Economists in Glass Houses

By John Mauldin

Apr 07, 2015

For many economists, the chicken and egg question is, which came first, consumption or production? What drives growth? Let’s continue with our series on debt, in which I have been contrasting my views with those of Paul Krugman.

Our differences aside, what Paul and I readily agree on is that the solution to our current economic dilemma is more and higher-quality growth. There is nothing like 5–7% nominal growth to tackle a problem of too much debt. And if the real growth is 3–4%, then so much better, as employment and wages will rise as well. But what drives growth? That’s actually a complex question with multiple answers. There is simply no one magic policy that you can pursue that is sufficient in and of itself to create growth. I would think Krugman and I also would agree that the stimulation of growth requires a whole bunch of smart policies, and we would likely agree on what some of those policies should be. Our policy disagreement stems from our differing views on fundamental economic questions as opposed to any simplistic analysis of today’s numbers.

Economists in Glass Houses

Last week we looked at some of the differences between Paul’s presuppositions and mine, presuppositions that most people might think of as being more philosophical than analytical in nature. That letter generated more response than any other letter I’ve written in a very long time. Most of the comments were really very thoughtful, and I appreciate them. We’re going to look at one reply in particular, because the writer offers legitimate criticisms and asks a number of questions that I believe deserve answers – and these are questions I get everywhere I go. Let’s look at the comment from Thomas Willisch:

Hi John: There is a saying: let those who live in glass houses not throw the first stone. Does either Paul Krugman or you live in a glass house? First, it is important to understand why Paul, and others of his economic point of view, believe that taking on additional debt in the form of fiscal stimulus is desirable when the private sector is in severe economic contraction. Then we will be in position to determine whether the argument in favor of such is compelling or weak. You look to answer this question but I don't believe really so. Pointing to Paul’s supposed presuppositional preference for government or contentions about the significance of owing money to ourselves does not really answer the question.

Among others, Paul’s arguments – semi mock him as “Homo neo-keynesianis” if you wish, but please interact with the substance of his central arguments – are that the accumulation of additional debt in fiscal stimulus is an effective temporary tool to stave off a much deeper economic collapse when widespread private consumption and investment have fallen off a cliff and unemployment is skyrocketing. In times of recovery, when stimulus should be reigned in (and Paul does believe stimulus should be reigned in in these circumstances), the burden of the debt stabilizes and eventually shrinks relative to the resulting higher GDP, potentially more so than would have been the case with less aggregate debt absent the stimulus but debt measured against collapsed tax receipts and collapsed GDP. Paul lays out his arguments in chapter and verse, in books and in peer reviewed economic papers, with much greater depth and expertise than I can pretend to do in a paragraph quickly written here. In important respects your and Paul’s views overlap, for example in your mention of the value of government infrastructure spending and scientific research, both of which Paul strongly supports, yet which your Republican party constantly undermines.

On the other side of the coin, my second point is that, in order to fairly weigh whether you live in more or less of a glass house than Paul, we first must know what your policy response would have been as opposed to Paul’s in response to the collapse of the Great Recession. While criticizing Paul, you continue to not clearly articulate his own policy recommendation, here or in prior newsletters. Saying that “too much” debt is undesirable and countries tend to eventually default when debt becomes too high, while true with the caveat of properly nuanced context, is hardly explicatory enough. Nor does it weigh against the alternatives from which some course of action had to be selected. Do you believe there should have been no fiscal stimulus? What should have taken its place? For how long? Do you believe in “expansionary austerity”? Should the economy have been allowed to completely implode and unemployment skyrocket much higher than it ac tually did, in the name of letting the private sector have its just dessert?

Paul’s argument is that there is a time when government intervention is necessary in order to stave off an economic collapse brought on by the private sector, because such collapse would be enormously deeper and impoverish many more people in its wake without the government intervention the nature of which he has detailed. John, what was your prescription, so that it can be set beside Paul’s? Once your own solution to how the 2008 downturn should have been met is cogently presented, readers should study Paul for themselves, not just encounter him through the eyes of an opponent (never a good approach in any intellectual debate), and also study Richard Koo’s books on balance sheet recessions for one, then decide whose house is made of what.

The Purpose of a Central Bank

Thomas, thanks for your comments, and I appreciate you outlining Krugman’s basic views so succinctly. Let me answer your second point first, as I think doing so will lead naturally into a response to your first point. (Readers please note that this is a short answer laying out principles that I would adhere to, rather than a full treatise.)

I’ve been quite clear over the years that I believe the primary purpose of a central bank, other than its mundane purpose as a clearing house, is to provide liquidity in times of a liquidity crisis. Central banks should follow Bagehot’s rule, which can be summarized as: “Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”

A little history lesson is in order, from Kurt Schuler, writing at Alt-M:

Walter Bagehot (1826-1877) was the most famous editor of The Economist. (His last name, by the way, is pronounced “BADGE-it.”) For his wisdom on financial matters, he was dubbed “the spare chancellor,” a reference to the Chancellor of the Exchequer, the British minister of finance. His book Lombard Street (1873), named after the English equivalent of Wall Street, criticized the Bank of England for not using its powers to alleviate financial crises. Bagehot argued that the Bank’s monopoly position gave it both the responsibility and the ability to do so, and that the Bank should not conduct itself as if it were an ordinary commercial bank. For its explanation of how the Bank of England should act, Lombard Street became the foundation document of modern central banking. (Schuler)

The causes of the Great Recession were many, and there were numerous culprits.

Many, but by no means all, of the problems can be laid at the feet of government.

However, that does not answer your question as to what we should do when we find ourselves in a crisis. I believe it was entirely appropriate for the Federal Reserve to step in and provide liquidity. As odious as it was, the Fed had to bail out the banks; or, as you say, the system would have collapsed. I would have wiped out shareholders of the major insolvent banks along with investors in junior debt, rather than bail them out. Because of the peculiar situation of senior debt in US banking, it would probably have cost as much or more to wipe out those who held it as it would to simply guarantee it, and failure to cover it would have potentially posed even greater systemic risk. Still, I would have had to hold my nose while covering it. The four or five banks that would have been taken over took on 30:1 lever age with the permission of the government. Clearly that was unwise, and to bail out management and investors, let alone reward them for imprudent decisions, is not proper.

That said, a complete guarantee of bank deposits had to be made. Otherwise we would have fallen into the abyss. The insolvent banks should have been recapitalized and sold by the FDIC, just as every insolvent bank has been for the last 50 years. It is likely that the FDIC would have been forced to break up the banks into smaller pieces in order for them to be absorbed and sold. If we had done that, we would probably not now have five even larger banks posing systemic risk.

On a side note, I had a lengthy conversation a few years ago with current Speaker of the House John Boehner. It was his forcefully argued view that his big mistake was to bail out the banks and their shareholders. When asked what he would do next time, he very graphically (in his colorful style) stated that shareholders and bank management operated at their own risk.

As to whether I would favor stimulus, that is a more nuanced question. Of course we maintain a safety net for individuals and families who fall on hard times, and that commitment certainly increases the deficit significantly. Much of the other stimulus that we did provide was generally a waste. It financed current consumption but provided no longer-term value.

As you noted, I would be in favor, if it were necessary, of providing stimulus for the funding of infrastructure projects during a recession. A couple of thoughts on that process. Even though we are some two to three trillion dollars behind in maintaining our nation’s core infrastructure, there were distressingly few “shovel-ready” projects available at the time of the Great Recession. Let me think outside my conservative box for a moment and offer the following possibilities.

There is always another recession in our future; we just don’t know when it will hit.

When it does, it will in fact reduce GDP and increase unemployment. Further, we know that we need to spend several trillion dollars on infrastructure upgrades in the coming decades. The reigning economic paradigm suggests that we need to “lean against” a recession by spending money. If that is the case, then let’s at least spend the money to get something that will be useful to our kids, since, when they grow up to be taxpayers, they will be paying part of that money back.

I would suggest that Congress today allocate $250 million (or whatever makes sense) of matching funds for infrastructure planning projects. Cities, counties, and states could access these funds for the planning required to refurbish their infrastructure: water systems, power grids, bridges, roads, etc. Then, when we do in fact hit the next recession, there will be an adequate number of shovel-ready projects. Congress can decide how much to allocate to implement those projects and determine what projects should take priority. Congress can even authorize the Federal Reserve to use quantitative easing if it so desires to help fund the projects.

Any such projects could be financed at low rates for 40 years and would require the borrowing entities to pay off the bonds during those 40 years. Congressional approval for such bonds should require a 60% supermajority. (For the record, Thomas, I’m in favor of a balanced-budget amendment that would require 60% supermajority approval to run a deficit. I would also like to see an amendment that would require a 60% supermajority to raise taxes.)

The Keynesian Conundrum

And that brings us to what I call the “Keynesian Conundrum,” which is at the heart of your first question. John Keynes suggested running deficits in times of recession but also advocated paying down that debt after a recession is over. I could get my head around that if I could ever get someone on the Keynesian side to say when exactly it is time to pay the debt back. Mr. Krugman, while giving lip service to paying the debt back, never actually articulates what that process would look like. To pay the debt back, you have to run surpluses or, at a very minimum, run deficits that are less than nominal GDP, so that the debt relative to the size of GDP is reduced.

I want to express a large quibble. People are constantly writing me and talking about “your Republicans” doing this or that as if somehow or another I approve of all things done by Republican officeholders. Let me state once again that I believe that what the second Bush administration did was categorically, unequivocally, emphatically wrong. We wasted the budget compromise of the Clinton/Gingrich years, which was actually paying down the debt. If we had continued to hold the line on spending, we would have gone into the Great Recession with very little debt, and a stimulus of a few trillion dollars here or there would not have done much damage. We have now run up a truly massive debt; and if we were to run into another recession, the felt need would be to run up even more debt, well past the 100% of GDP range.

We are not now in recession, yet Krugman argues that to hold the line on spending is somehow a resumption of what he calls austerity. I call it living with a budget.

Running a surplus certainly did not hurt the economy during the late ’90s. We had a recession in the 2000s because of a stock market bubble collapsing. That collapse was compounded by 9/11. That recession had nothing to do with budget surpluses or “austerity.” If the United States were now to freeze spending for a few years, we would once again be back in balance. There is nothing austere about the size of our federal government.

Yes, the deficits have been coming down, and that is a good thing. But that misses the point. We could have easily afforded the deficit spending we incurred during the Great Recession if we had gone into the recession with little or no debt. There has to be some type of disciplined process to keep a country from accumulating too much debt. Generally, the process is the market itself, which begins to ask for higher interest rates for perceived risk. Of course the United States could run more debt than any other country, because we are not perceived as being a risk. But just because we can run up a large debt doesn’t mean we should.

As the McKinsey report I cited last week demonstrates and a large body of other research confirms, outsized debt at some point becomes a drag on growth. Just because we aren’t there yet doesn’t mean it’s okay to pile up debt until we stop growing.

At a certain size relative to the ability to pay, debt is like a black hole. If it gets too big, it sucks in everything around it.

What Drives Growth?

“High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions.”

– The McKinsey Institute, “Debt and (not much) deleveraging

In very simplistic terms, Keynesians today assume that consumption is the driver of the economy. For them, it is all about empowering the consumer, even if consumption is driven by debt, whether the debt is absorbed by individuals or created (more preferably in their view) by the government.

Thus, they perceive that the remedy to a recession is to run deficits in order to increase consumption, which will stimulate production, which will create jobs.

On the other side of the economic fence, “Austrian” economist Friedrich Hayek asserted that it is actually production that stimulates the economy and drives consumption. An entrepreneur sees a need and figures out a way to fulfill that need.

It may even be a need that no one realizes they have until they see the product that addresses it. For Hayek it is production that sets the wheels of the economy spinning, and increased production comes about because of innovation and free capital markets. Economic cause and effect become far more complicated than that very quickly as you drill down into actual history and real data. Schumpeter took our understanding further with his research on creative destruction and the process of competition.

The next graph shows the rise of global economic growth in recent centuries, and the following one depicts per capita GDP in certain Asian countries compared to the US. I don’t think there’s any dispute that it was not an increase in government spending or consumption but rather it was innovation and enhanced production that drove the remarkable growth of GDP that we’ve seen in the last 250 years.

Niall Ferguson ascribes that growth to what he calls the “six killer apps of prosperity”:

1. competition
2. the scientific revolution
3. property rights
4. modern medicine
5. the consumer society
6. the work ethic

(You can see his quite revolutionary and unsettling Ted talk here.)

Ferguson’s first app is competition. You asked me if I believe in “expansionary austerity.” I guess we have to lay out definitions. I’ve already said that we do not need budget deficits in order to create an expansion in GDP. What is being tried in Europe (and is ridiculed as expansionary austerity), has nothing to do with expansion and everything to do with dealing with debt.

Austerity didn’t work in Greece not because they didn’t spend enough money but because the country itself is riddled with impediments to competition. Government has locked in numerous duopolies and erects all kinds of impediments in the way of launching new businesses. Greece is the ultimate in crony capitalism. Further, government direct participation is a huge drag on the economy. Greece has one of the most inefficient governments in the developed world. When I was there a few years ago, literally half of the country’s workers simply did no work; they just took checks as cogs in a system where politicians procured jobs for friends and relatives as favors for their votes and financial support. Taxes aren’t collected, books aren’t balanced – I could go on and on, but the incompetence of Greek government is legendary. Borrowing more money to spend on such inefficiency does nothing to increase GDP.

There will be no economic renaissance in Greece (or in any part of peripheral Europe for that matter) unless there are true labor reforms, a radical reorganization of the government, a complete overhaul of the regulatory environment, and an end to allowing government to favor certain businesses. Growth comes in very great part from innovative, competitive private production, but government can inhibit the environment for the growing of new businesses, which are the wellspring of growth. Eurozone rules and regulations stifle growth at every turn.

I could go on and on about Greece, but running large budget deficits will not solve their problems. The irony is that the majority of Greeks believe in the need for reform (a common belief in Europe). The Greeks are an inherently entrepreneurial people; it’s just that their entrepreneurs have migrated to other countries (to the great benefit of America and the rest of the world). Now, the Greeks want the rest of Europe to continue to lend them money that cannot be paid back so they can maintain their lifestyles without having to reform their economy. Yes, they offer token reforms but nothing that gets to the real issues. And the rest of Europe doesn’t want to press them too much on the real issues because they have the same problems in their own countries.

It does no good to balance a budget when competition and productivity are not allowed to flourish. For that matter it does no good to run a deficit under the same conditions, because eventually you will pile up an unsustainable amount of debt.

Sad to say, but much of Europe is well and truly hosed (a technical economics term) until they reform their labor markets and regulatory environment. The Greek crisis is just the opening act in what will be a long-running and intensifying drama.

Since you want to know what policies I would like to see enacted, Thomas, I can tell you that I am working on a short op-ed-type essay with Steve Moore (formerly of the Wall Street Journal and now with the Heritage Foundation), outlining a specific set of guidelines for serious reform of the regulatory process (across all industries and services), a radical restructuring of the tax code, and an overhaul of the bureaucracy. We have allowed our economy to be overwhelmed by a mishmash of bureaucratic policies, almost every one of which some interest group will push hard to keep. There will be something in our essay that is guaranteed to upset nearly everyone.

When GDP figures come out in a month, we’re going to learn that the first quarter was weak. I wrote last year, as oil prices were collapsing, that they would have a significant impact on the growth of the US economy. Without the growth that has comes from the revolution in US oil production, our GDP in the first half of this decade would have looked more like that of Europe. Now, with oil prices in the dumps, we’re about to find out how true that is.

This last chart is one of the most alarming I’ve seen in years. It’s from a May 2014 study by the Brookings Institution. The authors found declining business dynamism across all regions and states. It is difficult to imagine sustained economic growth if this trend is not reversed.          

It’s time to close out this week’s look at debt, but before I hit the send button I want to talk about a very special friend and a powerful new book I’m reading.

The Last Warrior

Remember those picture problems we had to solve when we were in elementary school? They would give us six pictures and ask us, which one doesn’t belong? I often feel like that odd picture, out of place but still on the page. There are moments when I feel like I’m really living in a dream, that I will wake up and find myself back in some mundane existence. Lately (in the past few years) I have often found myself in the company of truly extraordinary people and later wondered why I have been privileged to be there.

A few weeks ago I was invited to a small reception in Washington DC for Andrew Marshall. Andy Marshall, 93½ years old, was director of the United States Department of Defense's Office of Net Assessment, the Pentagon’s internal think tank, under 12 defense secretaries and 8 administrations. Appointed to the position in 1973 by President Richard Nixon, Marshall was reappointed by every president that followed.

He is the longest-serving and oldest federal employee in history.

The reception was to honor him on his recent retirement. To say that he has been the most influential person in US defense and intelligence thinking in the last 50 years is no exaggeration. It is almost impossible to overstate his influence. He was at the heart of US nuclear strategy in the ’50s and ’60s and was the first to recognize that the CIA assessment of Russia was incorrect in the mid-’70s. He developed the concept of “net assessment,” and Nixon created an office in the Pentagon just for him to pursue that work. In the late ’80s, as we were still faced off with Russia (which is the stance he had urged in the ’70s), he began to beat the drum that China would be our chief preoccupation in the next decade.

In the ’80s he was beginning to talk about the need to shift to precision warfare. He saw that need before any of the generals did, as he has almost every other shift in weaponry. He was on top of everything. His sources were legendary. He is one of the most amazing futurists on the planet. He truly seems to possess the ability to tease out significant insights regarding the future direction not just of defense systems but also of markets and national trends from seemingly unrelated data. The Russians were obsessed with his thinking. Even the Chinese have officially recognized that he was “one of the most important and influential figures” in changing their thinking about defense in the 1990s and 2000s.

He has served both Republican and Democratic administrations, quietly and in the background. The strong odds are that you have never heard of him. But, no matter where you live in the world, you have been influenced by his thinking. And you have heard of the names of those who went to school at what is called “St. Andrews Prep.”

As recently as 2012, Foreign Policy named Marshall among its “Top 100 Global Thinkers,” “for thinking way, way outside the Pentagon box.” Try being named a top global thinker at any time in your life, let alone at age 90 years.

I looked around the room at the reception and saw a lot of faces I recognized. Some were from the two weeklong summer events I participated in at the Naval War College, where we debated and theorized with Andy Marshall about possible contingent events that might happen to the United States in the future and how the country should prepare for the occurrence of non-consensus events.

As people were later introduced, though, I realized that I recognized only those associated with Republican administrations. Talk about a personal bias – there were probably as many people in attendance from Democratic administrations.

I recognized Vice-President Cheney, Paul Wolfowitz, and various secretaries, deputy secretaries, assistant secretaries, and deputy assistant secretaries of the Defense Department. As I was talking with Mr. Wolfowitz, he introduced me to Scooter Libby, whom I did not recognize, I’m embarrassed to say. Libby is a man who was as unjustly persecuted as any man in the history of this country, in my humble opinion. They couldn’t get to Cheney, so they went after Scooter for very obscure and who-gives-a-damn reasons. Collateral damage and all that. I hate that partisan bullshit, no matter which side shovels it on.

Andy Marshall, however, didn’t care what your politics were; he just wanted you to think about what was best for the country.

I’ve often been somewhat puzzled as to why Mr. Marshall invited me into his coterie. We initially met at two three-hour-long discussion groups where he listened to a number of economists and well-known money managers talk about the future of the world. Most were names you would recognize. I’m certainly not a name-brand economist, nor can I even rightly be called an economist – I’m more of a dilettante – but I got invited back for private meetings and then to additional meetings and to the weeks at the War College.

At the reception, one of the secretaries of defense, in noting the rather odd nature of the gathered group, said that Andy’s unique talent was in pulling together people with eclectic, if not downright eccentric,  thinking. There was a rather knowing laugh as everyone looked around and realized that the word eccentric defined those people in attendance they knew and maybe even themselves. Some of us were the people who helped Andy uncover obscure and counterintuitive facts and trends, and others were those he trained to use them in making assessments and charting strategy.

The next morning, Andy invited me to come by his apartment in Alexandria for a chat. Honored, I adjusted travel times and showed up on time. He started the conversation by reminding me that I had at one time asked him how he came to question the consensus thinking about the Soviet Union in the ’70s. He then proceeded to give me a tutorial on how to question orthodox thinking. His own investigation gave him facts that didn’t square with CIA thinking. “How did you know that?” I would ask. He would explain, and then like some five-year-old kid I would ask that question again and again, trying to understand how he came to the next insight. We kept deep diving until it became apparent that he was looking at some of the most obscure references and piecing together bits and pieces of information to complete a picture that nobody else saw. He referenced obscure German publications, interviews with the sons of Russian diplomats, and conversations with major and minor Russian leaders. He would commission studies of what it actually cost the Russians to build particular pieces of gear. For instance, Russian ferries were also designed as troop transport and military ships, with EMP-protected controls. That configuration drove the cost up and was not part of the CIA assessment. As it turned out, there was a lot the CIA missed. The actual cost of Soviet defense was double what the CIA thought. And the consensus Soviet GDP that not only the CIA but everybody else was operating by was actually 30 to 40% too high. Thus, in the mid-’70s Andy and then Secretary of Defense James Schlesinger began to realize that the Russians could not afford to keep up their massive defense spending.

“Aaah,” I said, “then you passed that information on to Reagan.” “No,” he said, “Reagan came to that conclusion on his own.” “Really?” I questioned. We went back and forth on how a Republican governor and former actor could arrive at such a non-consensus conclusion that was absolutely, totally correct. I kept insisting that somebody had to have given him an inside view. Andy confessed that he didn’t know how Reagan came to his conclusion, other than that he came into the White House with it. Remember, Andy served under every president from Truman onward and I assume was personally acquainted with every president after Nixon. Andy then told me that Scooter Libby was doing research and developing a paper on how Reagan came to that conclusion. It is truly one of the defining moments in American history and one that has remained a complete mystery, at least to me. Maybe the answer is as simple as that it was a presupposition: communists can’t win. I really want to get an early copy of Libby’s paper.

As we were wrapping up our talk, I looked over to Andy’s desk and saw a book titled The Last Warrior: Andrew Marshall and the Shaping of Modern American Defense Strategy. “When did this come out?” I asked him. “Last month,” he said.

It was his biography, which he had finally allowed to be published after he retired. He was gracious enough to autograph a copy for me, which I will proudly display in my library; but I immediately downloaded a copy to my Surface Pro on the subway ride back to Reagan Airport and began to read it on the plane. It is not a simple biography but rather an analysis of the intellectual journey of a man who came of age in the ’40s and who learned to question orthodox thinking in a manner that nobody had done before. He literally invented new forms of analysis. The book is causing me to rethink my approach to analyzing data and how it impacts our view of the future. It is a total mental reset. I’m going to have to make another trip to Washington DC for a few follow-up questions.

For the record, the title The Last Warrior is not a description of Andy’s personality, which is as decidedly low-key and non-combative as that of any person I’ve met. He is truly an analytical thinker with a quiet, thoughtful demeanor. I don’t think of the word warrior when I think of Andy. But he was part of what Tom Brokaw called “the Greatest Generation,” and at almost 94 he is truly one of the Last Warriors. Even today, he still goes in to the office a few days a week. I am honored to call him friend.
San Diego, Raleigh, and Atlanta

I am home for the next few weeks, except for some short personal one-day trips, getting a new speech ready for the Strategic Investment Conference at the end of the month. Then later in May I will do a speech at the Investors Institute in Raleigh before going to a Galectin Therapeutics board meeting in Atlanta. Right now there is a potential for a few days in New York City before I head up to Maine in early June for another presentation.

I was greatly saddened to get the news last night that my friend Kiron Sarkar passed away while he was visiting his home in India. I have used his work frequently in this letter and Over My Shoulder and have been corresponding with him several times a week for the past few years on various aspects of markets and investments. He was wise counsel and always a source of great insights. He will be missed.

It is time to hit the send button. I hope your week is going well.

Your wondering if I can work till I’m 93 analyst,

Central Banks, Credit Expansion, and the Importance of Being Impatient

John Mauldin

Apr 03, 2015

We live in a time of unprecedented financial repression. As I have continued writing about this, I have become increasingly angry about the fact that central banks almost everywhere have decided to address the economic woes of the world by driving down the returns on the savings of those who can least afford it – retirees and pensioners.

This week’s Outside the Box, from my good friend Chris Whalen of Kroll Bond Rating Agency, goes farther and outlines how a low-interest-rate and massive QE environment is also destructive of other parts of the economy. Counterintuitively, the policies pursued by central banks are actually driving the deflationary environment rather than fighting it.

This is a short but very powerful Outside the Box. And to further Chris’s point I want to share with you a graph that he sent me, from a later essay he wrote. It shows that the cost of funds for US banks has dropped over $100 billion since the financial crisis, but their net interest income is almost exactly the same. What changed? Banks are now paying you and me and businesses $100 billion less. The Fed’s interest-rate policy has meant a great deal less income for US savers.
It is of the highest irony that Keynesians wanted to launch a QE policy that would increase the value of financial assets (like stocks), which they claimed would produce a wealth effect. I made fun of this policy some five years ago by calling it “trickle-down monetary policy.” Subsequent research has verified that there is no wealth effect from QE. Well, it did make our stocks go up, on the backs of savers.

We’ve transferred interest income from savers into the stock market. We’ve made retirement far riskier for our older pensioners than it should be. 

As Chris writes: 

Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries [brokers, investment advisors and managers of pension funds and annuities] to meet the beneficiaries’ future investment return target needs through the prudent buying of securities.

Everywhere I go I talk with investment advisors and brokers who are scratching their heads trying to figure out how to create retirement portfolios that provide sufficient income without significantly moving out the risk curve at precisely the wrong time in their client’s lives. It is a conundrum that has been made for more difficult by Federal Reserve policy.

Economics Professor Larry Kotlikoff (Boston University) and our mutual friend syndicated financial columnist Scott Burns came by to visit me last week. I have talked with Larry on and off over the last few years, and Scott and I go back literally decades. A few years ago, Scott and Larry wrote a very good book called The Clash of Generations. Now, Larry has branched off on his own and written a really powerful manual on Social Security called Get What's Yours: The Secrets to Maxing Out Your Social Security.

I will admit I have not paid much attention to Social Security. I just assumed I should start mine when I’m 70, as so many columns I have read suggested. Larry and I recently spent an hour discussing the Social Security system (or perhaps it would be better to call it the Social Security Maze). Three thousand pages of law and tens of thousands of regulations and so many nuances and “gotchas” that it is really difficult to understand what might be best in your particular circumstances. Larry asked me questions for about two minutes and then proceeded to make me $40,000 over the next five years. It turns out I qualify for an obscure (at least to me) regulation that allows me to get some Social Security income for four years prior to turning 70 without affecting my post-70 benefits. There are scores of such obscure rules.

Larry says it is more often the case than not that he can sit down with somebody and make them more money than they thought they were going to get. As one reviewer says:

This book is necessary for three reasons: Social Security is not intuitive, and sometimes makes no sense at all. Two, Americans act against their best interests, leaving all kinds of money on the table. Three, there is usually a “however” with Social Security rules. Worse, Social Security is now up to three million requests every week, but Congress keeps cutting back budget, staff, hours and whole offices. Combine that with the complexity factor, and the authors conclude you cannot trust what Social Security advises. Great.

If you or your parents are on Social Security or you are approaching “that age,” you really should get this book. Did you know that if you are divorced you can get a check for half of your former spouse’s Social Security income without affecting their income at all? But you can’t know whether this is a good strategy unless you look at other options.

How many retirees or those nearing retirement know about such Social Security options as file and suspend (apply for benefits and then don’t take them)? Or start stop start (start benefits, stop them, then restart them)? Or– just as important – when and how to use these techniques?
Get What’s Yours covers the most frequent benefit scenarios faced by married retired couples, by divorced retirees, by widows and widowers, among others. It explains what to do if you’re a retired parent of dependent children, disabled, or an eligible beneficiary who continues to work, and how to plan wisely before retirement. It addresses the tax consequences of your choices, as well as the financial implications for other investments.

The book is written in Larry’s usual easy-to-read style, and you can jump to the sections that might be most relevant to you. The book is $11 on Kindle and under $15 at Amazon. This might be some of the better financial advice that you get from reading my letter: go get a copy of Get What’s Yours.

I can’t guarantee it will make you $40,000 in five minutes, but it can show you how to navigate the system. Larry also has a website with some inexpensive software to help you maximize your own Social Security. Seeing as how Social Security is the largest source of income for most US retirees, this is something everyone should pay attention to.

It is time to hit the send button. Quickly, we finalized the agenda for the 2015 Strategic Investment Conference. You can see it by clicking on the link. Then go ahead and register before the price goes up. This really is the best economic conference that I know of anywhere this year.

Your wondering how long they’ll pay me Social Security analyst,

John Mauldin, Editor
Outside the Box

Central Banks, Credit Expansion, and the Importance of Being Impatient

This research note is based on the presentation given by Christopher Whalen, Kroll Bond Rating Agency (KBRA) Senior Managing Director and Head of Research, at the Banque de France on Monday, March 23, 2015, for an event organized by the Global Interdependence Center (GIC) entitled New Policies for the Post Crisis Era.” KBRA is pleased to be a sponsor of the GIC.


Investors are keenly focused on the Federal Open Market Committee (FOMC) to see whether the U.S. central bank is prepared to raise interest rates later this year – or next. The attention of the markets has been focused on a single word, “patience,” which has been a key indicator of whether the Fed is going to shift policy after nearly 15 years of maintaining extraordinarily low interest rates. This week, the Fed dropped the word “patience” from its written policy guidance, but KBRA does not believe that the rhetorical change will be meaningful to fixed income investors. We do not expect that the Fed will attempt to raise interest rates for the balance of 2015.

This long anticipated shift in policy guidance by the Fed comes even as interest rates in the EU are negative and the European Central Bank has begun to buy securities in open market operations mimicking those conducted by the FOMC over the past several years. Investors and markets need to appreciate that, regardless of what the FOMC decides this month or next, the global economy continues to suffer from the effects of the financial excesses of the 2000s.

The decision by the ECB to finally begin U.S. style “quantitative easing” (QE) almost eight years after the start of the subprime financial crisis in 2007 speaks directly to the failure of policy to address both the causes and the terrible effects of the financial crisis. Consider several points:

  • QE by the ECB must be seen in the context of a decade long period of abnormally low interest rates. U.S. interest rate policy has been essentially unchanged since 2001, when interest rates were cut following the 9/11 attack. The addition of QE 1-3 was an effort at further monetary stimulus beyond zero interest rate policy (ZIRP) meant to boost asset prices and thereby change investor tolerance for risk.
  • QE makes sense only from a Keynesian/socialist perspective, however, and ignores the long-term cost of low interest rate policies to individual investors and financial institutions. Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries to meet the beneficiaries’ future investment return target needs through the prudent buying of securities. (See John Dizard, “Embrace the contradictions of QE and sell all the good stuff,” Financial Times, March 14, 2015.)
  • The downside of QE in the U.S. and EU is that it does not address the core problems of hidden off- balance sheet debt that caused the massive “run on liquidity” in 2008. That is, banks and markets in the U.S. globally face tens of trillions of dollars in "off-balance sheet" debt that has not been resolved. The bad debt which is visible on the books of U.S. and EU banks is also a burden in the sense that bank managers know that it must eventually be resolved. Whether we talk of loans by German banks to Greece or home equity loans in the U.S. for homes that are underwater on the first mortgage, bad debt is a drag on economic growth.
  • Despite the fact that many of these debts are uncollectible, governments in the U.S. and EU refuse to restructure because doing so implies capital losses for banks and further expenses for cash- strapped governments. In effect, the Fed and ECB have decided to address the issue of debt by slowly confiscating value from investors via negative rates, this because the fiscal authorities in the respective industrial nations cannot or will not address the problem directly.
  • ZIRP and QE as practiced by the Fed and ECB are not boosting, but instead depressing, private sector economic activity. By using bank reserves to acquire government and agency securities, the FOMC has actually been retarding private economic growth, even while pushing up the prices of financial assets around the world.
  • ZIRP has reduced the cost of funds for the $15 trillion asset U.S. banking system from roughly half a trillion dollars annually to less than $50 billion in 2014. This decrease in the interest expense for banks comes directly out of the pockets of savers and financial institutions. While the Fed pays banks 25bp for their reserve deposits, the remaining spread earned on the Fed’s massive securities portfolio is transferred to the U.S. Treasury – a policy that does nothing to support credit creation or growth. The income taken from bond investors due to ZIRP and QE is far larger.
  • No matter how low interest rates go and how much debt central banks buy, the fact of financial repression where savers are penalized to advantage debtors has an overall deflationary impact on the global economy. Without a commensurate increase in national income, the elevated asset prices resulting from ZIRP and QE cannot be validated and sustained. Thus with the end of QE in the U.S. and the possibility of higher interest rates, global investors face the decline of valuations for both debt and equity securities.
  • In opposition to the intended goal of low interest rate and QE policies, we also have a regressive framework of regulations and higher bank capital requirements via Basel III and other policies that are actually limiting the leverage of the global financial system. The fact that banks cannot or will not lend to many parts of society because of harsh new financial regulations only exacerbates the impact of financial repression. Thus we take income from savers to advantage debtors, while limiting credit to society as a whole. Only large private corporations and government sponsored enterprises with access to equally large banks and global capital markets are able to function and grow in this environment.

So what is to be done? KBRA believes that the FOMC and policy makers in the U.S. and EU need to refocus their efforts on first addressing the issue of excessive debt and secondly rebalancing fiscal policies so as to boost private sector economic activity. Low or even negative interest rate policies which punish savers in order to pretend that bad debts are actually good are only making things worse and accelerate global deflation. Around the globe, nations from China to Brazil and Greece are all feeling the adverse effects of excessive debt and the related decline in commodity prices and overall economic activity. This decline, in turn, is being felt via lower prices for both commodities and traded goods – that is, deflation.

In the U.S., sectors such as housing and energy, the effects of weak consumer activity and oversupply are combining into a perfect storm of deflation. For example, The Atlanta Fed forecast for real GDP has been falling steadily as the underlying Blue Chip economic forecasts have also declined. The drop in capital expenditures related to oil and gas have resulted in a sharp decline in related economic activity and employment. Falling prices for oil and other key industrial commodities, weak private sector credit creation, falling transaction volumes in the U.S. housing sector, and other macroeconomic indicators all suggest that economic growth remains quite fragile.

To deal with this dangerous situation, the FOMC should move to gradually increase interest rates to restore cash flow to the financial system, following the famous dictum of Adam Smith that the “Great Wheel” of circulation is the means by which the flow of goods and services moves through the economy:

“The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them” (Smith 1811: 202).

Increased regulation and a decrease in the effective leverage in many sectors of banking and commerce have contributed to a slowing of credit creation and economic activity overall. And most importantly, the issue of unresolved debt, on and off balance sheet, remains a dead weight retarding economic growth. For this reason, KBRA believes that investors ought to become impatient with policy makers and encourage new approaches to boosting economic growth. 

04/03/2015 06:28 PM

Proxy War in Yemen

Saudi Arabia and Iran Vie for Regional Supremacy

By Dieter Bednarz, Christoph Reuter and Bernhard Zand

A Saudi Arabia-led coalition continues to bombard Yemen in an effort to stop the advance of an Iran-backed Shiite militia there. The conflict is becoming a proxy war for regional supremacy. The risks to the House of Saud are great.

On recent evenings, as Western foreign ministers negotiated fervently with the Iranian leadership in Lausanne, Switzerland, two young women in the Yemeni capital of Saana spent their time gazing fearfully into the darkening night sky. Nina Aqlan, a well-known civil rights activist, and her friend Ranim were on the lookout for Saudi Arabian fighter jets. Ranim was staying with Aqlan because her own apartment stands next to the headquarters of the Political Security Organization, Yemen's domestic intelligence agency. The building is considered a potential target for the Saudis and their allies.

"In the beginning, we thought they might bomb us for one or two nights. But it keeps getting worse!" says Ranim. In the background, the thump of the anti-aircraft batteries can be heard, occasionally interrupted by the thundering explosions of bomb detonations. Sometimes, the attacks last from early evening to midnight, they say over a Skype connection that repeatedly crashes. At other times, the bombing begins later and only ends at dawn.

The nightly strikes come as a Saudi Arabia-led, largely Sunni coalition consisting of nine countries seeks to push back Iranian-backed rebels in Yemen. Coalition jets have struck military bases and intelligence agency headquarters, but also a cement factory, a dairy and a refugee camp. By Thursday, the death toll from the bombings, which began one week ago, had risen to over 90. "What kind of war is this?" Aqlan asks angrily. "Why is it being fought?"

There isn't a direct connection between the hostilities and the surprisingly comprehensive deal reached between the West and Iran on the country's nuclear program on Thursday night. But aside from Israel, no country views the pact with as much skepticism as Saudi Arabia. Indeed, following similar developments in Syria and Iraq, the conflict in Yemen is increasingly looking like a proxy war between Riyadh and Tehran. The two capitals are blatantly wrestling over supremacy in the region. Either Saudi Arabia, the traditional Western ally that is watching nervously as the United States slowly pulls back. Or Iran, which has been expanding its power in the region of late and which has just taken an historic step toward rapprochement with the US and its allies.

Thursday night saw Iran take another step forward. The Saudi monarchy, whose power is based on the country's vast oil reserves, were forced to watch from the sidelines in recent weeks as its historic ally America passionately pushed for a solution to the nuclear conflict with Iran.

The deal was announced late on Thursday by Iranian Foreign Minister Javad Zarif and European Union foreign policy chief Federica Mogherini -- and means that Iran has now moved a bit closer to the West and, first and foremost, to the US.

Aiming at Its Ideological Rival

The Saudi military coalition began its intervention in Yemen in the name of security. But after just a week, it has become clear that the top priority of the alliance is not that of creating a balance of power between the two adversarial camps in the Yemen conflict -- which pits Shiite Houthi rebels, who have joined together with former Yemeni President Ali Abdullah Saleh (who was ousted in a 2011 "Arab Spring" uprising), against Saudi-backed government troops. Indeed, the conflict is more of a complicated domestic struggle than a purely sectarian fight.

Still, the Saudi monarchy's intervention is primarily aimed at its ideological rival: Iran.

At the same time, the military operation is a chance for Saudi King Salman bin Abdulaziz Al Saud to demonstrate his independence from the US -- as well as to perhaps prove his country's military leadership in the region as a complement to its longstanding economic strength.

What is clear, however, is that the brewing Sunni-Shiite struggle in the Middle East has the potential for not just destroying Yemen, but also for turning into a disaster for Saudi Arabia.

It was only last fall that Riyadh badly miscalculated in Yemen by cutting off financial aid to Hadi, who has since fled his country for the Saudi capital. The Saudi monarchy believed that Hadi, a Sunni, was being far too lenient with the Shiite Houthis, which make up a third of the population of Yemen. But Hadi had only been striving for political survival between the various fronts -- a task made all the more difficult by the return of his Shiite predecessor Saleh. Without support from Riyadh, Hadi didn't have a chance.

Even if the Iranians are confessional brothers to the Houthis and have allegedly supplied them with weapons, it is ex-president Saleh who has been the primary reason for their triumphant march through the country. It is an ironic development, given that Saleh, while in power, waged a campaign of his own against Houthi insurgents. Now, however, he has placed his old elite troops -- which he once equipped with the help of hundreds of millions of dollars from the US -- at their disposal. The troops are akin to a private army, and Saleh has a fortune of billions he can use to finance them.

One of Saleh's Dances

Saleh once compared governing in Yemen to "dancing on the heads of snakes." What is now taking place is "one of Saleh's dances," says Abdulkader Alguneid, a leader of recent protests against the Houthis in the economically important city of Taiz, located in the highlands between Sanaa and Aden. "It wasn't foreign powers from outside who took over Taiz," he says. "It was Saleh's followers, soldiers who had defected." Nevertheless, the city is now under Houthi control and it has become the jumping off point for the Shiite militia's forays to the south.

Taiz, too, has become a target for the Saudi coalition's air strikes. "They aren't just killing Houthis," says parliamentarian Abdulkader Mughales, cursing the Saudis. "One-hundred years ago they already took three provinces away from us and still today they are afraid of a strong Yemen." So far, he says, there are no Iranian fighters in the country. "But if the Saudis keep on like this, the Iranians will come and turn our homeland into a battlefield in their war."

The military operation in Yemen is a significant departure from Saudi Arabia's foreign policy tradition. Riyadh has always relied on three strategies to pursue its interests abroad. First, it used its wealth to support allied governments or groups. Second, it established a global network of clerics and Koran schools to spread the puritanical interpretation of the Koran known as Wahhabism. And third, it practiced classic diplomacy and mediation, such as leading the peace talks that ended the 15-year civil war in Lebanon in the late 1980s.

Indeed, even experts on Saudi Arabia have never quite understood why the monarchy has spent decades -- and billions -- arming itself to the extensive degree it has. But the operation in Yemen has now provided the international community with an answer to that question. It is to defend itself from instability in Yemen, a country fractured along confessional and tribal lines.

Cross-border clans in addition to a small army of migrant workers have long bound Saudi Arabia tightly with its southern neighbor. The bin Laden family, one of the most influential in Saudia Arabia, is originally from Yemen as are the mothers of some Saudi princes. For King Salman, it is a nightmare that Iran -- Saudi Arabia's long-time rival for dominance in the region -- is now instigating its confessional brothers in Yemen and seeking to bring the country into its Shiite sphere of influence.

The Coming Generational Shift

Saudi Arabia's rivalry with Iran stretches back to the time of the Shah. But Iran's growing influence in the region is not the only explanation for Riyadh's foreign policy departure. King Salman has only been in power since January, but he is old and frail. His sons and nephews are now seeking to use the conflict in Yemen to position themselves for the coming generational shift in the House of Saud. The ruling family has been further unsettled by the apparent reorientation of its once-reliable protective power, the US.

After several tense days and nights, Iranian Foreign Minister Zarif and his American counterpart John Kerry -- together with the foreign ministers of Russia, China, France, Great Britain and Germany -- finally reached a framework agreement on Thursday. If finalized, the deal will restrict the amount of uranium that can be enriched at Natanz as well as reducing the degree to which uranium may be purified there. Furthermore, the underground facility at Fordow near Qom may now only be used for research purposes. The heavy-water reactor at Arak, meanwhile, may continue operation, but only in close cooperation with the West.

In response to Western demands for oversight, Iran has furthermore agreed to sign and ratify the additional protocol of the Treaty on the Non-Proliferation of Nuclear Weapons, meaning that inspectors from the International Atomic Energy Agency (IAEA) will be granted more inspection rights. The Vienna-based IAEA has for years been demanding more information from Iran regarding the "potential military dimension" of its nuclear program.

In return, the West has agreed to a step-by-step rollback of economic sanctions, provided that Iran fulfills its end of the bargain. The details, which still harbor plenty of room for conflict and dissent, are to be hammered out by June 30.

As such, Lausanne may not have hosted a historic handshake between Kerry and Zarif, but the deal was surprisingly concrete. Indeed, after the self-imposed Wednesday night deadline for an agreement passed, it looked for a time as though Iran wasn't even prepared to issue a declaration of intent -- which would have driven US President Barack Obama into a corner.

But on Thursday, Obama stepped in front of reporters in the Rose Garden at the White House to speak of a "good deal" and an "historic" agreement. He also warned Congress against blocking it. The framework agreement with Iran is a success for Obama, on whom pressure had been mounting following a year of talks. Criticism from Republicans and from within his own party had been mounting as were demands for significant concessions from Tehran. In Iran, meanwhile, the populace has high hopes that a deal might free them of painful sanctions and lead to an economic turnaround. Iranian President Hassan Rohani even went so far as to speculate about the possible reopening of the US Embassy in Tehran.

Negotiating at Eye Level

For hardliners from the nationalist-religious wing, such a vision is akin to treason against the revolution, even if a substantial majority of Iranians see America as the land of endless opportunity and yearn for rapprochement. But it isn't the cleric Rohani who has the final say in his country's nuclear policy. Important issues -- such as those dealing with war, peace and relations with the US -- are decided by Ayatollah Ali Khamenei alone. And for the 75-year-old Khamenei, signing a far-reaching nuclear deal by the end of June would represent an unbelievable reversal. It would mark a retreat from a confrontation that provides him, as leader of the revolution, with his legitimacy.

Still, after a quarter-century in power, Khamenei has a more confident grip on power in Iran than he has in a long time. Domestically, he has managed to defeat all adversaries. And he has perhaps even, it is said in Tehran, defeated testicular or prostate cancer.

The Western viewpoint holds that the sanctions have strangled the Iranian economy, thus forcing the Tehran leadership to the negotiating table. But Iran sees things differently. There, Khamenei is viewed as a leader who has elevated Iran to a potential nuclear power against the will of the West and is now negotiating with the USA as an equal.

Khamenei has certainly fulfilled his mandate: that of expanding and exporting the revolution. In southern Lebanon, the Iran-armed militia Hezbollah represents a direct threat to Israel. In Syria, Shiite militias ensure the survival of the Iran-allied dictatorship of Bashar Assad. In Iraq, armed groups under Iranian leadership are engaged in battle against the Islamic State.

And now, with the advance of the presumably Iran-backed Houthi rebels in Yemen, Shiite influence stretches from the Mediterranean Sea to the Gulf of Aden.

Risks to the House of Saud

Khamenei's adversaries on the Arabian Peninsula, by contrast, have been forced to reposition themselves following the death of King Abdullah in February. Thus far, it has been King Salman's favorite son Mohammed, who is doing his best to position himself as the frontrunner to succeed Saudi Arabia's aging monarch. Just 35-years-old, it was Mohammed, Saudi's foreign minister, who received Yemen's exiled President Hadi in Riyadh at the end of March. Two days earlier, he had been sitting next to his cousin, Interior Minister Mohammed bin Naif, 55, at the meeting of the newly created National Security Council during which the Yemen attacks were decided. It remains, unclear, however, which of the young princes might benefit most from the Yemen offensive. Neither seems to harbor any doubts that it is the correct step.

Still, the risks this war poses to the House of Saud are great. Thus far, the air raids have accelerated rather than slowed the advance of the Houthi militias. On Tuesday, the rebels even managed to take a military base directly on the Bab-el-Mandeb, the strait between Yemen and the Horn of Africa that is considered to be among the most strategically important waterways in the world.

The Saudis have dubbed their offensive "Operation Storm of Resolve." But they won't be able to win with air strikes alone; to avoid defeat, they must be prepared to fight on the ground as well. The country's army is hardly in a position to do so, but eyewitnesses have nonetheless reported seeing kilometer-long tank columns along the Saudi border while on the other side thousands of Houthi rebels prepare to do battle with the invaders.

Once before, back in the 1960s, a large regional power sent tens of thousands of soldiers into Yemen. But the operation ended in disaster. It is remembered by history as Egypt's Vietnam.