Greg Weldon has long been my favorite slicer and dicer of data – his charts and insights on charts really help me keep my eyes peeled. But in order to get across to us the drastic state of the economy as we plunge headlong into 2014 – a year that we all know will be pivotal – Greg has felt it necessary to resort to a rather trenchant metaphor from the year just past. Yes, says Greg, the economy is … Breaking Bad.

But – listen up now – bad is now good. At least temporarily.

Good, because bad macroeconomic data means an ongoing (if slightly tapering) supply of monetary steroids (Greg’s term) will be forthcoming from our pushers, the central banks of the developed world.

Greg reminds us that the “Breaking Bad Era” actually got underway decades ago. He traces its history back to pre-WWII manipulation of the bullion market; to the historic post-WWII Bretton Woods agreement that gave the US currency “seigniorage,” thus setting it up to become the world’s reserve currency; and right on through to the closing of the gold window by Richard Nixon in 1971.

Since then, the US economy has been dependent on steady – and of course ever-growing – doses of monetary steroids, with only one brief drug-free stint in the Paul Volcker Rehabilitation Center in the 1980s.

And of course the Greenspan Fed did try to do the tighten-up from time to time; but each attempt brought greater pain during withdrawal … and the ever-compassionate Dr. Greenspan took pity on us and increased our monetary prescription.

Now, Greg really socks it to us (and we haven’t even gotten to those charts yet … but we will):

Who, even a short ten years ago, would have ever thought that the most popular shows on US television would be about hero-serial-killers and methamphetamine ‘cooks’?? We could extrapolate to suggest that this reflects the intensifying socio-economic impact of the secular trend related to the polarization of wealth, the expanding production-output efficiency generated by technology, the rise in the level of poverty in the US, and the increased social unrest evidenced by ever more incidents of seemingly random, premeditated violence.

The story line in the award-winning US television show Breaking Bad is ‘Milton-esque’, in that it explores the internal war between good and evil as manifest within the lead character, a high school chemistry teacher who contracts brain cancer. In need of money to pay bills that his health insurance will not cover, the teacher turns to the nefarious underworld of ‘cooking’ crystal-meth.

Greed leads to violence, which in turn leads to chaos and intensifying desperation. Ultimately, things spin out of control, as the teacher-turned-meth-cook finds it impossible to maintain a balance between family values and the ruthlessness of his business.

Therein lies the analogy, as the global situation finally reached the desperation point and threatened to spiral out of control in 2008-09 … when withdrawal from Fed monetary tightening led to organ failure in the housing market, which nearly spilled over into the banking system, [leaving] the US economy perilously close to ‘death’.

We are tempted to say that the US has been in and out of a coma ever since, in the sense that “real” reflation remains flat-lined.

You get the picture.

But now Greg wants us to dig even deeper. Yes, the Fed has “saved” the banking system – for now. And yes, the Fed has refloated the US consumer – on the bloated back of the stock market. (“Note,” says Greg, “the exceptionally ‘tight’ positive-correlation between the Fed’s Balance Sheet, the US S&P 500 stock index, and US Household Net Worth” – great chart follows.)

But in doing all this saving of the economy from itself, Greg wants to argue, the Fed has already sown the seeds of the next macro-market deflationary wave. So let’s give Greg the floor and let him paint the Big Bad Picture for 2014. And be sure to catch his special offer for Outside the Box readers, at the end.

I write this note from Vancouver where I will shortly be speaking to the local CFA organization before traveling on to Edmonton and Regina to speak for their respective CFA groups. I came in to Vancouver early yesterday so that I could finally get the opportunity to meet Frank Giustra, one of the more storied and colorful names in the natural resources field. We have many mutual friends who had been suggesting we get together. The son of an immigrant miner, he is one of those wonderful rags to riches stories that you see from time to time.

Frank hosted a small dinner at his home. Randomly, there was a natural resources conference going on in Vancouver the same day, so Frank was able to get decades-long friend Frank Holmes of US Global to come along, as well as my business partner Olivier Garret, energy maven and speculator Marin Katusa, and a few others. It was one of those special nights where the conversation flowed vibrantly from one topic to the next. Of course we talked about natural resources, but also about robotics and the still-approaching Singularity, the future of work, and the nature of progress – etc. For those who aren’t familiar with Frank, he made most of his money investing in natural resources, was also a founder of the movie production giant Lionsgate, and is a running buddy of Bill Clinton’s. So naturally the talk turned to politics and movies. (Turns out Frank just purchased half the rights to Blade Runner, which may be my pick for all-time best science fiction movie. I am ready for an updated remake!)

Vancouver is one of the most beautiful cities I get to visit. The weather has been spectacular, although I’m told it will turn cold just about as soon as I head east to Edmonton and Regina.

(Wow! I just got word that my old friend Ross Beatty is in town and would like to get together. It’s been a long time. I first met him in the ’80s when he was trying to figure out how to get a little silver out of the ground. I understand that he’s made a few billion here or there in the meantime, mining all sorts of minerals and creating lots of wealth for his investors. Ross Beatty was always and still is a winner. It will be fun to catch up.)

You have a great week and stay warm.

You’re looking for his Under Armor gear analyst,

John Mauldin, Editor
Outside the Box[email protected]

---

Fourteen-For-Fourteen

Fourteen Macro-Market Trading Themes to Watch For During 2014

A Preview of Our Number-One Theme: The United States

We recently finished our 2014 outlook piece entitled “Fourteen-For-Fourteen”, with fourteen separate macro-market ‘trading themes’, all of which offer numerous specific ways in which to participate in a broad and diversified batch of global markets. Our coverage extends from stock indexes, individual equities, ETFs and ETNS, foreign exchange, fixed-income, precious and industrial metals, energy, and agricultural commodities, sectors we discuss every day in our Weldon LIVE research publication.

I have teamed up with my golf buddy John Mauldin to offer a slice (no pun intended) of our first, and perhaps most important, macro-market trading-theme for 2014, as it relates to US Federal Reserve policy, the US consumer, the US stock market, and US Bonds.

(Details on how to get our “Fourteen-For-Fourteen“, at a special, discounted, Outside the Box price, can be found at the end of our preview.)

We begin with a headline that caught my eye the other morning, culled from Bloomberg …

… “India’s SENSEX rose 1.8 percent today, the most in three weeks, after an unexpected drop in factory output spurred optimism that the central bank will not raise interest rates.”

We might call this the ‘Breaking Bad Era’.

Bad is now good.

Good, because bad macro-data means … a continued flow of monetary steroids from Central Banks.

Indeed, whether it be India, the UK, Japan, the EU, or the US, bad economic data is celebrated, as is so grossly evidenced by the reaction seen on television, amid stock market exuberance and the resultant extension in net worth/wealth reflation.

Indeed, just like any addict, the global markets, not to mention the underlying global macro-economy, have come to RELY ON a steady dose of monetary steroids, without which withdrawal kicks in, muscle atrophy intensifies, and eventually organ failure ensues.

We see this already, within the US labor market … atrophy without a steady, if not ever increasing, dose of monetary “roids”.

Our regular readers know that we have been all over this ‘theme’ for years.

In my book “Gold Trading Boot Camp” (Nov-2006) I examined the then-intensifying trend towards a blow-out in the massive credit bubble in US Housing facilitated by the Fed’s response to the 1997-98 global crisis, and the 2000-01 tech-bubble-bursting crash. I laid out the scenarios in which the Federal Reserve would need to ride their monetary white-horse to the rescue, to avert a full-blown credit crash and debt deflation …

… by conducting outright purchases of US Treasury securities.

Even as late as 2006, anyone opining such a blasphemous thought was considered a monetary heretic.

Now the history books are being ‘re-written’, while the un-written mandate of the US Federal Reserve and other global Central Banks  has subtly-yet-significantly shifted, exactly as we said it would way back in the nineties, from preventing a repeat of the 1970’s inflation, to circumventing a full-blown debt deflation and macro-economic depression.

We said quite blatantly, two decades ago, that … “someday the Fed will pursue inflation.”

Blasphemy !!! Pure monetary heresy !!!

Now it’s called the “new normal”.

But, as we laid-out in “Gold Trading Boot Camp”, what we now call the ‘Breaking Bad Era’ began decades ago.

We traced the history back to pre-WWII manipulation of the bullion market, the historic post-WWII Bretton Woods agreement that gave the US currency ‘seigniorage’, thus setting it up to become the ‘world’s reserve currency’, right through to the closing of the Gold window by US President Richard Nixon in August of 1971, the spark that truly started this ‘fire’.

The US macro-market has been taking monetary steroids since 1971, with a brief stint spent ‘drug free’, while residing in the Paul Volcker rehab center.

Each successive tightening brings greater pain during withdrawal, which then drives Central Bankers to increase the monetary dosage, to the point where the once unthinkable has occurred, and the Assets Held Outright by the Fed will balloon to more than $4 trillion, most of which is held in US government debt.

Indeed, consider this … who, even a short ten-years ago, would have ever thought that the most popular shows on US television would be about hero-serial-killers and methamphetamine ‘cooks’ ?? We could extrapolate to suggest that this reflects the intensifying socio-economic impact of the secular trend related to the polarization of wealth, the expanding production-output efficiency generated by technology, the rise in the level of poverty in the US, and the increased social unrest evidenced by evermore incidents of seemingly random, pre-meditated violence.

The story line in the award-winning US television show “Breaking Bad” is ‘Milton-esque’, in that it explores the internal war between good and evil as manifest within the lead character, a high school chemistry teacher who contracts brain cancer. In need of money to pay bills that his health insurance will not cover, the teacher turns to the nefarious underworld of ‘cooking’ crystal-meth.

Greed leads to violence, which in turn leads to chaos and intensifying desperation. Ultimately, things spin out of control, as the teacher-turned-meth-cook finds it impossible to maintain a balance between family values, and the ruthlessness of his business.

Therein lies the analogy, as the global situation finally reached the desperation point, and threatened to spiral out of control in 2008-09 … when withdrawal from Fed monetary tightening led to organ failure in the housing market, which nearly spilled over into the banking system, putting the US economy perilously close to ‘death’.

We are tempted to say that the US has been in and out of a coma ever since, in the sense that “real” reflation remains flat-lined.

Yet, there have been some bright spots, some limb movements and facial expressions emanating specifically from the US consumer, and from corporate America as it relates to streamlined efficiency and increased competitiveness.

The Fed successfully ‘saved’ the banking system, for now.

The Fed successfully kept the US consumer afloat.

Moreover, the Fed has facilitated an unprecedented reflation in US Net Worth. But, this reflation comes in PAPER wealth, NOT wage-income, which is still glaringly lacking.

Witness the chart below plotting the path of US Household Net Worth, which has spiked to a new all-time high, with a near-$22 trillion expansion from the 2009 secular crisis low.

But in so doing, we could argue that the Fed has already sown the seeds for the next macro-market deflationary wave.

We can directly connect the dots.

It all starts with Fed purchases of government debt …

… which has led to the reflation in the US equity market …

… almost single-handedly generating a huge expansion in US Net Worth.

From there we can continue to draw a straight-line to the fact that the strongest improvement within the underlying macro-economy has been seen specifically in sentiment-derived numbers …

… which leads us directly to the virtually unnoticed renewed blow-out in US consumer credit…

… which has ‘funded’ the robust recovery in retail sales and US final household demand.

And finally, it is an easy link to the upside outperformance and leadership exhibited in the stock market since the advent of QE, by the Consumer Discretionary sector.

Note the exceptionally ‘tight’ positive-correlation between the Fed’s Balance Sheet, the US S+P 500 stock index, and US Household Net Worth, as evidenced in the overlay chart below. Indeed, since the advent of QE-III the movements of the US stock market and the Fed’s Balance Sheet have become almost identical.

With US Households ‘feeling’ STRONG thanks to massive injections of monetary steroids, and a renewed feeling of invincibility among stock market investors, consumers are flexing their muscles by borrowing significant amounts of ‘cash’.

We offer hard-core data as evidence. As seen in the chart below, we can identify more months of double-digit (as in more than $10 billion) growth in the Fed’s own measure of Consumer Credit over the last three-years, than during ANY other period in the post-WWII timeline.

Note further, that the 5-Year Average of monthly borrowing has almost returned to the pre-2007 crisis highs.

In essence, we can very comfortably argue that the Fed has facilitated another credit-fueled recovery, wherein the US consumer is, again, borrowing aggressively against a collateral base that is ‘defined’ by paper wealth, rather than ‘real’ income growth.

The stock market has replaced the housing market as that collateral base against which the US consumer is now borrowing hand-over-fist.

Yes, there are differences, the ”breadth’ of this ‘reflation’ is not the same as it was with the mortgage market debacle. Banks are (allegedly) not involved, with bank lending growth remaining less than overtly reflationary.

But the similarities are intriguing, if not somewhat frightening, as US households place massive bets, again, that the stock market is in a Nirvana-like, perma-bull market, and that ‘tapering’ is not a threat …

… just like US households placed massive bets that housing prices were incapable of deflating.

Not only that, but tapering has a major impact on the US bond market, with buyers having become increasingly scarce, against which the tide of supply does NOT recede for several years, if even then.

A rise in interest rates that has a negative impact on the US stock market would require another dose of monetary steroids, because the implications of a deflation in stocks would be too significant for the underlying macro-economy to handle.

To simplify, the unwritten mandate of the Fed is now singular; to prevent the stock market from failing.

The greater fear stems from thoughts that the macro-market dynamic has been internally ravaged by years of steroid abuse, and anything less than an increase in ‘roid’ dosage from the Fed may lose its effectiveness in fighting macro-muscle atrophy.

We could say we see evidence of this already, in the expanding and recently developed divergences exhibited within the overlay chart on display below.

Notice how Gold led the charge into QE-II, peaked first, and rolled over first, breaking down, and plunging amid disinvestment and a rotation out of safety, and into risk assets.

Next it was Home Prices, peaking, and most recently … breaking down.

We could add Emerging Market stock indexes, Emerging Market Bond prices, Emerging Market currencies … and … the CRB Index … all of which have followed Gold to the downside, in a GLARING example of the ‘internal atrophy’ taking place, as per the global market’s narrowing response to Fed QE.

Subsequently, we theorize that there is significant risk associated with tapering, particularly when tapering turns into ‘tapping out’, when the Fed reaches the point where they are no longer buying-to-accumulate any assets. There is risk that ‘extends’ to the stock market, for its tight, reliant relationship with the Fed’s Balance Sheet (our detailed “Fourteen-For-Fourteen” digs deeper into this dynamic, with specific ‘predictions’ for the path of the S+P 500 in 2014, based on the pace of tapering).

But more pointedly the risk emanates from the potential impact on US Treasury Bond and Note yields, as a result of an eventual ‘tap out’ by the Fed.

We find it most interesting to observe the overlay chart below in which we plot the Fed’s Assets Held Outright (black line) versus Custody Holdings (foreign official holdings of US Treasury securities, red line). We first focus on the rise in the Fed’s Balance sheet associated with QE-III, during which time bond and note yields in the US have risen.

Secondly, and most importantly, we shine the spotlight on the peak in Custody Holdings, and the DECLINE in 2013. For sure, it is NOT a coincidence that foreign officialdom turned NET SELLERS of US Treasuries in May, precisely on the back of Fed Chair Ben Bernanke’s first mention of ‘taper’.

Demand from foreign officialdom is flat, at best.

The US ‘public’ is not buying bonds.

The US ‘public’ has followed the lead of the Pied Piper Ben Bernanke, the monetary maestro, who has carried the day on his back with some spectacular flute playing, calming the masses, resurrecting confidence, and facilitating a rotation out of safety (bonds, gold) and back into risk assets, stocks specifically.

So, from where will the marginal buyer of US Treasury bonds appear ??

No doubt, there is NO dearth of supply.

We examine the ‘schedule’ of ‘Treasury Obligations’ seen below.

Need we say more ??

A tsunami of Treasury supply, no matter how you slice-and-dice it.

And the Fed is potentially, probably, pulling the plug on a half-trillion a year in ‘support’??

Moreover, that ‘support’ which is to be removed represents pure monetization, actual evaporation of debt (for all intents and purposes).

Tapering to a ‘tap-out’ also means more supply in ‘perpetual roll-over’.

Over the next five-years, that is virtually $2.5 trillion.

When we add the new debt, needed to finance this year’s (fiscal) deficit, well the numbers start to add up very quickly. Yes, seeing the annual US deficit ‘shrink’ (laughter) by half, from $1 trillion, to something closer to $500 billion, could be labeled ‘improvement’. But, just five years ago the current deficits would have been record breaking, and still represent a significant, on-going, supply side issue.

So, who is the ‘marginal’ buyer of US debt ?? Who will help maintain ‘equilibrium’ to where Treasury yields will not rise ??

From a simple supply-demand dynamic, the risk-reward skew is to the upside in bond yields.

Of course things are never simple.

Especially in the Breaking Bad Era, where BAD is GOOD !!!

Evidence last week’s US payroll data … and the hundreds of thousands of chronically unemployed who simply fell out of the ‘equation’. This alone speaks volumes to the dysfunction in the US labor market.

But still, even during any initial ‘positive’ reaction to the ‘negative’ news, we might offer a thought: any macro-economic deflation that is deep enough to sway the Fed, will also have an impact on the fiscal side of this dual-headed coin … most probably towards increased bond supply.

Yet still, some might hypothesize that there is a major difference now, than during the housing-credit-deflation induced event of 2008-09, the banking system was saved, and is now solid.

As evidenced, of course, in this new era … by rising bank share prices.

For sure, banks are more ‘liquid’.

No debate.

Thanks to the Fed, and the Fed only, as is clear upon a survey of the overlay chart below revealing the link in Bank Balance Sheets, a distinctively direct link … to the Fed’s Balance Sheet.

And while bullish for the bank shares, this dynamic is not ‘positive’.

Indeed, only in the ‘Breaking Bad Era’ could this be construed as ‘positive’. But it is not positive, not when it means banks sit on their own mountain of ‘cash’ (aka, US Treasury securities), instead of lending that money.

Moreover, with huge holdings of US Treasuries, In the advent of another deflationary wave banks could well turn net sellers of government debt.

In other words, do not look to US financial institutions to plug any hole that might develop in the US bond market.

Another, less obvious reason that we say the rise in ‘cash’ held by banks is not ‘positive’, has to do with what is happening in the background with Bank Balance Sheets. The level of cash-securities held by US Commercial Banks, about $2.7 trillion, is peanuts compared to the level of risk banks are carrying in terms of ‘Derivative Holdings’.

In fact, as we try to comprehend the figures shown in the chart below, extracted from the FDIC’s Quarterly Banking Profile’s breakdown of Commercial Bank Balance Sheets … we are continually shocked.

Shocked to think that during this period of Fed largesse, during this period where the banks are allegedly healing as they do dispose of some non-performing assets … the risk is rising again, and rising rapidly.

Most troubling is the fact that the vast majority of the rise in, and the total of, Derivative holdings, roughly $225 trillion, yes trillion, are labeled as Derivatives Held for “Trading Purposes”, as opposed to being held for “Hedging Purposes’.

Indeed, it appears that risk and leverage in the banking system is still alive and well. No wonder the biggest banks, who hold the lion’s share of the derivative risk, now carry the moniker of ‘too big to fail.

They are called that because they are, literally … “too big” … specifically as it applies to their holdings of Derivatives for Trading Purposes (again, pegged at $225 trillion).

The simple fact that in the twelve-months ending June-2013 (data release lagged by the FDIC, one reason it goes largely unnoticed), Bank holdings of Derivative contracts linked to ‘trading'(aka profit generation) rose by more than $11 trillion …

… which dwarfs the expansion in Bank cash holdings …

… dwarfs the expansion in Bank Deposits …

… and, even more ‘tellingly’, dwarfs the expansion in the Fed’s Balance Sheet, over that same period, by about ten-to-one.

And most acutely frightening is the fact that the expansion in derivative exposure is most focused in Fixed-Income derivatives, by far, as seen below ($188.3 trillion, yes, trillion, in Fixed-Income contracts alone).

Clearly, the Fed is walking a tightrope.

Again, in our view, the risk-reward skew in the US Treasury market, for 2014, is tilted towards rising yields, which points us in the direction of strategies that accept that premise.

In our “Fourteen-For-Fourteen” we offer an even more detailed look at the US Treasury market specifically, from a technical perspective, and a strategic perspective.

We also take a closer look at the US consumer, household net worth, retail sales, and even gasoline prices, as factors that will play into the US based theme during 2014.

And that, is just our first of fourteen major macro-market themes for 2014, which encompass more than 200 pages of charts, graphs, and data slides covering both fundamental and technical analysis.

It is with a heartfelt thank-you that I nod in the direction of my colleague and conference-golf buddy John Mauldin; the man behind the curtain, Ed D’Agostino; the gang at Mauldin Economics; and my Kiawah Island golf buddy Grant Williams, for their willingness to participate with us in offering this preview of our 2014 Outlook.

Our fourteen market themes for 2014 include careful examinations of the monetary policy challenges faced by multiple Central Banks’ and the potential impact on the bond, FX and stock markets (including Exchange Traded Funds).

We also highlight some very specific currency challenges in some key regions especially as it relates to devaluations and competitive depreciation, and how that will impact the global markets. And, we shine the spotlight on a few very specific metals and energy opportunities with some compelling market charts and inter-market analysis.

Finally, we offer a few commodity plays in line with their underlying supply-demand fundamentals, including focus on the parallel opportunities within the commodity ETN universe.

All fourteen themes have been produced as separate chapters in video form (and come with a printable pdf version), all of which include detailed market charts and audio commentary.

ACT NOW to get all Fourteen Macro Themes at a special discounted rate (over 15% off) for readers of John Mauldin’s Outside the Box.

SEND $249.99 to [email protected] via www.paypal.com

Or email [email protected] and get special access now.

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PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

 

Piloting on the Mississippi River was not work to me; it was play — delightful play, vigorous play, adventurous play – and I loved it…

– Mark Twain

In the 1850s, flat-bottom paddlewheel steamboats coursed up and down the mighty Mississippi, opening up the Midwest to trade and travel. But it was treacherous travel. The current was constantly shifting the sandbars underneath the placid, smoothly rolling surface of the river. What was sufficient depth one week on a stretch of the river might become a treacherous sandbar the next, upon which a steamboat could run aground, perhaps even breaching the hull and sinking the ship. To prevent such a catastrophe, a crewman would throw a long rope with a lead weight at the end as far in front of the boat as possible (and thus the crewman was called the leadman). The rope was usually twenty-five fathoms long and was marked at increments of two, three, five, seven, ten, fifteen, seventeen and twenty fathoms. A fathom was originally the distance between a man’s outstretched hands, but since this could be quite imprecise, it evolved to be six feet.

The leadsman would usually stand on a platform, called “the chains,” which projected from the ship over the water, and “sound” from there. A typical sound would be expressed as “By the mark 7,” or whatever the depth was. In modern English language, it is interesting to note that the expression “deep six,” refers to this old method of measuring water. On the Mississippi River in the 1850s, the leadsmen also used old-fashioned words for some of the numbers; for example instead of “two” they would say “twain”. Thus when the depth was two fathoms, they would call “by the mark twain!” (bymarktwain.com)

And thus a young Samuel Clemens, apprentice Mississippi riverboat pilot, would take the “soundings” and from time to time would sing out the depth of two fathoms as “By the mark twain!” We think that is how he found his pen name. In Life on the Mississippi, Mark Twain describes sounding: “Often there is a deal of fun and excitement about sounding, especially if it is a glorious summer day, or a blustering night. But in winter the cold and the peril take most of the fun out of it.”

The pilot would much prefer to hear the sweet sing-song call of “no bottom,” as that meant there was no danger of running aground. “Mark twain,” or 12 feet, was getting rather shallow for some of the larger vessels and so sounded a note of caution.

On their surface today the markets seem as smooth and flowing as Old Man River, but are there sandbars lurking in the depths? Will the journey this year be as fast and easy as in the last five? Can we plunge on into the night, relishing the call of “No bottom” that we are hearing from the bulls? Or is that a cry of “Mark twain!” telling us to be cautious?

Perhaps we should take our own soundings from the data to see what might lie up ahead. This week, in the third part of my 2014 forecast, we’ll look in particular at the US markets as a proxy for markets in general. (This letter will print a little longer as there are lots of charts.)

But first, I am pleased to announce that my friend former House Speaker Newt Gingrich will be at my conference this May 13-16 in San Diego, joining (so far) Niall Ferguson, Kyle Bass, Ian Bremmer, David Rosenberg, Dr. Lacy Hunt, Dylan Grice, David Rosenberg, David Zervos, Rich Yamarone, Code Red coauthor Jonathan Tepper, Jeff Gundlach, Paul McCulley, and a few more surprises waiting to confirm. Nothing but headliners, one after the other.

When I first broached the idea of our conference with Jon Sundt, the founder of cosponsor Altegris, the one rule I had was that I wanted the conference to be one I would want to attend. The usual conference boasts a few headliners, and then the sponsors fill out the lineup. I wanted to do a conference where no speaker could buy his way onto the platform. That means we often lose money on the conference (hard as that may be to imagine, at the price, I acknowledge); however, the purpose is not to make money but to learn with – and maybe have some fun with – great people. We do put on a great show, and my partners make sure it is run well. But the best part will be your fellow attendees. A lot of long-term friendships are forged at this conference. You can learn more and sign up at http://www.altegris.com/sic.

It’s All About the Earnings

For over a dozen years I have regularly compared notes on S&P 500 earnings with my friend Ed Easterling. For Ed, the subject borders on an obsession. I am, of course, far more reserved in my enthusiasm. We have co-authored numerous articles, and Ed never fails to call to my attention anything unusual that happens on the earnings front. He is the ultimate data wonk, and I say that in an affectionate way. Ed has what I think is one of the best data research sites anywhere at www.crestmontresearch.com. So this week I read his latest email, about the uptick in the forecast earnings of the S&P 500, with considerable interest.

As they do at this time of year, S&P posted an update to their 2014 EPS (earnings per share) forecast. For newbies, “as-reported” earnings are earnings as reported to the tax authorities, and we can more or less think of them as real earnings. “Operating earnings,” on the other hand, are what companies like you to pay attention to. They exclude one-time charges and other things that companies find inconvenient. I call operating earnings “EBIH earnings” – earnings before interest and hype.

S&P conveniently gathers forecasted earnings data from numerous analysts and amalgamates it in one big spreadsheet along with the history of actual earnings. You can access their spreadsheet here. The data we will be looking at will come from the first tab, but there is also a lot of data commentary from Howard Silverblatt, the longtime curator and maven of all things earnings.

The forecast for 2014 as-reported earnings was $106 in late December. Now it’s $119.70 – up 13% from the previous forecast just two weeks ago and up 20% versus the 2013 estimate of $99.42. Since 2013 has concluded, that number will be revised only slightly. Silverblatt says the revised figure is based upon an improved outlook rather than something technical like an accounting change.

The table below is a screenshot from the Excel spreadsheet. Note that, depending on which set of earnings you want to use (and Ed and I prefer to use as-reported as opposed to operating earnings), if the forecasters are right, then the P/E ratio at the end of 2014 will be in the neighborhood of 15, less than the long-term average and down considerably from today’s. This can only be described as a bullish number.

Ed notes in a quick email, which spurred a long telephone conversation, that “The 2015 forecast is still a month or so away – yet just imagine the bull stampede if it comes in +15%. That’ll would take the figure to $138 and a forward “next year” P/E of only 13 when the trailing 20-year Shiller P/E10 is 25.4.”

I would have ended that sentence with an exclamation point (!), but Ed is more even-tempered in his writing. Still, a price-to-earnings ratio of 13, published on the official S&P website for all the world to see, would have the bulls salivating. It would even have me close to “pounding-the-table-bullish,” as a true P/E of 13 is quite favorable for the long term (say, ten years). So should we take the forward-looking view? If that P/E ratio of 13 based on today’s price of the S&P 500 turns out to be the reality, another 30% year is well within the scope of possibilities and might likely be considered the most probable outcome.

And the markets seem to think that will be the case. Lately, it seems every week (and sometimes every day) brings a new all-time high. For fans of Mad magazine, it’s an Alfred E. Newman world: “What? Me worry?” Volatility is back at pre-crisis lows, as the chart below illustrates.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but take heed: prices do not always reflect reality, and analysts’ expectations consistently tend to overstate actual earnings, as you can see in the following graph from a 2010 McKinsey on Finance Study, Equity analysts: Still too bullish. When that graph gets updated next year, we will see that nothing has changed.

For the record, I was citing similar research back in 2003 in my book Bull’s Eye Investing. In fact, there was a whole chapter on the topic of analysts’ estimates. They also tend to be too bearish at market bottoms. Basically, analysts tend to forecast for the near future more of what has happened in the recent past. At turning points they really miss the boat.

If we look at recent years in light of long-term valuations and market behavior, we see that the combination of high and rising valuations, low and suppressed volatility, and a relatively weak trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

The S&P 500 Index returned 32% excluding dividends from January 1, 2012, through January 17, 2014. Over that time frame, real earnings grew by less than 8%…

… while the trailing 12-month price-to-earnings multiple has expanded by nearly 30%, from 12.8x to 17.3x.

That means most of the recent gains in US equity markets have been driven by multiple expansion, in spite of sluggish real earnings growth. Despite an improvement in the real earnings trend since I dug into US stock market valuations, multiple expansion, and earnings last August, the disproportionate amount of gains attributable to multiple expansion versus gains attributable to earnings is a clear sign that sentiment, rather than fundamentals, may be the dominant force driving the markets higher.

Of course, the simple trailing 12-month price-to-earnings ratio can be misleading at critical turning points if you are trying to handicap the potential for long-term returns. For example, the collapse in real earnings during the global financial crisis sent the S&P 500’s trailing P/E multiple through the roof by March 2009. So, while trailing P/E is a useful tool for understanding what has already happened in the market, Dr. Robert Shiller’s “cyclically adjusted price-to-earnings ratio” (commonly known as the “Shiller P/E” or “CAPE”) is far more useful for calculating a reasonable range of expected returns going forward.

As I wrote back in August 2013 when the prevailing Shiller P/E sat near 24, this approach won’t help you much with short-term market timing; but current valuations have historically proven extremely useful in forecasting long-term returns. In his book Irrational Exuberance (2005), Dr. Shiller shows how this approach “confirms that long-term investors – investors who commit their money to an investment for ten full years – did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well-advised, individually, to lower their exposure to the stock market when it is high … and to get into the market when it is low.”

As you can see in in the graph above, compared to the more common trailing 12-month P/E ratio, the Shiller P/E metric essentially smooths out the series and helps us avoid false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past ten years. Historically, this ratio has peaked and given way to major market declines at around 29x on average (or 26x excluding the dot-com bubble), and it has bottomed in the mid-single digits.

Not only does today’s Shiller P/E of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years, coupled with sluggish earnings growth, suggests that this market is also seriously overbought. Today’s markets are just slightly less expensive than the 27x level seen at the October 2007 market peak and are only modestly below the levels seen before the stock market crash in 1929. Although we are nowhere near the all-time “stupid” peak of 43x reached in March 2000, a powerful narrative drove the markets to clearly unsustainable levels then, and a powerful narrative is driving markets today. In many ways, faith in the Federal Reserve today is roughly equivalent to faith in the words dot com in 1999.

While it may be impossible to accurately predict when this policy-driven market will break, history suggests it would be very reasonable for the secular bear to eventually bottom at a P/E multiple between 5x and 10x, opening up one of the rare wealth-creation opportunities to deploy capital at truly cheap prices.

Sometimes we have to wade through what may seem like deceptively dry technical details to sort out compelling conclusions, but I hope you’ll focus on the main idea: We are not talking about the potential for a modest 20% to 30% drawdown in the US stock market. If the historical relationship between Shiller’s P/E and consequent returns is any indication, we are talking about the potential for a 50%+ peak-to-trough drawdown and ten-year average annual returns as bad as -6.1%, according to the chart below from Cliff Asness at AQR. Such a result would fall in line with somewhat similar deleveraging periods such as the United States experienced in the 1930s and Japan has experienced since 1989. There is no way to sugarcoat it: too much equity risk can be unproductive and even destructive in this kind of economic environment.

But where there is danger there is also opportunity. I believe this is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios.

On that front, keep a lookout for a special report that we will release in the next week to share five critical steps you can take to defend your portfolio from economic disasters, bankrupt governments (or governments that are testing their borrowing limits), and increasingly desperate governments. It will be a free report for all Thoughts from the Frontline readers, and we hope you will share it with everyone you know.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

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In last week’s Thoughts from the Frontline I talked about the Age of Transformation, attempting to refute Robert’s Gordon rather stark and gloomy view of the future growth potential of the economy. That letter generated a rather significant amount of reader response, both pro and con, as not everyone agrees with my decidedly optimistic long-term view of the future.  It might be fun and thought-provoking, in fact, to do a letter that deals with some of the issues you raised. I really do have some of the smartest readers of any economics and investing letter out there.

Inside what was a long letter even for me, I buried a few quotes from George Gilder’s latest book, Knowledge and Power. I am not simply reading this book, I am thinking through it, as some of what he writes is truly pivotal for my own thought process.

For this week’s Outside the Box, George has graciously allowed me to reproduce chapters 1 and 3 from his book. It helps that George is a gifted wordsmith and a raconteur of the highest order. He doesn’t bury his insights in dry economics-speak that demands intense concentration if you are to stay focused on the topic. Rather, he draws you into and through the topic, until you find yourself on a delightful Slip ‘n Slide of thought. I think you will get a lot out of reading these chapters, and I strongly suggest you consider reading the whole book. It is an important one.

I write this note as I am wrapping up three days of meetings with my partners at Altegris Investments and Mauldin Economics, focusing on how to deliver better products and services to you. And we’ve enjoyed a few late-night conversations about where the world is going and how to surf the inevitable and the profitable.

In a few hours I will be off to Dubai and Riyadh, with maybe even a side trip to Abu Dhabi, after a very long layover in London, where I will jump into town to have lunch with Simon Hunt and delve deep into the happenings in China and Europe. I’ll also bounce a few ideas off him for this weekend’s letter.

I am really kind of excited about this trip, as all these places are new territory for me. You have a great week, and I will send you this weekend’s letter from Dubai.

Your wondering what I will find out there analyst,

John Mauldin, Editor
Outside the Box[email protected]

Knowledge and Power

By George Gilder

Chapter One: The Need for a New Economics

Economic life is full of surprises. We cannot predict the value of our homes or prices on the stock market from day to day. We cannot anticipate illness or automobile accidents, the behavior of our children or the incomes of our parents. We cannot know the weather beyond a week or so. We cannot gauge what course of college study will yield the best lifetime earnings or career. We are constantly startled by newspaper headlines or the eruptions of TV events. We are almost entirely incapable of predicting the future.

Yet from Adam Smith’s day to our own the chief concern of the discipline has been to render economic events unsurprising. Given a supply x of corn and a demand y, the price will be z. Change x or y and hold all else equal and the price will instead be a predictable z′. The discernment of orderly rules governing the apparent chaos of life was a remarkable achievement and continues to amaze. Economists such as Steven Leavitt of Freakonomics fame and Gary Becker of the University of Chicago became media stars for their uncanny ability to unveil what “we should have known.” Closer investigation, however, reveals that even these ingenious analysts are gifted chiefly with 20-20 hindsight. They prosper by explaining to us what has happened more than by anticipating the future with prescient investments.

The passion for finding the system in experience, replacing surprise with order, is a persistent part of human nature. In the late eighteenth century, when Smith wrote The Wealth of Nations, the passion for order found its fulfillment in the most astonishing intellectual event of the seventeenth century: the invention of the calculus. Powered by the calculus, the new physics of Isaac Newton and his followers wrought mathematical order from what was previously a muddle of alchemy and astronomy, projection and prayer. The new physics depicted a universe governed by tersely stated rules that could yield exquisitely accurate predictions. Science came to mean the elimination of surprise. It outlawed miracles, because miracles are above all unexpected.

The elimination of surprise in some fields is the condition for creativity in others. If the compass fails to track North, no one can discover America. The world shrinks to a mystery of weather and waves. The breakthroughs of determinism in physics provided a reliable compass for three centuries of human progress.

Inspired by Newton’s vision of the universe as “a great machine,” Smith’s theory—launched in The Wealth of Nations in 1776—sought to find similarly mechanical predictability in economics. In this case, the “invisible hand” of market incentives plays the role of gravity in classical physics. Codified over the subsequent 150 years and capped in Alfred Marshall’s Principles of Economics, the classical model remains a triumph of the human mind, an arrestingly clear and useful description of economic systems and the core principles that allow them to thrive.

Ignored in all this luminous achievement, however, was the one unbridgeable gap between physics and any such science of human behavior: the surprises that arise from free will and human creativity. The miracles forbidden in deterministic physics are not only routine in economics, they constitute the most important economic events. For a miracle is simply an innovation, a sudden and bountiful addition of information to the system. Newtonian physics does not admit of new information of this kind—describe a system and you are pretty much done. Describe an economic system and you have described only the circumstances—favorable or unfavorable—for future innovation.

In Newton’s physics, the equations encompass and describe change, but there is no need to describe the agent of this change, the creator of new information. (Newton was a devout Christian but his system relieved God or his angels of the need to steer the spheres.) In an economy, however, everything useful or interesting depends on agents of change called entrepreneurs. An economics of systems only—an economics of markets but not of men—is fatally flawed.

As the eminent mathematician Gregory Chaitin has pointed out, for human and biological processes, the calculus does not suffice. He writes: “Life is plastic, creative! How can we build this out of static, eternal, perfect mathematics? We shall use post-modern math…open not closed math, the math of creativity…”

Flawed from its foundation, economics as a whole has failed to improve much with time. As it both ossified into an academic establishment and mutated into mathematics, the Newtonian scheme became a mirage of determinism in a tempestuous world of human actions. Economists became preoccupied with mechanical models of markets and uninterested in the willful people who inhabit them.

Some economists become obsessed with market efficiency and others with market failure. Generally held to be members of opposite schools—“freshwater” and “saltwater,” Chicago and Cambridge, liberal and conservative, Austrian and Keynesian—both sides share an essential economic vision. They see their discipline as successful insofar as it eliminates surprise—insofar, that is, as the inexorable workings of the machine override the initiatives of the human actors.

“Free market” economists believe in the triumph of the system and want to let it alone to find its equilibrium, the stasis of optimum allocation of resources. Socialists see the failures of the system and want to impose equilibrium from above. Neither spends much time thinking about the miracles that repeatedly save us from the equilibrium of starvation and death.

The late financial crisis was perhaps the first in history actually to be caused by economists. Entranced by statistical models, they ignored the larger dimensions of human creativity and freedom. To cite an obvious example, “structured finance”—the conglomerations of thousands of dubious mortgages diced and sliced and recombined and all trebly insured against failure—was supposed to eliminate the surprise of mortgage defaults. The mortgage defaults that came anyway and triggered the collapse came not from the aggregate inability of debtors to pay as calculated by the economists, but from the free acts of home buyers. Having bet on constantly rising home prices, they simply folded their hands and walked away when the value of their houses collapsed. The bankers had accounted for everything but free will.

The real error, however, was a divorce between the people on the ground who understood the situation and the people who made the decisions. John Allison is the former CEO of a North Carolina bank, BB&T, which profitably surmounted the crisis after growing from $4.5 billion of assets in 1989 when he took over to $152 billion in 2008. Allison ascribed his success to decentralization of power in the branches of his bank.

But decentralized power, he warned, has to be guarded from the well-meaning elites “who like to run their system and hate deviations.” So as CEO, Allison had to insist to his managers that with localized decision-making, “We get better information, we get faster decisions, we understand the market better.”

Allison was espousing a central insight of the new economics of information. At the heart of capitalism is the unification of knowledge and power.  As Friedrich Hayek, leader of the Austrian school of economics, put it, “To assume all the knowledge to be given to a single mind … is to disregard everything that is important and significant in the real world.” Because knowledge is dispersed, so must be power. Leading classical thinkers such as Thomas Sowell and supply-siders such as Robert Mundell refined the theory. All saw that the crucial knowledge in economies originated in individual human minds and thus was intrinsically centrifugal, dispersed and distributed.

Enforced by genetics, sexual reproduction, perspective and experience, the most manifest characteristic of human beings is their diversity. The freer an economy is, the more this human diversity of knowledge will be manifested. By contrast, political power originates in top-down processes—governments, monopolies, regulators, elite institutions, all attempting to quell human diversity and impose order. Thus power always seeks centralization.

The war between the centrifuge of knowledge and the centripetal pull of power remains the prime conflict in all economies. Reconciling the two impulses is a new economics, an economics that puts free will and the innovating entrepreneur not on the periphery but at the center of the system. It is an economics of surprise that distributes power as it extends knowledge. It is an economics of disequilibrium and disruption that tests its inventions in the crucible of a competitive marketplace. It is an economics that accords with the constantly surprising fluctuations of our lives.

In a sense, I introduced such an economics more than 30 years ago in my book Wealth&Poverty and reintroduced it in 2012 in a new edition. It spoke of economics as “a largely spontaneous and mostly unpredictable flow of increasing diversity and differentiation and new products and modes of production…full of the mystery of all living and growing things (like ideas and businesses).” Heralding what was called “supply side economics” (for its disparagement of mere monetary demand), it celebrated the surprises of entrepreneurial creativity. The original work was widely popular around the globe, published in 15 languages and for six months reigning as the number one book in France. President Ronald Reagan made me his most quoted living author.

In the decades between the publication of the two editions of Wealth&Poverty, I became a venture capitalist and deeply engaged myself in studying the dynamics of computer and networking technologies and the theories of information behind them. In the process, I began to see a new way of addressing the issues of economics and surprise.

Explicitly focusing on knowledge and power allows us to transcend rancorous charges of socialism and fascism, greed and graft, “voodoo economics” and “trickle down” theory, callous austerity and wanton prodigality, conservative dogmatism and libertarian license.

We begin with the proposition that capitalism is not chiefly an incentive system but an information system. We continue with the recognition, explained by the most powerful science of the epoch, that information itself is best defined as surprise: by what we cannot predict rather than by what we can. The key to economic growth is not acquisition of things by the pursuit of monetary rewards but the expansion of wealth through learning and discovery. The economy grows not by manipulating greed and fear through bribes and punishments but by accumulating surprising knowledge through the conduct of the falsifiable experiments of free enterprises. Crucial to this learning process is the possibility of failure and bankruptcy. In this model, wealth is defined as knowledge, and growth is defined as learning.

Because the system is based more on ideas than on incentives, it is not a process changeable only over generations of Sisysphean effort. An economy is a noosphere (a mind-based system) and it can revive as fast as minds and policies can change.

That new economics—the information theory of capitalism—is already at work in disguise. Concealed behind an elaborate mathematical apparatus, sequestered by its creators in what is called information technology, the new theory drives the most powerful machines and networks of the era. Information theory treats human creations or communications as transmissions through a channel, whether a wire or the world, in the face of the power of noise, and gauges the outcomes by their news or surprise, defined as “entropy” and consummated as knowledge. Now it is ready to come out into the open and to transform economics as it has already transformed the world economy itself.

[Now, skipping some interesting work in chapter two, let’s jump to chapter 3.]

Chapter Three: The Science of Information

The current crisis of economic policy cannot be understood as simply the failure of either conservative or socialist economics to triumph over its rival.  It cannot be understood as New York Times Nobelist Paul Krugman or Ron Paul and the libertarians might wish, as a revival of the debate between Keynesian and Austrian schools—John Maynard Keynes and Paul Samuelson against Friedrich Hayek and Ludwig Von Mises. The hard science that is the key to the current crisis had not been invented when Keynes or Hayek were doing their seminal work.

This new science is the science of information. In its full flower, information theory is densely complex and mathematical. But its implications for economics can be expressed in a number of simple and intelligible propositions.

All information is surprise; only surprise qualifies as information. This is the fundamental axiom of information theory. Information is the change between what we knew before the transmission and what we know after it.

From Adam Smith’s day to ours, economics has focused on the nature of economic order. Much of the classical and neo-classical work was devoted to observing the mechanisms by which markets, confronted with change—especially change in prices—restored a new order, a new equilibrium. Smith and his successors followed in the metaphorical paths of Newton and Leibniz, mounting a science of systems.

What they lacked was a science of disorder and randomness, a mathematics of innovation, a rigorous measure and mandate for freedom of choice. In economics, the relevant science has arrived just in time. The great economic crisis of our day, a crisis of theory as well as practice, is a crisis of information. It can be grasped and resolved only by an economics of information. Pioneered by such titans as Kurt Gödel, John von Neumann, and Alan Turing, the mathematical structure for this new economics was consummated by one of the paramount minds of the 20th century, Claude Elwood Shannon.

In a long career at MIT and AT&T’s Bell Laboratories, Shannon was a man of toys, games, and surprises. They all tended to be underestimated at first and then become resonant themes of his time and technology—from computer science and Artificial Intelligence to investment strategy and Internet architecture. As a boy during the roaring twenties in snowy northern Michigan, young Claude—grandson of a tinkering farmer who held a patent for a washing machine—made a telegraph line using the barbed-wire fence between his house and a friend’s half a mile away. “Later,” he said, “we scrounged telephone equipment from the local exchange and connected up a telephone.” Thus he recapitulated the pivotal moment in the history of his later employer: from telegraph to telephone.

There is no record of what Shannon and the world would come to call the “channel capacity” of the fence. But later in the era Shannon’s followers at industry conferences would ascribe a “Shannon capacity” of gigabits per second to barbed wire, and joke about the “Shannon limit” of a long strand of linguini.

Shannon’s contributions in telephony would follow his contributions in computing, all of which in turn were subsumed by higher abstractions in a theory of information. His award-winning Master’s thesis from MIT kick-started the computer age by demonstrating that the existing “relay” switching circuits from telephone exchanges could express the nineteenth-century algebra of logic invented by George Boole, which became the prevailing logic of computing. A key insight came from an analogy with the game of Twenty Questions: paring down a complex problem to a chain of binary, yes-no choices, which Shannon may have been first to dub “bits”. Then this telephonic tinkerer went to work for Bell Labs at its creative height, when it was a place where a young genius could comfortably unicycle down the hallways juggling several balls over his head.

During the war, he worked on cryptography there and talked about thinking machines over tea with the great tragic figure Alan Turing. Conceiving a generic abstract computer architecture, Turing is arguably the progenitor of information theory broadly conceived. At Bletchley Park in Britain, his contributions to breaking German codes were critical to the Allied victory. Following the war, he committed suicide by eating a poisoned apple after having undergone court-mandated estrogen therapy to rein in his public homosexuality. (The Apple logo, with its missing bite, is seen by some as an homage to Turing, but Steve Jobs said he only wished he had been that smart).

The two computing-obsessed cryptographers, Shannon and Turing, also discussed during these wartime teas what Shannon described as his burgeoning “notions on Information Theory” (for which Turing provided “a fair amount of negative feedback”).

In 1948, Shannon published those notions on Information Theory in The Bell System Technical Journal as a 78-page monograph, “The Mathematical Theory of Communication.”  (The next year—with an introduction by Warren Weaver, one of America’s leading wartime scientists—it reappeared as a book.) It became the central document of the dominant technology of the age and still resonates today as the theoretical underpinning for the Internet.

Shannon’s first wife described the arresting magnetism of his countenance as “Christ-like.” Like Leonardo and fellow computing pioneer Charles Babbage, he was said by one purported witness to have built floating shoes for walking on water. With his second wife, herself a “computer” when he met her at AT&T, he created a home full of pianos, unicycles, chess-playing machines, and his own surprising congeries of seriously playful gadgets. These included a mechanical white mouse named Theseus—built soon after the information theory monograph—which could learn its way through a maze; a calculator that worked in Roman numerals; a rocket-powered Frisbee; a chair lift to take his children down to the nearby lake; a diorama in which three tiny clowns juggled 11 rings, 10 balls, and 7 clubs; and an analog computer and radio apparatus, built with the help of blackjack card-counter and fellow MIT professor Edward Thorp, to beat the roulette wheels at Las Vegas (it worked in Shannon’s basement but suffered technical failure in the casino). Later an uncannily successful investor in technology stocks, Shannon insisted on the crucial differences between a casino and a stock exchange that eluded some of his followers.

When I wrote my book, Microcosm, on the rise of the microchip, I was entranced with physics and was sure that the invention of the transistor at Bell Labs in 1948 was the paramount event of the post-war decade. Today, I find that physicists are entranced with the theory of information. I believe, with his biographer James Gleick, that Shannon’s Information Theory was a breakthrough comparable to the transistor. While the transistor is today ubiquitous in information technology, Shannon’s theories are immanent in all the ascendant systems of the age. As universal principles, they grow ever more fruitful and fertile as time passes. Every few weeks, I encounter another company crucially rooted in Shannon’s theories, full of earnest young engineers conspiring to beat the Shannon limit. The technology of our age seems to be at once both Shannon limited and Shannon enabled. So is the modern world.

Let us imagine the lineaments of an economics of disorder, disequilibrium, and surprise that could explain and measure the contributions of entrepreneurs. Such an economics would begin with the Smithian mold of order and equilibrium. Smith himself spoke of property rights, free trade, sound currency, and modest taxation as crucial elements of an environment for prosperity. Smith was right: An arena of disorder, disequilibrium, chaos, and noise would drown the feats of creation that engender growth. The ultimate physical entropy envisaged as the heat death of the universe, in its total disorder, affords no room for invention or surprise. But entrepreneurial disorder is not chaos or mere noise. Entrepreneurial disorder is some combination of order and upheaval that might be termed “informative disorder.”

Shannon defined information in terms of digital bits and measured it by the concept of information entropy: unexpected or surprising bits. Reported to have been the source of the name was John von Neumann, inventor of computer architectures, game theory, quantum math, nuclear devices, military strategies, cellular automata, among other ingenious phenomena. Encountering von Neumann in a corridor at MIT, Shannon allegedly told him about his new idea. Von Neumann suggested that he name it “entropy” after the thermodynamic concept (according to Shannon, von Neumann said it would be a great word to use because no one knows what it means).

Shannon’s entropy is governed by a logarithmic equation nearly identical to the thermodynamic equation of Rudolf Clausius that describes physical entropy. But the parallels between the two entropies conceal several pitfalls that have ensnared many. Physical entropy is maximized when all the molecules in a physical system are at an equal temperature (and thus cannot yield any more energy). Shannon entropy is maximized when all the bits in a message are equally improbable (and thus cannot be further compressed without loss of information). These two identical equations point to a deeper affinity that MIT physicist Seth Lloyd identifies as the foundation of all material reality—at the beginning was the entropic bit.

For the purposes of economics, the key insight of information theory is that information is measured by the degree to which it is unexpected. Information is “news,” gauged by its surprisal, which is the entropy. A stream of predictable bits conveys no information at all. A stream of uncoded chaotic noise conveys no information, either.

In the Shannon scheme, a source selects a message from a portfolio of possible messages, encodes it through resort to a dictionary or lookup table using a specified alphabet, then transcribes the encoded message into a form that can be transmitted down a channel. Afflicting that channel is always some level of noise or interference. At the destination, the receiver decodes the message, translating it back into its original form. This is what is happening when a radio station modulates electromagnetic waves, and your car radio demodulates those waves, translating them back into the original sounds or voices at the radio station.

Part of the genius of information theory is its understanding that this ordinary concept of communication through space extends also through time. A compact disk, iPod memory, or Tivo personal video recorder also conducts a transmission from a source (the original song or other content) through a channel (the CD, DVD, microchip memory, or “hard drive”) to a receiver chiefly separated by time. In all these cases, the success of the transmission depends on the existence of a channel that does not change significantly during the course of the communication, either in space or in time.

Change in the channel is called noise and an ideal channel is perfectly linear.  What comes out is identical to what goes in. A good channel, whether for telephony, television, or data storage, does not change in significant ways during the period between the transmission and receipt of the message. Because the channel is changeless, the message in the channel can communicate changes. The message of change can be distinguished from the unchanging parameters of the channel.

In that radio transmission, a voice or other acoustic signal is imposed on a band of electromagnetic waves through a modulation scheme. This set of rules allows a relatively high-frequency non-mechanical wave (measured in kilohertz to gigahertz and traveling at the speed of light) to carry a translated version of the desired sound, which the human ear can receive only in the form of a lower frequency mechanical wave (measured in acoustic hertz to low kilohertz and traveling close to a million times slower).  The receiver can recover the modulation changes of amplitude or frequency or phase (timing) that encode the voice merely by subtracting the changeless radio waves. This process of recovery can occur years later if the modulated waves are sampled and stored on a disk or long term memory.

The accomplishment of Information Theory was to create a rigorous mathematical discipline for the definition and measurement of the information in the message sent down the channel. Shannon entropy or surprisal defines and quantifies the information in a message. In close similarity with physical entropy, information entropy is always a positive number measured by minus the base two logarithm of its probability.

Information in Shannon’s scheme is quantified in terms of a probability because Shannon interpreted the message as a selection or choice from a limited alphabet. Entropy is thus a measure of freedom of choice. In the simplest case of maximum entropy of equally probable elements, the uncertainty is merely the inverse of the number of elements or symbols. A coin toss offers two possibilities, heads or tails; the probability of either is one out of two; the logarithm of one half is minus one. With the minus canceled by Shannon’s minus, a coin toss can yield one bit of information or surprisal. A series of bits of probability one out of two does not provide a 50 percent correct transmission. If it did, the communicator could replace the source with a random transmitter and get half the information right. The probability alone does not tell the receiver which bits are correct. It is the entropy that measures the information.

For another familiar example, the likelihood that any particular facet of a die turns up in a throw of dice is one sixth, because there are six possibilities all equally improbable. The communication power, though, is gauged not by its likelihood of one in six, but by the uncertainty resolved or dispersed by the message. One out of six is two to the minus 2.58, yielding an entropy or surprisal of 2.58 bits per throw.

Shannon’s entropy gauged the surprisal of any communication event taking place over space or time. By quantifying the amount of information, he also was able to define both the capacity of a given channel for carrying information and the impact of noise on that carrying capacity.

From Shannon’s Information Theory—his definition of the bit, his explanation and calculation of surprisal or entropy, his gauge of channel capacity, as well as his profound explorations of the impact and nature of noise or interference, his abstract theory of cryptography, his projections for multi-user channels, his rules of redundancy and error correction, and his elaborate understanding of codes—would stem most of the technology of this information age.

Working at Bell Labs, Shannon focused on the concerns of the world’s largest telephone company. But he offered cues for the application of his ideas in larger domains. His 1940 Ph.D. thesis had treated “An Algebra for Theoretical Genetics”. Armed with his later information theory insights, he included genetic transmissions as an example of communication over evolutionary time through the channel of the world. He estimated the total information complement in a human being’s chromosomes to be hundreds of thousands of bits. He vastly underestimated of the size of the genome, missing the now estimated six billion bits by a factor of four thousand. But he was the first to assert that the human genetic inheritance consisted of encoded information measurable in bits.

Thus Shannon boldly extended the sway of his theory to biological phenomena and perhaps implicitly authorized its extension into economics, though to the end of his life in 2001 he remained cautious about the larger social applications of his mathematical concept.

Ironically it was his caution, his disciplined reluctance to contaminate his pure theory with wider concepts of semantic meaning and creative content, that gives his formulations their huge generality and applicability. Shannon did not create a science of any specific kind of communication. It is not tied to telephone communication or television communications or physical transmission over radio waves or down wires, or transmission of English language messages or numerical messages, or measurement of the properties of music or genomes or poems or political speeches or business letters. He did not supply a theory for communicating any particular language or code, though he was fascinated by measures of the redundancy of English.

Shannon offered a theory of messengers and messages, without a theory of the ultimate source of the message in a particular human mind with specific purposes, meanings, projects, goals, and philosophies. Because Shannon was remorselessly rigorous and restrained, his theory became a carrier that could bear almost anything transmitted over time and space in the presence of noise or interference—including business ideas, entrepreneurial creations, economic profits, monetary currency values, private property protections, and innovative processes that impel economic growth.

An entrepreneur is the creator and manager of a business concept that he wishes to instantiate or reify—make real—over time and space. Let us envisage the canonical Steve Jobs and the iPod: when he conceives the idea in his head, he must then move to encode it in a particular physical form that can be transmitted into a marketplace. This requires design, engineering, manufacturing, marketing and distribution. It is an ineffably complex endeavor dense with information at every stage.

As an entrepreneur and CEO of Apple, Jobs controlled many of the stages. But the ultimate success of such a project depends on the existence of a channel that can enable the process to be consummated over nearly a decade, during which many other companies, outside his control, produce multifarious competitive or complementary creations. Vital to all Apple’s wireless advances are achievements in ceramic and plastic packaging, in digital signal processing, in radio communications, in miniaturization of hard disks, in non-volatile “flash” silicon memories, in digital compression codes, and in innumerable other technologies feeding an unfathomably long and roundabout chain of interdependent creations.

In biology itself, chemical and physical laws define many of the enabling regularities of the channel of the world. In the world of economics in which Jobs operated, he needs the stable existence of a “channel” that can enable the idea he conceives at one point in time and space to arrive at another point years later.  Essential to the channel is the existence of the Smithian order.  Jobs must be sure that the economic system that is in place at the beginning of the process remains in its essential parameters at the end. Smith defined the essential parameters of the channel as free trade, reasonable regulations, sound currencies, modest taxation, and reliable protection of property rights.  No one has much improved on this list.

In other words, the entrepreneur needs a channel that in these critical respects does not drastically change.  The technologies that accomplish these goals can radically change. But the characteristics of the basic channel for free entrepreneurial creativity cannot change significantly. A radical rise in tax rates, or imposition of laws against ownership of rights to music, or regulations gravely inhibiting international trade would all have tended to close off the channel for the iPod.

One fundamental information-theory principle distills all these considerations of the state of the channel: to transmit a high entropy, surprising product, requires a low entropy, unsurprising channel, largely free of interference. Interference can come from many sources. Acts of God, tsunamis, and class five hurricanes have been known to do the job, though otherwise vigorous economies quickly recover from these. For a particular entrepreneurial idea, a more powerful competing technology, though a clear signal in itself and a boon to the world, can inflict overwhelming interference.

The most common and destructive purveyor of noise, however, is precisely the institution on which we most depend to provide a clear and stable channel in the first place. When government either neglects its role as guardian of the channel, or still worse, tries to help by becoming a transmitter and raising the power on certain favored signals, the noise can be deafening.

A friendly government that excluded all Jobs’ rivals from the channel or mandated his iPod model alone as a way to distribute music might have benefited Jobs for one product. But a government that could ban competitive products would thwart all the necessary technological advances that could endow Jobs’ future products. By definition such a government would create a high-entropy, government-dominated channel, full of unpredictable political interference and noise, which would balk sacrificial long-term investment of capital. The horizons of the economy would shrink to the bounds of political expediency, and short term arbitrage and trading would prevail over investment and innovation.

As the entrepreneur contemplates his invention, crucial to the prospects for success is an estimate of its potential profitability. Profit is the name that economics assigns to the yield of investments. Expressing the average yield across an entire economy, the level of interest rates and their time and risk structure will reflect the existing pattern of production and expected values of currencies. Interest rates will define the opportunity cost of investments in new products: what other opportunities are missed on average as a result of pursuing one in particular.

In information theoretic terms, interest rates are a critical index of real economic conditions. If they are manipulated by government, they will issue false signals and create confusion that undermines entrepreneurial activity. If low interest rates, for example, are targeted to institutions that finance the government—as has been the case in the United States—they represent a serious distortion of the channel. They are noise rather than signal. Zero-interest-rate money enables a hypertrophy of finance as privileged borrowers reinvest government funds in government securities, only a minority of which finance even putatively useful “infrastructure” while the rest is burned off in consumption beyond our means.

An entrepreneur making large outlays to bring a major product to market over a process taking years will normally have to promise a profit, perhaps to venture capitalists or a board of directors, far exceeding the interest rate. This entrepreneurial profit is not expected by the economy at large. It is unanticipated by the large established companies that dominate the marketplace at the time. Profits differentiate between the normally predictable yield of commodities and the unexpected returns of creativity. Reflecting the surprisal in the new product or business, this payback will be surprising, disruptive, and disequilibriating to the existing order. If established companies can manipulate the channel to protect their own products and businesses and margins, a new product cannot pass through.

The unexpected financial profit is surprisal or entropy—what Peter Drucker termed an “upside surprise.” Drucker pointed out that most measured financial “profits” are not real in this sense. They merely cover the cost of capital—the return of interest. Innovation is the source of real profit, entropic profit, which derives from the upside surprises of entrepreneurial creativity.

In order for the entrepreneur to succeed, he must know that if his creation generates an upside surprise, the related profits will not be confiscated or taxed away. If they may be confiscated, his entire project will not be able to command the necessary resources to bring it to market in volume. Thwarted are the crucial processes of learning and knowledge-creation that constitute economic growth and progress.

Linking innovation, surprise, and profit, learning and growth, Shannon entropy stands at the heart of the economics of information theory. Signaling the arrival of an invention or disruptive innovation is first its surprisal, then its yield beyond the interest rate—its profit, a further form of Shannon entropy. As a new item is absorbed by the market, however, its entropy declines until its margins converge with prevailing risk-adjusted interest rates. The entrepreneur must move on to new surprises.

The economics of entropy depict the process by which the entrepreneur translates his idea into a practical form from the realms of imaginative creation. In those visionary realms, entropy is essentially infinite and unconstrained, and thus irrelevant to economic models.  But to make the imagined practical, the entrepreneur must make specific choices among existing resources and strategic possibilities. Entropy here signifies his freedom of choice.

As Shannon understood, the creation process itself escapes every logical and mathematical system. It springs not from secure knowledge but from falsifiable tests of commercial hypotheses. It is not an expression of past knowledge but of the fertility of consciousness, will, discipline, imagination, and art.

Like all logical systems founded on mathematical reasoning, information theory is dependent on axioms that it cannot prove. These comprise the content flowing through the conduits of the economy and they come from the minds of creators, endowed with freedom of choice. Once the entrepreneur reifies his plans in the world, projecting them into the channel of the economy as falsifiable experiments, they fall into the Shannon scheme. Measured by their entropy—their content and surprisal—new products face the test of the market that they create. They converge learning, knowledge and power in an experimental economy of freedom.

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Should auld acquaintance be forgot
And never brought to mind?
Should auld acquaintance be forgot,
And auld lang syne!

For auld lang syne, my dear,
For auld lang syne,
We’ll take a cup o’ kindness yet
For auld lang syne

It’s that time of year again, when we begin to think of what the next one will bring. I will be doing my annual forecast issue next week, but my friend Gary Shilling has already done his and has graciously allowed me to use a shortened version of his letter as this week’s Thoughts from the Frontline. So without any further ado, let’s jump right to Gary’s look at where we are and where we’re going.

Review and Forecast

By Gary Shilling

In the third quarter, real GDP grew 2.8% at annual rates from the second quarter. Without the increase in inventories, the rate would be 2.0%, in line with the 2.3% average growth since the economic recovery commenced in the second quarter of 2009.

Furthermore, the step-up in inventory-building from the second quarter may have been unintended, suggesting cutbacks in production and weaker growth in future quarters. Also, consumer spending growth, 1.5% in the third quarter, continues to slip from 1.8% in the second quarter and 2.3% in the first while business spending on equipment and software actually fell at a 3.7% annual rate for only the second time since the recovery started in mid-2009. Government spending was about flat with gains in state and local outlays offsetting further declines in federal expenditures. Non-residential outlays for structures showed strength as did residential building. The 16-day federal government shutdown didn’t commence until the start of the fourth quarter, October 1, but anticipation may have affected the third quarter numbers.

Recovery Drivers

The 2.3% average real GDP growth in the recovery, for a total rise of 10%, has not only been an extraordinarily slow one but also quite unusual in structure. Consumer spending has accounted for 65% of that growth, actually below its 68% of real GDP, as shown in the second column of Chart 1. Government spending—which in the GDP accounts is direct outlays for personal and goods and services and doesn’t include transfers like Social Security benefits—has actually declined. Federal outlays fell 0.4% despite massive stimuli since most of it went to welfare and other transfers to state governments. But state and local spending dropped 0.9% due to budget constraints.

Residential construction accounted for 9% of the gain in the economy. This exceeds its share of GDP, but still is small since volatile housing normally leaps in recoveries, spurred by low interest rates. But deterrents abound. The initial boost to the economy as retrenching consumers cut imports was later reversed. So net exports reduced real GDP growth by 0.4% in the 13 quarters of recovery to date.

Inventory-building accounted for a substantial 19% of the rise in real GDP, suggesting the accumulation of undesired stocks since anticipation of future demand has been consistently subdued. Nonresidential structures fell 0.1% as previous overbuilding left excess space. Equipment spending contributed 20% of the overall growth, but has failed to shoulder the normal late recovery burst.

Nevertheless, the small intellectual property products component, earlier called software, accounted for 5% of overall growth compared to its 3.9% share of GDP. This reflects the productivity-enhancing investments American business have been using to propel profit margins and the bottom line in an era when sales volume has been weak and pricing power absent.

As we predicted over three years ago in our book The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, and in many Insights since then, economic growth of about 2% annually will probably persist until deleveraging, especially in the financial sector globally and among U.S. consumers, is completed in another four or five years. Deleveraging after a major leveraging binge and the financial crisis that inevitably follows normally takes around a decade, and since the workdown of excess debt commenced in 2008, the process is now about half over. The power of this private sector deleveraging is shown by the fact that even with the immense fiscal stimuli earlier and ongoing massive monetary expansion, real growth has only averaged 2.3% compared to 3.4% in the post-World War II era before the 2007-2009 Great Recession.

Optimists, of course, continue to look for reasons why rapid growth is just around the corner, and their latest ploy is the hope that the effects of individual income tax hikes and reduced federal spending this year via sequestration have about run their course. Early this year when these negative effects on spending were supposed to take place, scare-mongers in and out of Washington predicted drastic negative effects on the economy. But federal bureaucrats apparently mitigated much of the effects of sequestration, and the income tax increases on the rich, as usual, didn’t change their spending habits much. So the positive influences on the economy as sequestration fades and income tax rates stabilize are likely to be equally minimal.

Furthermore, small-business sentiment has fallen recently. The percentage of companies that look for economic improvement dropped from -2 in August to -10 in September and -17 in October to a seven-month low. Those expecting higher sales declined from +8 to +2 in October. Most of the other components of the index fell, including those related to the investment climate, hiring plans, capital spending intentions, inventories, inflation expectations and plans to raise wages and prices. Other recent measures of subdued economic activity include the New York Fed’s survey of manufacturing and business conditions and industrial production nationwide, which fell 0.1% in October from September.

The New York Fed’s Empire State manufacturing survey index for November fell to 2.21%, the first negative reading since May. Every component dropped—orders, shipments, inventories, backlogs, employment, the workweek, vendor performance and inflation.

Global Slow Growth

The ongoing sluggish growth in the U.S. is indeed a global problem. It’s true in the eurozone, the U.K., Japan and China. Recently, the International Monetary Fund, in its sixth consecutive downward revision, cut its global growth forecast for this year by 0.3 percentage points to 2.9% and for 2014, by 0.2 percentage points to 3.6%.

It lowered its 2013 forecast for India from 5.6% to 3.8%, for Brazil from 3.2% to 2.5% and more than halved Mexico’s to 1.2%. For developing countries on average, the IMF reduced its 2013 growth forecast by 0.4 percentage points to 5%, citing the drying up of years of cheap liquidity, competitive constraints, infrastructure shortfalls and slowing investment. It also worries about their balance of payment woes. For 2014, the IMF chopped its growth forecast for China from 7.8% to 7.3% and from 2.8% to 2.6% for the U.S.

Fiscal Drag

Fed Chairman Bernanke continually worries about fiscal drag. Without question, the federal budget was stimulative in earlier years when tax cuts and massive spending in reaction to the Great Recession as well as weak corporate and individual tax collections pushed the annual deficit above $1 trillion. But the unwinding of the extra spending, income tax increases and sequestration this year and economic recovery—weak as it’s been—have reduced the deficit to $680 billion in fiscal 2013 that ended September 30.

From here on, the outlook is highly uncertain with persistent gridlock in Washington between Democrats and Republicans. So far, they’ve kicked the federal budget and debt limit cans down the road and they may do so again when temporary extensions expire early next year. It looks like many in Congress have no intention of resolving these two problems and may be jockeying for position ahead of the 2014, if not the 2016, elections.

In our many years of observing and talking to Congressmen, Senators and key Administration officials of both parties, it’s clear that Washington only acts when it has no alternative and faces excruciating pressure. A collapsing stock market always gets their attention, but the ongoing market rally, in effect, tells them that all is well or at least that it doesn’t require immediate action.

The Fed

With muted economic growth and risks on the downside, distrust in the abilities or willingness of Congress and the Administration to right the ship, and falling consumer and business confidence, the burden of stimulating the economy remains with the Fed. Janet Yellen, the likely next Chairman, seems even more committed than Bernanke to continuing to keep monetary policy loose. The Fed plans to reduce its buying of $85 billion per month in securities but the negative reactions by stocks (Chart 2), Treasury bonds (Chart 3) and many other securities to Bernanke’s hints in May and June that purchases would be tapered and eliminated by mid-2014 made a strong impression on the Fed. Similarly, the release of the minutes of the Fed’s October policy meeting— which again said officials looked forward to ending the bond-buying program “in coming months” if conditions warranted—resulted in an instant drop in stock and bond prices.

The Fed is trying to figure out how to end security purchases without spiking interest rates, to the detriment of housing, other U.S. economic sectors and developing economies. It’s moving toward “forward guidance,” more commitment to keep the short-term interest rate it controls low than its present pledge to keep it essentially at zero until the current 7.3% unemployment rate drops to 6.5% and its inflation rate measure climbs to 2.5% from the current 1.2% year-over-year.

The hope is that a longer-term commitment to keep short-term rates low will retard long rates as well when the Fed tapers its asset purchases. This strategy appears to be having some success. Treasury investors are switching from 10-year and longer issues to 2-year or shorter notes. This is known as the yield-steepening trade as it pushes short-term yields down and longer yields up. As a result, the spread between 2-year and 10-year Treasury obligations has widened to 2.54 percentage points, the most since July 2011. Banks benefit from a steeper yield curve since they borrow short term and lend in long-term markets. But borrowers pay more for loans linked to long-term Treasury yields. There’s a close link between the yield on 10-year Treasury notes and the 30-year fixed rate on residential mortgages.

The Fed has already signaled that it may not wait to raise short rates until the unemployment rate, a very unreliable gauge of job conditions as we’ve explained in past Insights, drops below 6.5%. Bernanke recently said that “even after unemployment drops below 6.5%, the [Fed] can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.” At that point, the Fed will consider broader measures of the job market including the labor participation rate. If the participation rate hadn’t fallen from its February 2000 peak due to postwar baby retirements, discouraged job-seekers and youths who stayed in school since job opportunities dried up with the recession, the unemployment rate now would be 13%.

The Fed is well aware that other than pushing up stock prices, its asset-buying program is having little impact on the economy. In a recent speech, Bernanke said that while the Fed’s commitment to hold down interest rates and its asset purchases both are helping the economy, “we are somewhat less certain about the magnitude of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed’s balance sheet.” We wholeheartedly agree with this sentiment, as discussed in detail in our October Insight. Tapering Fed monthly purchases only reduces the ongoing additions to already-massive excess member bank reserves on deposit at the Fed.

Inflation-Deflation

Inflation has virtually disappeared. The Fed’s favorite measure of overall consumer prices, the Personal Consumption Expenditures Deflator excluding food and energy (Chart 4), is rising 1.2% year-over-year, well below the central bank’s 2.0% target and dangerously close to going negative.

There are many ongoing deflationary forces in the world, including falling commodity prices, aging and declining populations globally, economic output well below potential, globalization of production, growing worldwide protectionism including competitive devaluation in Japan, declining real incomes, income polarization, declining union memberships, high unemployment and downward pressure on federal and state and local government spending.

With the running out of 2009 federal stimulus money and gas tax revenues declining as fewer miles are driven in more efficient cars, highway construction is declining and construction firms are consolidating and reducing bids on new work even if their costs are rising. Highway construction spending dropped 3.3% in the first eight months of 2013 compared to a year earlier. Also, states are shifting scarce money away from transportation and to education and health care. We’ve noted in past Insights that aggressive monetary and fiscal stimuli probably have delayed but not prevented chronic deflation in producer and consumer prices.

Why does the Fed clearly fear deflation? Steadily declining prices can induce buyers to wait for still-lower prices. So, excess capacity and inventories result and force prices lower. That confirms suspicions and encourages buyers to wait even further. Those deflationary expectations are partly responsible for the slow economic growth in Japan for two decades.

Low Interest Rates

With the Fed likely to continue to hold its federal funds rate close to zero, other short-term interest rates will probably remain there too. So the recent rally in Treasury bonds may well continue, with yields on the 10-year Treasury note, now 2.8%, dropping below 2% while the yield on our 32-year favorite, the 30-year Treasury “long bond,” falls from 3.9% to under 3%. Even-lower yields are in store if chronic deflation sets in as well it might. Ditto for the rise in stocks, which we continue to believe is driven predominantly by investor faith in the Fed, irrespective of modest economic growth at best. “Don’t fight the Fed,” is the stock bulls’ bellow. Supporting this enthusiasm has been the rise in corporate profits, but that strength has been almost solely due to leaping profit margins. Low economic growth has severely limited sales volume growth, and the absence of inflation has virtually eliminated pricing power. So businesses have cut labor and other costs with a vengeance as the route to bottom line growth

Wall Street analysts expect this margin leap to persist. In the third quarter, S&P 500 profit margins at 9.6% were a record high but revenues rose only 2.7% from a year earlier. In the third quarter of 2014, they see S&P 500 net income jumping 14.9% from a year earlier on sales growth of only 4.7%. But profit margins have been flat at their peak level for seven quarters. And the risks appear on the downside.

Productivity growth engendered by labor cost-cutting and other means is no longer easy to come by, as it was in 2009 and 2010. Corporate spending on plant and equipment and other productivity-enhancing investments has fallen 16% from a year ago. Also, neither capital nor labor gets the upper hand indefinitely in a democracy, and compensation’s share of national income has been compressed as profit’s share leaped. In addition, corporate earnings are vulnerable to the further strengthening of the dollar, which reduces the value of exports and foreign earnings by U.S. multinationals as foreign currency receipts are translated to greenbacks.

Speculation Returns

Driven by the zeal for yield due to low interest rates and the rise in stock prices that has elevated the S&P 500 more than 160% from its March 2009 low, a degree of speculation has returned to equities. The VIX index, a measure of expected volatility, remains at very low levels (Chart 5). Individual investors are again putting money into U.S. equity mutual funds after years of withdrawals. “Frontier” equity markets are in vogue. They’re found in countries like Saudi Arabia, Nigeria and Romania that have much less-developed—and therefore risky—financial markets and economies than Brazil and Mexico.

The IPO market has been hot this year. The median IPO has been priced at five times sales over the last 12 months, almost back to the six times level of 2007. And many IPOs have used the newly-raised funds to repay debt to their private equity backers, not to invest in business expansion. Through early November, IPOs raised $51 billion, the most since the $62 billion in the comparable period in 2000. Some 62% of IPOs this year are for money-losing companies, the most since the 1999-2000 dot com bubble. Some hedge fund managers are introducing “long only” funds with no hedges against potential stock price declines.

The S&P 500 index recently reached an all-time high but corrected for inflation, it remains in a secular bear market that started in 2000. This reflects the slow economic growth since then and the falling price-earnings ratio, and fits in with the long-term pattern of secular bull and bear markets, as discussed in detail in our May 2013 Insight.

High P/E

Furthermore, from a long-term perspective, the P/E on the S&P 500 at 24.5 is 48% above its long run average of 16.5 (Chart 6), and we’re strong believers in reversions to well-established trends, this one going back to 1881. The P/E developed by our friend and Nobel Prize winner, Robert Shiller of Yale, averages earnings over the last 10 years to iron out cyclical fluctuations. Also, since the P/E in the last two decades has been consistently above trend, it probably will be below 16.5 for a number of years to come.

This index is trading at 19 times its companies’ earnings over the past 12 months, well above the 16 historic average. This year, about three-fourths of the rise in stock prices is due to the jump in P/Es, not corporate earnings growth. Even always-optimistic Wall Street analysts don’t expect this P/E expansion to persist in light of possible Fed tightening. Those folks, of course, are paid to be bullish and their track record proves it. Since 2000, stocks have returned 3.3% annually on average, but strategists forecast 10%. They predicted stock rises in every year and missed all four down years.

Housing

Residential construction is near and dear to the Fed’s heart. It’s a small sector but so volatile that it has huge cyclical impact on the economy. At its height in the third quarter of 2005, it accounted for 6.2% of GDP but fell to 2.5% in the third quarter of 2010 (Chart 7). That in itself constitutes a recession, even without the related decline in appliances, home furnishings and autos.

Furthermore, the Fed can have a direct influence on housing. Monetary policy is a very blunt instrument. The central bank only can lower interest rates and buy securities and then hope the economy in general will be helped. In contrast, fiscal policy can aid the unemployed directly by raising unemployment benefits. But by buying securities, especially mortgage-related issues, the Fed can influence interest rates and help interest-sensitive housing. The rise in 30-year fixed mortgage rates of over one percentage point last spring probably has brought the housing recovery to at least a temporary halt. Each percentage point rate rise pushes up monthly principal and interest payments by about 10%.

Of course, many other factors besides mortgage rates affect housing and have been restraining influences. They include high downpayment requirements, stringent credit score levels, employment status and job security and the reality that for the first time since the 1930s, house prices have fallen—by a third at their low.

Capital Spending

Many hope that record levels of corporate cash and low borrowing costs will propel capital spending. And spending aimed at productivity enhancement, much of it on high-tech gear, has been robust as business concentrates on cost-cutting, as noted earlier. But the bulk of plant and equipment spending is driven by capacity utilization, and while it remains low, there’s little zeal for new outlays.

That’s why capital spending lags the economic cycle. Only after the economy strengthens in recoveries do utilization rates rise enough to spur surges in capital spending. And as our earlier research revealed, it’s the level of utilization, not the speed with which it’s rising, that drives plant and equipment outlays. So this is a Catch-22 situation. Until the economy accelerates and pushes up utilization rates, capital spending will remain subdued. But what will cause that economic growth spurt?

Government Spending

It’s unlikely to be government spending. State and local outlays used to be a steady 12% or so of GDP and a source of stable, well-paying jobs. But no more. State tax revenues are recovering (Chart 8), but the federal stimulus money enacted in 2009 has dried up, leaving many states with strained budgets.

Pressure also comes from private sector workers who are increasingly aware that while their pay has been compressed by globalization and business cost-cutting, state and local employees have gotten their usual 3% to 4% annual increases and lush benefits. As a result, those government people have 45% higher pay than in the private sector, 33% more in wages and 73% in additional benefits. Oversized retiree obligations have sunk cities in California and Rhode Island and pushed Illinois to the brink of bankruptcy. Hopelessly-underfunded defined benefit pensions are a major threat to state and local government finances.

Municipal government employment is down 3.3% from its earlier peak compared to -0.2% for total payroll employment (Chart 9). And since these people are paid 1.45 times those in the private sector, two job losses is the equivalent of three private sector job cuts in terms of income. Real state and local outlays have fallen 9.5% since the third quarter of 2009.

Federal direct spending on goods and services, excluding Social Security, Medicare and other transfers, has also been dropping, by 7.2% since the third quarter of 2010. Both defense and nondefense real outlays are dropping, and this has occurred largely before the 2013 sequestration. At the same time, federal government civilian employment, civilian and military, has dropped 6% from its top (Chart 10).

U.S. Labor Markets

The U.S. labor market remains weak and of considerable concern to the Fed. Recent employment statistics have been muddled by the government’s 16-day shutdown in October and the impasse over the debt ceiling. Initially, 850,000 employees were furloughed although the Pentagon recalled most of its 350,000 civilian workers a week into the shutdown.

The unemployment rate has been falling, but because of the declining labor participation rate. We explored this phenomenon in detail in “How Tight Are Labor Markets?” (June 2013 Insight). As people age, their labor force participation rates tend to drop as they retire or otherwise leave the workforce. With the aging postwar babies, those born between 1946 and 1964, this has resulted in a downward trend in the overall participation rate—but it doesn’t account for all of the decline.

The irony is that participation rates of younger people tend to be higher than for seniors, but are declining. For 16-24-year-olds, the rate has declined sharply since 2000 as slow economic growth, limited jobs and rising unemployment rates have encouraged these youths to stay in school or otherwise avoid the labor force.

Meanwhile, the participation rates for those over 65 have climbed since the late 1990s as they are forced to work longer than they planned. Many have been notoriously poor savers and were devastated by the collapse in stocks in 2007-2009 after the 2000-2002 nosedive, two of only five drops of more than 40% in the S&P 500 since 1900.

Part-Timers

An additional sign of job weakness is the large number of people who want to work full-time but are only offered part-time positions—”working part-time for economic reasons” is the Bureau of Labor Statistics term (Chart 11)—and these people total 8 million and constitute 5.6% of the employed. This obviously reflects employer caution and the zeal to contain costs since part-timers often don’t have the pension and other benefits enjoyed by full-time employees.

This group will no doubt leap when Obamacare is fully implemented in 2015, according to its current schedule. Employers with 50 or more workers have to offer healthcare insurance, but not to those working less than 30 hours per week. When these people and those who have given up looking for jobs are added to the headline unemployment rate, the result, the BLS’s U-6 unemployment rate, leaped in the Great Recession and is still very high at 13.8% in October.

The weakness in the job market is amplified by the fact that most new jobs are in leisure and hospitality, retailing, fast food and other low-paying industries, which accounted for a third of the 204,000 new jobs in October. Manufacturing, which pays much more, has added some employees as activity rebounds but growth has been modest.

Real Pay Falling

With all the downward pressure on labor markets, real weekly wages are falling on balance. The folks on top of the income pile have recovered all their Great Recession setbacks and then some, on average. The rest, perhaps three-fourths of the population, believe they are—and probably still are—mired in recession due to declining real wages, still-depressed house prices, etc. Consequently, the share of total income by the top one-fifth, which has been rising since the data started in 1967, has jumped in recent years. The remaining four quintile shares continue to fall, although falling shares do not necessarily mean falling incomes.

The average household in the top 20% by income has seen that income rise 6% since 2008 in real terms and the top 5% of earners had an 8% jump. The middle quintile gained just 2% while the bottom 29% are still below their pre-recession peak. A study of household incomes over the 2002-2012 decade shows that the top 0.01% gained 76.2% in real terms but the bottom 90% lost 10.7%. In 2012, the top 1% by income got 19.3% of the total. The only year when their share was bigger was 1928 at 19.6%.

Real median household income, that of the household in the middle of the spectrum, continues to drop on balance, only leveling last year from 2011 (Chart 12). In 2012, it was down 8.3% from the prerecession 2007 level and off 9.1% from the 1999 all-time top. Americans may accept a declining share of income as long as their spending power is increasing, but that’s no longer true, a reality that President Obama plays to with his “fat cat bankers” and other remarks.

Households earning $50,000 or more have become increasingly more confident, according to a monthly survey by RBC Capital Markets, but confidence among lower-income households stagnated, created a near-record gap between the two. Of the 2.3 million jobs added in the past year, 35% were in jobs paying, on average, below $20 per hour in industries such as retailing and leisure and hospitality. Since the recession ended, hourly wages for non-managers in the lowest-paying quarter of industries are up 6% but more than 12% in the top-paying quarter. These income disparities are reflected in consumer spending. In the first nine months of this year, sales of luxury cars were up 12% from a year earlier but small-car sales rose just 6.1%.

Consumer Spending

With housing, capital spending, government outlays and net exports unlikely to promote rapid economic growth in coming quarters, the only possible sparkplug is the consumer. Consumer outlays account for 69% of GDP, and with falling real wages and incomes, the only way for real consumer spending to rise is for their already-low saving rate to fall further.

Even the real wealth effect, the spur to spending due to rises in net worth, is now muted. In the past, it’s estimated that each $1 rise in equity value boosted consumer spending by three cents over the following 18 months while a dollar more in house value led to eight cents more in outlays. But now the numbers are two cents and five cents, respectively.

True, the ratio of monthly financing payments to their after-tax income has been falling for homeowners, freeing money for spending. Those obligations include monthly mortgage, credit card and auto loan and lease payments as well as property taxes and homeowner insurance. Nevertheless, for the third of households that rent, their average financial obligations ratio has been rising in the last two years as rents rise while vacancies drop.

Declining gasoline prices have given consumers extra money for other purchases, and are probably behind the recent rise in gas-guzzling pickup truck and SUV sales. Furthermore, the automatic Social Security benefit cost-of-living escalator will increase benefits by 1.5% in 2014 for 63 million recipients of retirement and disability payments. Still, with low inflation in 2013, the basing year, that increase is smaller than the 1.7% rise last year and the lowest since 2003, excluding 2010 and 2011 when there were no increases due to a lack of inflation. Social Security retirement checks will rise $19 per month to $1,294, on average, starting in January.

In any event, retail sales growth is running about 4% at annual rates recently, about half the earlier recovery strength (Chart 13). And a lot of this growth has been spurred by robust auto sales, allegedly driven by the need to replace aged vehicles.

Shock?

Insight readers know we’ve been waiting for a shock to remind equity investors of the fundamental weakness of the economy, and perhaps push the sluggish economy into a recession. With underlying real growth of only 2%, it won’t take much of a setback to do the job.

Will the negative effects of the government shutdown and debt ceiling standoff, coupled with the confusion caused by the rollout of Obamacare, be a sufficient shock? The initial Christmas retail selling season may tell the tale, and the risks are on the down side. Besides the consumer, we’re focused on corporate profits, which may not hold up in the face of persistently slow sales growth, no pricing power and increasing difficulty in raising profit margins.

Nevertheless, we are not forecasting a recession for now, but rather more of the same, dull, slack 2% real GDP growth as in the four-plus years of recovery to date.

If you like what you read and would like to keep up with Gary for the next year, you can subscribe to Gary Shilling’s Insight for one year for $335 via email. Along with 12 months of Insight you’ll also receive a free copy of his full report detailing why he believes it will be “advantage America” in the coming years and a free copy of Gary’s latest book, Letting Off More Steam. To subscribe, call 1-888-346-7444 or 973-467-0070 between 10 am and 4 pm Eastern time or email [email protected]. Be sure to mention Thoughts from the Frontline to get the special report and free book in addition to your 12 months of Insight (available only to new subscribers).

Dubai, Saudi Arabia, Canada, and Auld Lang Syne

(For a little mood music, you can listen to James Taylor croon “Auld Lang Syne.” Or here’s the Beach Boys’ version.)

I am home for the holidays until January 8, when I leave for Dubai and then Riyadh for a week. There is the potential for a day trip to Abu Dhabi to meet with Maine fishing buddy Paul O’Brien. Then I am back home for a week before I fly to Vancouver, Edmonton, and Regina for a three-day speaking tour at those cities’ respective annual CFA forecast dinners. A note from a reader in Edmonton pointed out that it is already -30 there. I am actively hunting for my thermal underwear.

Oddly enough, my calendar then shows me home for four weeks before I head to Laguna Beach, CA, for a speech and then hop a plane to Miami. You would think that someone who flies as much as I do would have done a cross-country flight more than a few times, but this will be my first time ever to fly coast to coast in the US.

As noted last week, all my kids will be in town tonight, and we will celebrate our “official” family Christmas tomorrow. The poor grandchildren have had to wait three extra days to open their presents, but I keep telling them that waiting builds character. I get looks back from them that say they’re not sure what character is but they want nothing to do with it.

I have always enjoyed this time of year as an interlude for contemplating the future. For whatever reason, since I was in college I have paused as the new year approached to think about where I wanted to be in five years. Given that I’m 64, that means I’ve gone through this process some 42 times and seen the completion of 37 five-year planning cycles.

My batting average to date is 0 for 37. I never end up where I thought I was going to be, although there are times when I at least get the direction right, and fortunately there even a few times when the new midcourse correction means things turn out even better than planned.

Next week I write my 2014 forecast, for which the theme will be “Uncertainty.” Yet even in the face of overwhelming uncertainty, I will still come up with a personal five-year plan. Given the rather unique set of opportunities that have been presented to me in the past year, the plan is rather ambitious. And I expect it to change a lot. Among other projects, I expect to be announcing several new letters in the coming months that will be specifically directed to strategic portfolio planning. Right now our plan is to make these letters more or less freely available.

But the one thing that will hopefully not change is that I will be writing this letter to you, as together we try to make sense of the world. As the year draws to a close, I want to thank you for being part of my family of readers. And may the coming year surpass all your most wildly optimistic plans.

Your hearing “Auld Lang Syne” analyst,

John Mauldin, Editor
Thoughts from the Frontline[email protected]

 

Today’s Outside the Box comes to us from my good friend and business partner Niels Jensen of Absolute Return Partners in London. Niels gives us an excellent summary of how QE has affected the global economy (and how it hasn’t). I have found myself paraphrasing Niels all week.

I also want to call to your attention an interview first posted at ZeroHedge between my friends Chris Whalen and David Kotok. This is an inside-baseball view of a not-so-minor issue involving central banks and ZIRP. The FDIC charges 7-10 basis points on deposits for the national deposit insurance scheme. At close to the zero bound, the fee means that banks can lose money on deposits. As Chris and David point out, this is just another distortion being fed into the system. David was the first to introduce me to this concept (and rather passionately). I have not written about it because it gets complicated quickly, but it highlights a very serious problem and one that is not dissimilar to the deflationary aspects of the Basel III requirements, working at odds with what central bankers are trying to do. This goes with my long-held contention that the models the Fed and all central banks are working with are simply inadequate to describe the complexity of the global economy, and we have no true idea what we are doing, just a guess and a hope.

Then there’s this quote that appeared in the Wall Street Journal this weekend, from Friedrich A. Hayek’s lecture “The Pretense of Knowledge,” delivered upon accepting the Nobel Prize in economics, Dec. 11, 1974:

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the over-confident because their experiments may after all produce some new insights. But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority.

Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based—a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed.

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

There is danger in the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, “dizzy with success,” to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society—a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

Finally, and speaking of Zero Hedge, I want to offer a personal note about what I think is an egregious affront to the integrity of a close friend. Zero Hedge published and then expanded upon a rather silly article written in the Toronto Globe and Mail about the “sweet” deal that Gluskin Sheff chief economist David Rosenberg gets, noting that his $3,000,000 salary seems high for a top-five executive at a public firm, and implying that Rosie decided to turn bullish in return for the pay increase, that in essence his opinion could be bought.

Let me state that Rosie is a close personal friend and that we try to spend as much time as possible together and keep up with each other on the phone about our views on the world. Since we are more or less in the same business (writing and speaking on investments), we also share rather deep data on our personal business situations. I know Rosie’s business situation first-hand. I have offered Rosie advice on that compensation package.

First, the sweet deal is Gluskin Sheff’s. I have argued to some of their management that Rosie is underpaid. I think I might have used the word massively. Why? Because he writes a newsletter that has 3,000 subscribers who pay a $1,000 a year – roughly equal to his salary. But in addition GS gets his brand – and it is a valuable one– more or less for free and still works Rosie’s ass off traveling the country meeting with clients, all while he puts out a lengthy daily letter. The man is a machine. Now, kudos to Gluskin Sheff for getting that deal. I wish I could get him for that for Mauldin Economics. But Rosie is not overcompensated, based on his actual production numbers.

Rosie is one of the most popular speakers at my annual conference. This year, after having been bearish for years, he turned bullish while at my conference and presented the reasons why. He had been at GS for several years as a very firm, committed bear. He gets no more money contractually whether he is bearish or bullish. Like me, he just wants to get it right. We win some and lose some, but we call it the way we see it. To suggest that someone like Rosie can be bought (with what I think of as his own money from his newsletter sales) is ridiculous. Zero Hedge owes Rosenberg a major apology.

And one final point. The “author” of the ZH piece is “Tyler Durden,” which is a pseudonym. The name comes from a movie character in Fight Club. If you are going to trash someone, at least have the testosterone to do it using your real name. Man up, guys. And kudos to my readers, who when they respond to my letters almost always do with their real names and photos. None of this hiding behind the web BS. I notice that even when my thoughts get trashed, it is done civilly and with the respect of people arguing different opinions. As opposed to the situation on some other websites. But then, I always knew my readers were a cut above.

Time to hit the send button, as another meeting here in NYC is coming up in a few minutes. Tomorrow should be a very interesting day, and I will report what I learn at the CIO Investment Summit this weekend.

Your thanks for letting me vent analyst,

John Mauldin, Editor
Outside the Box[email protected]

Euthanasia of the Economy?

Niels C. Jensen
The Absolute Return Letter, November 2013

“Crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”
– Rudi Dornbusch, economist

In his masterpiece The General Theory of Employment, Interest and Money John Maynard Keynes referred to what he called the ‘euthanasia of the rentier’. Keynes argued that interest rates should be lowered to the point where it secures full employment (through an increase in investments). At the same time he recognised that such a policy would probably destroy the livelihoods of those who lived off their investment income, hence the expression. Published in 1936, little did he know that his book referred to the implications of a policy which, three quarters of a century later, would be on everybody’s lips. Welcome to QE.

Before I go any further, please allow me to inject a brief personal comment. This month’s Absolute Return Letter is the last before my partner, Nick Rees, departs for the Canary Islands for the final preparations before he sets off to row, unaided, from La Gomera on 2 December on his conquest of the Atlantic. I don’t think any of us can quite comprehend what a mammoth task it is to row 3,000 miles across the Atlantic. Nick and his rowing partner Ed will be in the boat for 50-60 days before arriving in Antigua in late January, and they probably won’t speak to each other for 50-60 months thereafter! It is all done in support of Breakthrough Breast Cancer, one of the leading cancer research charities globally, and you can read more about the project here. Many of you have already supported Nick, and for that he is eternally grateful but, if you have somehow missed it, it is not too late to make a contribution. So many people continue to be diagnosed with breast cancer every year, 1 in 8 women over the course of their lifetime. Nick’s wife, Ellen, was one of them. Please click here if you would like to support this great cause.

Now back to QE – the topic of this month’s Absolute Return Letter. Over the past couple of years it has gradually become the consensus view that QE has failed because it hasn’t created the economic growth that everyone was hoping for. I find that view overly simplistic and naïve in equal measures. QE – or broadly similar monetary policy initiatives – has saved the world from a nasty and potentially very damaging financial meltdown not once, but twice – following the Lehman bankruptcy in the autumn of 2008 and during the depths of the Eurozone crisis in the second half of 2011. It is not clear at all (because it is impossible to quantify) how much worse off we would have been without QE, but worse off – in terms of GDP growth – we almost certainly would have been. Estimates range from 5% to 15% below actual numbers, but nobody really knows.

QE’s effect on asset prices

The second indisputable effect QE has had is on asset prices. The central banks’ unprecedented buying of bonds have had a material, and overwhelmingly positive, effect on asset prices – to the point where more and more people worry that we are in the process of forming a new bubble. Chart 1 below, borrowed with gratitude from the Financial Times, illustrates very well how effective QE has been in terms of moving asset prices higher but, at the same time, it demonstrates the dilutive effect over time. QE2 did not deliver returns of the same magnitude as QE1 and QE3 has been even less effective, at least when measured in this way.

Chart 1: The effect of QE on various asset classes

Source: The license to print money is running out, FT Money, 19-20 October 2013

I do not wish to enter into a longer discussion about whether this is bubble territory or not, as that is the subject of next month’s Absolute Return Letter, but let me make one thing clear. The current equity bull market is not a rally based on irrational behaviour. To the contrary, investors are behaving perfectly rationally. As policy makers continue to signal an intent to keep rates low for a very long time, investors merely respond to such intent. That, on the other hand, is not akin to saying that buying equities at current valuations is a virtually risk free proposition, but more about that next month.

Misguided inflation concerns

When QE was introduced in late 2008ⁱ there was plenty of concern that it would lead to higher inflation. Some even suggested it could lead to hyperinflation and the gold bugs suddenly found themselves with plenty of wind in their sails. As QE became QE2, the inflation protagonists gathered further momentum and the price of gold took another leap. Suddenly you were no longer considered an extremist by suggesting that the Fed would turn the USA into the United States of Zimbabwe.

And what happened? The reality is that almost exactly five years after the introduction of QE, the so-called ‘money printing’ⁱⁱ has had little or no effect on consumer price inflation. If anything, it looks as if QE has paved the road to Tokyo rather than Harare (chart 2).

Chart 2: Consumer price inflation in selected countries

Source: ECB, FRED, ONS

How could nearly everyone get it so horribly wrong? Could it be that we haven’t seen the inflation ghost yet? Are we in the lull before the storm? Is it possible that QE is in fact long term deflationary? The reality is that we have seen plenty of inflation already from QE – just not in the places nearly everyone expected it to show up. Asset price inflation is also inflation, and we have had asset price inflation galore. Many emerging economies have struggled with consumer price inflation in recent times. It looks as if we have been very good at exporting it.

I rarely brag about my predictions when, occasionally, I turn out to be on-the-money, partly because my mum taught me always to be humble, and partly because it usually comes back and bites you in the tail if you get too big-headed. Having said that, I never believed the scare mongering, and I still don’t. I am absolutely convinced that QE will generate little or no consumer price inflation in the western world, although I do recognise that some countries (for example the U.K.) have higher structural inflation rates than others. This is not the lull before the storm.

Is it Japan all over again? I believe the jury is still out on that one. Good friend and business partner John Mauldin made me aware of a very interesting study presented by the Bank of England back in 2011 which appears to suggest that at least the U.K. central bank expects QE to deflate asset prices, consumer prices and economic growth in the long run (chart 3). That is not akin to saying that we have already fallen into the same deflation trap as Japan; however, given the disinflationary trend we are currently in, we are perhaps only one or two policy mistakes away from deflation – in particular in the Eurozone. Extending QE could be one such mistake.

Chart 3: The qualitative economic impact of QE

Source: Quarterly Bulletin, Bank of England, 2011 Q3

Does QE destroy economic growth?

Let’s take a closer look at a very important question raised by chart 3. Does QE actually destroy economic growth in the long run? In order to understand the dynamics at work, let’s start with a quick snapshot of how much the world has actually de-levered since the lofty levels of 2007 when the first signs of crisis began to materialise (chart 4).

Chart 4: Gross debt as % of GDP (excl. financial sectors)

Source: Back to Black, Citi Research, October 2013.

For the sake of clarity I should mention that, in the following, I focus on QE. In reality, most countries have combined QE with various austerity measures which makes it difficult to distinguish the effect of one policy measure from another. Having said that, the U.S. hasn’t engaged in austerity to any meaningful degree which gives us good insight into the (side) effects of QE.

The first, and very important observation, when looking at chart 4 is that total debt is higher almost everywhere since the outbreak of the crisisⁱⁱⁱ. It is indeed a case of robbing Peter to pay Paul as Matt King of Citi Research so succinctly puts it. Where household debt has been reduced (for example in the U.S. and the U.K.) government debt has replaced it.

Italy’s government debt has jumped from 121% to 132% of GDP over the past two years alone. Spain’s debt-to-GDP has gone from 70% to 94% and Portugal from 108% to 124% over the same period. An interesting brand of austerity I might add! Expanding the government deficits at such speed would have been devastatingly expensive in the current environment without QE. And to those of you who want to jump at me and say that the ECB does not engage itself in QE (yes, I am aware that its charter strictly prohibits such activity), I say look at the ECB’s balance sheet. It may not be QE in the legal sense of the word, but the end result is no different.

So, in effect, QE has permitted a number of crisis countries to fund their escalating deficits at rates which would have been impossible to obtain in a free market, but that’s the least of my concerns. QE has also permitted banks in those same crisis countries to re-capitalise themselves without the use of tax payers’ money. At one level that is good news, because using tax payers’ money would only have made government deficits worse. However, there is a bothersome side effect of such an approach.

Think about it the following way. When deploying its capital, a commercial bank effectively has the choice between lending it to its customers or engaging in proprietary trading activities. With central banks underwriting the cost of capital in the banking industry by promising to keep policy rates at record low levels for some extended period, the choice is a relatively simple one. On a risk-adjusted basis, margins on lending simply cannot compete with the profits that can be made on proprietary activities. This in effect deprives the real economy of working and investment capital and thus has a detrimental effect on economic growth longer term. This, and other possible side effects of QE, was pointed out in a brilliant paper published by the Federal Reserve Bank of Dallas last year, which you can find here.

For the economy to grow, not only is it necessary for banks to be willing to lend, but borrowers must also be willing to borrow. Many consumers were over-leveraged going into the crisis and are taking advantage of the lower interest rates to de-lever faster than they could otherwise hope to do, but that is not the only reason why consumers may refrain from borrowing at present. There are signs that QE may in fact be having a direct, and negative, effect on the appetite for borrowing.

Here is how it works. Seeking to impact inflation expectations forms an integral part of monetary policy, and policy makers have been very effective at anchoring those expectations around 2% in recent years. Needless to say, if inflation expectations had moved significantly as a result of QE, I would have had to write a very different letter this month.

Behind all of this is some economic gobbledygook called the ‘rational expectations hypothesis’ which suggests that economic agents (read: consumers and businesses) make rational decisions based on their expectations. So, when the Fed – and other central banks with it – keep ramming home the same message over and over again (and I paraphrase): “Folks, we will keep interest rates low for some considerable time to come”, consumers and businesses only behave rationally when they postpone consumption and investment decisions. They have seen with their own eyes that central bankers have been able to talk interest rates down, so why borrow today if one can borrow more cheaply tomorrow?

QE’s effect on income

Charles Gave of GaveKal Research produced a very interesting paper earlier this year, linking the low income growth to QE – another nail in the coffin for economic growth. Charles found that during periods of negative real interest rates (which is a direct follow-on effect from QE), income growth in the U.S. has been low or negative (chart 5). I am sure we will hear more from GaveKal on this topic in the future. It is the first time I have seen anyone present this hypothesis which, if true, has dramatic implications for monetary policy going forward. It is well known, for example, that President Obama has been keen to find ways to get income growth back on a more positive trajectory again.

Chart 5: The link from QE to income growth

Source: The emergence of a U.S. underclass, GaveKal Research, July 2013

QE was meant to stimulate economic growth and I believe it worked well as a short term crisis management tool in 2008 and 2011. However, for policy makers to expect a longer lasting, and positive, effect on economic growth, they would have had to assume that the wealth effect (from rising asset prices) would kick in and stimulate economic growth through increased consumption. When making this calculation, they may have underestimated the power of demographics, though.

As I demonstrated in last month’s letter, middle-aged and old people, who control the majority of wealth (chart 6) do not create economic growth. Young people do, but QE may have deprived the younger – and income dependent – generations of growth capital for the reasons already discussed, whilst making the wealthy even wealthier. One could say that QE has increased inequalities in income and wealth.

Chart 6: Distribution of UK household financial assets by age group

Source: The distributional effects of asset purchases, Bank of England, July 2012.

Note: Numbers exclude pension assets.

Time to clean up the banks

When talking about the financial sector and how they have been able to take advantage of QE to re-capitalise their damaged balance sheets, it ought to be said that QE has effectively allowed banks to ignore their underlying problems. QE has become a life support machine for the financial sector at virtually no cost to them but at a significant cost to the rest of society. That cannot go on ad infinitum. At some point in the not so distant future it will be financial reckoning day for the sector which bodes particularly badly for the European banks, most of which are way behind their U.K. and U.S. peers in terms of cleaning up their balance sheets.

The IMF provided some very granular information on the state of European banks in their most recent Financial Stability Report. More than 50% of Spanish companies with loans in Spanish banks have an interest coverage ratio of less than one. In other words, the EBITDA of over half of all Spanish corporates does not even cover their interest expense (you would expect a healthy corporate borrower to have an interest coverage ratio of 3-5 times depending on the nature of the business). What’s worse, the situation in Italy and Portugal is only marginally better. All of these problems have been largely ignored since the ECB stepped in with their brand of QE about two years ago and saved the European banking sector from a complete meltdown, but few, if any, of the underlying issues have yet been addressed.

Other unintended consequences

Meanwhile, QE has left a trail of potential problems in the rest of the world. Ultra easy monetary policy in the West has resulted in a virtual credit explosion in many EM economies, many of which pursue a policy which is either directly or indirectly linked to U.S. monetary policy (chart 7). This is a key reason why I predicted in the September Absolute Return Letter (see here) that we may have to face a re-run of the EM crisis of 1997-98 before this crisis is well and truly over.

In China, the transformation currently taking place may have some unexpected consequences for inflation in our part of the world. From a peak of 10.1% of GDP in 2007, its current account surplus now stands at 2.5% of GDP and the surplus continues to trend down. In September, Chinese exports to the rest of the world dropped by 0.3% when compared to the same month last year, whereas imports grew by 7.4%.

Consequently, China is no longer building massive amounts of foreign exchange reserves, and it is quite likely that the Chinese balance of payments will turn negative in the foreseeable future. We had a foretaste of that in 2012 when they posted the first quarterly deficit since 1998. All of this is important in the context of inflation v. deflation because the renminbi may actually begin to weaken as capital outflows gather momentum – a nightmare scenario for us in the West as we would then begin to import deflation from China at a most inopportune time.

Chart 7: Change in private sector debt (gross, non-financial, % of GDP)

Source: Global Economic Outlook and Risks, Citi Research, September 2013

I could go on and on about how QE has created, and will continue to create, unintended consequences. I haven’t really touched on how QE has distorted market mechanisms in the financial markets and the implications of that. For example, as a direct result of QE, dealer inventories have been dramatically reduced since 2008 during a period where assets under management in the mutual fund and ETF industry have exploded (chart 8). When the herd wants out of credit, who is going to provide the liquidity to facilitate that?

Chart 8: U.S. credit mutual fund assets v. dealer inventories

Source: Back to Black, Citi Research, October 2013.

I have failed to mention how QE has undermined the retirement plans for millions of people across Europe and the United States as their pension savings no longer provide a sufficient income to live on. I have not entered into any discussion about how QE could quite possibly undermine the credibility of central banks longer term and how that may impact the effectiveness of monetary policy and possibly even present a threat to global financial stability.

Could the U.S. lose its reserve currency status?

All of these are important issues that deserve a mention; however, I am running out of time and space. Allow me to leave you with one thought, though. Since the end of World War I, the U.S. dollar has retained its position as the reserve currency of choice. Such a position carries with it many advantages. Approximately 60% of the world’s foreign exchange reserves are held in U.S. dollars today. In an era where the U.S. government spends considerably more than it earns, the status as the world’s preferred reserve currency comes in quite handy. Having that status is equivalent to writing cheques that nobody cashes in. What a wonderful position to be in.

The Americans seem to take their status for granted. Perhaps they need a reminder that reserve currency regimes come and go (chart 9). Given its status as a large debtor nation with insufficient domestic savings to finance its deficits internally, it could prove very painful, should the rest of the world decide that it is time for a change. The longer QE goes on for, the more likely that is to happen.

Chart 9: Reserve currency regimes since the middle ages

Source: JP Morgan via Zero Hedge

My good friend Simon Hunt reminded me the other day that, only a couple of weeks ago, an article in China’s official news agency called for a new reserve currency to be created to replace the U.S. dollar. According to Simon, the renminbi’s share of world trade has grown from zero in 2009 to around 17% in the first half of this year. Given its exponential rise, it could easily account for 40% or perhaps even 50% of world trade by 2017.

Conclusion

It is time to call it quits. QE proved to be a very effective crisis management tool, but we have probably reached a point where the use can no longer be justified on economic grounds. Just as John Maynard Keynes talked about the euthanasia of the rentier back in 1936, we are now facing the euthanasia of the economy, unless we change course. The obvious problem facing policy makers, though, is that if financial markets are the patient, QE is the drug that keeps the underlying symptoms under control. We have already seen once how dependent the patient has become of this drug (think 22 May when Bernanke mentioned the mere possibility of tapering), and the market reaction clearly scared central bankers on both sides of the Atlantic.

The western world was very critical (and rightly so) of Japan in the 1990s for not dealing decisively with its sick banking industry. Twenty years later, Japan is still paying the price for its dithering. The problem is that we are now making precisely the same mistake. QE has proven effective of suppressing the underlying symptoms, but that doesn’t mean we should stay on that medicine forever. In order to reinvigorate economic growth, and avoid falling into the Japanese deflation trap, we need a healthy banking industry. That will only happen if it is thoroughly cleaned up once and for all.

PS. To all those out there who think that the world is returning to normal, that everything will be safe and sound as long as we give it a bit more time (a strategy also known as kicking the can down the road), I suggest you read this piece in the FT.

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Hussman Strategic Advisors

This week’s Outside the Box is unusual, even for a letter that is noted for its unusual offerings. It is a speech from last week by Charles I. Plosser, President of the Federal Reserve Bank of Philadelphia at (surprisingly to me) the Cato Institute’s 31st Annual Monetary Conference, Washington, DC.

I suppose that if Dallas Fed President Richard Fisher had delivered this speech I would not be terribly surprised. I suspect there are some other Federal Reserve officials here and there who are in sympathy with this view Plosser presents here, but for quite some time no serious Fed official has outlined the need for a limited Federal Reserve in the way Plosser does today. He essentially proposes four limits on the US Federal Reserve:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;
• And fourth, limit the boundaries of its lender-of-last-resort credit extension.

“These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.”

Some of you will want to read this deeply, but everyone should read the beginning and ending. I find this one of the most hopeful documents I have read in a long time. Think about the position of the person who delivered the speech. You are not alone in your desire to rein in the Fed.

Two points before we turn to the speech. Both Fisher and Plosser will be voting members of the FOMC this coming year. Look at the lineup and the philosophical monetary view of each of the members of the FOMC. Next year we could actually see three dissenting votes if things are not moving in a positive direction, although another serious proponent of monetary easing is being added to the Committee, so it may be that nothing will really change.

I am not seriously suggesting that the reigning economic theory that directs the action of the Fed is going to change anytime soon, but you will see assorted academics espousing a different viewpoint here and there. I think there may come a time in the not-too-distant future when the current Keynesian viewpoint is going to be somewhat discredited and people will be open to a new way to run things. This will not happen due to some great shift in philosophical views but because the current system has the potential to create some rather serious problems in the future. This is part of the message in my latest book, Code Red.

A lot of education and change in the system is needed. I want to applaud Alan Howard and his team at Brevan Howard for making one of the largest donations in business education history to Imperial College to establish the new Brevan Howard Centre for Financial Analysis to study exactly these topics and counter what is a particularly bad direction in academia. The two leaders at the new center, Professors Franklin Allen and Douglas Gale, are renowned for their pioneering research into financial crises and market contagion – that is, when relatively small shocks in financial institutions spread and grow, severely damaging the wider economy. This new center will help offer a better perspective. What we teach our kids matters. I hope other major fund managers will join this effort!

And speaking of Code Red, let me pass on a few quick reviews from Amazon:

“Excellent review of our current economic circumstances and what we can do about it to protect our assets. Even better, it is written with the non-economist in mind.”

“I read this book from cover to cover in 24 hours and was glued to every page. Do I know how to protect my saving exactly? No. But I have the critical information necessary to make informed decisions about my investments. My husband recommended this book to me after reading a brief article, and I’m so glad I impulsively bought it. It will definitely change my investment decisions moving forward and perhaps even provide me with more restful nights of sleep.”

You can order your own copy at the Mauldin Economics website or at Amazon, and it is likely at your local book store.

It is getting down to crunch time here in Dallas as far as the move to the new apartment is concerned. Work is coming along and most of it is done, although some things will need to be finished after I move in. Furniture is being delivered and moved in as I write, and today an the new kitchen is being entirely stocked, courtesy of Williams-Sonoma – they’ll be showing up in a few minutes. I am fulfilling a long-held dream (maybe even a fantasy or fetish) of throwing everything out of the kitchen and starting over from scratch. Between my kids and a returning missionary couple, all the old stuff will find a new home, and I will renew my role as chief chef with new relish next week.

I have always maintained that I think I am a pretty good writer but I a brilliant cook. With a new kitchen from top to bottom, I intend to spend more time developing my true talent. Between the new media room and my cooking, I hope I can persuade the kids (and their kids!) to come around more often. Yes, there are a few bumps and issues here and there, but in general life is going well. I just need to get into the gym more. Which we should all probably do!

Your feeling like a kid in a candy store analyst,

John Mauldin, Editor
Outside the Box[email protected]

---

A Limited Central Bank

Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
Cato Institute’s 31st Annual Monetary Conference, Washington, D.C.

Highlights

• President Charles Plosser discusses what he believes is the Federal Reserve’s essential role and proposes how this institution might be improved to better fulfill that role.
• President Plosser proposes four limits on the central bank that would limit discretion and improve outcomes and accountability.
• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;
• And fourth, limit the boundaries of its lender-of-last-resort credit extension.
• These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.

Introduction: The Importance of Institutions

I want to thank Jim Dorn and the Cato Institute for inviting me to speak once again at this prestigious Annual Monetary Conference. When Jim told me that this year’s conference was titled “Was the Fed a Good Idea?” I must confess that I was little worried. I couldn’t help but notice that I was the only sitting central banker on the program. But as the Fed approaches its 100th anniversary, it is entirely appropriate to reflect on its history and its future. Today, I plan to discuss what I believe is the Federal Reserve’s essential role and consider how it might be improved as an institution to better fulfill that role.

Before I begin, I should note that my views are not necessarily those of the Federal Reserve System or my colleagues on the Federal Open Market Committee (FOMC).

Douglass C. North was cowinner of the 1993 Nobel Prize in Economics for his work on the role that institutions play in economic growth.¹ North argued that institutions were deliberately devised to constrain interactions among parties both public and private. In the spirit of North’s work, one theme of my talk today will be that the institutional structure of the central bank matters. The central bank’s goals and objectives, its framework for implementing policy, and its governance structure all affect its performance.

Central banks have been around for a long time, but they have clearly evolved as economies and governments have changed. Most countries today operate under a fiat money regime, in which a nation’s currency has value because the government says it does. Central banks usually are given the responsibility to protect and preserve the value or purchasing power of the currency.² In the U.S., the Fed does so by buying or selling assets in order to manage the growth of money and credit. The ability to buy and sell assets gives the Fed considerable power to intervene in financial markets not only through the quantity of its transactions but also through the types of assets it can buy and sell. Thus, it is entirely appropriate that governments establish their central banks with limits that constrain the actions of the central bank to one degree or another.

Yet, in recent years, we have seen many of the explicit and implicit limits stretched. The Fed and many other central banks have taken extraordinary steps to address a global financial crisis and the ensuing recession. These steps have challenged the accepted boundaries of central banking and have been both applauded and denounced. For example, the Fed has adopted unconventional large-scale asset purchases to increase accommodation after it reduced its conventional policy tool, the federal funds rate, to near zero. These asset purchases have led to the creation of trillions of dollars of reserves in the banking system and have greatly expanded the Fed’s balance sheet. But the Fed has done more than just purchase lots of assets; it has altered the composition of its balance sheet through the types of assets it has purchased. I have spoken on a number of occasions about my concerns that these actions to purchase specific (non-Treasury) assets amounted to a form of credit allocation, which targets specific industries, sectors, or firms. These credit policies cross the boundary from monetary policy and venture into the realm of fiscal policy.³ I include in this category the purchases of mortgage-backed securities (MBS) as well as emergency lending under Section 13(3) of the Federal Reserve Act, in support of the bailouts, most notably of Bear Stearns and AIG. Regardless of the rationale for these actions, one needs to consider the long-term repercussions that such actions may have on the central bank as an institution.

As we contemplate what the Fed of the future should look like, I will discuss whether constraints on its goals might help limit the range of objectives it could use to justify its actions. I will also consider restrictions on the types of assets it can purchase to limit its interference with market allocations of scarce capital and generally to avoid engaging in actions that are best left to the fiscal authorities or the markets. I will also touch on governance and accountability of our institution and ways to implement policies that limit discretion and improve outcomes and accountability.

Goals and Objectives

Let me begin by addressing the goals and objectives for the Federal Reserve. These have evolved over time. When the Fed was first established in 1913, the U.S. and the world were operating under a classical gold standard. Therefore, price stability was not among the stated goals in the original Federal Reserve Act. Indeed, the primary objective in the preamble was to provide an “elastic currency.”

The gold standard had some desirable features. Domestic and international legal commitments regarding convertibility were important disciplining devices that were essential to the regime’s ability to deliver general price stability. The gold standard was a de facto rule that most people understood, and it allowed markets to function more efficiently because the price level was mostly stable.

But, the international gold standard began to unravel and was abandoned during World War I.⁴ After the war, efforts to reestablish parity proved disruptive and costly in both economic and political terms. Attempts to reestablish a gold standard ultimately fell apart in the 1930s. As a result, most of the world now operates under a fiat money regime, which has made price stability an important priority for those central banks charged with ensuring the purchasing power of the currency.

Congress established the current set of monetary policy goals in 1978. The amended Federal Reserve Act specifies the Fed “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Since moderate long-term interest rates generally result when prices are stable and the economy is operating at full employment, many have interpreted these goals as a dual mandate with price stability and maximum employment as the focus.

Let me point out that the instructions from Congress call for the FOMC to stress the “long run growth” of money and credit commensurate with the economy’s “long run potential.” There are many other things that Congress could have specified, but it chose not to do so. The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

Many discussions about the Fed’s mandate seem to forget the emphasis on the long run. The public, and perhaps even some within the Fed, have come to accept as an axiom that monetary policy can and should attempt to manage fluctuations in employment. Rather than simply set a monetary environment “commensurate” with the “long run potential to increase production,” these individuals seek policies that attempt to manage fluctuations in employment over the short run.

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment. As the FOMC noted in its statement on longer-run goals adopted in 2012, “the maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.” In my view, focusing on short-run control of employment weakens the credibility and effectiveness of the Fed in achieving its price stability objective. We learned this lesson most dramatically during the 1970s when, despite the extensive efforts to reduce unemployment, the Fed essentially failed, and the nation experienced a prolonged period of high unemployment and high inflation. The economy paid the price in the form of a deep recession, as the Fed sought to restore the credibility of its commitment to price stability.

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. For the Fed, it could mean a loss of public confidence. I fear that the public has come to expect too much from its central bank and too much from monetary policy, in particular. We need to heed the words of another Nobel Prize winner, Milton Friedman. In his 1967 presidential address to the American Economic Association, he said, “…we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making.”⁵ In the 1970s we saw the truth in Friedman’s earlier admonitions. I think that over the past 40 years, with the exception of the Paul Volcker era, we failed to heed this warning. We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

The so-called dual mandate has contributed to this expansionary view of the powers of monetary policy. Even though the 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.⁶

I believe that the aggressive pursuit of broad and expansive objectives is quite risky and could have very undesirable repercussions down the road, including undermining the public’s confidence in the institution, its legitimacy, and its independence. To put this in different terms, assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability. I base this on two facts: Monetary policy has very limited ability to influence real variables, such as employment. And, in a regime with fiat currency, only the central bank can ensure price stability. Indeed, it is the one goal that the central bank can achieve over the longer run.

Governance and Central Bank Independence

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices. Good governance requires a healthy degree of separation between those responsible for taxes and expenditures and those responsible for printing money.

The original design of the Fed’s governance recognized the importance of this independence. Consider its decentralized, public-private structure, with Governors appointed by the U.S. President and confirmed by the Senate, and Fed presidents chosen by their boards of directors. This design helps ensure a diversity of views and a more decentralized governance structure that reduces the potential for abuses and capture by special interests or political agendas. It also reinforces the independence of monetary policymaking, which leads to better economic outcomes.

Implementing Policy and Limiting Discretion

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. As I have already argued, a narrow mandate is an important limiting factor on an expansionist view of the role and scope for monetary policy.

What other sorts of constraints are appropriate on the activities of central banks? I believe that monetary policy and fiscal policy should have clear boundaries.⁷ Independence is what Congress can and should grant the Fed, but, in exchange for such independence, the central bank should be constrained from conducting fiscal policy. As I have already mentioned, the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms. One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold.

In its System Open Market Account, the Fed is allowed to hold only U.S. government securities and securities that are direct obligations of or fully guaranteed by agencies of the United States. But these restrictions still allowed the Fed to purchase large amounts of agency mortgage-backed securities in its effort to boost the housing sector. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries. As I’ve already noted, such programs to allocate credit rightfully belong in the realm of the fiscal authorities — not the central bank.

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner.⁸ It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority. Yet, research has discussed the benefits of rule-like behavior for some time. Rules are transparent and therefore allow for simpler and more effective communication of policy decisions. Moreover, a large body of research emphasizes the important role expectations play in determining economic outcomes. When policy is set systematically, the public and financial market participants can form better expectations about policy. Policy is no longer a source of instability or uncertainty. While choosing an appropriate rule is important, research shows that in a wide variety of models simple, robust monetary policy rules can produce outcomes close to those delivered by each model’s optimal policy rule.

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals.

Congress is not the appropriate body to determine the form of such a rule. However, Congress could direct the monetary authority to communicate the broad guidelines the authority will use to conduct policy. One way this might work is to require the Fed to publicly describe how it will systematically conduct policy in normal times — this might be incorporated into the semiannual Monetary Policy Report submitted to Congress. This would hold the Fed accountable. If the FOMC chooses to deviate from the guidelines, it must then explain why and how it intends to return to its prescribed guidelines.

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.

What is the answer? I see three: Simplify the goals. Constrain the tools. Make decisions more systematically. All three steps can lead to clearer communications and a better understanding on the part of the public. Creating a stronger policymaking framework will ultimately produce better economic outcomes.

Financial Stability and Monetary Policy

Before concluding, I would like to say a few words about the role that the central bank plays in promoting financial stability. Since the financial crisis, there has been an expansion of the Fed’s responsibilities for controlling macroprudential and systemic risk. Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort, offering liquidity to solvent firms in times of extreme financial stress to forestall contagion and mitigate systemic risk. This liquidity is intended to help ensure that solvent institutions facing temporary liquidity problems remain solvent and that there is sufficient liquidity in the banking system to meet the demand for currency. In this sense, liquidity lending is simply providing an “elastic currency.”

Thus, the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. Subsequently, the Dodd-Frank Act has limited some of the lending actions the Fed can take with individual firms under Section 13(3). Nonetheless, by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

Just as it is true for monetary policy, it is important to be clear about the Fed’s responsibilities for promoting financial stability. It is unrealistic to expect the central bank to alleviate all systemic risk in financial markets. Expanding the Fed’s regulatory responsibilities too broadly increases the chances that there will be short-run conflicts between its monetary policy goals and its supervisory and regulatory goals. This should be avoided, as it could undermine the credibility of the Fed’s commitment to price stability.

Similarly, the central bank should set boundaries and guidelines for its lending policy that it can credibly commit to follow. If the set of institutions having regular access to the Fed’s credit facilities is expanded too far, it will create moral hazard and distort the market mechanism for allocating credit. This can end up undermining the very financial stability that it is supposed to promote.

Emergencies can and do arise. If the Fed is asked by the fiscal authorities to intervene by allocating credit to particular firms or sectors of the economy, then the Treasury should take these assets off of the Fed’s balance sheet in exchange for Treasury securities. In 2009, I advocated that we establish a new accord between the Treasury and the Federal Reserve that protects the Fed in just such a way.⁹ Such an arrangement would be similar to the Treasury-Fed Accord of 1951 that freed the Fed from keeping the interest rate on long-term Treasury debt below 2.5 percent. It would help ensure that when credit policies put taxpayer funds at risk, they are the responsibility of the fiscal authority — not the Fed. A new accord would also return control of the Fed’s balance sheet to the Fed so that it can conduct independent monetary policy.

Many observers think financial instability is endemic to the financial industry, and therefore, it must be controlled through regulation and oversight. However, financial instability can also be a consequence of governments and their policies, even those intended to reduce instability. I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

The Fed and other policymakers need to think more about the way their policies might contribute to financial instability. I believe that it is important that the Fed take steps to conduct its own policies and to help other regulators reduce the contributions of such policies to financial instability. The more limited role for the central bank I have described here can contribute to such efforts.

Conclusion

The financial crisis and its aftermath have been challenging times for global economies and their institutions. The extraordinary actions taken by the Fed to combat the crisis and the ensuing recession and to support recovery have expanded the roles assigned to monetary policy. The public has come to expect too much from its central bank. To remedy this situation, I believe it would be appropriate to set four limits on the central bank:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;
• And fourth, limit the boundaries of its lender-of-last-resort credit extension and ensure that it is conducted in a systematic fashion
• These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and, at the same time, they would make it easier for the public to hold the Fed accountable for its policy decisions. These changes to the institution would strengthen the Fed for its next 100 years.

* The views expressed are my own and not necessarily those of the Federal Reserve System or the FOMC.

¹ For more about Douglass C. North and his cowinner Robert W. Fogel and the 1993 Nobel Memorial Prize in Economic Sciences, see Nobel Media, “The Prize in Economics 1993 – Press Release,” (1993), www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1993/press.html (Accessed November 11, 2013). See also Douglass C. North, “Institutions,” Journal of Economic Perspectives, 5:1 (1991), pp. 97-112.

² Countries can and do pursue different means of setting the value of their currency, including pegging their monetary policy to that of another country, but I will not concern myself with such issues in these comments.

³ See Charles Plosser, “Ensuring Sound Monetary Policy in the Aftermath of Crisis,” speech given to the U.S. Monetary Policy Forum, The Initiative on Global Markets, University of Chicago Booth School of Business, New York, NY, February 27, 2009, and Charles Plosser, “Fiscal Policy and Monetary Policy: Restoring the Boundaries,” a speech to the same group, February 24, 2012.

⁴ See Ben S. Bernanke, “A Century of U.S. Central Banking: Goals, Frameworks, Accountability,” speech to the National Bureau of Economic Research, Cambridge, MA, July 10, 2013; and Jeffrey M. Lacker, “Global Interdependence and Central Banking,” speech to the Global Interdependence Center, Philadelphia, November 1, 2013.

⁵ See Milton Friedman, “The Role of Monetary Policy,” American Economic Review, 58:1 (March 1968), pp. 1-17.

⁶ See Daniel L. Thornton, “The Dual Mandate: Has the Fed Changed Its Objective?” Federal Reserve Bank of St. Louis Review, 94 (March/April 2012), pp. 117-33.

⁷ See Plosser (2009) and Plosser (2012).

⁸ See Charles Plosser, “The Benefits of Systematic Monetary Policy,” speech given to the National Association for Business Economics, Washington Economic Policy Conference, Washington, D.C., March 3, 2008. Also see Finn E. Kydland and Edward C. Prescott, “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, 85 (January 1977), pp. 473-91.

⁹ See Plosser (2009).

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My good friend Dylan Grice takes a very interesting tack in the latest issue of his Edelweiss Journal, today’s Outside the Box. Rather than attacking our macroeconomic problems directly with economic tools, he approaches them from the point of view of what he calls a “subtle but significant devaluation of language.” Now, you might think that the words we use to describe and understand the economy are not in themselves very powerful economic determinants, but Dylan lays out a convincing case to the contrary.

Dylan has fun with a Google app called Ngram Viewer, which allows users to search for the occurrence of words or phrases (or n-grams, which are combinations of letters) in 5.2 million books published between 1500 and 2008, containing 500 billion words, in American English, British English, French, German, Spanish, Russian, and Chinese.

Using Ngram, Dylan and colleagues have detected an exponential increase in the past few decades of such phrases as economic crisis, macroeconomic stability, policy intervention, financial engineering, and wealth management, and in such words as leveraged, arbitrage, risk, and growth. Use of the word financial overtook industrial shortly after 1980, he notes, and now far exceeds it. Likewise, spending now outstrips saving.

OK, so there’s a lot of funny money floating around these days, and we like to yak about it. But does that mean our language is influencing our economic outcomes? It’s a subtle but powerful process, Dylan says. Most of us appreciate that language shapes our ability to formulate, recall, and modulate the concepts that we then implement as world-changing actions; so language really is fundamental. And, Dylan asserts, when we vastly inflate key terms that we use in describing – and in attempting to manage – the economy, we create the dangerous illusion that we are all-powerful.

Dylan sets us straight in his opening paragraph:

Regular readers of our irregular publication will be aware of our thoughts on inflation, but for those who are not we would summarize them thus: inflation is not measurable. We can summarize our views on money with similar succinctness: it is poorly understood. And as for the economy, we know only this: it is a complex system. From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen.

And in his closing paragraph he sums things up more succinctly and pithily than I ever could:

Today’s language of inflation embeds so many of these false ideas that the full rottenness of what passes for financial thinking today is obscured.

I wrote the following note to Dylan upon reading this piece over lunch the other day.

Dylan,

This reads so pure and profound as to make me weep, on one hand for the pleasure of reading your prose and on the other hand for not having written it myself – or maybe more precisely, for not having the skill to write with such beautiful style and clarity. Those sitting around me here at lunch must wonder at my composure and beatitude as I ignore my sushi and pour over your latest. This may be your finest composition; it’s at least the best thing of yours I have read. And with such a body of impressive work, that is saying something.

This is a briefer and far more eloquent statement of the driver behind Code Red, that central banks are indeed steering us ever closer to a “monetary trap,” an alley, if you will, in which we are very likely to be mugged. This way be dragons.

I believe you will enjoy this piece. Incidentally, I notice that some of Dylan’s Ngram curves that were trying to go asymptotic (straight up) have started to roll over since the Great Recession hit.  I do wonder what that means.

Code Red made the Wall Street Journal best-seller list this weekend. Thanks to those of you who have bought the book and made that happen. The reviews are quite positive so far. Fixed-income maven Richard Lehman over at Forbes wrote a very nice piece about Code Red this weekend. I am very pleased that he spoke so well of it:

If you read only one book on finance this year, read Code Red: How To Protect Your Savings From the Coming Crisis by John Maudlin and Jonathan Tepper. It is a recounting of current Federal Reserve Bank’s “Code Red” policies for dealing with its mandate of promoting full employment while maintaining financial stability. The Code Red moniker is intended to draw attention to the unprecedented nature of those policies and the dangers we face when they are finally undone.

He goes on to say,

The book finishes with the most important chapters, what you can do to protect yourself from the almost certain negative fallout these policies will produce. This section alone makes the book a must read…. The authors see the end of a long secular bear market, but on the brink of a new secular bull market. Despite their dour outlook for the short term, they are basically bullish on America.

“But,” he concludes, “No book review is considered complete without saying something negative; so, I think they should have titled it Code Blue.” I’ll accept that, Richard.

I am off to NYC early tomorrow morning to be at the NASDAQ for the closing-bell ceremony, to celebrate the launch of a new ETF called ROBO, focused on robotics, automation, and 3-D printing. Then I’ll be on Bloomberg radio from 8-9 with Tom Keene and on other media throughout the day. I’ll hang around for the evening to be with my old friend Steve Forbes for an interview Thursday morning before heading back to Dallas to see what progress, or lack thereof, has been made on the new apartment.

Finally, my good friend Reid Walker launched an organization called Capital for Kids that raises money from the Dallas investment community (and their clients!) in order to help kids in all manner of activities. They have their big annual soiree Thursday, November 21 at the F.I.G. here in Dallas. Join me and several hundred fun people to help kids who need it. And bring your checkbook. The silent auction is loaded with cool items. Click on the link and look for me when you get there!

Your thinking about how we use words analyst,

John Mauldin, Editor
Outside the Box[email protected]

---

The Language of Inflation

By Dylan Grice

Edelweiss Journal, No. 14, November 2013

Regular readers of our irregular publication will be aware of our thoughts on inflation, but for those who are not we would summarize them thus: inflation is not measurable. We can summarize our views on money with similar succinctness: it is poorly understood. And as for the economy, we know only this: it is a complex system. From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen.

One such unintended consequence of the past three decades’ economic experiments with “inflation” targeting has been the unprecedented inflation of credit which today leaves the world burdened with debt as it has never been burdened before. In Issue 12 we wrote about another unintended consequence of this monetary experiment, a redistribution of wealth from the poor to the rich and, relatedly, a growing distrust both within countries and between them. Since money is based on trust, we concluded, devaluing money devalues trust.

Now, with the help of Google’s fabulous Ngram Viewer (which allows users to search word usage in five million digitized books published since 1600) we’ve recently stumbled upon another possibility, which is that the past three decades’ hidden devaluation of money has caused a subtle but significant devaluation of language too.

This might sound abstract. But language is the machinery with which we conceptualize the world around us. Devaluing language is tantamount to devaluing our ability to think and to understand. Inflation, whether credit inflation or otherwise, messes things up because it sends false signals. For the ordinary steward of capital in such an environment the near impossible task of judging what is real from what is not is difficult enough. But what chance does he have if in addition, his linguistic software has coding errors to which he is oblivious? This is a question which is perplexing us here at Edelweiss and what follows is an exploration of some of the issues as best we can untangle them.

We start our journey into the financial imagination at the beginning, by tracing an important idea which has had a profound effect, namely that society and the economy are things to be manipulated by expert policy makers. As Taleb opines in his wonderful book Antifragile:

Modernity is not just the postmedieval, postagrarian, and postfeudal historical period as defined in sociology textbooks. It is rather the spirit of an age marked by rationalization (naive rationalization), the idea that society is understandable, hence must be designed, by humans. With it was born statistical theory, hence the beastly bell curve. So was linear science. So was the notion of “efficiency”—or optimization.

Supporting Taleb’s idea, the following chart shows how the word “optimal” has steadily gained prominence in the 20th century.

As the Taleb quote alludes to, much of today’s pseudo-science was facilitated by a hijacking of the statistical bell curve distribution, the growing psychic predominance of which can be seen here too.

Meanwhile, the growth in what is quite a modern idea of a controllable society can be seen in the following chart.

This new interventionist idea was brought into the realm of economics through the Trojan horse of macroeconomic theory and, in particular, its defining metaphor that the economy is basically an engine. Originally, this metaphor gave economists an excuse to use the same mathematics physicists had used with such great success in the 19th century. The hope was that such tools would afford them similar acclaim. But by the time of the Great Depression Keynes was explaining the slump as being somewhat akin to failure in a car’s electrical system. More recently, Nobel Prize winning clever-clogs Paul Krugman updated the metaphor by describing the current malaise as “magneto trouble.”

Today, the metaphor gives another kind of comfort. One that allows economists to pretend that like an engine, the economy is something that a well-trained expert, perhaps with a PhD from Princeton, should be in control of, and “do things to.” They can optimize it, fine-tune it, or manipulate it in some other way so as to achieve the outcomes most beneficial to “society.” Such experts think they know how to “drive” the economy the way a well-talented astronaut might fly a space shuttle. You’ve probably heard them talk about the economy reaching “escape velocity” or being stuck at “stall speed.” Now you know where they get it from.

They see their job as to constantly monitor the economic engine, check its gauges and dials, ensure its satisfactory performance while all the time standing ready to intervene should anything untoward happen. Thus, writing in January 2012 Larry Summers claimed that “government has no higher responsibility than ensuring economies have an adequate level of demand,” as though doing so were no more complicated than pouring out the correct measure of fuel into a tank. Should the economy ever become too hot and aggregate demand too high, the engineers are supposed to be able to spot this and put the brakes on before anything bad happens. In doing so, the idea is for economic fluctuations to be smoothed, macroeconomic stability achieved and an otherwise unruly world safely delivered into a “ruly” land of milk and honey. But this too is also a new obsession, only really gaining prominence since the 1980s.

The problem is that the metaphor is wrong, the conclusions derived from its use are misleading, and any attempt to achieve “macroeconomic stability” using its prescriptions is doomed to failure. Or at least, now that the results have come in over the past few decades, there isn’t much supporting evidence. If anything, the more obsessed that economists and policy makers became with stabilizing the economy, the less stable the economy became. Certainly the usage of the terms “economic crisis” and “financial crisis” displays a clear trend. (Note the time series ends in 2008; one would expect subsequent updates to show a renewed interest given what happened then and since).

Also, as a matter of empirical fact, the period during which the frequency of financial calamities has clustered is the very same period during which the idea of controlling through policy intervention became so fashionable. The chart below shows the incidence of financial crises as documented by Charles Kindleberger in his classic Manias, Crashes and Panics and updated for the various fiascos of the past decade. As can be seen, financial crises have noticeably clustered around the very period economists started playing God.

Volcker did a wonderful thing in taming CPI inflation in the early 1980s. But this was a watershed moment. His successors used the platform to launch their great experiment. In the name of macroeconomic stabilization they developed the habit of lowering interest rates at the first sighting of any clouds and keeping them low until the sky was blue again. While this all gave the illusion of relatively stable growth, artificially cheap money fueled a background credit inflation the likes of which has never been seen before. The chart below shows total US credit to GDP exploding from 1980 onwards, the great unintended consequence of attempts to stabilize and, of course, the source of the increased instability we have since borne witness to.

But there were other unintended consequences too. The artificial growth in debt saw an artificial growth in the size of the financial sector. And the financial sector did what the financial sector does. It financialized everything. Look at the explosion of these hitherto sparsely used words.

Ideas like these became glamorous because the people using them were becoming rich. In 1981 there was one financial professional in the top fifty names on the Forbes rich list. Thirty years later there were twelve. Cheap credit fueling higher assets benefitted those with access to credit, those who owned assets and the intermediaries who arranged the deals. Typically, such people were already rich. This in turn widened the great disparity between rich and poor we’ve discussed on these pages before, redistributing wealth from the asset poor to the asset rich. Or more simply just from the poor to the rich. Finance became king. Industry became an afterthought, something people “used to do.” Or at least, in the 1980s usage of the term “financial” overtook that of “industrial.”

But what does this all mean? Economists use the notion of “time preference” to describe an individual’s patience, or “discount rate.” The higher his time preference, the higher his discount rate, and someone with a high time preference would have a high preference to spend today compared to tomorrow. Something else which can be detected in these linguistic changes is an underlying change in time preferences. Remember the fundamentals of wealth accumulation: spend less than you earn. It’s no great secret. By working hard and saving you’re more likely to grow wealthy than if you don’t. Those with a lower time preference and a longer time horizon save more and are consequently rewarded more. Patience, thrift and hard work are all a part of the same package, and all serve in the natural process of capital formation and wealth accumulation.

But inflation inverts this calculus. With high price inflation of the traditional variety (i.e., an inflation of high street prices, or CPI), tomorrow’s money is worth less. Thrift makes no sense. Only idiots save. Patience is punished too, the more rational action being to pursue instant gratification by spending money while you can. (It has been well documented by Bernd Widdig, Gerald Feldman and others that during the Weimar hyperinflation, Berlin was simultaneously gripped by a wave of hedonism in which night bars, cabarets and strip clubs expanded as rapidly as the money supply.)

An inflation of credit is different in form but not substance. Why save up for something when you can cheaply borrow the money and have it today? Both types of inflation distort time preferences. Both types of inflation reduce the rewards of patience and thrift. Both types of inflation consequently distort the process through which wealth is created. The following chart reveals this inflated time preference through increased usage of the phrases “right now” and “fast money.”

To say, as almost everyone seems to, that there has been no inflation over the last thirty years and that there is no inflation today is a huge and misleading simplification in our view. What people mean, we think, is that there has been no inflation of the CPIs. Of course, this is true. But there has been a grotesque inflation of credit during this same period, and central banks are pulling out the stops to ensure that it continues. To do this they are engineering a staggering inflation of government bond prices which is inflating nearly all other asset prices. And all the while, there has been a commensurate inflation of economists’ confidence in themselves, of ordinary time preference and, as we shall now see, of expectations for the future. In other words, inflation is everywhere but the CPI.

But to understand the practical consequences it must be understood that language isn’t only a reflection of thought and action. It is a driver too. Language is our cognitive machinery; it shapes our ability to interpret, recall and process concepts. Lera Boroditsky, writing in Edge a few years ago, describes an Australian Aboriginal community whose language references direction in absolute terms, rather than the relative ones Indo-European languages use. Instead of telling someone to “watch out for the ditch ahead,” for example, someone from the tribe might warn a fellow member to “watch out for the ditch southeast.” Boroditsky writes that “the result is a profound difference in navigational ability and spatial knowledge” between the tribesmen and their spatially-relativist Indo-European speaking brethren.

One of the first studies to look into the effect of language on competence makes it even easier to understand why. Studies performed in 1953 on the ability of the indigenous Zuni tribes of New Mexico and Arizona found them to have difficulty retaining and recalling the colors yellow, orange and combinations thereof compared to AngloSaxons performing the same tests. As it happens, the Zuni have no separate words for the colors yellow and orange and therefore insufficient linguistic precision to process the difference. It is often said that sloppy language leads to sloppy thought. These studies and others like them conclude the same from the other direction: linguistic precision leads to cognitive precision. If distinct concepts are poorly defined they will be poorly understood.

It turns out that many of the terms we have long suspected of being hollow and gimmicky are in fact products of this era of financialization, and have only recently gained prominence in usage. As a first example, the following chart shows the Ngram for “wealth management.” It begs several questions. Like, was no one wealthy before 1980? Was there no “wealth” to be managed before then? Have serial asset price inflations and easy credit availability distorted what people understand as “wealth”? Or is it merely that the inflation of all things financial has fostered the creation an entirely new class of professional parasites called “wealth managers”?!

We don’t know. But we attended a lunch recently in which one such “wealth manager” was promoting his services to those around the table. An Italian gentleman claimed to be relieved to have finally found someone who could help him. “At last!” He gasped after the banker’s pitch, “I could really use some help managing my family’s wealth. We own vineyards and a processing plant in Italy, some land and a broiler farm in Spain, some real estate scattered around Europe and the Americas… We are fortunate indeed to have such wealth, but managing it all is increasingly challenging. Can you help?”

The poor banker looked forlorn. Of course, he didn’t mean that kind of wealth, the old-fashioned, productive kind of stuff. He meant the modern, papery, electronic kind. The stuff that blinks at you all day from a screen. Green on an “up” day, red on a “down”… He meant the kind of stuff you can buy and sell. He meant liquidity, we think. His pitch was for the management of the attendees’ “liquid” wealth, presumably because he wanted other people’s money to play with. (We have little doubt our Italian friend would have felt poorer had he sold up his estate and transferred the proceeds to the banker.)

Of course liquidity is an important component of wealth. But liquidity is not wealth. It’s needed to pay the bills that keep the lights on, the house running, the kids at school, provide for unforeseen events and so on. But why does the whole thing need to be liquid? A completely liquid portfolio of investments is important only for those who are intent on trading, and who might need to quickly exit their trades. Such activity may be the niche of a few financial market traders and talented speculators, but of the many who try to build or protect wealth using such methods few succeed. Why should it be so crucial to your average “wealth manager”? What has such activity got to do with the management of real wealth? And anyway, how is someone as confused by the difference between liquidity and wealth as they are between trading and investing supposed to manage anyone’s wealth, exactly? The explosion of wealth managers has seen a commensurate increase in the fetish for things which are liquid, a contrasting and relatively new fear of things which are illiquid.

Another linguistic distortion which has arisen during this age of financialization can be seen in the notion of “risk.” Indeed, the ngram for “risk management” looks similar to that of “wealth management” and again we ask ourselves similar questions. Was there no “risk” to be managed prior to 1980? Has the nature of “risk” changed since then? Or has the conceptualization and therefore understanding of risk changed during this time?

We suspect the latter. Within the space of a generation, bankers have become obsessed with “value-at-risk,” “risk-budgets” and more recently “risk-parity.” All such concepts use the volatility of market prices as the sole input into the calculation of “risk.” But price volatility is not risk and it is frankly dangerous to think that it is. There are so many different types of risks to consider in the practice of capital stewardship that we could write a book about them. Some are to be avoided without exception, others are to be embraced. But all require judgment because none are measurable. In the broadest sense possible, the greatest and most fundamental risk is the risk of not knowing what you’re doing. To the extent these “risk models” trick “risk managers” into thinking they do, they are dangerous because they blind users to the true nature of risk. The paradoxical outcome is that such risk managers are making the financial world far riskier than it would otherwise be.

Perhaps the most concerning distortion though is the obsession with “growth.” So deeply ingrained is it in our thinking today that one could be forgiven for thinking it has always been thus. But it is actually quite new. Increasingly, we see it as a part of the widespread though subtle inflation of expectations.

As can be seen, this growth fetish also seems to have developed during the credit inflation. Note also the relation to inflated time preferences. The fixation on growth can encourage behavior which may seem beneficial in the short term but is detrimental to the long term. The debt-overhung world we live in today is a very good macro-level example of the long-run damage this growth obsession can cause. But the corporate world is strewn with them. Most companies even tie executive compensation to implied or explicit EPS growth targets. These, not to mention the primacy of expected growth in the broader financial community, create a pressure on management to behave in a manner they otherwise might not. It also encourages executives to focus more on their stock price than on their business, which can be quite devastating.

For example, a survey of 169 CFOs polled for a recent study into earnings quality found that 20% “manage their earnings to misrepresent economic performance” in any given period. In their book Financial Shenanigans, Howard M. Schilit and Jeremy Perler write that “investors are beginning to harbor a troubling suspicion about corporate financial reporting: that management now plays tricks… Sadly, these suspicions are well founded.” Indeed, the bulk of the frauds analyzed in their book turn out to be perpetrated by executives fearful of disappointing the growth expectations they had previously fostered among their shareholders.

Don’t misunderstand us, there is nothing wrong with growth. We like growth and we like the companies we have ownership stakes in to grow. But we like growth as the outcome of an outstanding business process. An enterprise which is better at solving its customers’ problems than its competitors will soon find itself with more customers. Such a business will inevitably grow and this is a natural and good thing. But a company pursuing growth for the sake of it, or because Wall Street demands it, or because remuneration has been structured around it, is less likely to be concerned with the long-term health of the business. The pressure on them to engage in the financial shenanigans that Schilit and Perler document in their book will be greater, all else equal. So it is no longer necessary to merely keep a weather eye on the manner in which companies report their numbers. Today, stewards of capital must also make sure executives haven’t succumbed to the growth disease.

Recently, for example, we examined a company which is regionally dominant in an industry we are interested in and have some knowledge of. But its forty-six page investor roadshow presentation used the word “growth” forty-eight times. The company in the sector we already own a stake in mentioned growth in its forty-four page presentation only four times. Unsurprisingly, the company we investigated had twice as much debt as the one we already owned and had doubled its share count in the last fifteen years (ours had steadily and consistently shrunk its own). Unsurprisingly again, Mr. Market gave the growth-obsessed company a higher multiple than our one because Mr. Market loves growth. But to us, this tendency suggests a company’s clear willingness to either take or ignore risks with its health in the name of its cherished growth. We didn’t pursue our interest.

On a related note, we’ve recently come to the conclusion that there seems to be a widespread misunderstanding of what “capital” is. We happened to stumble across a fabulous book called Talent is Overrated (no sarcastic emails on why we were so attracted to such a title, please) written by the well-regarded Forbes journalist Geoff Colvin. To be clear upfront, is an excellent book which we learned a lot from. But consider the following extract (our emphasis):

For roughly five hundred years—from the explosion of commerce and wealth that accompanied the Renaissance until the late twentieth century—the scarce resource in business was financial capital. If you had it, you had the means to create more wealth, and if you didn’t, you didn’t. That world is now gone. Today, in a change that is historically quite sudden, financial capital is abundant. The scarce resource is no longer money…

“Financial capital” indeed. We found it striking that Mr. Colvin, a distinguished journalist of a distinguished business magazine should use the concepts of capital and credit completely interchangeably. Yet this is a fundamental error of thought. Capital is not money. One is scarce, the other is infinite. And we might not have thought anything of this sloppy language had we not been talking to an economist a few days earlier who feared for the future of euro. The situation remained grave, he said, and there was surely no alternative than for the ECB eventually to “print more capital”…

What he meant, we think, was printing more money. But it’s not what he said. He had confused money with capital as Mr. Colvin did in his book.

Like the Zuni tribes struggling to deal with the difference between yellow and orange without sufficient linguistic precision, we face the same problem in our financial system. As stock markets blink green on more QE supposedly making us all more wealthy, the developed world is saving less than it has at any time since WWII. And as central banks are conjuring up ever more liquidity, more thoughtful observers scratch their heads over the lack of collateral in the system. Of course, the problem is solvency, not liquidity. Capital comes from savings, and the policy of cheap credit with its inflation of time preference has encouraged spending, not saving. Scarce capital is growing ever scarcer.

One day, the price of capital will reflect its underlying scarcity, because one day it must. But in the meantime we think very carefully about the capital requirements of the businesses we own, growing increasingly wary of those which depend on artificially cheap “financial capital” for their survival. We note in passing that physical gold bullion is the oldest and purest capital there is…

What is the moral of this story for the steward of capital? Success in the long run requires that thought and action be fully independent from the false ideas of the herd. Yet today’s language of inflation embeds so many of these false ideas that the full rottenness of what passes for financial thinking today is obscured. One increasingly reads of capital stewards complaining that things seem more difficult today. We think it’s because they are. We are also increasingly mindful of conversations with friends, family and colleagues that reveal a widespread perception that something is very wrong, though people can’t quite put their finger on what it is. As we have just argued, we think the answer is that the inflation of credit has driven an inflation of asset prices, which has driven an inflation of future expectations, which has driven an inflation of time preference… and that while the consequences of these various inflations are profound, the new language of inflation which it has spawned is shallow. Therefore, not only is there insufficient capital to ensure future prosperity and insufficient realism to deal with the future this implies, there is insufficient linguistic precision for most people to articulate the problem let alone understand it. And when language itself becomes so grotesquely distorted, how does one go about substituting the customers’ unattainable hopes and expectations of never-ending growth with the need for principled and honest action?

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

 

The US Senate Banking Committee will hold hearings on Thursday, November 14, on the nomination of Janet Yellen for Federal Reserve chair. There will be the usual softball questions, for example, “Do you think high unemployment is a problem in the United States and if so what do you intend to do about it?” (which allows a senator to express his concern over unemployment and for the nominee to agree that it’s a problem). Or the always popular question, “What is the basis under which you would continue to hold interest rates at their current low level?” – as if she would answer anything other than, “Any future policy decision is of course data-dependent” or some variation on that response. Boring.

There have been a flurry of new research papers this week by Federal Reserve economists, IMF economists, and even Paul Krugman, all suggesting various policy responses going forward, but none suggesting a return to normal any time soon. I would be far more interested in getting a response from Yellen to some of that research, but even the questions raised in those papers don’t get to the real heart of the matter. So today, let’s pretend we are prepping our favorite Banking Committee senator (members here) for his or her few questions. What would you like to know? In this week’s letter I offer a few questions of my own.

First a brief caveat. Each of the questions below deserves multiple pages of background. I get that. There is only so much I can write in one letter. Further, some of the questions are intended to provide an insight into Yellen’s thinking and what research she considers to be relevant. Those are more the “inquiring minds wants to know” type of question. And since Senator Rand Paul is not on the committee, I have omitted some of the questions he might ask. Not that they aren’t interesting and shouldn’t be asked, but there is only so much space.

What Questions Would You Ask Janet Yellen?

Secondly, I know for a fact that a few Senators on this committee and even more of their staff members read my letter from time to time. I would expect that to be the case this week. I also know that I have some of the smartest and most thoughtful readers of any writer I know. If you want to address a committee staffer about questions you think your senator should be asking Janet Yellen, the comments section at the end of this letter would be an appropriate place to do so. Your comments will get read. Be polite, offer links to supporting documents, and have fun. I’m sure I’ve missed several important questions, including ones you’ll think I should have listed, so this is your opportunity to get them in front of the right people. Whether they will get asked is a different matter entirely, of course.

Finally, I am assuming that Yellen will be confirmed. While I would favor a Fed chair with a different economic philosophy, that is not going to happen. So rather than fantasizing about what is not going to happen, let’s think about what we would like to actually learn.

The Fed’s Dilemma

Conveniently, Ray Dalio and his team at Bridgewater penned an essay this week highlighting the Fed’s dilemma. I offer a few key paragraphs and a chart or two as a setup to my list of questions. Turning right to their very prescient comments:

In the old days central banks moved interest rates to run monetary policy. By watching the flows, we could see how lowering interest rates stimulated the economy by 1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).

All that changed when interest rates hit 0%; “printing money” (QE) replaced interest-rate changes. Because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed’s ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees (for logical reasons, given who owned the assets and their decreasing marginal propensities to consume). As shown in the charts below, the marginal effects of wealth increases on economic activity have been declining significantly. The Fed’s dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias. In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness.”

(In the following charts HH stands for “Household.”)

We expect this limit to worsen. As the Fed pushes asset prices higher and prospective asset returns lower, and cash yields can’t decline, the spread between the prospective returns of risky assets and those of safe assets (i.e. risk premia) will shrink at the same time as the riskiness of risky assets will not decline, changing the reward-to-risk ratio in a way that will make it more difficult to push asset prices higher and create a wealth effect. Said differently, at higher prices and lower expected returns the compensation for taking risk will be too small to get investors to bid prices up and drive prospective returns down further. If that were to happen, it would become difficult for the Fed to produce much more of a wealth effect. If that were the case at the same time as the trickling down of the wealth effect to spending continues to diminish, which seems likely, the Fed’s power to affect the economy would be greatly reduced.

What Would Yellen Do?

With that as a setup, let’s turn to our hypothetical hearing.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

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The Affordable Care Act is the single most contentious political action of my lifetime since the Vietnam War. It touches everyone in one way or another, and often in profoundly personal ways. Some see it is a godsend and others as an arrow aimed directly at the heart of the American experiment. Some will experience healthcare that is now available for themselves and their families for the first time, while others will experience the loss of a system that had served them well. The story in the Wall Street Journal this week of the cancer survivor Edie Littlefield Sundby, who lost her doctors and affordable care in the middle of a true life-and-death battle, is poignant. It turns out that not only can she not buy insurance that will cross state lines, she cannot buy insurance in California that will cross county lines!

As I highlighted a few weeks ago, the US system is dysfunctional, yet the potential for positive change is rather spectacularly illustrated by work done by Dr. Jeff Brenner in Camden, New Jersey. Basically, he found that 1% of the patients in Camden were responsible for 30% of hospitalization costs. Sometimes called super utilizers, high utilizers, or frequent fliers, these patients have complex medical conditions and often lack social services such as transportation or knowledge about how to use the health system most effectively. By some estimates, 5% of these patients account for more than 60% of all healthcare costs. This is a system that is so dysfunctional that it does not even work for those who are getting the care! There are scores of such opportunities throughout the healthcare system to reduce costs and improve services, so I write not of a bleak healthcare future, just a profoundly changing one.

Peggy Noonan writes compellingly today about the problematical rollout of Obamacare.

They said if you liked your insurance you could keep your insurance – but that’s not true. It was never true! They said if you liked your doctor you could keep your doctor – but that’s not true. It was never true! They said they would cover everyone who needed it, and instead people who had coverage are losing it – millions of them! They said they would make insurance less expensive – but it’s more expensive! Premium shock, deductible shock. They said don’t worry, your health information will be secure, but instead the whole setup looks like a hacker’s holiday. Bad guys are apparently already going for your private information.

And now there are reports the insurance companies are taking advantage of the chaos of the program, and its many dislocations, to hike premiums. Meaning the law was written in such a way that insurance companies profit on it.

Today the Manhattan Institute released a report that shows that insurance premiums are going up an average of 41% in 49 states, although there are seven “blue” states where the costs go down. Go figure. New York sees a drop of 40%. The analysis of the HHS numbers shows Obamacare will increase underlying insurance rates for younger men by an average of 97 to 99 percent, and for younger women by an average of 55 to 62 percent. Worst off is North Carolina, which will see individual-market rates triple for women and quadruple for men. Older people acquire a large advantage over younger people in the insurance cost game.

And the rest of the world looks on and wonders what we are thinking. And how can we manage to do this so badly? Not just the roll-out – I mean, they don’t understand our whole healthcare system. This weekend my Code Red coauthor, Jonathan Tepper, sent out a note that not only illustrates the confusion and dismay in much of the world about US healthcare policies but also gives us a true Outside the Box lesson in how not to design a healthcare system.

Jonathan is quite special. He speaks about five languages fluently with no accents and is a former Rhodes scholar, a wicked smart economist, and a good writer; and he seemingly works around the clock. While Jonathan is a US citizen, he is quintessentially European, having grown up in Europe, with much of his early life spent in Madrid, at a drug rehab center that his parents founded and directed. He mentions with a smile that his playmates as a young boy were drug addicts. His view of the US has a definite European flavor to it, and as you read this, think about it coming from the pen of a conservative European economist (there are a few!).

I left in the 19 links Jonathan provides as the sources for his thoughts, for those interested in a further deep-dive exploration. It will be interesting to see the comments, all of which I make a point of reading, by the way. If you can take the time to write to me, the least I can do is read.

I started this note in Cleveland, where I finished up a daylong health check-up with Dr. Mike Roizen, which went better than I had hoped. I asked frontline employees all day what they thought of the new healthcare law. I was not hearing happy thoughts, as many are concerned about their jobs. And then I dropped by to see my 96-year-old mother on the way home, and we talked about her healthcare. “I have not seen a doctor for a long time, but it’s OK. I think all they do today is just make guesses anyway,” she remarked – the state of healthcare from the point of view of the elderly.

The focus tonight is the future of healthcare. Dr. Mike West, CEO of Biotime, is in Dallas for a layover between flights, and we will catch up on the state of stem cell research and on my personal genome, which he arranged to get done – but more on that in a few weeks.

It is odd. We have made such progress on so many technological fronts, and the price of new tech keeps going down – except in healthcare. But then, politicians and lobbyists are involved, which I guess is part of Jonathan Tepper’s point.

Have a great week and get some exercise, eat healthy, and invest wisely, because you are going to live a lot longer than you thought.

Your watching my apartment construction completion date keep slipping analyst,

John Mauldin, Editor
Outside the Box[email protected]

---

Jonathan Tepper on Obamacare

Dear friends,

Please pardon this long email, but after reading endless drivel on Obamacare, I needed to write this.

I’m afraid almost all discussions on the left and right regarding the Affordable Care Act (ACA) miss some very basic things. So I hope this email will explain a few economic ideas and put them into perspective for you, whether you’re on the left or right and whether you like Obamacare or not.

Before I do that, though, let me say that I’m a raging capitalist and I’m in favor of universal healthcare coverage. I’m indifferent as to having either (1) a 100% government-guaranteed single-payer system or (2) a 100% private solution where the government guarantees that the poor are fully covered. Each has its pros and cons. For countries like Spain and the UK, a single-payer national system works. (I’ve lived in both countries almost all my life, and their healthcare systems work. The only time I’ve ever paid $250 for an aspirin was in a US hospital.) On the other hand, private solutions work very well for Singapore and Switzerland. So one model is purely public, and it works; and the other is purely private, and it works. There is a lot of demand for healthcare, so you have to ration medical care via price or quantity. That’s basic economics. It is for voters and politicians to decide what they prefer. I’m indifferent to the solution, as long as it is well thought out and implemented and in fact provides universal coverage. The problem is that the ACA takes the worst elements of public and private and fails to provide universal coverage for millions of people. 

Now, let’s look beyond good intentions and see how the ACA works in practice.

The main egregious problem with the ACA is that it increases concentration in the insurance and medical markets. It forces consumers to buy into oligopolistic and monopolistic marketplaces. Insurance and medical companies stocks have all gone up since Obamacare passed. (They’ve gone up twice as much as the S&P this year.) What these companies are all telling us is that the act is good for their business and good for their margins.

Before the ACA, the US health insurance market was extremely uncompetitive, as this article in the NY Times notes:

As a general rule, the larger, more densely populated states have the most choice — and even the biggest insurer controls only a minority share of the market. According to statistics from the American Medical Association, the leading insurance provider in California covers 24 percent of the population, while in New York the figure is 26 percent and in Florida, 30 percent.

But there are nine states where a single insurer covers 70 percent or more of the people. In Hawaii, one insurer covers 78 percent. In Alabama, it’s 83 percent. And in at least 17 other states one insurer covers at least half the population.

Some members of the Senate Finance Committee, which is taking a lead on health care legislation, come from states where the insurance market is highly concentrated. The Democratic chairman, Senator Max Baucus, is from Montana, where 75 percent of people are covered by one major insurer, Blue Cross Blue Shield of Montana. For Senator Charles E. Grassley, Republican of Iowa, the figure is 71 percent, by Wellmark. For Senator Olympia Snowe, Republican of Maine, it’s 78 percent, by WellPoint.

“For many Americans, the idea that they have a choice of health plans is about as mythical as unicorns,” said Jacob Hacker, professor of political science at Yale University.

In theory, the ACA could have improved things, and many supporters think it does through exchanges. Unfortunately, it didn’t. Under the Affordable Care Act there will be far fewer choices and less competition. Don’t take my word for it; read this NY Times article.

Of the roughly 2,500 counties served by the federal exchanges, more than half, or 58 percent, have plans offered by just one or two insurance carriers, according to an analysis by The Times of county-level data provided by the Department of Health and Human Services. In about 530 counties, only a single insurer is participating. 

This is truly staggering, when you consider it. Citizens will now be forced to buy insurance from oligopolies and in many cases monopolies. They’re not getting healthcare from the government; they’re being forced to buy from private companies that have pricing power and market dominance. Insurance companies are still exempt from anti-trust supervision. This would never happen in other industries. You don’t need to know anything besides basic economics to understand that oligopolies and monopolies are bad for consumers. Consider having to pay for phone services from one or two phone providers. (Wait, we already had that, and Ma Bell was broken up…)

Medical companies are also exempt from fair pricing laws. If you go to a hospital, you’ll get a different price depending on whether you’re uninsured or Medicaid pays for you or your insurance pays for you. You can’t drive into a gas station and be charged an arbitrary cost after you’ve filled your car, but you can be charged an arbitrary number by a hospital. (Imagine: a black, a WASP, and a Jew go to a gas station, and they all get different prices. Wait, we got rid of that injustice too…) In theory, the ACA fixes fair pricing laws, but it doesn’t apply to most hospitals. See “Federal health law falls short of a goal” in the Boston Globe.

In the 21st century, states still control and regulate insurance, which means fragmentation, very high barriers to entry, and local oligopolies. It is insane that the Federal government regulates banks at a national level via the Federal Reserve and the FDIC but allows insurers to have local market dominance. (The law that allows this is the 1945 McCarran-Ferguson Act.) If you’re curious about how insurance companies are oligopolies, read here. And read this‪ … and this.‪

You can ship and sell Coca Cola across state lines, but you can’t sell insurance across state lines. Some argue that you could get one lax insurance regulator in North Dakota, and then insurance companies would all set up shop there and start selling across state lines. That has an easy solution: have one national regulator and let insurance companies compete across state lines.

Not only is there a lack of competition among insurers, there is a lack of competition among hospitals. This has happened because antitrust policy has been so inadequate for so long in the health sector. See “Health Care Needs Stronger Market Forces” in Forbes. (Here is a more in-depth paper, if you’re curious.)

The problems that arise from a lack of competition are rife on the pharmaceutical and medical side as well. Obamacare will do almost nothing to change that. See “How a Cabal Keeps Generics Scarce” in the NY Times. It should come as no surprise that medical and pharma companies helped draft the ACA. Who said Congress won’t turn a few tricks for the right price? See “ObamaCare’s Secret History” in the WSJ.

In theory, the ACA will control costs and won’t let insurance companies and hospitals gouge us, but these types of regulations haven’t worked in the past. Howard Dean is a doctor and a Democrat. His very thoughtful views on how pricing regulations haven’t worked are presented here. If you think costs will fall and insurers won’t profit, I’ve got a bridge to sell you in Brooklyn. The law is complex, badly written, and will be gamed. See “The Coming Clash over Insurers’ Compliance with Obamacare” from the Independent Institute and “HHS Releases Final Medical Loss Ratio Regulations” in the WSJ.

I highly recommend you read Matt Taibbi’s chapter on Obamacare in his book Griftopia. The book is highly worth buying and reading. It is informative, entertaining, and extremely infuriating. Your blood will boil after you read it. Taibbi establishes the point that the Affordable Care Act will screw Americans. This case is also made by the Institute of Economic Affairs, in “The scourge of Obamacare.”

In the United States, one of the most protuberant and harmful political myths — one shared by subscribers to almost all political persuasions — is the odd, naive idea that big business and big government are permanent antagonists. As a historical and empirical matter, of course, nothing could be further from the truth, a reality thrown into sharp relief by the political machinations underlying Obamacare. The new law is fundamentally anti-competitive and anti-small business, riddled with onerous regulations and handouts to favoured corporations. As usual, the relationship between big business and big government is not one of rivalry, but of symbiosis, routing genuine free markets in favour of collusion.

The ACA won’t cover everyone, and it will force people seeking coverage to buy from monopolists. Many people will get subsidies for their new insurance policies, and many people who didn’t have coverage will now have coverage. This is great news. However, it would be hard to design a worse system if you tried. There are simpler ways by which we could have covered everyone without forcing people to participate in private oligopolies and monopolies.

One of the biggest problems in the US are medical costs. We spend far more than any other country, almost twice the OECD average. This problem will not be fixed by Obamacare and indeed will only get worse due to the spiralling of price increases between insurance companies and hospitals, given the lack of competition.

Source

Furthermore, as you can see from this interactive table, we spend trillions of dollars more than other countries do, yet we don’t achieve better outcomes.

Chile, Hong Kong, and Singapore, for example, spend one fourth what we do and achieve better outcomes and longer lifespans. So spending more money isn’t a solution. In fact, imagine what we could do if we cut our healthcare spending in half. We’d free up over a trillion dollars for other things. That’s what economists call consumer surplus. Even in crazy Washington, where congressmen think money grows on trees, a trillion is a large number.

In America one subject that is taboo is healthcare before death. Almost all healthcare costs are incurred in the last twelve months of people’s lives. Modern medicine tends to delay natural death rather than extend healthy life. That is why doctors consume less healthcare than the average person. They understand what medicine can do and can’t do. I highly recommend reading this article in the WSJ. Ask any doctor, and they’ll confirm this.

In a 2003 article, Joseph J. Gallo and others looked at what physicians want when it comes to end-of-life decisions. In a survey of 765 doctors, they found that 64% had created an advanced directive — specifying what steps should and should not be taken to save their lives should they become incapacitated. That compares to only about 20% for the general public. (As one might expect, older doctors are more likely than younger doctors to have made “arrangements,” as shown in a study by Paula Lester and others.)

Why such a large gap between the decisions of doctors and patients? The case of CPR is instructive. A study by Susan Diem and others of how CPR is portrayed on TV found that it was successful in 75% of the cases and that 67% of the TV patients went home. In reality, a 2010 study of more than 95,000 cases of CPR found that only 8% of patients survived for more than one month. Of these, only about 3% could lead a mostly normal life.

Furthermore, 5% of patients create 50% of costs. These costs are all in the last days of life. See this article in Forbes.

Dr. Susan Dale Block, Chair and Director of Psychosocial Oncology and Palliative Care at the Dana Farber Cancer Institute and Brigham and Women’s Health Care, recently shared some data with her colleagues. In the Archives of Internal Medicine, a study asked if a better quality of death takes place when per capital cost rise. In lay terms (because trying to explain the data and methodology requires about 100 IQ points that I don’t have) the study found that the less money spent in this time period, the better the death experience is for the patient.

It seems that no matter how much money you use during that last year/month, if the person is sick enough, the effort makes things worse. A lot of the money being spent is not only not helping, it is making that patient endure more bad experiences on a daily basis. The patient’s quality of life is being sacrificed by increasing the cost of death.

We will all die. There is no way around that. Until we have an adult conversation about how we die and recognize that we spend too much on medicine we don’t need, we won’t reduce our costs.

Sorry for such a long email. These are a few brief thoughts on the key issues that the press neglects to mention. I’d have to write a book to discuss all the relevant issues. I’ve provided more links in the postscript to my email if you’re curious about the problems of oligopoly, market concentration, and local regulation in the US insurance and healthcare sectors.

While the US lines the pockets of insurance companies, I’ll be enjoying the socialized medical system in the UK. My guess is that Obamacare has been made purposefully grotesque in order to make people clamor for a single-payer system. I’m sure the US will eventually get one. Personally, I think congressmen and -women are too stupid and venal to do anything good. Until then, we’ll have to wait for the ACA to derail before we see any genuine reform.

Best,

Jonathan

P.S. If you’re curious about the problems of insurance, medicine, and oligopolies, you can read further.

Regional monopolies

The American Medical Association’s bi-annual survey of the nation’s health insurance marketplace, released Tuesday, found 60 percent of the nation’s metro areas where two insurers had a combined share of 70 percent or more of the market. That’s up from 53 percent two years ago.

Dominant insurer market share

Hospital oligopolies

Increase in premiums under Obamacare

Worst outcomes for mix of public and private

Local competition

Out of control oligopolies — how they’re blowing up our medical budget

Statistics on oligopolies

Health Care for America Now! (HCAN) released a report in May that uses data provided by the American Medical Association to demonstrate that 94% — more than 9 out of 10 — of the country’s insurance markets meet the Justice Department definition of “highly concentrated,” in relation to the potential for anti-trust action. So extreme is the level of consolidation, that HCAN has sent a letter [Note: PDF file] to the Justice Department’s Antitrust Division, asking it to investigate the state of the health insurance marketplace.

The rest of the report’s findings are every bit as striking:

• In the past 13 years, more than 400 corporate mergers have involved health insurers, and the small number of companies that now dominate local markets haven’t delivered on promises of increased efficiency.

• Shrinking competition has allowed the remaining firms to charge higher fees, and premiums have gone up more than 87 percent, on average, over the past six years.

• Meanwhile, profits at ten of the country’s largest publicly traded health insurance companies rose 428% from 2000 to 2007, from $2.4 billion to $12.9 billion.

• Consolidation of market share among a smaller number of insurers disproportionately disadvantages rural and lower population states. In Hawaii, Rhode Island, Alaska, Vermont, Alabama, Maine, Montana, Wyoming, Arkansas, and Iowa, the two largest health insurers control at least 80 percent of the statewide market.

Fragmented regulation insurance. Also here. And here.

Commerce clause and restraints of trade

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Last Thursday, prior to the FOMC announcement, I was having an early lunch with Kyle Bass so he could get back to the office in time for the announcement. As we were finishing up, I was invited to come sit with another group of friends and traders who also happened to be in the same restaurant. Everyone was sure there would be some type of tapering. That message had been clearly communicated to the markets. When the announcement came, the telephones went off and everyone erupted with various forms of surprise. I fully admit to being speechless. I kept waiting for some kind of explanation, and none came. The more we talked about it and the more I thought about it later, the more convinced I became that this was one of the more ham-handed policy announcements from the Fed in a very long time. Why would you go to the trouble of getting the market all ready for the onset of tapering, build expectations, and then jerk out the rug? What in the wide, wide world of sports is going on?

I’ve been with Louis Gave and David Rosenberg this weekend here in Toronto. Everyone is searching for an answer on the FOMC’s move. Louis came up with what I’m affectionately calling his conspiracy theory. He thinks Obama is quite upset that he can’t have Summers as Fed chair and that his staff is crossways with Yellen. Reports suggest she has not even been interviewed yet. Really? If that’s the case then perhaps Obama would rather stick with Bernanke for another two years and then make another try for Summers or maybe even a rested Geithner. Steve Cucchiaro (of $18.5 billion-under-management Windhaven fame) asked if Summers had maybe communicated through back channels to Bernanke that he wanted to end the tapering, and Bernanke was helping him out; but then when he was no longer in the running for Fed chair, Janet Yellen came and said, “Ben, I’m not ready to end tapering yet,” so Bernanke took one for the team.

I heard directly from another friend that he was in the offices of one of the world’s largest bond managers, and they had actually been at the Fed the previous week and were confident there would be a small tapering. Did you see the way bonds got ripped after the announcement? These bond managers were pissed (that’s a technical economics term). Can we trust the Fed now? Years of work building transparency and a confidence in the narrative, and then they blow it on a meaningless non-taper?

This week’s Outside the Box is from Ben Hunt. It echoes some of my own concerns about the Fed and raises others. Quoting:

Two things happened this week with the FOMC announcement and subsequent press conferences by Bernanke, Bullard, etc. – one procedural and one structural. The procedural event was the intentional injection of ambiguity into Fed communications. As I’ll describe below, this is an even greater policy mistake than the initial “Puttin’ on the Ritz” show Bernanke produced at the June FOMC meeting when “tapering” first entered our collective vocabulary. The structural event … which is far more important, far more long-lasting, and just plain sad … is the culmination of the bureaucratic capture of the Federal Reserve, not by the banking industry which it regulates, but by academic economists and acolytes of government paternalism. These are true-believers in too-clever-by-half academic theories such as management of forward expectations and in the soft authoritarianism of Mandarin rule. They are certain that they have both a duty and an ability to regulate the global economy in the best interests of the rest of us poor benighted souls.

This is one of the more incendiary OTBs in a while, and I think you should set aside some time to think on the implications Ben is writing about.

One of the important things the Federal Reserve provides when there is a crisis is that sense that “daddy’s home.”. Whether or not you personally believe the Fed has any significant power to actually do anything, the general market does believe it, and that’s the important thing. Now the Fed is at significant risk of damaging its reputation for decisiveness and clarity. We can only hope there is not another crisis coming out of Asia or Europe in the next few months that would require Federal Reserve action. What could they do now that would actually be credible? And while I don’t see a crisis developing in a short timeframe, it is the things that we don’t see, the Lions in the Grass, that create so many problems. Just saying…

I am at the airport in Toronto as I write this note. Tonight I get to have dinner with my friends Art Cashin, Barry Ritholtz, Barry Habib, Rich Yamarone, Christian Menegatti, and David Rosenberg; and Jack Rivkin may show up a little later. Ian Bremmer is supposed to drop by for early drinks before he heads off for dinner with Prime Minister Abe of Japan. It looks like it will be a spirited evening, with lots to talk about. I am not sure what I will write about this weekend, but I bet I’ll get a few ideas this evening.

And speaking of the venerable Art Cashin, I will not be the only one at the table tonight who is mystified by the Fed’s action. And apparently some members of the FOMC agree with Art and me. Art wrote this morning:

 Candor With A Capital C – Yet Again – One of the Fed speakers yesterday was the President of the Dallas Fed, Mr. Richard Fisher.  Mr. Fisher is a favorite of floor traders since, when he speaks, the message is clear, not couched in monetary argot.  He didn’t deviate from that habit at all yesterday.

His speech was on current banking trends and a post-Lehman review.  He said that too big to fail banks were “a dagger pointed at the heart of the economy.”  At the end of his speech he said:

A Deliberate Deflection

As I said at the beginning of my remarks, I am going to try to avoid answering questions you might have about last week’s FOMC meeting and what some in the press have now labeled “the taper caper.” Nearly every Federal Reserve Bank president and his or her sister will be speaking to this topic this week, so you will be getting an earful of cacophonous comments on this subject.

Today, I will simply say that I disagreed with the decision of the committee and argued against it. Here is a direct quote from the summation of my intervention at the table during the policy “go round” when Chairman [Ben] Bernanke called on me to speak on whether or not to taper: “Doing nothing at this meeting would increase uncertainty about the future conduct of policy and call the credibility of our communications into question.” I believe that is exactly what has occurred, though I take no pleasure in saying so.

While he may have deflected further questioning on the “taper caper,” he did not deflect all questions.  Again his candor brought headlines.  Here’s a bit from Bloomberg on the Fed Chair succession:

“The White House has mishandled this terribly,” Fisher said today in response to a question from the audience after giving a speech in San Antonio, Texas. “This should not be a public debate,” he said, adding that the Fed “must never be a political instrument.”

On another question, Mr. Fisher apparently said that although Janet Yellen was dead wrong in her policy direction, she would make a great Chair.

We doubt that Mr. Fisher ever hears the question, “What exactly do you mean by that?”  We could use more such candor elsewhere.

You have yourself a good week, and I’ll report back. And now sit down while we hear from Ben Hunt.

Your wishing he knew what was going on in Bernanke’s head analyst,

John Mauldin, Editor
Outside the Box[email protected]

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Uttin’ On the Itz

By Ben Hunt, Ph.D.

High hats and arrowed collars, white spats and lots of dollars
Spending every dime, for a wonderful time
If you’re blue and you don’t know where to go to
Why don’t you go where fashion sits,
Puttin’ on the Ritz.
– Irving Berlin

Hegel remarks somewhere that all great, world-historical facts and personages occur, as it were, twice. He has forgotten to add: the first time as tragedy, the second as farce.
– Karl Marx

I never could bear the idea of anyone expecting something from me. It always made me want to do just the opposite.
– Jean-Paul Sartre, “No Exit”

Every time I hear a political speech or I read those of our leaders, I am horrified at having, for years, heard nothing which sounded human.
– Albert Camus

The structure of a play is always the story of how the birds came home to roost.
– Arthur Miller

In Young Frankenstein, Mel Brooks and Gene Wilder brilliantly reformulate Mary Shelley’s Frankenstein; or, The Modern Prometheus, a tragedy in the classic sense, as farce. The narrative crux of the Brooks/Wilder movie is Dr. Frankenstein’s demonstration of his creation to an audience of scientists – not with some clinical presentation, but by both Doctor and Monster donning top hats and tuxedos to perform “Puttin’ on the Ritz” in true vaudevillian style. The audience is dazzled at first, but the cheers turn to boos when the Monster is unable to stay in tune, bellowing out “UTTIN ON THE IIIITZ!” and dancing frantically. Pelted with rotten tomatoes, the Monster flees the stage and embarks on a doomed rampage.

Wilder’s Frankenstein accomplishes an amazing feat – he creates life! – but then he uses that fantastic gift to put on a show. So, too, with QE. These policies saved the world in early 2009. Now they are a farce, a show put on by well-meaning scientists who have never worked a day outside government or academia, who have zero intuition for, knowledge of, or experience with the consequences of their experiments.

Two things happened this week with the FOMC announcement and subsequent press conferences by Bernanke, Bullard, etc. – one procedural and one structural. The procedural event was the intentional injection of ambiguity into Fed communications. As I’ll describe below, this is an even greater policy mistake that the initial “Puttin’ on the Ritz” show Bernanke produced at the June FOMC meeting when “tapering” first entered our collective vocabulary. The structural event … which is far more important, far more long-lasting, and just plain sad … is the culmination of the bureaucratic capture of the Federal Reserve, not by the banking industry which it regulates, but by academic economists and acolytes of government paternalism. These are true-believers in too-clever-by-half academic theories such as management of forward expectations and in the soft authoritarianism of Mandarin rule. They are certain that they have both a duty and an ability to regulate the global economy in the best interests of the rest of us poor benighted souls. Anyone else remember “The Committee to Save the World” (Feb. 1999)? The hubris levels of current Fed and Treasury leaders make Rubin, Greenspan, and Summers seem almost humble in comparison, as hard as that may be to believe. The difference is that the guys on the left operated in the real world, where usually you were right but sometimes you were wrong in a clearly demonstrable fashion. A professional academic like Bernanke or Yellen has never been wrong. Published papers and books are not held accountable because nothing is riding on them, and this internal assumption of intellectual infallibility follows wherever they go. As a former cleric in this Church, I know wherefore I speak.

There’s frequent hand-wringing among the chattering class about whether or not the Fed has been “politicized.” Please. That horse left the barn decades ago. In fact, with the possible exception of Paul Volcker (and even he is an accomplished political animal) I am hard pressed to identify any Fed Chairman who has not incorporated into monetary policy the political preferences of whatever Administration happened to be in power at the time.

Bureaucratic capture is not politicization. It is the subversion of a regulatory body, a transformation in motives and objectives from within. In this case it includes an element of politicization, to be sure, but the structural change goes much deeper than that. Politicization is a skin-deep phenomenon; with every change in Administration there is some commensurate change, usually incremental, in policy application. Bureaucratic capture, on the other hand, marks a more or less permanent shift in the existential purpose of an institution. The WHY of the Fed – its meaning – changed this week. Or rather, it’s been changing for a long time and now has been officially presented via a song-and-dance routine.

What Bernanke signaled this week is that QE is no longer an emergency government measure, but is now a permanent government program. In exactly the same way that retirement and poverty insurance became permanent government programs in the aftermath of the Great Depression, so now is deflation and growth insurance well on its way to becoming a permanent government program in the aftermath of the Great Recession. The rate of asset purchases may wax and wane in the years to come, and might even be negative for short periods of time, but the program itself will never be unwound.

There is very little difference from a policy efficacy perspective between announcing a small taper of, say, a $10 billion reduction in monthly bond purchases and announcing no taper at all. But there is a HUGE difference from a policy signaling perspective between the two. Doing nothing, particularly when everyone expects you to do something, is a signal, pure and simple. It is an intentional insertion of uncertainty into forward expectations, a clear communication that the self-imposed standards for winding down QE as established in June are no longer operative, that the market should assume nothing in terms of winding down QE.

Think of it this way … why didn’t the Fed satisfy market expectations, their prior communications, and their own stated desire to wait cautiously for more economic data by imposing a minuscule $5 billion taper? Almost every market participant would have been happy with this outcome, from those hoping for more accommodation for longer to those hoping that finally, at last, we were on a path to unwind QE. Everyone could find something to like here. But no, the FOMC went out of its way to signal something else. And that something else is that we are NOT on automatic pilot to unwind QE. A concern with self- sustaining growth and a professed desire to be “data dependent” are satisfied equally with either a small taper or doing nothing. Choosing nothing over a small taper is only useful insofar as it signals that the Fed prefers to maintain a QE program regardless of the economic data. And that’s a position that almost every market participant can find a reason to dislike, as we’ve seen over the past few days. I mean … when even Fed apologist extraordinaire Jon Hilsenrath starts to complain about Fed communications (although his latest article title remains “Market Misreads Signals”), you know that you have a Fed whose preference functions are not identical to the market’s.

Moreover, Bernanke and his team are taking steps to prevent future FOMC’s or Fed Chairs from reversing this transformation of QE from emergency policy to government program. In addition to the implicit signal given by choosing no taper over a small taper, there was an explicit signal in both Bernanke’s comments on Wednesday and in Bullard’s interviews on Friday – the Fed is adding an inflation floor to its QE linkages, alongside the existing unemployment linkage. Previously we were told that QE would persist so long as unemployment is high. Now we are told that QE will also persist so long as inflation is low. Importantly, these are being presented as individually sufficient reasons for QE persistence. If unemployment is high OR inflation is low, QE rolls on. Precedent matters a lot to any clubby, self- consciously deliberative Washington body, from the Supreme Court to the Senate to the FOMC, and by setting multiple explicit macroeconomic linkages to QE – all of which are one-way thresholds designed to continue asset purchases – this Fed is making it much harder for any future Fed to reverse course.

But wait, there’s more …

Given the manner in which inflation statistics are constructed today – and just read Janet Yellen’s book (The Fabulous Decade: Macroeconomic Lessons from the 1990’s, co-authored with Alan Blinder) if you think that the Fed is unaware of the policy impact that statistical construction can achieve … changing inflation measurement methodology is one of the key factors she identifies to explain how the Fed was able to engineer the growth “miracle” of the 1990’s – inflation is now more of a proxy for generic economic activity than it is for how prices are experienced. In a very real way (no pun intended), the meaning and construction of concepts such as real economic growth and real rates of return are shifting beneath our feet, but that’s a story for another day. What’s relevant today is that when the Fed promises continued QE so long as inflation is below target, they are really promising continued QE so long as economic growth is anemic. QE has become just another tool to manage the business cycle and garden- variety recession risks. And because those risks are always present, QE will always be with us.

In Pulp Fiction the John Travolta character plunges a syringe of adrenaline into Uma Thurman’s heart to save her life. This was QE in March, 2009 … an emergency, once in a lifetime effort to revive an economy in cardiac arrest. Now, four and a half years later, QE is adrenaline delivered via IV drip … a therapeutic, constant effort to maintain a certain quality of economic life. This may or may not be a positive development for Wall Street, depending on where you sit. I would argue that it’s a negative development for most individual and institutional investors. But it is music to the ears of every institutional political interest in Washington, regardless of party, and that’s what ultimately grants QE bureaucratic immortality.

It is impossible to overestimate the political inertia that exists within and around these massive Federal insurance programs, just as it is impossible to overestimate the electoral popularity (or market popularity, in the case of QE) of these programs. In the absence of a self-imposed wind-down plan – and that’s exactly what Bernanke laid out in June and exactly what he took back on Wednesday – there is no chance of any other governmental entity unwinding QE, even if they wanted to. Which they don’t. Regardless of what political party may sit in the White House or control Congress in the years to come, it will be as practically impossible and politically unthinkable to eliminate QE as it is to eliminate Social Security or food stamps. QE is now a creature of Washington, forever and ever, amen.

The long-term consequences of this structural change in the Fed are immense and deserve many future Epsilon Theory notes. But in the short to medium-term it’s the procedural shifts that have been signaled this week that will impact markets. What does it mean for market behavior that Bernanke intentionally delivered an informational shock by forcing uncertainty into market expectations?

First, it’s important to note that this is not really an issue of credibility. The problem is not that people don’t believe that Bernanke means what he said on Wednesday, or that they won’t believe him if he says something different in October. The problem is that the Fed is entirely believable, but that the message is not one of “constructive ambiguity” as the academic papers written by Fed advisors intend, but one of vacillation and weakness of will.

From a game theoretic perspective, ambiguity can be a very effective strategy in pretty much whatever game you are playing. Alan Greenspan was a master of this approach, famous for the lack of clarity in his public statements. Other well-known practitioners of intentionally opaque statements include Mao Zedong (hilariously lampooned in Doonesbury when Uncle Duke had a short-lived stint as the US Ambassador to China) as well as most Kremlin communications in the Soviet era. Clarity and transparency can also be a very effective strategy in pretty much any game, particularly if you’re playing a strong hand or you want to make sure that your partner follows your lead. For example, throughout the Cold War both the Americans and the Russians would place certain strategic assets in plain sight of the other country’s surveillance apparatus so that there would be no mistaking the strength and intent of the signal.

The key to the success of both strategies – intentional ambiguity and intentional clarity – is consistency and, very rarely, the “gotcha” moment of a strategy switch. To use a poker analogy, the tight player who has a reputation for never bluffing can take down a big pot with a bluff much more easily than a player who is impossible to read and has a reputation as a frequent bluffer. Of course, this bluff can only be used once in a blue moon or the reputation for being a tight player will be lost, as will future bluffing effectiveness. Also, the reputation as a tight player must be established effectively prior to the first bluff.

To stick with the poker analogy, here’s my take on what the Fed has done. For the past four months, they’ve tried to create a reputation as a tight player, meaning that they have laid out fairly clear standards for how they will interpret labor data (the equivalent of cards dealt face up) to set the extent and timing of QE tapering. The market responded as it always does, setting its expectations on the basis of the Fed’s statements, and moving up or down as each new labor data card was revealed. But then on Wednesday, the Fed revealed a bluff to win … nothing … and announced that they would now be playing in an unpredictable fashion. It was almost as if Bernanke had read a beginner’s poker instruction book when he was at Jackson Hole in late August that said you have to be a hard-to-read player who bluffs a lot to succeed at poker, and decided as a result to change his entire strategy. I don’t know what you would think about a player like that in your poker game, but words like “weak”, “fish”, and “donkey” come to my mind.

In fact, I think that the poker instruction book metaphor is just barely a metaphor, because we know that several papers at Jackson Hole took Bernanke to task for his communication policy to date. For example, Jean-Pierre Landau, a former Deputy Governor of the Bank of France and currently in residence at Princeton’s Woodrow Wilson School, presented a paper focused on the systemic risks of the massive liquidity sloshing around courtesy of the world’s central banks. For the most part it’s a typical academic paper in the European mold, finding a solution to systemic risks in even greater supra-national government controls over capital flows, leverage, and risk taking. But here’s the interesting point:

“Zero interest rates make risk taking cheap; forward guidance makes it free, by eliminating all roll-over risk on short term funding positions. … Forward guidance brings the cost of leverage to zero, and creates strong incentives to increase and overextend exposures. This makes financial intermediaries very sensitive to “news”, whatever they are.”

Landau is saying that the very act of forward guidance, while well-intentioned, is counter-productive if your goal is long-term systemic stability. There is an inevitable shock when that forward guidance shifts, and that shock is magnified because you’ve trained the market to rely so heavily on forward guidance, both in its risk-taking behavior (more leverage) and its reaction behavior (more sensitivity to “news”). This argument was picked up by the WSJ (“Did Fed’s Forward Guidance Backfire?”), and it continued to get a lot of play in early September, both within the financial press and from FOMC members such as Narayana Kocherlakota.

I think that Bernanke took these papers and comments to heart … after all, they come from fellow trusted members of the academic club … and decided to change course with communication policy. No more clearly stated forward guidance, but rather the oh-so-carefully crafted ambiguity of an Alan Greenspan. Here would be a Monster that can sing and dance, one that can be trotted on stage in a tux and tails and is sure to delight the audience with a little number by Irving Berlin. What could possibly go wrong? Well, the same thing as the first performance back in June – a complete misunderstanding of the real-world environment into which these signals are injected.

At least in June the Fed still projected an aura of resolve. Today even that seems missing, and that’s a very troubling development. Creating a stable Narrative is a function of inserting the right public statement signals into the Common Knowledge game. As described above, it really doesn’t matter what the Party line is, so long as it is delivered with confidence, consistency, and from on high. But once the audience starts questioning the magician’s sleight-of-hand mechanics, once the Great and Terrible Wizard of Oz is forced to say “pay no attention to that man behind the curtain”, the magician has an audience perception problem. Fair or not, there is now      a question of competence around Fed policy and its decision-making process. Sure the Monster can sing, but can it sing well?

Unfortunately, I think that this perception of an irresolute, somewhat confused Fed is poised to accelerate in the forthcoming nomination proceedings for a new Chair, not dissipate. If strength of will and resolve of purpose is the quality you need to project, then the Fed needs a Strongman on a Horse:

not a Wise Oracle Baking Cookies.

Sorry, but it’s true.

I mean, does anyone doubt that Janet Yellen is a consensus builder who would feel more at home at a faculty tea with Elizabeth Warren than a come-to-Jesus talk with Zhou Xiaochuan? Does anyone doubt that Larry Summers is the polar opposite, a bureaucratic Napoleon who would absolutely revel in lowering the boom on Zhou or Tombini … or Bullard or Yellen, for that matter? But it looks like Yellen is the shoo- in candidate, so whatever perceptions of Fed wishy-washiness and indecision that are currently incubating are likely to grow, no matter how unfair those perceptions might be.

What does all this mean for how to invest in the short to medium-term? Frankly, I don’t think that “investment” is possible over the next few months, at least not as the term is usually understood, and at least not in public markets. When you listen to institutional investors and the bulge-bracket sell-side firms that serve them, everything today is couched in terms of “positioning”, not “investment”, and as a result that’s the Common Knowledge environment we all must suffer through. This is the fundamental behavioral shift in markets created by a Fed-centric universe – the best one can hope for is a modicum of protection from the caprice of the Mad God, and efforts to find some investable theme are dashed more often than they are rewarded. The Narrative of Central Bank Omnipotence – that all market outcomes are determined by monetary policy, especially Fed policy – is stronger than ever today, so if you’re looking to take an exposure based on the idiosyncratic attributes or fundamentals of a publicly traded company … well, I hope you have a long time horizon and very little sensitivity to the price path in the meantime. I will say, though, that the counter-narrative of the Fed as Incompetent Magician, which is clearly growing in strength right alongside the Omnipotence Narrative, makes gold a much more attractive option than this time a year ago.

As for where all this game-playing and stage-strutting ultimately ends up, I want to close with two quotes by academics who are very far removed from the self-consciously (and self-parodying) “scientific” world view of modern economists. Weaver and Midgley are from opposite ends of the political spectrum, but they come to very similar conclusions. I’ll be examining the paths in which the “birds come home to roost”, to use Arthur Miller’s phrase, in future notes. I hope you will join me in that examination, and if you’d like to be on the direct distribution list for these free weekly notes please sign up at Follow Epsilon Theory.

The scientists have given [modern man] the impression that there is nothing he cannot know, and false propagandists have told him that there is nothing he cannot have.
– Richard M. Weaver, “Ideas Have Consequences”

Hubris calls for nemesis, and in one form or another it’s going to get it, not as a punishment from outside but as the completion of a pattern already started.
– Mary Midgley, “The Myths We Live By”

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