something in return (that trade-deficit problem), they will be forced to change their lifestyles. Wages must drop or productivity rise to be competitive with northern Europe. And that differential is about 30%. I am not certain, as I have not been to Greece in a long time, but my bet is, you won't find many Greeks who think they are overpaid by 30%. But that is what the market is going to say. And that is the third problem, which Europe is not addressing. Germany and the northern tier are simply more productive than the Southern periphery. (With the possible exception of Northern Italy, but Italy all gets lumped together, which is why many Northern Italians want to be their own country and not have to pay taxes that go to Southern Italy. I am not taking sides, just observing what we read in the papers.) Until Germany consumes more from the peripheral countries or the peripheral countries become more productive, the imbalance will not allow a positive solution.
Prior to the euro, the imbalances would be handled by currency exchange rates. The value of the drachma would go down relative to the value of the deutschmark. Things would balance over time. Now, all of the eurozone countries are effectively on a gold standard, with the euro standing in for gold this time. Britain, the US, and Japan print their own currencies. Their currencies can rise or fall over long periods of time, based on national accounts and the desires of foreigners to buy goods or invest in their countries. Greece and the other peripheral countries face a difficult choice. Do we stay in the euro and pay as much as we can, and watch our economy drop; pay nothing and watch our economy drop (as we get shut out of the bond market); or leave the euro and go back to our own currency and watch our economy drop?
They have no choices that allow them to grow and prosper without first suffering (for perhaps a long time) some very real economic pain. As I have written in previous letters, leaving the eurozone has severe consequences; but the economic pain of leaving would go away sooner and allow for quicker adjustments, than if they stayed. However, the initial pain would be worse than the slow pain they'd suffer by staying in the euro. Their choice is, simply, which pain do they want – or maybe, which pain do they think they want? Because whatever they choose, they are not going to like it.
And just as I was finishing this section, this note came from Naked Capitalism:
"The three Troika inspectors—Poul Thomsen from the IMF, Mathias Morse from the EU, and Klaus Mazouch from the ECB—are supposed to head to Greece next week to inspect its books; the budget deficit is once again higher than the revised limit that Greece had vowed to abide by. And they're supposed to negotiate additional 'structural reforms.' But there probably won't be three inspectors, according to senior IMF sources. Missing: Poul Thomsen. The IMF has had enough.
"Already, according to more leaks, IMF Managing Director Christine Lagarde had warned German Chancellor Angela Merkel and French President Nicolas Sarkozy that the fiscal and economic situation in Greece had deteriorated. Hence, the 'voluntary' haircut on Greek bonds held by private sector investors should be increased to more than 50% to maintain the goal of bringing Greece's debt load down to 120% of GDP. And the second €130 billion bailout package, agreed upon on October 26, should be enlarged by 'tens of billions of euros.'
"The German reaction was immediate. 'There has to be a line somewhere,' said Michael Fuchs, deputy leader of Merkel's party, the CDU. 'This cannot be a bottomless barrel.' Even if Merkel were amenable to committing more taxpayer money to bail out Greece, she'd face a wall of opposition in her own party. And he wasn't brimming with optimism: 'I don't think that Greece, in its current condition, can be saved,' he said."
The article goes on with a description of the chaos in Greece. It is worse than I have described. Really. And so terribly sad.
As I was munching through a delicious butter chicken the other day marveling at the different flavours, the wonderful aroma and the eye pleasing richness of its colour it occurred to me that if you were born and lived your life in a Marxist state then you would never know what this wonderful dish tasted like.
It's ironic that someone born in Cuba - and by 'someone' I mean your average Joe and not a high party official that travels the world - could live their whole life and never know of the existence, let alone the taste, of butter chicken but a cigar aficianado in Mumbai will most likely know the flavour of a Cuban cigar.
In any state in which the government tells the citizenry what they can and cannot do, and the Marxist kind is the purest example, there is simply no driver that could ever lead to such exotic additions to the culinary landscape. The 'need' in 'to each according to their need' does not include butter chicken. How could it?
During both World Wars, as well as the Depression, rationing and food shortages led to long lines outside the local butcher or grocer. In free economies these events are rare and the fact they happened has led to much historical analysis and commentary in order to be able to avoid them again.
But in countries in which the state controls all aspects of people's lives these queues are normative. During my time in the Soviet Union I used to marvel at the length of the lines for such basics as bread, milk and meat, even in well below zero temperatures. It left an indelible impression on me and is one of the reasons that I was anti the left early in my life. In free societies queues are normally the result of the release of a new Apple product or of tickets to see the world's hottest bands.
This insular thinking leads to a xenophobic result, whether planned or otherwise, in which anything from the outside - including people, their ideas and their culture - are shut out. If you're drawing up 5 or 10 year plans then one of those things that never seems to make the list is:
[101] b) iii) Allow immigration of 500,000 Indians so that we can not only take advantage of their ideas but also go to Indian restaurants to eat yummy butter chicken.
That's assuming that you could find any Indians who wanted to emigrate, as well as anyone who could afford to pay for a restaurant meal.
Thus, the net result of planned, Marxist states is a decaying and calcifying of life due to the inhibition of new ideas from outside, free thought and individual liberty.
Free trade, underpinned by Adam Smith's 'invisible hand', has made available to consumers all around the world a vast array of quality of life improving products and services that they could otherwise never have had access to, assuming they knew they existed.
Yanis Varoufakis has been in the media a fair bit recently given his academic status, clarity of thought and expression, and Greece's prominence in discussions of the financial crisis that has beset Europe.
In this interesting interview they cover the Greek situation, Euro politics and his three pronged solution to it all.
He discusses a topic that I've been meaning to cover in greater depth, which I'll do so in a future post, and that is the concept of national dignity - a different thing to terms you often hear such as national pride or nationalism.
Update: By the way, Yanis is a self described Marxist so it's a funny, old world when the crisis is so bad that Marxists and capitalists are lying in the same bed! I guess that in WW2 many partisan groups fighting with the Allies were also Communists and the need to fight against the common enemy brought them together.
I encourage everybody to watch the following video, which provides an easy to understand overview of Europe's debt woes, how they got there and what their options are.
It really does show that the social democratic state eventually falls to bits under the increasing financial burden of the promises that the left has to make to various constituencies in order to gain power, which leads to the gigantic Ponzi scheme they've got going at present.
With Europe on the brink of financial collapse, the USA spending itself into perdition, China's manufacturing contracting and the rest of the emerging economies in various stages of expansion and contracting what can we look forward to in 2012?
Here are my predictions for 2012. Some are big, bold and brave and some are a bit obvious. We'll see how I go in a year's time.
Europe
The pressure on the banking system is now so great that it's hard to see how they can get through 2012 without some sort of financial ruction. The ECB has recently introduced a scheme in which it will lend money at around 2% to banks that are having trouble raising capital. At the same time as it has made 200 billion Euro available European banks have actually deposited 250 billion Euro with the ECB at a 0.5% rate. What does that tell you? That interbank lending is completely broken and they'd rather get near zero interest rates from the ECB than much higher rates by lending to other banks, which they don't trust. Part of the problem is that banks are not forced to mark assets to market so their balance sheets are completely false. If forced to mark to market a large number of banks would be insolvent.
Prediction 1: A number of large, well known European banks will go belly up in 2012. Their governments will engineer mergers with other banks in the same way that Lehman Bros was.
The infamous PIIGS are in even worse shape now than they were a year ago so the outlook for them is somewhat grim. Whether the technocrats that have been installed in Italy and Greece by the Euro elites can undo the rot remains to be seen. What is clear, though, is that there is a major attempt by European politicians to avoid the situation in which any country leaves, or can leave, the EU. Greece's problems are simply a matter of social and political corruption. People have come to expect an easy ride paid for by the government lavishing wages and entitlements on them that they have not earned. For its part the government has simply borrowed and borrowed - especially once it joined the EU and could borrow at the same rate as Germany - and paid off its constituents and cronies. There are no innocent parties in Greece in that regard. Spain is simply suffering from the excesses of democratic socialism taken to their logical conclusion. Government borrowing in order to pay for a plethora of social programs has really killed their economy. Youth unemployment is something like 50% and their housing market crash makes what happened in the US look like a walk in the park. Italy, on the other hand, can get its house back in order with some reasonably simple financial discipline. I was listening to John Mauldin a few weeks back and he highlighted that in France there are around 35,000 drivers (chauffeurs) for public officials in a population of 65 million. With a few million less people that number in Italy is 160,000 and that if they simply got rid of 75% of them then it would take care of 25% of their deficit. Which is pretty amazing when you think about it.
Prediction 2: No country will leave the EU in 2012.
USA
Given that it's an election year Mr Obama will pull out all stops to get re-elected including doing things that will boost his standing in the short term but hurt the United States subsequently. The Republican field of presidential contenders is probably up to the normal standard of years gone by but because we live in such difficult times people are looking for a strong Reagan-like figure and there simply isn't one there. It's odds on that Mitt Romney will take the nomination and enter what will be one of the most contentious, negative election races in US history.
The US Fed will respond to any quantitative easing by rolling out another round themselves in order to maintain an exchange rate of around 1.3 to the Euro. QE3 could happen in 2012 but it's not a prediction.
Prediction 3: In one of the closest races in US history Mr Obama will be elected to a second term.
The validity of the election result will be questionable given the Democrats' penchant for voter fraud and there may be grounds for appeal in certain electorates.
Prediction 4: Republicans won't have learned to correct the type of fraud that saw Al Franken steal his seat in Minnesota and we'll see repeats in 2012.
Prediction 5: The stock market will end 2012 up 20% so the Dow at around 14,500.
China
Chinese manufacturing is in a contraction at present due to demand for their products from Europe and the USA falling. Inflation, which has been a problem (and was exported to China from the US), is now coming under control so the government will need to look at ways of keeping their export machine going.
Prediction 6: The Chinese will re-peg the Yuan to the US dollar. This will increase their export competitiveness but will force the US to consider countermeasures in the form of quantitative easing and that will lead to an inflation problem again down the track.
Australia
Australia will continue to look like it's doing well while at the same time the foundational strength of our economy is stripped away by the most incompetent government in our history. Fair Work legislation will really bite in 2012, industrial disputes will hit a 10 year high, business investment will slow in the 2nd half due to the dual impacts of the insane Carbon Tax and Mining Tax, and the government debt will top $250B (a staggering number when you consider it was zero in 2007 and is due nearly 100% to ill-disciplined spending). The Reserve Bank will be forced to reduce interest rates in order to keep our dollar from appreciating too much against those other countries that are in the process of money printing. In an environment of rising inflation that could spell trouble for the Australian economy in 2013. All of which makes the next prediction pretty simple.
Prediction 7: The next election will be called early, probably in the last quarter of the year.
Other Comments
With many governments increasingly unable to fund themselves they will turn to the only source of funds left that they can access - pension funds. This will be a disaster, of course, but I expect that governments will force pension funds to invest a percentage of their assets - say 25% - in government bonds. If this happens then make sure you have many, many assets to fund your retirement, as you won't be able to rely on your pension maintaining its purchasing power.
Precious metals will continue their volatility in 2012. Gold is heading up and now is a good time to be buying. The current drop in prices is a result of raising cash to meet margin calls and, while there might be some slight downside still to go, I expect gold to top $2000 by year's end. Silver is a bit more problematic but I think that there's at least 10% in it and maybe more so I'll call $35 and see how I go.
Hope everyone has a terrific 2012. Remember to focus on your health and happiness first, as without that you're nothing!
Update: Prediction 8: Nothing will change in Syria. Assad will not be forced out now or anytime soon.
Update 2: Prediction 9: There's a fair chance that if any other regime is going to fall in the Middle East this year then it'll be Iran.
For the modern left John Maynard Keynes is the source of all wisdom on matters of the economy.
Keynes was no dummy and his The General Theory of Employment, Interest and Money is a major piece of work and serves as the economic bible for many economists to this day.
Being a major piece of work doesn't make it right, though. Marx was an intelligent man but still manage to bring to life The Communist Manifesto, which brought so much suffering to, especially, people in the 20th century. Like Tolkein, Marx and Keynes invented their own reality and then proceeded to solve all of the problems within it.
However, Keynes's reputation suffered a severe blow in the 1970s when major economies around the world went through a period of stagflation - the combination of high unemployment and high inflation - that Keynes said was impossible.
Due to this failure of Keynesianism, modern economists adjusted his theories and refer to themselves as "New-Keynesian", which replaced the term "Neo-Keynesian". As is the way in all branches of economics there are divergent opinions of which Krugman, Mankiw and Stiglitz are three such examples.
But how do they differ from the plain, old, vanilla Keynesian of days of yore?
Anyone who has even the shallowest understanding of economics will have heard of the term "pump priming", which comes from Keynes's theory that when economic activity slows the government can "prime the pump" by spending money to stimulate the economy.
"How does that differ from what Krugman is saying?", I hear you ask.
Here's the only real difference between Keynes and the Modern Keynesian...
Keynes believed that governments should create a fund into which surpluses would be placed when times were good so that those funds could be used when times were slow.
Saving for a rainy day, as my grandmother used to say.
Instead of using a pool of surplus funds as the source of government stimulus, Modern Keynesians use the next generation of taxpayer in the form of government deficit.
And that's all there is to it.
Modern Keynesianism is about giving the bill to your kids.
That's why Keynes has made a comeback; it provides political cover to those governments whose preference is to spend money rather than reduce in size.
Yet another example of the deep immorality of left wing policies and their ruinous effect on the world.
The United States, like the majority of Western nations, is spending itself into oblivion at worst and massive civil strife at best.
There is some good economic news. The red ink the US is swimming in is not as bad as projected in February. Yes, at $1.471 trillion, it's still huge – 10 percent of the nation's gross domestic product – but an improvement of $84 billion from earlier estimates.
But bad news still looms large. In the next fiscal year, according to the mid-season review released by the White House Office of Management and Budget (OMB) Friday, the US deficit will be $150 billion more than earlier projections. It is expected to come in at $1.416 trillion, or 9.2 percent of GDP.
The White House, which released the change in budget estimates, was careful not to overplay the changing numbers.
“These are not substantial changes and nothing we want to make too big a deal about,” said Peter Orszag, director of the OMB in a press call with reporters. “The economy remains weaker than we would like and the unemployment rate higher than we would like.”
So, how the heck much is 1.4 trillion dollars?
Is it actually possible to increase taxes on the rich and deal with the debt (assuming that there's no impact on employment or investment)?
I thought, why not simply confiscate all of the wealth that the rich have? That ought to solve all of the problems. Right?
I looked up the Forbes list of world's billionaires that are domiciled in the United States and are doing business and paying taxes there.
The richest person on the 395 name list is Bill Gates with $53B, followed by Warren Buffett with $47B and a gap back to Larry Ellinson at $28B.
Now, here's the kicker - and the sobering reality check for the soak-the-rich left - if you confiscated ALL of the wealth of these 395 people in order to fund the debt (which means it would need to be sold to overseas interests, of course, as there'd be nobody rich enough in the US to buy it anymore) then how much would you raise?
Ready?
1.328 trillion dollars.
You'd still need to find another $143B to break even for the year! And your wealth creators have now got nothing! Good luck with that...
Here's another way of looking at that $1.471 trillion deficit.
Consider the following: there are 113,146,000 households in the US, which means that in just one year each household now has an extra $13,000 added to its debt. No wonder the Congressional Budget Office describes the debt situation as unsustainable.
Competition from emerging economies in China, India and Brazil, coupled with declining birth rates, undermine the modern Western (immoral) indulgence of giving people money who haven't earned it while putting the bill onto the next generation...and the one after that...in a gigantic, populate or perish, Ponzi scheme.
2010 is a momentous year in world history, I believe, as history will mark it down as the year that the welfare state, in its current form, ended.
Every so often a study comes along that so profoundly confirms common sense and the real world that it takes one's breath away.
Zeljka Buturovic and Daniel Klein of Econ Journal Watch will make no friends on the left with the publication of the results of a 2008 Zogby poll on 'economic enlightenment'.
Who is better informed about the policy choices facing the country—liberals, conservatives or libertarians? According to a Zogby International survey that I write about in the May issue of Econ Journal Watch, the answer is unequivocal: The left flunks Econ 101.
Zogby researcher Zeljka Buturovic and I considered the 4,835 respondents' (all American adults) answers to eight survey questions about basic economics. We also asked the respondents about their political leanings: progressive/very liberal; liberal; moderate; conservative; very conservative; and libertarian.
Rather than focusing on whether respondents answered a question correctly, we instead looked at whether they answered incorrectly. A response was counted as incorrect only if it was flatly unenlightened.
Consider one of the economic propositions in the December 2008 poll: "Restrictions on housing development make housing less affordable." People were asked if they: 1) strongly agree; 2) somewhat agree; 3) somewhat disagree; 4) strongly disagree; 5) are not sure.
Basic economics acknowledges that whatever redeeming features a restriction may have, it increases the cost of production and exchange, making goods and services less affordable. There may be exceptions to the general case, but they would be atypical.
Therefore, we counted as incorrect responses of "somewhat disagree" and "strongly disagree." This treatment gives leeway for those who think the question is ambiguous or half right and half wrong. They would likely answer "not sure," which we do not count as incorrect.
In this case, percentage of conservatives answering incorrectly was 22.3%, very conservatives 17.6% and libertarians 15.7%. But the percentage of progressive/very liberals answering incorrectly was 67.6% and liberals 60.1%. The pattern was not an anomaly.
The questions were:
1) Mandatory licensing of professional services increases the prices of those services 2) Overall, the standard of living is higher today than it was 30 years ago 3) Rent control leads to housing shortages 4) A company with the largest market share is a monopoly 5) Third World workers working for American companies overseas are being exploited 6) Free trade leads to unemployment 7) Minimum wage laws raise unemployment 8) Restrictions on housing development make housing less affordable
How did the six ideological groups do overall? Here they are, best to worst, with an average number of incorrect responses from 0 to 8: Very conservative, 1.30; Libertarian, 1.38; Conservative, 1.67; Moderate, 3.67; Liberal, 4.69; Progressive/very liberal, 5.26.
Americans in the first three categories do reasonably well. But the left has trouble squaring economic thinking with their political psychology, morals and aesthetics.
To be sure, none of the eight questions specifically challenge the political sensibilities of conservatives and libertarians. Still, not all of the eight questions are tied directly to left-wing concerns about inequality and redistribution. In particular, the questions about mandatory licensing, the standard of living, the definition of monopoly, and free trade do not specifically challenge leftist sensibilities.
Yet on every question the left did much worse. On the monopoly question, the portion of progressive/very liberals answering incorrectly (31%) was more than twice that of conservatives (13%) and more than four times that of libertarians (7%). On the question about living standards, the portion of progressive/very liberals answering incorrectly (61%) was more than four times that of conservatives (13%) and almost three times that of libertarians (21%).
The survey also asked about party affiliation. Those responding Democratic averaged 4.59 incorrect answers. Republicans averaged 1.61 incorrect, and Libertarians 1.26 incorrect.
Adam Smith described political economy as "a branch of the science of a statesman or legislator." Governmental power joined with wrongheadedness is something terrible, but all too common. Realizing that many of our leaders and their constituents are economically unenlightened sheds light on the troubles that surround us.
We all have good friends on the left, people that we love, like and respect for their decency and humanity. However, we all know that when it comes to matters of economics they're dim bulbs. Their views are not only not part of the solution to the world's problems they are the root cause of most of the issues we face today. Not that the left would ever admit to that basic truth. As Dennis Prager likes to say, being on the left means never having to say you're sorry.
The full study is available here and makes great reading.
There are some interesting tables in the study. Firstly, correlation between education level and response (and they give some reasons for the results):
Here's the most amusing table in the whole study:
I must admit that I am truly astonished by the disparity in understanding of economics between the left and right. Given I got all 8 correct - they're hardly difficult - I also admit to being a bit surprised that the results weren't a lot better across all groups.
Naturally, the left will deal with this study in its usual manner: criticise the qualifications of those undertaking the research; impugn their motives for doing so; and accuse them of being in the pay of Big Left Wing Enemy du Jour. So much easier than refuting the results.
Seriously, though, wouldn't it be great if 16 year olds were taught the basics of economics so that they could answer all of these questions correctly? Perhaps the next generation of politicians would be more careful with the nation's economy than the current lot of left wing incompetents.
As an aside, it's ironic that in the West left wing governments are only ever elected when they campaign on conservative, 'responsible' economic grounds when the reality is that they really don't understand economics at all well. Once they're in power, however, the inner Keynesian pops out, they spend whatever surpluses the previous government has left and then make a good, solid attempt to spend the wealth of the next generation, and the one after that, before being turfed out amidst massive financial upheaval, as has just happened in the UK.
I'll have another post on why 2010 will be marked down in history as one of the most important years in modern history. Needless to say, ignorance of economics will be a major theme.
It goes without saying that commenting on Michael Moore's latest assault on truth actually plays into his hands by increasing the publicity he receives.
No matter, sane voices are needed to counter his distortions.
Having told lies about guns, 9/11 and the health system, Moore now takes aim at capitalism in his new falsumentary, "Capitalism: A Love Story".
Being Moore, he conflates the excesses of Wall Street with capitalism while studiously avoiding the fact that Wall Street gives more money to the Democrats than Republicans.
The film ends with:
"Capitalism is an evil, and you cannot regulate evil."
Unwittingly, Moore boils down all leftist thought into one line and in the process exposes the intellectual fantasyland the left inhabits.
How does the left explain the rise of China in recent decades? Of India? Of Brazil?
How does the left explain the fact that for the first time ever more than 50% of the world's population is defined as middle class?
Where are the examples of anything other than capitalism - sheer and naked, as in the examples of China and India - lifting hundreds of millions of people out of poverty?
If that's evil then we need more of it.
And here's a key insight that the left doesn't understand - capitalism is like gravity. It's an ever present force the effects of which operate in all societies.
It is shackled and suppressed in socialist countries, which is why they have hardly advanced themselves in the last 50-60 years.
Inhibiting capitalism is the reason that California is in such a parlous financial state in spite of all of its advantages.
Putting taxes on it is why so many state and local governments are losing their populations to other, freer jurisdictions.
Calling capitalism evil because a bunch of thieves on Wall Street co-opted government and, effectively, stole hundreds of billions of dollars from ordinary folk is the same as saying that gravity is evil for the negative effect it has on plummeting aircraft from time to time or that the sea is evil for occasionally sending a weak swimmer to a watery grave or that peanuts are evil for having a potentially fatal effect on 0.001% of the population.
I lived in the Soviet Union. I lived in backward Asian countries. I lived in Africa.
Not once did I see a local person who was as fat as Michael Moore.
Now, I'm not having a crack at Moore and his obvious battle with weight.
I'm highlighting that in non-capitalist countries Moore simply wouldn't have the opportunity to over eat. The food nazis out there might think that's a great idea but reasonable people believe that everyone should be able to make their own decisions and then live with the consequences of those decision - good or bad.
"Capitalism is evil" might go down well with the usual suspects: university professors; the mainstream media; Chavez, Castro and their ilk; America haters; and the Hollywood set, but anyone with a lick of commonsense understands it to be nonsensical.
The leading sign that Keynesian economics is alive and well are the ubiquitous references by the Obama administration, parroted by their acolytes in the media, about the effectiveness of the stimulus program and the so-called 'green shoots' that are turning the economy around.
The US, and the rest of the world, which is not devoid of Keynesian nonsense itself, will pay a heavy price for the policies currently in place.
New jobs data has been released for August showing yet another decline in employment. How will this information by spun? Probably by saying that the rate of decrease is slowing.
Consider the following from the indespensible Chart of the Day:
Today, the Labor Department reported that nonfarm payrolls (jobs) decreased by 216,000 in August. Today's chart puts that decline into perspective by comparing job losses during the current economic recession (solid red line) to that of the last recession (dashed gold line) and the average recession from 1950-2006 (dashed blue line). As today's chart illustrates, the current job market has suffered losses that are more than six times as much as average (20 months after the beginning of a recession). In fact, if this were an average recession/job loss cycle, the number of jobs would have begun to increase five months ago.
Hands up all of the people who think that this is nothing more than a normal recession?
Does anybody really think that the recession has ended, as has been trumpeted by a number of leading media commentators?
Folks, the US is not out of the woods by any stretch of the imagination.
There is another real estate shock to come in 2010 when commercial property mortgages reset, which at the very least will retard growth.
Then there is the massive issue of banks falsifying their balance sheets by not marking asset values to the market in order to stave off insolvency.
I would be surprised if the majority of banks in the US today are not technically insolvent.
The problem is that the FDIC doesn't have the funding to deal with a large scale bank collapse.
Into this environment the Obama administration wants to introduce its healthcare bill, which is nothing more than an outrageous takeover of 16% of the US economy, and cap and trade legislation, which will have no effect on global climate - ever - but will definitely transfer wealth from the ordinary, hard working, tax paying folk to enviro-scammers on Wall Street.
The healthcare debate currently raging in the United States has produced some terrific comments not least of which was when one wag asked why President Obama was trying to slam healthcare reform through Congress in 3 weeks when he took 6 months to choose a dog for his kids.
On one side of the argument are those who understand that the US provides the highest level of healthcare in the world but accept there are issues that need to be addressed.
On the other are those who think that the moral high ground is achieved through a government provided scheme, which requires tearing down the existing structure and starting again.
Organisations such as the United Nations and The Economist don't help the argument by coming up with world rankings on healthcare that show the US a long way down the list.
How can this be when it's the US that all world leaders choose to fly to when they're ill? The country that has John Hopkins, Mayo Clinic etc etc?
The answer is that these rankings heavily weight whether the healthcare is 'free', insofar as anything is when provided by the government. When health outcomes are analysed, how long people live when diagnosed with cancer, diabetes, heart disease etc the US far exceeds the rest of the world.
Quality
Time and again we are asked by proponents of Obamacare, and its predecessors, whether it is fair that only the wealthy can afford the best healthcare.
For some reason, the questioners fail to appreciate the truism that wealth means health. One only needs to compare the outcomes in Africa to any halfway advanced country to find the proof.
Here's another question. Is it fair that only the wealthy can buy $100,000 Mercedes?
If the government provided cars to everyone then do you think everyone would get a Mercedes or, perhaps, something of much, much lower quality?
If there were no wealthy people then there would be no $100,000 Mercedes.
Equally, no wealthy people means no high cost medical procedures.
The fact is that the advancement in the quality of healthcare that has come about due to the remarkable achievements of the pharmaceutical companies in the US - which are responsible for two-thirds of the world's medicines - can only occur because of the free market system that allows them to spend billions of dollars developing a single drug and getting it to market. Even the large European drug companies can only develop the solutions they do because of the sales they achieve in the US.
Make no mistake about it. Without US drug companies the world will have lower quality medical solutions going foward.
Comparisons with the rest of the world fail to take into account that the rest of the world is sponging off the US health dollar by being able to buy treatments that it couldn't afford to produce itself.
Do proponents of the government plan think that these drugs will still be developed when it's the government deciding how much will be spent?
Rationing lowers quality. It increases the length of time to receive treatment including for serious conditions.
Is it fair that people die who otherwise wouldn't simply because they can afford better healthcare but can't get access to it?
If the public option was so great then Congress wouldn't exempt itself from it.
Public kills Private
Most non-Americans don't understand how the US health insurance system works.
Here in Australia we take out insurance with our preferred insurer and to the level we desire/can afford, pay the premiums for the rest of our lives and receive an OK level of service. With our low population and large area it's not possible to make a proper comparison with other countries, as we have issue unique to Australia, as do all countries.
Most insurance in the US is provided by a person's employer. You can look up the history of how that came about but it dates back to World War II and companies' attempts to attract workers in a low unemployment environment in which salaries were fixed by the government due to the war effort.
A major issue in the US is that when someone leaves a job then they have no health insurance until they start their new job. These people who are between jobs need to take out temporary insurance until they start their new job. Bizarrely, the ten or so million of them are included in the statistics that add up to the "47 million Americans without healthcare", as do more than that many illegals. The question asked in the health insurance survey is 'Have you at any time through the year been without health insurance?' Obviously, if you've left your job and haven't taken out temporary cover, or can't afford to, then the answer is yes in spite of the fact that it might only be for a week or two.
After taking into account the fact that young people choose not to take out health insurance when they can afford to - preferring to spend their money on clothes, a car or a now upside down home mortgage - there are only 15 or so million who are in genuine need.
Better tear down the system to address the 5% of the population with a problem, then.
So how does the public option kill private health insurance?
Let's leave aside the fact that Congress has a bottomless pit of money to play with and is not going to be inclined to see it fail thus guaranteeing even further increases in spending into the future.
Consider two companies:
Acme Corporation has 1000 employees involved in the production of a very popular widget. It's a publicly listed company that turns over $150 million and makes an after tax profit of $3 million.
Acme's major competitor is Blue Sky Enterprises that, coincidentally, has 1000 employees, makes a competing product to the Acme widget, turns over $150 million and produces a profit of $3 million.
Both companies provide the same health insurance cover to their employees, sourced from the same insurance company. The insurance costs them $5,000 per person.
Now, let's say that Obamacare enters the market offering $3,000 health cover. It's not quite the same level as the $5,000 cover but people think it'll generally be OK unless you get really sick.
The management team at Acme decide to shift all of their employees from the private option to the public option. Blue Sky chooses not to.
So what happens?
After one year with this new health insurance in place, Acme has turned over the same $150 million but due to lower insurance cost has increased its profit to $5 million from $3 million (1000 employees x $2000 saving = $2 million).
Meanwhile, Blue Sky has also had a solid year, posting $150 million in sales and at the expected profit of $3 million.
See the problem?
No?
If you're an investor then which company are you going to invest in?
Obviously, Acme Corporation.
Therefore, Blue Sky Enterprises is forced to take up the public option, as well. Otherwise its competitor gains a huge advantage.
While this is all happening, private insurance companies are having to raise costs to maintain the same health cover level or reduce the level of cover to compete with the government option.
Thus, private health insurance slowly withers on the vine as more and more companies are forced into the government plan.
Who wins?
Not anybody who gets sick, that's for sure.
Medicare and Medicaid
No pro-Obamacare proponent has yet explained how the public option will not end up the financial black hole that is Medicare and Medicaid.
The following graph highlights the coming crisis, and when I use the term crisis I use it accurately:
Simple improvements are there for the taking
All Congress needs to do to make a huge improvement is the following:
Allow healthcare to be portable between health companies and across state lines. This also deals with the situation in which people develop a condition that would inhibit their ability to obtain health insurance if they changed jobs.
Implement tort reform. This is the biggest single cost in the medical system. Loser pays will stop people bringing frivilous lawsuits. Trial lawyers are the Democrat Party's second largest donor behind labour unions so don't look for this any time soon.
These two steps would allow many more Americans to afford health insurance cover.
President Obama
From President Obama the other day:
"We've got some work to do. I don't mind, by the way, being responsible. I expect to be held responsible for these issues because I'm the president," Obama said. "But I don't want the folks that created the mess -- I don't want the folks who created the mess to do a lot of talking. I want them just to get out of the way so we can clean up the mess.
"I don't mind cleaning up after them, but don't do a lot of talking," Obama said.
I wonder whether the President also includes the architects of the current financial crisis - Barney Frank, Chris Dodd, Alan Greenspan, Larry Summer and Ben Bernanke - in the list of those who should shut up and get out of the way?
Many commentators on the state of the US economy are telling us that the recession is basically over and that while there are still a few jobs to be lost it's all going to turn out alright shortly, the so-called green shoots are taking bloom so just wait and see.
These are the same economic commentators who didn't see the mess coming in the first place and they're going to be shown to be wrong again.
How does Uncle Jack know this?
Because he seems to have a better understanding of what makes up a strong economy than these supposed experts.
How does an economy grow?
People and companies make investments in new opportunities. Some of them succeed and some fail.
In order to make investments people and companies must have savings or earnings.
So how are companies' earnings going?
From Chart of the day:
Today, several companies (i.e. Ford, eBay and AT&T) reported better than expected earnings and as a result the stock market rallied on the news. While some companies have reported better than expected earnings for Q2 2009, others have struggled. Today's chart provides some perspective on the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. Today's chart illustrates how earnings are expected (38% of S&P 500 companies have reported for Q2 2009) to have declined over 98% since peaking in Q3 2007, making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.
Can someone please explain to me how the economy is going to pick up in 2010 when earnings have plummeted to their lowest level ever?
People are pointing to the improvement in housing approvals as proof the economy has turned.
All that is happening is that the bubble is being reinflated and the next time it pops it's going to be even worse than the first time around.
People are taking advantage of fantastically low interest rates and a heap of stimulus-injected cash washing around in the financial system.
Does anyone remember that the housing market is massively over supplied?
That's one of the reasons things collapsed in the first place.
When commercial real estate loans reset there's going to be another major market collapse. This is already locked in and can't be avoided.
Far from being a recovery, 2010 will be even worse than what has gone before.
