Public Pensions: Live and Let Die

By John Mauldin

Jun 20, 2015


When you were young and your heart was an open book
You used to say live and let live…
But if this ever-changing world in which we're living
Makes you give in and cry… Say live and let die.

– Paul McCartney, the Bond movie theme, performed by Wings

I am not sure if my heart was ever that much of an open book, but I like to think I’m still relatively young. Nevertheless, I must admit that sometimes I want to “give in and cry.” This is especially so when I look at our nation’s public pension funds.

It’s not as if no one saw the problem coming. Experts, including your humble analyst, have been harping on it for decades. Politicians at all levels of government knew very well that a train wreck was inevitable and still did nothing. In some places, like Illinois, the politicians actually did something worse than nothing: they bought votes with promises of future benefits. Even worse, many states had their pension funds sell bonds, thinking they would be able to profit on the difference. Then along came the Great Recession. Oops. Stellar timing.

Now the future is here. Where are the benefits?

In this week’s letter we’re going to return to the worsening problem of public pensions. I offer an analogy between what is happening in Greece today and what will soon happen in Illinois. There are no easy solutions when you kick the can down the road, as politicians are going to find out.

An Unexpected Decade

Ten years ago this week my topic was “Public Pensions, Public Disasters.” Here is how I started this letter on June 17, 2005:

This week we will look with fresh eyes at an old problem: US pension funds, both public and private, are underfunded; and the situation is getting worse. And the US taxpayer is going to get to fund the difference.

The recent slew of data on pension funds suggests that little is being done to correct the huge and mounting problems I have written about for years. Even the recent market upturns of the past few years have not been as big a help as they should have been.

I doubt anyone would have noticed had I led with that same paragraph today. Every word is just as true now as it was then.

  • Pensions are still underfunded.
  • The situation is still generally getting worse (with some exceptions, thankfully).
  • Taxpayers are still going to fund the difference.
  • Recent market upturns have helped some, but not as much as you might think.

I’ve visited the topic of pensions repeatedly over the years. Some of my headlines are darkly amusing in hindsight:

How Not to Run a Pension (my personal favorite)

Why have we not hit the wall yet? In that 2005 letter, I wrote this, referring to corporate pensions:

Let's look at a typical 60% stock, 40% bond asset allocation mix. Let's generously assume you can make 5% annualized on your 40% bond portfolio allocation in the next ten years. That means to get your 8% (assuming a lower average target) you must get 10% on your stock portfolio. Now, about 2% of that can come from dividends. That means the rest must come from capital appreciation.

Hello, Dow 22,000 in 2015. Care to make that bet with me? But pension plan managers are doing precisely that.

Here we are in 2015, and the Dow is at 18,115, not 22,000. The 10-year average annual total return (including dividends) in the SPDR Dow Jones Industrial Average ETF (DIA) was 7.99% as of 3/31/15. Stocks lagged about 2% per year behind what I thought pensions needed to see.

 If stock performance didn’t bail out pensions, what about bonds? Was assuming a 5% annualized return back in 2005 a good move?

Actually, it was. The iShares Core US Aggregate Bond ETF (AGG) had a 4.77% 10-year average annual total return through 3/31/15. If you focused just on government bonds with the iShares 20+ Year Treasury Bond ETF (TLT), you had an average annual total return of 7.93%. However, you have to realize that the majority of those returns were capital gains and not actual interest income. Since rates really can’t drop all that much from here, and we are in a low-interest-rate environment for the foreseeable future, those types of returns are not going to happen in the next 10 years.

So, a balanced pension fund would have done better than expected in bonds, almost enough to offset the worse-than-expected return in stocks. That bought some time, assuming that the politicians provided the necessary contributions. As we will see, in many states they did not, so things have gotten decidedly worse even as the market has risen.

It is not the case that all pension funds stayed balanced for the whole decade. We had some severe bumps in 2008-2009. More than a few pension managers tweaked their strategies in response. Adding alternative investments to the mix has been a popular enhancement. The degree to which they enhanced your performance depends almost entirely on the alternative managers you picked. And if you were picking by means of hindsight, relying on past performance, you probably didn’t pick good managers for the recent environment.

So, to generalize, most pensions had “OK” investment returns in the last ten years but not enough to catch up without increasing contributions from governments, which in the main did not happen. However, those returns at least kept them on an even keel. Until the next recession, that is. But the modest performance managers eked out most certainly did not give legislators the luxury of promising even higher benefits to their retirees. But – you guessed it – many politicians made those promises anyway.

Spending Money You Don’t Have on Promises You Can’t

Unless you are a national government and can print your own currency, and with enough effective means to discourage would-be foreclosure, you can run a spending deficit for only so long. Greece is presently learning this the hard way.

State and local governments in the United States must, by law (with the rare exception), somehow balance their budgets. So must their pension plans. As of ten years ago, they were generally succeeding. Here is Census Bureau data for FY 2002-2003:

State and local pensions had total receipts of $147.7 billion that year and total payments of $134.8 billion. This is aggregate data, so any given plan might have done better or worse. Still, the overall picture doesn’t appear to be bad. Why was I so worried?

As my mother would often remind me, appearances can be deceiving. I was worried because we knew the next tens of millions of Baby Boomers would soon start retiring, driving payment obligations sharply higher. Simply doing the math told us that even given the robust assumptions that pension funds were making, many pensions were going to be massively underfunded in the future. And if you made more realistic assumptions, there were numerous pension plans that were going to be in serious trouble.

Notice too that about half the total receipts came from earnings on investments instead of employee or government contributions. That’s important, as any portfolio manager knows, because you can’t spend an entire year’s earnings if you also need to accrue long-term capital gains. You have to reinvest. In fact, the bulk of planned payments in 30 years don’t come from current contributions but come instead from compounding returns on current portfolios. If you are using those current portfolios to pay benefits today, the money clearly will not be there. And every dollar you pay out today that should be used for investing means that eight dollars will not be there 30 years in the future. And that’s assuming you get the better-than-7% returns everyone is projecting they will make.

Now, let’s fast-forward ten years from 2003. The Census Bureau changed its data format, but I believe this is a comparable data set for 2013.

Apparently, the Census Bureau also decided to pull investment earnings out of the contribution subtotal. Total 2013 contributions were $153.8 billion. Total payments were up to $260.8 billion in 2013, thanks to my fellow Baby Boomers. That would seem to leave a big deficit. It didn’t, because the plans also had $383 billion in investment earnings. About $107 billion of that went immediately to pay retirees.

Again, the problem with these numbers is that there is no guarantee investment earnings will be this high in any given year. That number could even be negative, as it has been at times in the past. Then what?

In 2013, CalPERS managed $230 billion. The fund calculates that it is underfunded by $80 billion. The management arrives at this number by assuming they will make 7.5% (which they only recently dropped from 7.75%). In 2009, they estimated that the fund was underfunded by only $49 billion. That means they missed their target by $30 billion in a roaring bull market.

In a December 2011 study, former Democratic assemblyman Joe Nation, a public finance expert at Stanford University, estimated that CalPERS’s long-term pension debt is a sizable $170 billion if CalPERS achieves an average annual investment return of 6.2 percent in years to come. If the return is just 4.5 percent annually – a rate close to what more conservative private pensions often shoot for – the fund’s long-term liability rises to a forbidding $290 billion. (Steven Malanga)

Last year I was in Norway. It has a sovereign fund that is larger than CalPERS but that benefits from some of the best management in the world. My talks with people involved in the fund and those who are very familiar with it suggest that they would be very happy to get 4% over the next 5–10 years. CalPERS ranks in the bottom 1% of all pension fund managers. Given all the resources they have, they are spectacularly bad at managing money. And when I say “they,” I mean the board of directors.

Malanga points out that CalPERS is a wholly owned subsidiary of the government-employee trade unions that control the board. He painstakingly chronicles the extent to which the unions dictate policy and investment decisions, leaving the professional management shackled.

And this is the issue. Nearly every public pension plan dramatically overstates its future potential income and returns, which makes the unfunded liabilities look better than they actually are. In coming weeks we’re going to be exploring in depth why the next decade is going to provide, on average, lower returns for pension funds and individual investors who are mired in traditional forms of investing.

In May, Moody’s downgraded Chicago bonds to junk status. One of their examiners pointedly asked, why is Chicago any different in Puerto Rico? Why indeed? My friend Mish Shedlock believes that Chicago is not alone in its misery. He thinks at least seven Illinois cities are in serious and immediate trouble. Detroit was not the last major city that will have to default on its obligations.

Sidebar: I know that many people invest in municipal bonds. Many of these, in fact most, are solid investments. Then there are some real dogs that are going to be extremely problematic. You need to look at, or have someone who is knowledgeable look at, bonds in your portfolios. I’m sure there are some properly run cities in Illinois, but I think I would throw the baby out with the bathwater there. There is no telling what politicians are going to require taxpayers in cities to do. It wouldn’t be the first time they took from the have-cities and give to the have-nots. Sadly, to my great chagrin and embarrassment, we did exactly that in Texas when we were forced to do so by judges. 

State and local pensions, in aggregate, are running severely negative present cash flow. If we get a bad market year (and we will), they will have to dip into their principal, cut benefits, turn to taxpayers, or borrow cash. Local governments can also file bankruptcy; states can’t, except in theory. We may see that theory tested in the next 10 years.

None of those choices are good. If pensions have to sell into a falling market, cash flow will fall even more. Such a scenario probably means the economy is weak and tax revenues are falling. That makes raising taxes and issuing bonds problematic.

Cutting benefits might be the only choice. But guess what: in many states, cutting benefits to current retirees is unconstitutional. Let’s look at the dilemma this poses for one state.

Hello, Illinois, Anyone Home?

Courtesy of Bloomberg, here are the ten most underfunded state pension plans as of 2013, the latest available data. Notice how poorly – one could almost use the word disastrously – these bottom 10 states have performed in what has essentially been a bull market for the last five years. Their funding ratios have dropped anywhere from 15% to 25%. And that was in good times!

Illinois has had the questionable honor of leading this list every year since 2008. For whatever reason, the state seems to be generous to its retired workers but reluctant to set aside enough money to actually pay for this generosity.

The situation is Illinois is unique enough to make Salman Khan use it as an example in his Khan Academy civics curriculum. I highly recommend watching his 7-minute presentation. He explains very clearly how Illinois arrived at this point.

Now, in their defense, the Illinois legislature tried to avoid the train wreck. In December 2013 they passed a package of reform measures after what sounds like an ugly fight. Here is how the a described it at the time. (This attempt at reform bears review because what happened in Illinois may be coming to a state near you unless adequate action is taken immediately.)

The top leaders of both legislative houses, Democrats and Republicans, had cobbled together the bill and pushed strenuously for its passage, supported by the state Chamber of Commerce and the Illinois Farm Bureau. Union leaders and some Democratic lawmakers opposed it, just as strenuously, arguing that the bill fell too harshly on state workers who had paid into their pension plans over the years with the understanding that the benefits would be there when they retired. Some Republicans also opposed the bill, saying it did not trim enough to solve the state’s pension troubles.

“Today, we have won,” Gov. Pat Quinn, who made overhauling the pension system a focus of his administration, said in a statement after the vote. “This landmark legislation is a bipartisan solution that squarely addresses the most difficult fiscal issue Illinois has ever confronted.” He is expected to sign the legislation on Wednesday.

We Are One Illinois, a coalition of labor unions that opposed the bill, issued a very different assessment. “This is no victory for Illinois,” it said in a statement, “but a dark day for its citizens and public servants.”

The battle now turns to the courts, where union leaders have promised to take the legislation. Some opponents have asserted that it violates the State Constitution by illegally lowering pension benefits.

The plan’s architects said the measures would generate $90 billion to $100 billion in savings by curtailing cost-of-living increases for retirees, offering an optional 401(k) plan for those willing to leave the pension system, capping the salary level used to calculate pension benefits, and raising the retirement age for younger workers, in some cases by five years. In exchange, workers were to see their pension contributions drop by 1 percent. The measure also calls for the state to increase payments into the system by $60 billion to $70 billion.

As expected, the battle then moved into court. On May 8 of this year, the Illinois Supreme Court ruled unanimously that the changes violated the state constitution. That leaves Illinois back where it started.

In their written opinion, the seven justices showed zero sympathy for the state’s legislative branch. I thought this was outcome actually a bit refreshing. More from the NYT:

The court’s decision on Friday had long been predicted by legal experts here. In a 38-page written opinion, the justices sounded an unsympathetic note to suggestions that the state was forced to take drastic action when faced with what amounted to a financial emergency. The court noted that state lawmakers had, over decades, delayed or shorted what they should have contributed into the system, which covers state workers, teachers outside Chicago and others.

The General Assembly may find itself in crisis, but it is a crisis which other public pension systems managed to avoid,” Justice Karmeier wrote. He added later, “It is a crisis for which the General Assembly itself is largely responsible.”

Anyone who has raised teenagers will recognize this tone. Faced with the consequences of failing to plan ahead, they look to Mom and Dad for a bailout. The Illinois justices put the onus back where it should have been all along.

(I’ll quibble with Justice Karmeier on one point. In fact, many other public pension systems haven’t managed to avoid this problem. In many cases, politicians and other states have elected to do the same thing that Illinois did and have simply postponed the inevitable. Most of them will find themselves in the same sort of crisis at some point.)

Illinois must now go to Plan B, which is not going to be much easier. Governor Bruce Rauner wants to amend the state constitution to allow pension reforms. Passing such a bill will take a three-fifths majority of both the state house and senate, and then a minimum six-month wait before it can go to voters in the next general election. Then it has to get 60% in favor.

That process will almost certainly take years. In the meantime, the state has to keep paying benefits it can’t afford, which will force it to raise taxes and/or reduce other spending. Any of the choices will probably make the state less attractive to potential new residents and businesses, putting downward pressure on property values and tax revenue. There was an interesting chart in the Khan Academy presentation showing that pension benefits are now absorbing 50% of the Illinois budget for education, and the amount keeps rising every year. Either school taxes have to go up, or an already stressed system will become even more stressed. (On a side note, I have never understood why a seemingly sane man like Rahm Emanuel wanted to be mayor of Chicago. It’s like volunteering to be captain of the Titanic just as the ship scrapes into the iceberg.)

As I said, all the options are bad. Very bad. Be very careful before you throw stones at Illinois, however. Your state, county, or city may not be far behind. Especially if you are in California. And sadly, there are some parts of Texas that are going to be just as bad as Illinois within 10 years unless action is taken soon.

How Many Trillions Did He Say?

The problem will not solve itself. Something has to change. Let me note that some 12 years ago I was writing about how US pension funds were underfunded by $2 trillion. I was considered alarmist by many. It turns out that once again I was overly optimistic instead. Wharton Business School called the pension funding problem the “invisible crisis” in a recent report:

Wharton finance professor Robert Inman provided this cautionary perspective: … researchers who have studied this crisis have “corrected a fundamental flaw in the way that people were thinking about these unfunded liabilities.” The bottom line, Inman said, was that there were $3 trillion worth of unfunded pension liabilities at the state level, and $400 billion of unfunded liabilities at the large-city level. That turns out to be about $10,000 per American citizen. (emphasis mine)

When you throw in all counties and cities, it gets even worse! If you were to use what I think of as more realistic 10-year return numbers (which assume at least one recession) and a low-interest-rate environment for at least half that time, that number gets to be over $4 trillion!!!

Stop here a second. In the 2005 letter I quoted above, I pointed to research that the public pension shortfall could be $2 trillion in 10 years. I added exclamation points then, too, because the number was so alarming.

Here we are ten years later. After the rather impressive bull market that began in 2009, we now find that unfunded liabilities have doubled. Does anyone seriously think that the Dow is going to 50,000 by 2025? Or that long-term rates are going back to 5–6%? And even if both of those things were to happen, unfunded liabilities would still be significantly worse in 2025 than they are today.

But there are pockets of problems that simply cannot go without a solution until 2025. Inman noted, for example, that Chicago’s unfunded liabilities are 10 times its revenues. “Just assume that they’re going to have to pay 5% of that [number annually]. That means you’re looking at 50% of their cash that will have go to pensions.” Philadelphia, Boston, New York, Houston, and other major cities will face similar challenges. “What does it mean for cities to do this?” Inman asks. “If that number is 50%, then $1 has to get you back at least twice the benefits [you spend].” That’s a very high threshold for city services to have to meet.

It is obvious to me that there are no good solutions. Current taxpayers will wind up having to pay higher taxes and/or receive a lower level of services in return for their contributions. That means more potholes, fewer new roads, and less money for education and parks and all those things that make up a city. Or, as Inman noted, the “solution” can come in the form of lower property values. Higher taxes mean the value of your home declines relative to the cost of the taxes. That’s just a fact.

The ultimate losers will be the people who own those properties whose value declines. As Inman notes, there is no way that businesses and households “are going to move into a city unless they are absolutely certain that they will get dollars back for every dollar they spend.” Who wants to move into a city where 50% or more of your tax dollars are used to pay the pensions of people who were working and retiring well before you moved in?

Politics being what it is, the losing groups will be the most diffuse, unorganized ones: taxpayers and property owners. Until they revolt. There will be a backlash. You can only squeeze blood from a turnip for so long before the turnip gets annoyed.

Illinois residents are already getting squeezed. Their state taxes are high and going higher. Their home values may also be high; but, at the very least, growth in the value of those homes is going to slow down. Illinois homes may well lose value in the next few years, and possibly a lot of value.

Put yourself on the other side of the trade. Would you buy Illinois real estate right now? Not unless you can get it at a steep discount. If you’re a business owner, would you expand into Illinois, knowing you and your workers will payer higher taxes for reduced public services?

The answers are obvious, and not just for Illinois. What we see there will be only the dress rehearsal for similar problems in other states with underfunded pensions. They won’t all have the constitutional barrier that is gumming up the works in Illinois, but it won’t be fun anywhere.

For what it’s worth, the five states with the best 2013 pension funding ratios, according to Bloomberg, are Wisconsin, South Dakota, North Carolina, Washington, and Tennessee. Note that these are not all “red states.” Proper fiscal controls can happen under liberal politicians as well. In a previous letter I went through the data on underfunded cities. Many of those were, surprisingly, cities you would have thought of as conservative. Local politics being what it is, and given how surprisingly few people actually get involved in local politics, budget shenanigans can happen anywhere.

Why Illinois Is the Next Greece

Pension shortfalls are a thorny problem. I have great sympathy for people who devoted their careers to civil service and counted on a certain level of benefits. Depending on the city or state backing those benefits, many will not realize them in full. I have sympathy also for homeowners who aren’t going to see their investments pay off, and for average citizens who will have to suffer through traffic that is heavier and lines that are longer than they should be. We’re all going to feel this.

The one group I don’t sympathize with is the governors and legislators who approved pension deals they had to know were wildly unrealistic. Even worse are the consultants who told them the deals would work. A plague on both their houses. These politicians used public goods to buy votes and thought they could kick the can down the road forever. They were wrong.

Illinois is going to have a “come to Jesus moment” within the next few years. They will either have to amend their constitution to allow for reduced benefits, with all the weeping and wailing and gnashing of teeth that will accompany such a move, or the judges will force them to raise taxes or to reduce spending on other essential services, which will again be accompanied by weeping and wailing and gnashing of teeth by those being asked to pay ever-higher taxes for reduced services. You’re going to continue to see companies leave Illinois, when they can move across the state line and be more competitive.

The federal government will not come to the aid of Illinois. You will not be able to find a majority in the Senate willing to vote to bail out Illinois. That vote won’t fly back in their home states.

So why is Illinois like Greece? Because Germany and the rest of the “northern” countries have basically told Greece to get its budgetary act together and to do so on the backs of its own people. Tsipras is negotiating as hard as he can, but he simply has nothing to negotiate with. The Europeans are no longer scared that Greece might leave the EU. However, if Greece were to leave, it would owe some €95 billion against bank balances of what may now be less than €120 billion, as money flies out of the country.

Remember Cyprus? Its bank depositors were, in many cases, simply wiped out. 100%. Some banks were able to negotiate a $100,000 insured deposit, but not the largest banks, and only if they were allied with a non-Cypriot bank. Basically, that is what Draghi is going to tell the Bank of Greece: “If you default, we will take all the collateral, and that means the deposits, too.” That is precisely what they are allowed to do under the rules. And while the Eurozone is working towards implementing deposit insurance, those rules have not yet taken effect. I’ve seen estimates that Greek depositors could lose as much as €.95 on the euro.

That would of course mean a return of the drachma and immediate economic collapse, with even higher unemployment than the current 25%; and the government would almost immediately be thrown out. But of course, if Tsipras does what he will have to do, which is to accede to European (read German) demands, then there will almost immediately be a vote of no confidence, and he will not be reelected. Tsipras is a dead politician walking.

Germany and its counterparts are using Greece as a moral object lesson for the rest of the periphery. You can bet that Portugal, Spain, and Italy (and France!) are watching and realizing they have to become far more serious in their reforms. Not that they are not already trying, but they are going to need to double down on reforms.

Illinois is going to provide the same object lesson to the rest of the 49 states. You can look at the table we highlighted earlier and see whether your state is headed in the wrong direction. Many states are in relatively good shape, and a few reforms can make them even better. There are some cities that are disaster zones, and they will be sad cases; but a serious majority can fix their problems if their politicians start to take action now. Pension reform will not be popular with the unions; but, as we can see from Illinois, even relatively modest changes were unpopular, and now the state is careening towards a civic financial collapse.

On the other hand, the Democratic leadership in Rhode Island actually pursued and got reform. Other states and cities are doing the same. If your state is in pursuing reform and using more realistic assumptions about future returns, then it is up to you to support such moves.

A lot of people will choose simply to move rather than stay and fight the good fight. Sad, but true. The data clearly shows that there is a general tendency to move from high-tax states to lower-tax states. While my former governor Rick Perry likes to take credit for all the jobs that have been created in Texas, the real growth factor was corporations fleeing high-tax states to come to Texas. It was the Texas state legislature that was the driver on low taxes. For sure, Perry was the evangelist and took advantage of their wisdom. But there are many other low-tax states, and nearly all of them are benefiting.

New York, Maine, and Boston

I will be ensconced for another three weeks in the area of Manhattan known as NoHo, which is a funky little neighborhood once known to me as the Bowery. The eponymous street is literally 60 feet away from our apartment, and Bleeker and Mulberry Streets are right around the corner. The Simon and Garfunkel song pops into my head every time I come across Bleeker; and given the number of times I’ve read Dr. Seuss to my kids, there have been rhymes running in my head. Some things you just can’t shake. There must be at least 100 restaurants within five or six blocks. I’m learning to navigate the subway system, as there are four subway entrances within a few blocks, all with different connections to everywhere.

One of the fun things I get to do is accept invites to a few dinners and meet interesting people. Last night was special, as my friend Steve Moore invited me to a small dinner put on by the Committee to Unleash American Prosperity (cofounded by Steve, Larry Kudlow, Art Laffer, and Steve Forbes), where they and other guests grilled Louisiana Governor Bobby Jindal for two hours. Sitting around the table were a few journalists, a former Federal Reserve vice chairman, and a number of conservative activists and businessmen. The range of questions was quite wide. This is part of a series to which they have been inviting presidential candidates in order to learn more about them. I was impressed with the breadth and depth of understanding of the details of government that Governor Jindal demonstrated.

I have now met six of the Republican candidates for the presidential nomination and expect to meet a few more. I was talking with a few people as the meeting broke up. Some of them of have met almost a dozen candidates. The only thing we had in common was that we are all confused. It is simply not clear at this point whom we want to support. We could not even agree on who should be in the top 10, except that none of us thought Donald Trump was a serious contender.

I agree with Newt Gingrich when he wrote this week that this is the most wide-open Republican nomination in 160 years. As he personally knows most of the candidates, he went down the list talking about their strengths. He only casually mentioned Governor Jindal at the end, which says something about the depth and strength of the bench on the Republican side. In almost any other year that I can remember, Governor Jindal would have been on the short list. Now it is hard to imagine how he makes the “Final Four.” If you are a political junkie, and I know many of you are, this is simply going to be fascinating to watch.

Someone should start a website where you can make your guess about the “Final Four” and then the ultimate winner sometime in October and see whose prediction actually turns out to be right.

I’ve said this before, but I actually wish the Democrats were going through the same process, as this country really does need to have a discussion about the direction it wants to go in. Right now, it doesn’t appear as if Hillary is going to be seriously challenged, which almost gives her a free ride before she has to really begin to explain where she would like to see the country go.

I was on Fox Business with Trish Regan yesterday for a rather long segment with Charlie Gasparino and Ambassador John Bolton. We talked first about Donald Trump and Carl Icahn and then about Russia and Greece. I am curious whether Putin thinks he can come up with €90 billion to bail out the Greek banking system. You can see the segment here. We never did get to my new book on China, so Trish invited me to come back on Monday afternoon at 2 PM. I’m sure something will happen over the weekend that will give us a little bit more to talk about.

It’s time to hit the send button. I’ve got a lot of catch-up emails and phone calls to make this weekend, but I still intend to get out here and there. I’m trying to revive the habit of getting my letter finished before Friday evening so that I can have my weekends back. Let’s see if it works out.

Your getting into the New York vibe analyst,

John Mauldin

Up and Down Wall Street

Should Stock Investors Fight the Fed?

History says that the first rate hikes by the central bank don’t hurt the stock market. But, this time, history could be wrong.

By Randall W. Forsyth           

Updated June 20, 2015 12:17 a.m. ET

There was a time, one I well remember, when few folks paid attention to Federal Reserve policy and still fewer fully understood its implications for investments.

Nowadays, to paraphrase Richard Nixon, we are all Fed watchers. Literally so, since the Fed Chair routinely holds a televised press conference following alternate meetings of the Federal Open Market Committee.

That helps to explicate not only the FOMC’s policy directive, but also the economic forecasts and projections for the federal-funds rate, the central bank’s traditional key policy tool.

Of course, Marty Zweig decades ago advised investors never to fight the Fed. But, back then, the only press conference held was a rather curious one conducted by the New York Fed for a handful of banking and money-market reporters. They pored over sheets of arcane numbers on loans and reserves, and sought to pry some details from the public information officer to help enlighten their readers about what the dry data meant (with little success, usually).

Moreover, the Fed back then didn’t even announce when it made changes in its fed-funds target. Fed watchers and reporters had to infer as much from reading the tea leaves of its open-market operations. And even after the central bank began to announce fed-funds rate changes in the early 1990s, then-Chairman Alan Greenspan famously quipped that he spent “a substantial amount of my time endeavoring to fend off questions and worry terribly that I might end up being too clear.”

These days, however, monetary policy has become almost a spectator sport. The FOMC’s statements, the background forecasts, the so-called dot plots graphing the panel’s members’ rate expectations, and the post-meeting presser are endlessly scrutinized. The aims have been first, to glean when the Fed will lift its fed-funds target from the 0% to 0.25% floor where it has been stuck since December 2008, at the depths of the financial crisis. And then, to figure out the upward course for rates from there.

As I wrote in the June 17 online edition of this column, even if Janet Yellen & Co. deliver a rate hike later this year, the trajectory afterward is likely to be lower than implied by the FOMC’s dot plot. And that also was the determination of the Treasury market last week.

If copper is often called the commodity with a Ph.D. in economics, then the Treasury’s two-year note is your all-purpose Fed watcher. Last week, its yield fell a hefty 10 basis points (a tenth of a percentage point), to 0.62% from 0.72%. That doesn’t sound like much in absolute terms, but it represented a 14% decline.

The rate of change in interest rates once was an important indicator for the stock market, notes Doug Ramsey, the chief investment officer at the Leuthold Group. But with rates at historically low levels near zero, percentage changes tend to get amplified. That is one legacy of the Fed’s quantitative-easing program, which more than quadrupled the size of its balance sheet from its precrisis levels.

Of course, the stock market has moved up pretty much in tandem with that balance sheet from its March 2009 lows when the Fed stepped up its securities purchases. Since then, the U.S. stock market’s value has increased 226%, or some $18.6 trillion, according to Wilshire Associates.

And since the announcement of the second phase, or QE2, in August 2010, stocks have added 104%, or $13.1 trillion. And since September 2012, when the launch of QE3 was revealed, U.S. stocks are up 49%, or $8.4 trillion.

More recently, Ramsey points out, the Fed’s balance sheet has stopped growing and actually has shrunk slightly in the past five months. The drop has been only about $25 billion out of a $4.45 trillion balance sheet, but the total no longer is shooting skyward.

And while the Nasdaq Composite and the Russell 2000 index of small-capitalization stocks made new highs last week, Ramsey notes that participation in the equity market’s advance has narrowed. Although the major averages are also within about a percent of their historic highs, less than half of New York Stock Exchange–listed stocks are above their 30-week moving average, a sign of waning momentum. That’s consistent with a topping process, which shouldn’t be surprising, coming after what he called in a phone chat last week an “historic bull run” of some 215% in the Standard & Poor’s 500 over some 75 months.

Meanwhile, the Fed seems hypersensitive to short-term stock swings. Ramsey recalled that its vice chairman, Stanley Fischer, commented recently—before there has been a single rate hike—that the pace of rate increases could be slowed if growth falls short. “It scares me what they could do if there were a 15% decline with zero interest rates,” he added.

Far from igniting inflation, contends Ramsey, zero interest rates have been deflationary by keeping noneconomic businesses funded, instead of dying. (Think of the so-called zombie companies kept alive during Japan’s two decades of zero rates.) Similarly, Ed Yardeni, the strategist whose name adorns the shingle of his advisory firm, contends that ultralow rates have spurred the expansion of supply more than demand. (Think of the shale-oil boom.)

Because of that, Ramsey recommends not chasing laggard groups in the current market, notably energy and materials stocks. In the previous cycle that peaked in 2007, value players flocked to financial issues—with disastrous results. Stick with winners, such as health care and technology.

In sum, Ramsey advises, this might be a time to ignore the hoary “Don’t Fight the Fed” notion. While other strategists’ data- mining suggests that the first couple of rate hikes won’t hurt the stock market, this time could be different.

Viewed from the perspective of the Fed’s balance sheet rather than interest rates, the tightening has started. And in this bull market, the course of the averages has been set by the balance sheet.

IT’S NOT EXACTLY THE DOGS of the Dow. But it seems somehow appropriate that the Shanghai Composite should be punished with its worst week since the 2008 financial crisis, ahead of the notorious Yulin Dog Meat Festival in Southwest China. As the Financial Times reported last week, the event, resulting in the slaughter of some 2,000 pooches, has rightly drawn the ire of animal activists.

More likely, the 13% swoon in the Shanghai index, including a 6.4% plunge on Friday, came amid the increasingly frothy conditions described here a week ago (“A World of Speculation,” June 15). Even as China’s market entered correction territory, it was still up 122% from the level a year earlier, which suggests that there could be more air to come out of—dare one say it?—a bubble. Corrections always are deemed to be “healthy,” except, that is, by those who rushed in near the highs.

In any case, while Chinese farmers were tending to their portfolios instead of their fields, Shanghai took a hit. Meanwhile, U.S. investors were exiting from bond funds, especially the riskier high-yield variety. Some $10.3 billion fled bond funds last week, as noted by our colleague Chris Dieterich on his Focus on Funds blog at, while equity funds added some $10.8 billion.

The shift to stocks comes just as the June 30 deadline for Greece to avoid default draws ever closer. With no agreement in sight, there’s a growing acquiescence that a default is likely and that Athens’ exit from the euro zone wouldn’t be catastrophic.

Much the same was said about Lehman Brothers before its failure in September 2008, especially given the warning signs from the near-collapse of Bear Stearns, staved off six months earlier by being absorbed into JPMorgan Chase JPM  (ticker: JPM.)

It may be that the Greek situation is hopeless, but not serious (to crib from David P. Goldman, the head Americas strategist at ReOrient Group in Hong Kong).

Research Affiliates’ Chris Brightman and Shane Shepherd write that the Greeks have accumulated debts that no honest man can pay, as Bruce Springsteen wrote in Atlantic City, his song about another bust place.

On that score, they observe, “For Greek citizens, tax evasion rises to the level of a national sport.”

To pay its debts, they say, Greece must either create wealth through sufficient economic growth, transfer wealth from other programs, or kick the can further down the road. The last is what has happened so far.

And as global markets hover near records, bulls wonder why it can’t continue, especially given the trivial size of the Greek economy.

The euro always was a marriage of convenience. The question now is whether the price of divorce is greater than the cost of staying together. Approximately two-thirds of Greeks would prefer to retain the euro, according to most polls.

Grexit, according to Brightman and Shepherd of Research Affiliates, would mean that Greek banks would fail and that capital controls would be imposed. A reintroduced drachma would spur exports, but imports would become prohibitively expensive. And the Greeks would still be constrained to living within the means of their economy.

While the lion’s share of Greece’s debts are held by official institutions, rather than European banks, as was the case when the crisis surfaced in 2010, to say the situation is contained seems to tempt the fates. After all, the same was said about subprime mortgages nearly a decade ago, and we know how that turned out: tragically.

Greek debt crisis is the Iraq War of finance

Guardians of financial stability are deliberately provoking a bank run and endangering Europe's system in their zeal to force Greece to its knees

By Ambrose Evans-Pritchard

6:29PM BST 19 Jun 2015

The Parthenon in Athens Photo: ALAMY
Rarely in modern times have we witnessed such a display of petulance and bad judgment by those supposed to be in charge of global financial stability, and by those who set the tone for the Western world.

The spectacle is astonishing. The European Central Bank, the EMU bail-out fund, and the International Monetary Fund, among others, are lashing out in fury against an elected government that refuses to do what it is told. They entirely duck their own responsibility for five years of policy blunders that have led to this impasse.
They want to see these rebel Klephts hanged from the columns of the Parthenon – or impaled as Ottoman forces preferred, deeming them bandits - even if they degrade their own institutions in the process.
If we want to date the moment when the Atlantic liberal order lost its authority – and when the European Project ceased to be a motivating historic force – this may well be it. In a sense, the Greek crisis is the financial equivalent of the Iraq War, totemic for the Left, and for Souverainistes on the Right, and replete with its own “sexed up” dossiers.
Does anybody dispute that the ECB – via the Bank of Greece - is actively inciting a bank run in a country where it is also the banking regulator by issuing this report on Wednesday?
It warned of an "uncontrollable crisis" if there is no creditor deal, followed by soaring inflation, "an exponential rise in unemployment", and a "collapse of all that the Greek economy has achieved over the years of its EU, and especially its euro area, membership".

The guardian of financial stability is consciously and deliberately accelerating a financial crisis in an EMU member state - with possible risks of pan-EMU and broader global contagion – as a negotiating tactic to force Greece to the table.

It did so days after premier Alexis Tsipras accused the creditors of "laying traps" in the negotiations and acting with a political motive. He more or less accused them of trying to destroy an elected government and bring about regime change by financial coercion.

I leave it to lawyers to decide whether this report is a prima facie violation of the ECB’s primary duty under the EU treaties. It is certainly unusual. The ECB has just had to increase emergency liquidity to the Greek banks by €1.8bn (enough to last to Monday night) to offset the damage from rising deposit flight.

In its report, the Bank of Greece claimed that failure to meet creditor demands would “most likely” lead to the country’s ejection from the European Union. Let us be clear about the meaning of this. It is not the expression of an opinion. It is tantamount to a threat by the ECB to throw the Greeks out of the EU if they resist.

Greece's central bank in Athens

This is not the first time that the ECB has strayed far from its mandate. It forced the Irish state to make good the claims of junior bondholders of Anglo-Irish Bank, saddling Irish taxpayers with extra debt equal to 20pc of GDP.

This was done purely in order to save the European banking system at a time when the ECB was refusing to do the job itself, betraying the primary task of a central bank to act as a lender of last resort.

It sent secret letters to the elected leaders of Spain and Italy in August 2011 demanding detailed changes to internal laws for which it had no mandate or technical competence, even meddling in neuralgic issues of labour law that had previously led to the assassination of two Italian officials by the Red Brigades.

When Italy’s Silvio Berlusconi balked, the ECB switched off bond purchases, driving 10-year yields to 7.5pc. He was forced from office in a back-room coup d’etat, albeit one legitimised by the ageing ex-Stalinist EU fanatic who then happened to be president of Italy.

Lest we forget, it parachuted in its vice-president – Lucas Papademos – to take over Greece when premier George Papandreou merely suggested that he might submit the EMU bail-out package to a referendum, a wise idea in retrospect. That makes two coups d’etat. Now Syriza fears they are angling for a third.

The creditor power structure has lost its way. The IMF is in confusion. It is enforcing a contractionary austerity policy in Greece – with no debt relief, exchange cushion, or offsetting investment - that has been discredited by its own elite research department as scientifically unsound.

The Fund’s culpability in this fiasco is by now well known. As I argued last week, its own internal documents show that the original bail-out in 2010 was designed to rescue the EMU banking system and monetary union at a time when it had no defences against contagion. Greece was sacrificed.
One should have thought that the IMF would wish to lower the political temperature, given that its own credibility and long-term survival are at stake. But no, Christine Lagarde has upped the political ante by stating that Greece will fall into arrears immediately if it misses a €1.6bn payment to the Fund on June 30.

In my view, this is a discretionary escalation. The normal procedure is to notify the IMF Board after 30 days. This period is a de facto grace period, and in a number of past cases the arrears were cleared up quietly during the interval before the matter ever reached the Board.

The IMF could have let this process run in the case of Greece. It has chosen not to do so, ostensibly on the grounds that the sums are unusually large.

Klaus Regling, head of the eurozone bail-out fund (EFSF), entered on cue to hint strongly that his organisation would trigger cross-default clauses on its Greek bonds – 45pc of the Greek package – even though there is no necessary reason why it should do so. It is an optional matter for the EFSF board.

He seems to be threatening an EFSF default, even though the Greeks themselves are not doing so, a remarkable state of affairs.

It is obvious what is happening. The creditors are acting in concert. Instead of stopping to reflect for one moment on the deeper wisdom of their strategy, they are doubling down mechanically, appearing to assume that terror tactics will cow the Greeks at the twelfth hour.

Personally, I am a Burkean conservative with free market views. Ideologically, Syriza is not my cup tea. Yet we Burkeans do like democracy – and we don’t care for monetary juntas – even if it leads to the election of a radical-Left government.

As it happens, Edmund Burke would have found the plans presented to the Eurogroup last night by finance minister Yanis Varoufakis to be rational, reasonable, fair, and proportionate.

They include a debt swap with ECB bonds coming due in July and August exchanged for bonds from the bail-out fund. They would have longer maturities and lower interest rates, reflecting the market borrowing cost of the creditors.

Syriza said from the outset that it was eager to work on market reforms with the OECD, the leading authority. It wants to team up with the International Labour Organisation on Scandinavian style flexi-security and labour reforms, a valid alternative to the German-style Hartz IV reforms that have impoverished the bottom fifth of German society and which no Left-wing movement can stomach.

It wished to push through a more radical overhaul of the Greek state that anything yet done under five years of Troika rule – and much has been done, to be fair.

As Mr Varoufakis told Die Zeit: “Why does a kilometer of freeway cost three times as much where we are as it does in Germany? Because we’re dealing with a system of cronyism and corruption.

That’s what we have to tackle. But, instead, we’re debating pharmacy opening times."

The Troika pushed privatisation of profitable state assets at knock-down depression prices to private monopolies, to the benefit of an entrenched elite. To call that reforms invites a bitter cynicism.

The only reason that the Troika pushed this policy was in order to extract money. It was acting at a debt collector. “The reforms were a smokescreen. Whenever I tried talking about proposals, they were bored. I could see it in their body language," Mr Varoufakis told me.

Yanis Varoufakis, the Greek finance minister

The truth is that the creditor power structure never even looked at the Greek proposals. They never entertained the possibility of tearing up their own stale, discredited, legalistic, fatuous Troika script.

The decision was made from the outset to demand strict enforcement of the terms agreed in the original Memorandum, which even the last conservative pro-Troika government was unable to implement - regardless of whether it makes any sense, or actually increases the chance that Germany and other lenders will recoup their money.

At best, it is bureaucratic inertia, a prime exhibit of why the EU has become unworkable, almost genetically incapable of recognising and correcting its own errors.

At worst, it is nasty, bullying, insistence on ritual capitulation for the sake of it.
We all know the argument. The EU is worried about political “moral hazard”, about what Podemos might achieve in Spain, or the eurosceptics in Italy, or the Front National in France, if Syriza is seen to buck the system and get away with it.

But do the proponents of this establishment view – and one hears it a lot – really think that Podemos can be defeated by crushing Syriza, or that they can discourage Marine Le Pen by violating the sovereignty and sensibilities of a nation?

Do they think that the EU’s ever-declining hold on the loyalty of Europe’s youth can be reversed by creating a martyr state on the Left? Do they not realize that this is their own Guatemala, the radical experiment of Jacobo Arbenz that was extinguished by the CIA in 1954, only to set off the Cuban revolution and thirty years of guerrilla warfare across Latin America?

Don’t these lawyers – and yes they are almost all lawyers - ever look beyond their noses?

The Versailles victors assumed reflexively that they had the full weight of moral authority on their side when they imposed their Carthiginian settlement on a defeated Germany in 1919 and demanded the payment of debts that they themselves invented. History judged otherwise.

The Sino-Russian Marriage

Robert Skidelsky

JUN 18, 2015

 .Xi Jingping Vladimir Putin

LONDON – The Chinese are the most historically minded of peoples. In his conquest of power, Mao Zedong used military tactics derived from Sun Tzu, who lived around 500 BC; Confucianism, dating from around the same time, remains at the heart of China’s social thinking, despite Mao’s ruthless attempts to suppress it.
So when President Xi Jinping launched his “New Silk Road” initiative in 2013, no one should have been surprised by the historical reference. “More than two millennia ago,” explains China’s National Development and Reform Commission, “the diligent and courageous people of Eurasia explored and opened up several routes of trade and cultural exchanges that linked the major civilisations of Asia, Europe, and Africa, collectively called the Silk Road by later generations.” In China, old history is often called to aid new doctrine.
The new doctrine is “multipolarity” – the idea that the world is (or should be) made up of several distinctive poles of attraction. The contrast is with a “unipolar” (that is, an American- or Western-dominated) world.
Multipolarity is a political idea, but it is about more than power relations. It rejects the notion that there is a single civilizational ideal to which all countries should conform. Different world regions have different histories, which have given their peoples different ideas about how to live, govern themselves, and earn a living. These histories are all worthy of respect: there is no “right” road to the future.
Eurasia is an idea whose time, it is said, has come around again. Recent historical research has rescued the old Silk Road from historical oblivion. The late American sociologist Janet Abu-Lughod identified eight overlapping “circuits of trade” between northwest Europe and China that, under the aegis of a Pax Mongolica, flourished between the thirteenth and fourteenth centuries.
According to Abu-Lughod, Western imperialism superimposed itself on these older circuits, without obliterating them. Islam continued to spread across geographic and political boundaries. Chinese and Indian migrations did not stop.
Now a unique conjuncture of economic and political developments has created an opportunity for Eurasia to emerge from its historical slumbers. In recent years, Western self-assurance was humbled by the financial crisis of 2008-2009 and political catastrophes in the Middle East. At the same time, the interests of the two potential builders of Eurasia, China and Russia, seem – at least superficially – to have converged.
China’s motive for reviving Pax Mongolica is clear. Its growth model, based largely on exporting cheap manufactured goods to developed countries, is running out of steam. Secular stagnation threatens the West, accompanied by rising protectionism sentiment. And, although Chinese leaders know that they must rebalance the economy from investment and exports to consumption, doing so risks causing serious domestic political problems for the ruling Communist party. Reorienting investments and exports toward Eurasia offers an alternative.
As China’s labor costs rise, production is being re-located from the coastal regions to the western provinces. The natural outlet for this production is along the New Silk Road. The development of the road (actually several “belts,” including a southern maritime route) will require huge investments in transport and urban infrastructure. As in the nineteenth century, reduction in transport costs will open up new markets for trade.
Russia, too, has an economic motive for developing Eurasia. It has failed to modernize and diversify its economy. As a result, it remains predominantly an exporter of petroleum products and an importer of manufactured goods. China offers a secure and expanding market for its energy exports. The big transport and construction projects needed to realize Eurasia’s economic potential may help Russia recover the industrial and engineering might it lost with communism’s fall.
This year Russia, Armenia, Belarus, Kazakhstan, and Kyrgyzstan have joined together in a Eurasian Economic Union (EEU), a customs union with a defense component. The EEU is seen by its advocates as a step toward re-establishing the old Soviet frontiers in the form of a voluntary economic and political union, modeled on the EU – a project to take the sting out of the West’s “victory” in the Cold War.
Official Russian opinion looks forward to “the interpenetration and integration of the EEU and the Silk Road Economic Belt” into a “Greater Eurasia,” which will afford a “steady developing safe common neighborhood of Russia and China.” On May 8, Putin and Xi signed an agreement in Moscow that envisages the establishment of coordinating political institutions, investment funds, development banks, currency regimes, and financial systems – all to serve a vast free-trade area linking China with Europe, the Middle East, and Africa.
How realistic is this dream? Russia and China both feel “encircled” by the United States and its allies. China’s anti-hegemonic aim, expressed in almost inscrutable prose, is to secure “tolerance among civilizations” and respect for the “modes of development chosen by different countries.”
Putin, meanwhile, has ratcheted up his much more explicit anti-American rhetoric since the Ukraine crisis, which he sees as a prime example of Western interference in Russia’s domestic affairs.
Boosting trade flows between Russia and China, and strengthening political and security coordination, will reduce their vulnerability to outside interference and signal the emergence of a new center of world power.
It may be considered a singular success for Western statesmanship to have brought two old rivals for power and influence in Central Asia to the point of jointly seeking to exclude the West from the region’s future development. The US, especially, missed opportunities to integrate both countries into a single world system, by rebuffing reforms of the International Monetary Fund that would have strengthened China’s decision-making influence, and by blocking Russia’s overtures for NATO membership. This led both countries to seek an alternative future in each other’s company.
Whether their marriage of convenience will lead to an enduring union – or, as George Soros predicts, a threat to world peace – remains to be seen. There is an obvious sphere-of-influence issue in Kazakhstan, and the Chinese have been squeezing the Russians for all they can get in bilateral deals.
For the time being, though, squabbles over the New Silk Road seem less painful to the two powers than enduring lectures from the West.