The Smartest Man is a Firedancer

[sjk]

Interesting read for those of us who follow the markets.

Regards,

07/02/2012
The Smartest Man is a Firedancer

When the New Democracy party in Greece defeated the anti-bailout Syriza, I was anxious to learn what The Smartest Man in Europe thought of it all. The next day I flew across the Atlantic to meet him and we had a long discussion about the world financial outlook. Many of you remember The Smartest Man from earlier essays; I have been writing about him annually for more than a decade. He has been a friend for thirty years, and during that period he has shown an almost uncanny ability to see major events affecting the financial markets before other observers. Among these were the fall of Japan as an economic power in the 1980s, the economic changes in China and their significance the early 1990s, and the serious consequences of excessive borrowing in the developed world in the last decade.

His DNA endowed him with a certain amount of business acumen. His ancestors operated canteens along the Silk Road, selling food, weather protection and supplies to travelers to India and China. He apprenticed in finance in New York, but returned to Europe to take advantage of opportunities created during the post-war recovery there. Along the way he has acquired the ABC’s of European wealth – an airplane, a Bentley and a house on a Cap in the French Riviera. The depth and breadth of his art collection is impressive, but material things are not what gives him a high. He gets his thrills from identifying a problem, thinking it through and being right in determining how it gets resolved. In his ninth decade, he is an inspiration to me.

He started out by saying he had done some preparation for our visit. “I think the title of your essay should be ‘Dancing around the Fire of Hell.’ For years I’ve been telling you that the accumulation of debt was going to be the ending of the developed world and for years you have been telling me my views are too extreme. The problem is you are an optimist and I am a realist. You go around with a smile on your face thinking that there are serious problems facing us, but that everything will turn out favorably because the policy makers will do what they have to do to avoid disaster, and so far you have been right. The developed economies and their stock markets have plodded along and investors haven’t made or lost much money in spite of the challenges. At a certain point, however, the temporary measures that the policy makers put in place to avoid financial catastrophe prove insufficient and that’s where we are now. I’m not saying that it will happen tomorrow but events are falling into place that will take the smile off your face.

“The problem is that most investors think incrementally. They don’t step back and look at the whole landscape, which includes how we got here and where we might end up. In democracies the people always want the government to do more for them, but they don’t want to pay higher taxes. Politicians get elected by promising benefits, not by raising the revenues necessary to avoid increasing debt. In a developed economy real growth should equal the population increase plus productivity. For Europe and the United States that’s about 2%, but people there want their economies to grow more than that so the government provides the stimulus to create faster growth and takes on the debt necessary to do it. Everything is fine as long as the cost of ten-year debt doesn’t exceed the nominal growth rate, but when it does the cost of servicing the debt becomes an unsustainable burden, and that’s where Spain and Italy are. The United States isn’t quite there yet.

“When governments finally get around to recognizing they are in trouble, what do they do? They accept the fact that they cannot produce more growth by providing fiscal stimulus because that would only increase the debt problem, and they can’t take the risk of a recession that might clean out the legacy debt obligations because that would prevent future borrowing, so they do the only thing they can do: they print money. That’s what the Federal Reserve did in 2008 when they increased the Fed balance sheet from $1 trillion, virtually all in the U.S. Treasurys, to $2.5 trillion, with the increase mostly in mortgage-backed securities. That’s what the European Central Bank (ECB) did in 2011 when the sovereign debt problems of the weaker countries became severe. The balance sheet of the ECB increased from €2.0 trillion to €3.0 trillion, and the increase was mostly made up of the sovereign debt of the weaker countries.

“This may go on for a while, but it can’t go on forever. In Europe’s case Germany will stop backing the monetary expansion and the U.S. Fed will get uneasy as well. As Milton Friedman persistently argued, inflation is always and everywhere a monetary phenomenon. So far, however, inflation has remained tame because house prices and wages haven’t risen in most places in Europe and the United States (except real estate in London and New York, where foreign capital has flowed in). At some point, however, inflation will become a factor.

“Right now we’re witnessing a kind of convergence. The standard of living in the developed world is declining and the standard of living in the developing world is increasing. Debt to Gross Domestic Product (GDP) ratios in the developed world are about 100%, where, as Ken Rogoff and Carmen Reinhart have pointed out in This Time Is Different, growth becomes modest. In the developing world debt to GDP is only about 35%, so these countries have a long way to go.

“When you think about it, there are a lot more people producing things these days than there were thirty years ago. Up until 1980 the United States was a major manufacturer and accounted for the dominant share of world GDP, about twice as much as it does now. By 1980 Europe was producing goods for export and Japan was selling cars, cameras and consumer electronics to everyone. Now China is the second largest economy in the world and is a major manufacturer, having come from nowhere in the 1970s. With so many places producing so much and some doing it at relatively low cost, is it any wonder that a lot of people in higher labor cost areas like Europe and the United States are out of work? The U.S. today is primarily a service economy with a trade deficit. Germany is a manufacturing economy with a trade surplus. Do you have to ask why one is doing well and the other isn’t?

“Going back to the Greek election, I think it will prove to be a non-event. Antonis Samaras will agree to adhere to the austerity program the previous government signed in March in exchange for financial relief, but it will be hard for him to deliver as required. The Greek people won’t tolerate the pain they will be forced to endure. They are hot-blooded and want to see results quickly. There are only two ways to solve the problems of the weaker countries: austerity, which would mean a 10% contraction in GDP (and Greece is already doing worse than that) or default, which is the route that Russia and Argentina took to get back on track. Ireland is a good example of a country that successfully took the austerity route.

“Before we experience widespread defaults the authorities will pull out every trick in the book to prevent catastrophe. That’s because there is a general belief that the European Union was a good idea. In order to compete against the United States and Asia, the European countries had to hang together. It was as much a geopolitical decision as an economic one. There needs to be more cooperation among the European leaders. The first step is to create a coordinated banking system to prevent a run on the banks. Deposit insurance won’t do the job. It’s too much to expect the various governments to agree to a political union at this time, but there could be a banking union to prevent the European banking system from collapsing.

“The next step will be for every central bank in the world to keep printing money. Ultimately this will bring on a higher level of inflation, but I think the world is ready to accept that. World leaders will agree that growth should be their objective and inflation will be the price they will have to pay for it. This may result in some instability among currencies. Before this happens there will have to be more suffering. Spain and Greece will default. There won’t be outright financial disaster because by the time the defaults take place the banks will have sold most of the troubled sovereign debt on their balance sheets to the European Central Bank. France’s deficit will get worse as Hollande implements some of the programs he talked about in his campaign. Human beings and governments have an unlimited imagination and they will use it to delay the day of reckoning. In the longer term the crisis may turn out to be a good thing because the pain of what we are about to go through will prevent it from ever happening again.

“In the short term interest rates should keep rising because debt is increasing faster than GDP. This should be true in the United States also, but capital is moving there for perceived safety reasons. After the defaults occur, there will be slow growth. The defaults will ultimately create a banking crisis, and that will result in a World Economic Conference where the leaders will agree on an objective of 7% nominal growth made up of the 2% real growth and 5% inflation.

“The Federal Reserve has to keep printing money to prevent a recession. Europe is already in a recession and the ECB will keep printing money, but the Fed may be more aggressive and that could weaken the dollar further. What we are experiencing is an accumulation of bad decisions. The worldwide banking system was able to work together effectively to deal with the financial crisis of 2008 but hasn’t done so well since then. The banks need more capital. Their loans are being written down. Their government bond holdings are declining in value. On top of this, Basel III is imposing additional capital requirements. How does that make sense? It’s impossible. I don’t know whether a default or an economic conference comes first, but in democracies, a crisis usually causes a conference. In the meantime, capital in Europe will continue to flee to Germany, Finland and the Netherlands.

“So what am I doing with my money? It is hard to hide in stocks. Even Danone is reporting disappointing earnings; people are so worried they aren’t even buying yogurt. The French auto companies are in trouble. I think gold is going much higher. I am buying energy stocks because I want to own something real. Preserving capital is my focus now, not making money, but I like IBM and Apple. Also some Swiss multi-nationals. If Obama wins in November the market will go down. A Romney victory will create a rally, but once he gets into office he will find there is not much he can do to make things better.”

I left The Smartest Man’s office somewhat dazed. My optimism was clearly diminished by what he had to say, but I still believe that somehow disaster has a way of usually not happening. It seems clear that world leaders are going to do everything possible to avert a financial catastrophe and I think they have the resources to accomplish that goal. It does seem, however, that the developed world has to resign itself to a prolonged period of slow growth.

* * * * *

http://www.blackstone.com/news-views/market-commentary/blog-detail/byron’s-market-commentary/2012/07/02/the-smartest-man-is-a-firedancer

[CA renter]

Thank you very much for sharing this, sjk.

It all makes sense, except for the part where he suggests that printing money and inflation are the answer to our problems. I think default and deflation would be preferable in the medium-to-long term, especially to workers, but workers do not have a voice in these matters, unfortunately.

We are certainly not out of the woods, and I find it funny that some think we have avoided catastrophe because of all the bailouts and manipulations. IMHO, those are short-term, temporary solutions to much bigger problems.

[spdrun]

You may still get your chance. Keep in mind that Japan had deflation through the 90s and 2000s, despite the manipulations of the merry banksters there.

[CA renter]

[quote=spdrun]You may still get your chance. Keep in mind that Japan had deflation through the 90s and 2000s, despite the manipulations of the merry banksters there.[/quote]

Yes, but I believe it is/was bank intervention that causes the prolonged deflationary environment. If allowed to happen in a swift and severe manner, I believe the deflationary period would be much shorter, and lead to a much healthier recovery.

[The-Shoveler]

The reason Japan had deflation for 20 years it’s that the majority of their citizen were older and or retired and transitioning to fixed income Plus the Japanizes are world class money savers.
The politicians were playing to that base.
Deflation only works for people on fixed income or who have a ton of cash in the bank.

[The-Shoveler]

In short Japan did everything they could not to have inflation.

[CA renter]

[quote=The-Shoveler]In short Japan did everything they could not to have inflation.[/quote]

Exactly. This is what made the deflationary period last so long, IMHO. If they had let it happen swiftly, all those Japanese savers would be in a better position today, IMO.

They also had deflation because of the enormous debt they carried. Debt is inflationary when it’s being incurred, but it’s deflationary in the future as the carrying costs eat away at the purchasing power of workers in the future.

[The-Shoveler]

[quote=CA renter][quote=The-Shoveler]In short Japan did everything they could not to have inflation.[/quote]

Exactly. This is what made the deflationary period last so long, IMHO. If they had let it happen swiftly, all those Japanese savers would be in a better position today, IMO.

They also had deflation because of the enormous debt they carried. Debt is inflationary when it’s being incurred, but it’s deflationary in the future as the carrying costs eat away at the purchasing power of workers in the future.[/quote]

In the case of Japan’s government debt almost all of it is owned by its citizens, so the real carrying cost is almost zero.

It is almost the same with most of the recent U.S.A. debt incurred as almost of it is owned by the Fed. (Almost 6 trillion) and the carrying cost of that is “ZERO”.

Almost all the rest is owned by U.S.A. pension funds (again the real carrying cost of that is almost zero).

China has the most U.S.A. debt of any country at slightly more than one trillion (OK that has a real carrying cost).

[moneymaker]

Great read, until the end. I don’t think energy stocks are nearly as solid as gold, remember Enron?
I personally am going to invest in large cap companies that are paying a dividend above the CPI and in my estimation have a very small chance of going bankrupt. Since China holds so much of our debt, what is their opinion? What is their 5 year plan? I’m pretty sure that while their standard of living may be increasing in general that many of their factory workers probably feel like slaves. I work in the service industry and would love to produce a product but how do you compete against slave labor and a country that would steal your ideas and doesn’t really believe in trademark or patent rights?

[The-Shoveler]

Yes China owns about 7% of all U.S.A. Debt, that is a lot.

Ok if we remove what the Fed owns (which is not really real debt since the service cost is zero), is closer to 10%

But it is growing so it is a problem that really needs to be addressed don’t get me wrong, it’s just not the end of the world just yet.

[The-Shoveler]

Also the labor in China is getting too expensive so from what the experts have been saying it is likely to move a lot closer to home (Mexico).

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