Double Debt Problem

By John Mauldin

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The selloff in GE is not an isolated event. More investment grade credits to follow. The slide and collapse in investment grade debt has begun… (and later) Don’t be fooled by bond prices holding up, because trading volumes are down. There are fewer bids in the market, and the dispersion of bids is wider. It is time to jog—not walk—to the exits of credit and liquidity risk.
 
- Scott Minerd, Guggenheim Partners Chief Investment Officer
 
 
From a 50,000-feet viewpoint, we're probably in a global debt bubble…Global debt to GDP is at an all-time high…This is going to be a very challenging time for policymakers moving forward.
 
- Paul Tudor Jones at the Greenwich Economic Forum in Connecticut, November 15, 2018
 
 
Last week, I talked about Ray Dalio’s new book on debt cycles. He describes how debt is inherently cyclical, because it enables more spending now that must be offset by less spending later.
 

Ray’s book helped me refine my description of The Great Reset. It’s a critical refinement, too. After reading the book, I realized it is entirely possible we will have another debt crisis before what I think of as The Great Reset. I firmly believe the latter is still coming, but there may be another “mere” credit crisis beforehand.
 
 
In last week’s letter, we began reviewing Ray’s book called Principles for Navigating Big Debt Crises in which he examines those debt cycles and what we can do about them. The book is a must-read resource for anybody who wants to understand the economic and financial world we are living in and what increasingly looks like another debt crisis around the corner. I read it on my recent trip to Frankfurt, and I highly recommend you do the same. (That link is for Amazon, but you can also get a free PDF copy here. I read it on my Kindle so I could highlight and save notes.)
 
I referred to the section I bolded below, promising a deeper dive, which we will do today. I’ve included some preceding text and chart for context.
 
The chart below shows the debt and debt service burden (both principal and interest) in the US since 1910. You will note how the interest payments remain flat or go down even when the debt goes up, so that the rise in debt service costs is not as great as the rise in debt. That is because the central bank (in this case, the Federal Reserve) lowers interest rates to keep the debt-financed expansion going until they can’t do it any more (because the interest rate hits 0 percent). When that happens, the deleveraging begins.

 
While the chart gives a good general picture, I should make clear that it is inadequate in two respects: 1) it doesn’t convey the differences between the various entities that make up these total numbers, which are very important to understand, and 2) it just shows what is called debt, so it doesn’t reflect liabilities such as pension and health care obligations, which are much larger. Having this more granular perspective is very important in gauging a country’s vulnerabilities, though for the most part such issues are beyond the scope of this book.
 

Source: Ray Dalio
 
 
Close to the beginning of the book, Ray tells us that his debt cycle descriptions are just that: a description of past debt cycles. He excludes government liabilities like pensions and healthcare that, which while not technically “debt,” look and act just like it to those who are planning on it.
 
People assume those payments will appear. If they don’t, then some sort of deleveraging, default, or liquidation process must occur. It will be painful to everyone.
 

Ray clearly knows about the government debt problem but compartmentalizes for the sake of analysis. The book looks specifically at private-sector debt and how it interacts with the economic cycle.
 
Government debt is a different problem with different characteristics. But as we all know, it’s still debt, as most of us think of debt: an obligation that must be paid in the future... and it is definitely still a problem.
 

The fact that government pensions and obligations are not on the balance sheet doesn’t change the fact that millions of people around the world expect to get them. Those future payments are part of their retirement planning, every bit as much as a 401(k) or other savings. For most people, at least in the United States, it is almost all their retirement planning.
 
Without those payments already-bleak retirement prospects would look even worse. So it’s hard to overstate their importance.
 
 
Let’s review how big this problem is.
 

The US government on-budget deficit was $100.5 billion in October. It was $63.2 billion in the same month a year earlier. There are always revenue timing issues comparing any previous months, but that’s the wrong direction. I see little hope it will reverse. There is no appetite in Congress or the public for lower spending. Nor will we see the kind of tax-policy changes that would generate more revenue. (I still think my VAT idea is the best answer, but I’m way out on a limb there.)
 

Federal debt has grown with little complaint (except from a few of us curmudgeons) because it was mostly painless over the last decade. Interest rates and inflation were historically low, and the Federal Reserve was buying Treasury bonds by the truckload. Those helpful factors are now changing. Last year, interest on the federal debt was $263 billion, or 1.4% of GDP. The Congressional Budget Office expects it will rise to $915 billion by 2028, or 3.1% of GDP.
 

Let’s stop right there for a minute. You can review the CBO’s budget outlook here.
 
The interesting numbers start about page 43, and then the actual projected deficits at page 84. The total projected 2028 deficit (on and off budget) is $1.5 trillion. Take that number with a grain of salt; they were only projecting the total debt for this year (2018) to increase $779 billion, when it actually rose $1.2 trillion including off-budget items. The CBO also assumes no recessions, wars, or other crises in the next 10 years.
 
And yet they still project, even with optimistic assumptions, that interest on the debt will overtake defense spending plus other “discretionary” expenses. It is quite likely that fiscal 2019 will see a $1.5 trillion deficit (assuming no recession), and that if (when) we have a recession, total debt will increase at least $2 trillion a year. Considering that we are already at $23 trillion of total debt, it is very likely that by the mid-2020s we will have $30 trillion worth of debt and already see that $915 billion interest expense they were projecting for the end of the decade.
 

And that’s not all. Look back at my June 29, 2018 “Unfunded Promises” letter for some staggering numbers on the various non-debt obligations that our political heroes have placed on “We the People” beyond Social Security and Medicare. They’ve made lots of other guarantees, explicitly or not.
 

For example, consider the Pension Benefit Guaranty Corporation, which stands behind thousands of private defined-benefit retirement plans. The plans pay premiums but not enough to cover the number of failures we could see in a severe recession and debt crisis, much less the Great Reset.
 

If we learned anything from 2008, it is this: Congress will open the national wallet in a crisis, even if it means creating new guarantees out of thin air.
 
They did it with TARP, the Troubled Asset Relief Program. No such program was anywhere on the radar until the big banks wobbled. If, say, some large state pension plans can’t meet their obligations, will Congress face similar pressure to fund the gap?
 
You bet it will, and I have little doubt what will happen.
 

Now, if you are a Keynesian you might think that’s ok. The government is supposed to stimulate the economy through troubled times. But Lord Keynes also advised us to run surpluses in growth periods, so we could afford the stimulus.
 
We haven’t, except briefly two decades ago. So even if the Keynesian path works, we are already way off of it.
 

As bad as all this is, however, I think Ray Dalio is right to analyze it separately from the more “normal” debt crises. That was the most important revelation for me in reading his book. We have two different problems that may or may not overlap.
 
 
Physicians have an unpleasant-sounding term called “comorbidity.” It is as bad as it sounds. It is when two separate health conditions affect a patient simultaneously. They might be related but are medically distinct problems. Heart disease and diabetes often go together, for example. Evaluating them separately is important in making treatment decisions.
 
Such is the case with our debt disease.

  • We have a big problem with private-sector debt, with many overleveraged corporations likely to default if the economy weakens.

  • We have another big problem in government debt and unfunded liabilities, with politicians making commitments the taxpayers can’t keep.
 
Both problems are serious. To some degree they overlap, because the government draws its funding (whether taxes or borrowing) from the same population and wealth pool as private borrowers. But they are distinct problems we should analyze separately.
 

There may be at least a little bit of good news in this. Since these are distinct problems, maybe they won’t explode at the same time. That would make each one more manageable.
 

We saw this in 2008, in fact. Subprime mortgages and related derivatives led to contagion in commercial paper. As terrible and frightening as it was, the Federal Reserve was there as a backstop. So was the US Treasury. We had a lot to worry about, but I don’t recall anyone seriously thinking the government would collapse. (Whether it did the right things is a different question.)
 

Will the same happen next time? We should all hope so. I’m skeptical because federal debt is now roughly twice as big a percentage of GDP as it was in 2008. The Fed’s balance sheet is considerably larger, too. They have less room to maneuver, but maybe they’ll find some new tools.
 
Nevertheless, at some point the government will hit a debt wall and probably drag private debt down, too. That will lead to what I think of as actually the Great Reset. But we could have one (or more) smaller debt crises first.
 
The Great Reset will occur when global government debt grows so large that merely rolling it over becomes a problem. It will crowd out private lending, forcing interest rates higher, which is definitely not good for economic growth. Or else the government resorts to “unusual actions.” In either case, a private debt crisis at the same time could be really painful…
 

At some point, the private market will just not be able to fund such massive debt increases. Then we’ll have a “crisis” and the government will resort to “unusual actions.” Like Congress authorizing the Federal Reserve to buy Treasury debt.

 
That’s not crazy. The Bank of Japan is doing it right now. The BOJ has well over 140% of Japanese GDP on its balance sheet. It is now, like the Swiss National Bank and the ECB, buying equities and private debt in order to push money into the economy, with seemingly no consequences.
 

And so maybe that’s what the US will do. But once politicians and voters realize they can tap the central banks, will there be any motive to balance the budget? Maybe not, unless monetizing the debt creates yet another crisis.
 

One of the debt crises that Dalio describes in detail is the German Weimar Republic and the hyperinflation of that period. Germany was monetizing the government debt that they assumed from World War I. I’d like to ask Dalio whether he chose that particular debt crisis as a warning about what happens when governments play around with printing money.
 

It is very difficult to predict the path The Great Reset will take. We can’t know what the political environment will be as technology begins to eat into the employment rate. Will increasing productivity reduce consumer prices or will inflation rise? If it’s the latter, will the Fed react by raising rates and trigger a Volcker-style recession? Will Congress order the Fed to monetize the debt? Like I said, 2008 clearly showed that Congress and the executive branch will do almost anything in the midst of a panic to avoid accepting pain.
 

But in economic jargon, that yawning government debt chasm will have to be “rationalized.” Retirees and others receiving government benefits will expect to keep receiving them. There is no political will to reduce those benefits. The money will be found; the question is where? Hint: not under the sofa cushions.

 
When you begin to “wargame” the problem, the options are both limited and severe. Japan’s experience of Japan, even though it is apples and oranges to the US and Europe, will be so enticing. Just authorize the central bank to print money. When the world’s two main currencies begin to monetize debt at a significant rate—more than the small percentage of GDP that occurred in 2008–2009—and when that world is in a global recession, which is by definition deflationary, what will the consequences be?
 

The answer is we don’t really know. We only have economic theory as a guide, and we know how theory works in a crisis. I will admit that I have trouble imagining that whatever happens will be less than painful, no matter which theory you adhere to.
 

Dealing with too much debt, even debt of the “merely” promised kind, always involves some kind of pain to someone, and more likely to everyone, leaving nobody happy.
 

But that’s a story for another letter. To be continued…
 
 
I have a quick last-minute trip to Houston for one night next week, then back to Dallas for more meetings. Shane and I will be going to Puerto Rico in early December, then to Cleveland for a complete checkup with Dr. Mike Roizen at the Cleveland Clinic along with my friends Mike West and Pat Cox. I can envision some very interesting dinners. Then in late January, I go to Boca Raton to speak at an investment conference.
 

Quick anecdote from my time in Frankfurt. I spoke for fund manager Lupus Alpha to approximately 250 pension fund managers, representing most of Germany’s retirement monies. I asked for a show of hands on whether they liked being part of the European Union. Almost everyone raised their hands.
I then asked if they thought participating in the euro was a good thing. Probably 80% raised their hands. When asked who doesn’t like the euro, maybe 10% of the hands went up.
 

Then the money question. I asked if they would be willing to take Italy’s debt and all the debt of every eurozone member and put it on the European Central Bank balance sheet, with caveats about controlling national budgets. Fewer than 20% of the hands went up.
 

I then engaged the audience further, saying, the last two questions were essentially the same. If you want to keep the euro, you’ll have to do something about the imbalances between the countries and debts. No monetary union in history has ever survived without becoming a fiscal union as well. Even reminding them that failure to do this might cause the euro to break up and bring back the Deutschmark didn’t seem to change many opinions. I reminded them that a Deutschmark would mean a serious recession/depression in Germany as it would raise the price of all German exports by at least 50%. Mercedes and BMWs are expensive enough for Germany’s customers, let alone at a 50% price hike.
 

This audience should have easily accepted the argument for putting all European debt on the ECB balance sheet. Imagine if I asked the typical German voter, especially those in rural areas. That tells me Europe could have a bumpier future than I thought.
 

My mind is still reeling with the implications of that impromptu survey. That’s going to be a letter someday. I invite comments from my European counterparts about what they think of that process in their own countries.
 

It’s time to hit the send button. I hope your Thanksgiving week was as great as mine, as I had all my kids over and many of my grandkids. I made prime rib, mushrooms, and all the fixings, accompanied by smoked turkey… and I even made a banana nut cake. (He does macroeconomics and bakes too!)
 

I always enjoy the season as it is a good time to get together with friends. And I always enjoy spending time with you in this letter. Thanks for taking the time to be with me.
 

Your really thinking about the future analyst,


John Mauldin
Chairman, Mauldin Economics


Japan risks repeating some old mistakes

The central bank is muddying its commitment to easy monetary policy

Robin Harding



In April 1997, Japan raised consumption tax and a promising economic recovery ended in recession. In August 2000 and again in July 2006, the Bank of Japan raised interest rates, only to cut them again as the economy slid into recession. Undeterred, prime minister Shinzo Abe raised consumption tax in April 2014. The result: another recession.

There is something of a pattern here. Yet Japan is once again flirting with making the same mistake.

Mr Abe came to office in 2012 on a pledge to revive the economy and end the deflation that has plagued Japan since its bubble burst back in 1990. He appointed governor Haruhiko Kuroda to the Bank of Japan and together the two men launched the stimulus known as Abenomics.

The BoJ has purchased assets equal to 100 per cent of Japanese output, delivering a weaker yen, five years of strong economic growth and a drop in the unemployment rate to 2.3 per cent.

Now there are signs of stimulus fatigue. Mr Abe has a maximum of three years left in office. Before leaving, he is eager to declare victory for Abenomics and defeat for deflation. The prime minister insists he will go ahead with another rise in consumption tax next autumn, albeit offset with some dubious stimulus schemes.

Meanwhile, Mr Kuroda says Japan is “no longer in a situation where decisively implementing a large-scale policy to overcome deflation was judged as the most appropriate policy conduct”. To an extent little recognised outside the country, the BoJ is muddying its commitment to easy monetary policy, and edging away from further stimulus.

This stance would make sense if deflation truly were defeated. But it is not. Japan’s economy is doing much better, but underlying inflation, up by 0.4 per cent on a year ago, is still far below the BoJ’s 2 per cent objective.

At some point the long global expansion will end. If Japan has truly escaped deflation, it will endure the resulting shock without a fall in prices. Few would bet on that outcome today.

The clearest sign of waning commitment to Abenomics came with the BoJ’s move this summer to raise its effective cap on 10-year bond yields from about 0.1 per cent to about 0.2 per cent. The BoJ said this was necessary to “enhance the sustainability” of what will otherwise be a policy of continued easing. Nonetheless, it amounted to a tightening of financial conditions at a time when the central bank is still far from its inflation goal.

That decision adds to a tangled mess of promises. The BoJ continues to state it is buying government bonds at an annual pace of ¥80tn, even though it has tapered the actual pace of buying down to about ¥45tn.

It has an “inflation-overshooting commitment”, which sounds tough, but will actually allow it to raise interest rates well before inflation hits 2 per cent. Then there is its new vow to keep interest rates on hold for “an extended period of time” (in the English version of the statement) or “for the time being” (in the Japanese).

Mr Kuroda says the BoJ’s intended meaning is closer to the English phrase. Nonetheless, the overall impression is of a deeply conflicted central bank that no longer seems certain what it is trying to achieve. So far, the BoJ has been lucky: rising interest rates in the US have helped to keep the yen under control. It cannot count on this luck continuing, especially if it were tempted to raise the yield curve cap again.

Such contortions from the BoJ would be easier to accept if there was more evidence of negative side-effects from its huge bond purchases, but the central bank’s own financial stability report finds “no signs of overheating”. It is certainly true that Japan’s banks struggle to make money with such a low level of interest rates. That, however, is because Japan has far too many banks. It is not the central bank’s task to make them profitable.

The temptation to step off the accelerator is understandable. Why, after all, is it necessary to reach 2 per cent inflation when profits are high and unemployment is low? Is the current situation not rather desirable?

But that is like saying you feel better so forget about the rest of the antibiotics. Halting stimulus halfway caused all the previous failures and it will never be possible to control Japan’s public debt unless investment and consumption are strong enough to replace government spending.

That is the whole point of Abenomics.

The right path forward is clear. The Bank of Japan should stop mucking about and clearly state its intention to maintain stimulus until inflation is above 2 per cent. The prime minister should cancel his tax increase until the same goal is achieved.

Together, Mr Abe and Mr Kuroda have achieved great things. They have a duty to continue.

This may be Japan’s last chance to escape the debilitating effects of economic stagnation and falling prices — it is hard to imagine anybody finding the political will to try again.

To give up now, or claim a false victory for political convenience, would be a tragic mistake.


Gold Is Setting Up For A Nice First-Half Rally

by John Rubino


Precious metals investors don’t have much to console them these days. Just about the only bright spot is the nice, though ephemeral, pop in the gold/silver price that seems to happen every January. Sometimes it persists for six or so months, sometimes it ends before the snows do. But either way it’s more fun than the rest of the year.


Gold price 5 years Gold January rally


This pattern repeats because Asians like to give gold and silver jewelry as wedding gifts, and they like to have their weddings in the Spring. So they do their anticipatory buying in January, which tends, other things being equal, to push up the price.

There’s no reason to expect Asian buying to depart from the usual this January, so – especially given 2018’s grinding price decline which has put the metals on sale – it’s reasonable to expect positive trends to kick in shortly.

In fact, the set-up this time is looking a lot like 2016, by far the best run of the past five years.

Because in addition to the normal seasonal factors, the structure of the paper (i.e., futures contract) markets is also bullish. This past week, commercial traders – who tend to be right at big turning points – went aggressively long and are not far from being net long, meaning they strongly expect higher prices in the next few months. Speculators, meanwhile, tend to be wrong at turning points, and they’re now net short, which is also both unusual and very bullish.

Gold COT Gold January rally
Silver COT Gold January rally


Here’s the same data for gold in graphical form, which illustrates how unusual the current structure has become.


Gold COT chart Gold January rally


So let’s fantasize a bit about a replay of 2016, when both gold and silver rose for a solid six months, and recall the fire that that lit under the mining stocks. Here’s silver miner ETF SIL, one of many fond memories that would be nice to revisit:

SIL 2016 Gold January Rally


The Stock Market Economy

By: Peter Schiff


Currently, some market watchers have begun to openly question whether the bull market in stocks has finally come to an end. They certainly have cause to worry. Valuations are frothy after a record run-up in the last few years. Bond yields across the yield curve are rising sharply, as the Fed Funds Rate breaks into territory not seen since before the market crash of 2008. Much higher costs of capital are already putting pressure on rate-sensitive industries such as housing and autos. The boost to earnings provided by the corporate tax cuts will fade and rising prices resulting from past monetary policy and import tariffs may be expected to slow consumption and take a toll on balance sheets. All this points to possible lackluster performance, with stocks essentially flat so far this year.

But even while many expect a difficult period for stocks, we must come to grips with the fact that generations of investors have come and gone who have not experienced a grinding and protracted bear market. Such a scenario is unthinkable given the narrative to which these investors have been exposed. But the page may about to be turned and there are reasons to believe that the bill may finally be coming due.

Falling interest rates are generally regarded as good for stocks. Not surprisingly then, since Treasury bond yields began falling in 1982 (based on data from U.S. Dept. of Treasury), stocks have trended higher. The memorable declines that we have had since then, the Black Monday Crash of 1987, the sell off after the ’90 recession, the Dotcom and September 11 implosion of 2000-2001, and the Crash of 2008, were really just interludes in an otherwise surging bull market that has risen more than 30 times in nominal terms, according to data from the World Bank. In those events, the brunt of selling happened quickly and was over before investors really knew what had happened.

In ’87, a 35% drop in the Dow occurred in just 3 months, from August to October. In ’90 an 18% fall, also in 3 months, again from August to October. In ’98, the Russian economic crisis pushed the Dow down 18% in a month, from July to August. In all these instances, stocks made new highs within two years of the initial drop, in August ’89, April ’91 and January ’99, respectively. Entering the current century, the more difficult pullbacks have occurred, but were manageable nevertheless. Beginning in January 2000, the Dow dropped 35% over a period of 33 months. It then took an additional 4 years to make fresh nominal highs. In October 2007, the Dow began falling and plunged 53% in 16 months. But after that, stocks climbed steadily and made fresh highs almost exactly four years after the bottom. (Yahoo!Finance, DJIA interactive charts)

Those who assume that these cases represent the worst-case scenarios of what we could see in the future are ignoring the brutal bear market that lasted 16 years between January 1966 and August 1982. While the nominal point drop of 18% during that time was not particularly bad, the move downward was memorable by its duration and the degree to which it was made far worse by inflation, which often approached double digits during that time.

Inflation-adjusted real values of stocks fell by a shocking 70% from 1966 to 1982. (Macrotrends Dow Jones 100 Year Historical Chart) Let that sink in. Over 16 years, the real value of stocks fell by almost three quarters! And it’s not like investors found refuge in bonds, which were also falling at that point due to the ravages of inflation and increased government borrowing. (10-year Treasury bonds hit nearly 16% in September 1981). (FRED Economic Data, St. Louis) Given how much stock and bond prices were falling in real terms, it’s surprising that the real economy didn’t implode along with it. Yes, GDP was generally sub-par during the stagflation “Malaise Days” of the 1970’s, but real GDP was positive in all but four years between 1966 and 1982, and growth averaged 2.95% over the entire period. (That’s higher than the 2.85% GDP growth has averaged since 1983). (based on data from the Bureau of Economic Analysis) That’s fairly impressive given the performance in the stock and bond markets.

Our relatively good fortune was made possible by the fact that the market was not nearly as important to the economy then as it has become now. Back in 1966, when the market had hit a peak (after a bull run that began in the early 1950’s) (Macrotrends Dow Jones 100 Year Historical Chart), by using the Dow Jones Index’s relationship to GDP from 1966 to 1971, the year when data begins for the Wilshire 5000, we estimate that the Wilshire 5000 (the broadest measure of the U.S. stock market) would have had a collective market cap of approximately 42% of GDP, meaning that stocks were worth less than half of the whole U.S. economy. Over the next 16 years, inflation pushed up the value of just about everything consumers bought…gas, clothing, movie tickets, medical services, etc. But stock valuations lagged significantly. As a result, by 1982 the collective valuation of the stock market was only 18% of GDP. (based on data from FRED Economic Data, St. Louis) 
Graph created by Euro Pacific Capital, a division of Alliance Global Partners using data from the Federal Reserve



How different the world looks today. After more than 35 years of nearly steady gains, the Wilshire 5000 is now worth 173% of the overall economy, more than four times as big, in relative terms, to where it was in 1966. I believe this did not happen by accident. What the Federal government and the Federal Reserve have done in recent years has helped push people into stocks and other financial assets, like bonds and houses. The principal driver of this has been the Fed’s overly accommodating monetary policy that can fuel inflation, divert investment into “risk” assets, and lessen the fear of losses due to a belief that the Fed will be there to pick up the pieces after a possible crash. Government deficits add to the inflation. Tax policy, corporate accounting rules, and financial technology have also added to the trend, but the big factor has always been the Fed.

The relative insignificance of the stock market in comparison to the larger economy may explain why inflation manifested itself primarily in consumer prices in the 1970’s and in financial assets more recently. The trillions of dollars created by the Fed need to go somewhere..and wherever it went it would tend to push up prices. Given the mechanism by which monetary stimuli impact the markets, it makes sense inflation has shown up primarily in financial assets. But that trend should reverse once the air comes out of the stock bubble.

When prices of stocks, bonds, and real estate go up, the “wealth effect” makes the economy appear healthier than it actually is. But beneath a veneer of strength, the real economy slowly decays. For much of our history this was not the case. The real economy could be found elsewhere, on Main Street, in factories, shipyards, warehouses, and family businesses.

As an important corollary to all this, our asset-based economy tends to favor those people who own financial assets, who tend to be wealthy. In other words, the rich have gotten richer, and those people who don’t own such assets have tended to languish. Sound familiar? The left is not wrong when they point out that these problems exist, and the right looks more and more foolish when they pretend that they don’t. Unfortunately, both sides of the political spectrum seem to favor the kinds of monetary and fiscal policies that will continue the trends rather than reverse them.

Those who argue that the more modest pullbacks of the 1990’s are more likely scenarios are not paying attention to the bond market. After Treasury bond prices rose fairly steadily for more than three decades from 1982, most analysts agree that the top of the bond market occurred in July 2016 when yields on the 10-year Treasuries hit a low of 1.37%. Since then, yields have moved up to 3.22%, the highest levels since 2011. (FRED Economic Data, St. Louis, 10-yr Treasury Constant Maturity Rate) What’s worse is that they show no signs of reversing. This could mean that the decades-old trend of rising bond prices and steadily falling yields may be over.

Given the quantity of bonds the Fed and the Treasury may need to sell to finance government deficits and to draw down the Fed’s balance sheet, record amounts of bonds could hit the market in the years ahead. But the buyers who have absorbed the inventory in the past, leveraged hedge funds, foreign central banks, and the Fed itself, may not be there to buy in quantities that will prevent yields from rising.

Stocks have not had to contend with persistently rising rates since the 1970’s, and they present a clear danger to valuations. Not only do rising rates increase the cost of capital and discourage leverage, but they also give people a viable alternative to stock investment. The downside risks could be much greater than the 20% short term bear market that the more pessimistic minds on Wall Street currently suggest, especially given the unprecedented gains we have seen in the last decade.

But what would happen to the country if the stock market entered into a protracted bear market like it did in the 1970’s, a grinding downward move lasting more than a decade? What would happen if the real value of stocks fell by 50%, let alone the 90% that would be required for market capitalization to match the percentage of GDP in 1982, when the current long-term bull market began? Given the size of the stock market, and the way in which our economy has adapted to it, such declines could be devastating.

To try to stop that from happening, the Fed could cut rates to zero at the first sign of serious trouble. But that may be just the opening note of a symphony of monetary and fiscal stimulus that could last for years, if not decades. Quantitative easing might return, but this time the Fed’s purchases of bonds could be larger than they were in 2009 and 2010. The Fed might monetize the entire Federal budget deficit, which could come in at 2-3 trillions of dollars per year, if not more. It might look to buttress the housing market with trillions of dollars per year of mortgage bond purchases. And next time, QE activity might include stock market purchases in order to support the equities markets.

And while these activities may put a nominal floor under asset prices, the massive increase in money supply could unleash much higher inflation across the broader economy, pushing stock prices down in real terms just as they did from 1966 to 1982. In real terms, the rich may not be as wealthy. While this outcome may please progressives, it would also mean that the tax base would dry up, and help cause already ballooning deficits to go up that much faster. The resulting inflation could be expected to be felt most heavily by the poor, and elderly living on fixed incomes.

All this could mean that the driving policy goals of the coming decade would be to keep asset prices from falling. While the government can not be successful in this endeavor (in real terms), it would be successful in helping destroy confidence in the dollar. This should inspire those with some forethought to look for investments to hedge such a scenario. The window of opportunity to make such a shift may soon close.


How Not to Fight Income Inequality

Trying to combat income inequality through mandated wage compression is not just an odd preference. It is a mistake, as Mexico's president-elect, Andrés Manuel López Obrador, will find out in a few years, after much damage has been done.

Ricardo Hausmann  

Andres Manuel Lopez Obrado


CAMBRIDGE – Suppose two people hold different opinions about a policy issue. Is it possible to say that one is right and the other wrong, or do they just have different preferences? After all, what is the difference between an odd preference and a mistake?

A preference influences a choice that is expected to deliver the goal the chooser wants to achieve. A mistake is a choice based on a wrong belief about how the world works, so that the outcome is not what the chooser expected. Unfortunately, this may be a costly way to learn. It also may be inconclusive, because it is always possible to attribute the mistake’s bad consequences to other factors.

A case in point is the decision by Mexican President-elect Andrés Manuel López Obrador (AMLO), to lower the salaries of the higher echelons of the civil service, including himself, capping them at $5,707 per month. Many greeted the decision, announced in July, with glee. It showed that AMLO was committed to fiscal austerity and income equality.

But what appears to be a well-articulated preference will prove to be a serious mistake.

Unfortunately, AMLO will find out only in a few years, by which point the damage inflicted on Mexico will be huge.

Interfering with market prices to achieve fairness – an idea that harks back to St. Thomas Aquinas and even Aristotle – is probably one of the worst economic policies ever. Governments in many countries regularly set prices – especially for energy, foreign exchange, or credit – artificially low, leading predictably to under-investment and shortages. Venezuela is an extreme case that dramatizes the consequences. But are public sector wages another example of this practice?

The answer is more nuanced. In general, governments pay their employees significantly more on average than the private corporate sector, because government services such as education, health care, justice, and administration are on average more skill-intensive. As a result, government employees have significantly higher levels of schooling – four more years, on average, in Mexico. But even controlling for this, a study by the CAF Development Bank showed that average wages are higher in the public sector in Latin America. In Mexico, government employees’ wages were about 13.5% higher than private-sector wages in 2012.

The same study also showed that wages in the public sector are significantly less unequal than in the private sector. This means that while the public sector pays more than the private sector at the median, the situation is reversed at the top end of the pay scale. This was not the case in Mexico, where the public-sector premium fell to zero but did not become negative. AMLO now wants to join the rest of the continent.

The compressed wage structure that AMLO will introduce typically means that, at the low end, public sector jobs are highly coveted: they offer higher pay, shorter hours, better benefits (such as pensions and health insurance), and greater stability. Turnover tends to be very low and political parties try to make sure that jobs go to their supporters.

By contrast, at the high end, governments often struggle – and often fail – to attract and retain talent. As a consequence, government agencies never develop the deep knowledge, institutional memory, and competence they need to perform their functions effectively. Central banks, with their separate pay scale, often are the exception that proves the rule.

To cope with this competence deficit in their client countries, multilateral development institutions, such as the World Bank, often create project-management units run by higher-paid consultants, and dismantle them when the project is completed. These workarounds are not ideal, because they don’t develop long-term institutional capabilities. To a large extent, Mexico had been an exception, because it paid salaries that enabled the government to attract and retain highly educated career bureaucrats.

Politicians such as AMLO should ask themselves why profit-maximizing firms believe that they cannot boost their bottom lines by saving on senior management salaries. As firms compete for skills, they bid up wages, leaving the public sector with less qualified employees. Clearly, many young people want to work for the government out of an idealistic commitment to public service and as a learning opportunity. But when public-sector wages are depressed, they usually do so for just a few years, before they start a family, and certainly not for a lifetime, which is what many complex public-sector agencies often require.

Is this a problem? Good governments rightly want major firms and the rich to pay their fair share of taxes. They want corporations not to abuse their market power, pollute the environment, or sell unsafe products. They want to protect people from criminal gangs. They want the currency to be stable and financial institutions to be safe, so that people’s savings are secure and taxpayers do not have to bail out the banks. They want public projects that are well conceived and structured, and procurement processes that protect the budget from opportunistic or corrupt suppliers. They want oil and mining concessions to be allocated efficiently and to maximize government revenue.

Trying to accomplish these valuable tasks while paying below-market salaries is penny wise but pound foolish. Tax collectors, regulators, and prosecutors need adequate resources to win their difficult battles.

AMLO’s decision to lower the wages of public employees has already led many high-ranking officials to seek employment elsewhere. Those who are entitled to early retirement are taking it, rather than waiting for AMLO’s cut. Many in AMLO’s own party will celebrate, because they can fill the vacancies with loyalists. But these benefits will come at the cost of a less capable state that is less able to deliver on AMLO’s most cherished goals.

Trying to achieve greater equality through mandated wage compression is not just an odd preference; it is a mistake. It will deliver a state less able to contribute to a more just society.


Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Director of the Center for International Development at Harvard University and a professor of economics at the Harvard Kennedy School.


Teddy Roosevelt Goes to Panama

For the U.S., the Panama Canal symbolized the expansion of its geopolitical power.

By GPF Staff          

In November 1906, Theodore Roosevelt became the first sitting U.S. president to make a diplomatic visit outside the continental United States. On Nov. 9, he sailed for Panama to view the construction of the Panama Canal, a symbol of the expansion of U.S. geopolitical power, for himself.
At its narrowest point, the isthmus of Panama separates the Atlantic and Pacific oceans by a mere 30 miles (50 kilometers). Since the 1500s, explorers and entrepreneurs had dreamed of a path that would drastically cut the time and resources required to cross from one ocean to the other: Sea transit between the U.S. east and west coasts was a weekslong, 13,000-mile journey.
Control over such a path gave Washington a valuable source of revenue and immense geopolitical influence. Alfred Thayer Mahan, the great naval and geopolitical writer, knew that U.S. control of the Central American isthmus, and the possibility of a trans-isthmus canal, would be pivotal for the projection of U.S. military and commercial power. Roosevelt, too, was keenly aware of this; he had served as secretary of the Navy under President William McKinley, who had bolstered U.S. influence in international affairs by extending the U.S. Navy’s geographic reach.
Panamanian author Ovidio Diaz Espino put it simply: “The canal was a geopolitical strategy to make the United States the most powerful nation on earth.” The U.S. would go on to operate the canal for the remainder of the century, bringing in billions of dollars in revenue from the tens of thousands of vessels that used the canal each year. In 1977, with the signing of two U.S.-Panama treaties, the United States agreed to hand over control of the canal to the Panamanian government. The transfer was completed in 1999.