By John L. Chapman, Ph.D. June 20, 2012 Washington, D.C.
The Greek elections passed without incident on Sunday, and the so-called “center-right” party, New Democracy, captured 30% of the vote in a seven-party contest, and hence the right to form a government. President Obama was one of many political leaders who hailed the result as meaning Greeks can now work with their “international partners” to ensure the “Greek people….succeed and prosper.” But the fact is, stock market rallies based on that sentiment – and on anticipated Fed easing and German eurobond issuance in support of, ultimately, Eurozone liquidity, are the very definition of ephemeral. Caveat redemptor.
Now that the panic ruminated upon by doomsayers has apparently been averted, what are we to make of the vote in Greece? Global equities are up, led by the U.S. markets and including, prominently, the Athens Stock Exchange, which is up 7% in the two days after the vote, and 14% in the last week. Spanish bond yields are off their recent all-time highs (>7%) for the Euro era, too, and all this has contributed to the increasing volume of chatter that the vote has afforded a greater chance for “stability” in Greece, and the Eurozone as a whole. Is this accurate?
We’re on record recently as stating that the vote would change nothing in a fundamental economic sense, and is but the latest installment in what is now a long road of prior debt forbearance, outright bail-out agreements, summit meetings, Eurozone wide accords (e.g., creation of the ESM and EFSF, still not fully funded), ECB actions, and other national plebiscites (then, repeat cycle), all of which had a salutary effect on markets in a very temporary way around the event itself, but then faded after initial “emotional” lift. In our view, this is no different, and we still say, the Eurozone cannot exist in its present form much longer: as the great economist Ludwig von Mises was famous for saying, the laws of economics cannot be annulled. That is to say, the internal contradictions of the Eurozone have now been made manifest over the last three years, and the European continent, less well-capitalized than the U.S. economy in a macro sense and far less cohesive as an economic or political entity, will continue to go through convulsions on the way to some level of devolution in the next several years.
In any case, we have learned some things in the last few days thanks to the vote and surrounding discussions, and it is important for investors to apprehend and categorize these lessons, none of them new but all worth driving home via reiteration that this moment affords, because in a long secular bear market that will likely last years, discerning major market-making events (such as, which countries will leave the Eurozone, and when) confers advantage across a long, flat, sideways-or-down market. And so the following seems obvious to us at the moment:
(1) The ghost of Keynes and his very ill-begotten policy advice is alive and well. In the wake of the vote in Greece and turmoil now front and center in the news about Spain, many analysts are pointing to a slowing U.S. economy as a victim of what has transpired in Europe, and thus in need of massive stimulus once again. Bloomberg’s Senior Economist Rich Yamarone’s pre-Fed meeting analysis is typical of such thinking, as he states:
A sinking economy requires stimulus from two agents, the Federal Reserve and the government. There are periods throughout history when monetary policy prescriptions from the Fed have a better influence on the economy than the government’s fiscal responses. Sometimes the government’s actions rule the day. Ultimately, the economy is righted by some combination of these two sources.
Today, monetary policy is rendered impotent since the U.S. economy is mired in a liquidity trap, and the Fed’s actions have been as effective as “pushing on a string.” Part of the reason for monetary policy’s impotence is related to cyclical factors, while structural factors in the economy account for the other part and may take decades to sort out.
……Contrary to popular belief, we never had a legitimate fiscal stimulus – what we got was largely an extension of unemployment benefit insurance. This, as most economists will remind you, is nothing more than a disincentive to look for a job. ….. There is nothing stimulative about unemployment benefit insurance – it is a safety net for those that have fallen. In my longer than 25 year history on Wall Street I have collected unemployment benefits on seven occasions. [Finance is a very cyclical industry, and the economist is usually the first to be jettisoned when tough times surface. So, if you are a good economist – and I am – you know when you're about to get fired.] ……….
We experienced a depression in 2007-2009– a prolonged period of contracting economic activity associated with a steep decline in employment. …The only way out of a depression is to adopt an incredibly easy-money Fed policy – which we did –combined with bold expansionary fiscal policy – which we did not.
What should have happened, and perhaps looking ahead, may be the only effective government response, is a direct work relief program like in the 1930s…..it may be the only choice. Cutting taxes haven’t helped; it’s not exactly clear how reducing a tax burden on an underemployed individual or on a business that has fewer people passing through its doors will employ more people? You may get more hiring of minimum wage retail workers; again, not the type of job creation to get the economy back on a path of prosperity.
…..If we had shovel ready, boots-to-the ground jobs like we were promised in 2008 rather than extended benefits (food stamps, jobless benefits, tax credits, etc.) we’d have employed a good portion of those idled construction workers, manufacturers, machinists, etc. They would have fixed our dilapidated highways, bridges, tunnels, railways, ports, electrical grid, and airports (that can’t land the newest planes). Like FDR’s New Deal works program, we’d have a legacy after it was all over.
Like all good Keynesians since the Master himself, much of what Mr. Yamarone writes sounds appealing, even unarguable – in a superficial sense. Who would dispute that monetary policy has been ineffective in stimulating growth, of late? Or that we are in a liquidity trap – if you believe in liquidity traps – given that the current moment does exemplify the textbook definition of one? Or yet again, that employing idle resources in public works programs for infrastructure improvements will be ameliorative and conduce to a strong economy in the future, as well as evincing common sense in the present? And of course, it is a time-honored strategy in policy debate to make a sweeping charge that appeals to emotion, if not based in fact, such as saying that all the ramped-up spending in recent years went to unemployment benefits, and none went to “public investments” (that is flatly untrue, but it sounds good).
The trouble with all this, and all such calls for public investment, is that the other half of the half truths that add up to their endorsement are all quite incorrect, have been shown to be so empirically, and indeed are laced with basic errors in policy logic that lead to impoverishment. We certainly agree, for example, that some types of public investment are better than others. The Eisenhower Interstate Highway System, for example, while not disproving the counterfactual that a system of privatized roadways and/or state-based highway systems would be superior in design and more cost-effective, has been a good thing for American transportation and commerce. And, it certainly represents federal tax-payer dollars better spent than, say, were those on CETA (Comprehensive Employment and Training Act) job-training, ACORN grant programs, or Solyndra-type “investments.”
But we beg to differ with Mr. Yamarone’s self-description as a “good economist,” (and indeed, anyone who shamelessly accepts unemployment benefits seven times in one career exemplifies the reliance on big government transfer programs that are, alas, inimical to growth and prosperity – as Mr Yamarone himself, missing the irony, admits!). For as critics of Keynes have long pointed out, including those on this very point who pre-dated him such as Frederic Bastiat, the good economist distinguishes himself in both understanding secondary effects, which often occur after policy implementation, such as in the long run (Keynes disdained any mention of the long run), and/or are results that are “unseen” (such as, for example, the capital investment and job creation that does not happen thanks to the resources being diverted to the public works programs Mr. Yamarone desires).
Mr. Yamarone’s frustration with the current torpor is certainly understandable. But his equating of public spending – albeit done “smartly” according to his lights, and not “stupidly” according to Washington politicians – with wealth/job creation and effective demand generation is regrettable, because anyone who claims the appellation of “economist” should be promoting clarity, and not obfuscation, for a confused and fearful public. Spending, of whatever variety, is an effect, and not a cause, of economic growth and prosperity. There is in fact, as empirically demonstrated so often as to be received canon in economics, an inverse correlation between public spending and the growth in an economy. Bluntly, if this were not true, Soviet kommissars would still have jobs.
We also cannot fail to note the time honored trope offered by all Keynesian spending advocates: the big spending levels we have had in recent years were just not “bold” enough, says Mr. Yamarone (without offering any evidence of this), and it was this lack of boldness which led to policy ineffectiveness. So, our problem is, as Paul Krugman would agree, we have not nearly run big enough deficits in the last four years. Setting up an unprovable straw-man is a time-honored debate tactic, but again, the empirical reality of the limited effectiveness of public spending – even “smart” spending on roads and bullet trains such as Mr. Yamarone claims the prescience to favor – cannot be, as we say, annulled.
The one other serious quibble we have with such thinking as Mr. Yamarone’s is his seeming reverential faith that activist monetary policy can, at least in certain times if not in liquidity traps, effect growth and induce prosperity. Markets now rise and fall in hair-trigger fashion on whispers about central bank actions or intentions, thus aiding and abetting volatility that cannot be helpful to an objectively correct allocation of resources. One would hope that the voluminous literature on this topic ever since Friedman and Schwartz would have served to show the folly of monetary activism, and that the Fed can actually be more pro- than counter-cyclical. But the fact that the U.S. bond market is now itself blown into a spectacular bubble thanks to Fed ratification of fiscal profligacy, and that there can be no “clean” (that is to say, harmless) wind-down from the current extended indebtedness evidently fazes Mr. Yamarone and his pro-government works program advocates as little as it did the Master himself. We will all be dead one day, after all, so concern about future repercussions of current policy should be ignored given today’s exigencies.
In sum, the Keynesian faith in (a) government-led spending and (b) monetary activism is seemingly as unshakable as it is ubiquitous in the modern world. That’s a negative in terms of prospects for prosperity, because both sides of that policy mix ignore – as Keynes, sadly, did himself – the crucial role that capital plays in the process of economic growth. Indeed this twin policy plank is the core essence of the Keynesian shibboleth that the Greek situation evinces so perfectly: (a) promotion of spending at the expense of saving, as though the latter actually harms growth and is tantamount to “hoarding”, and (b) equating of money with capital, that is to say, the real wealth that alone underlies effective demand, undergird policy-making in the modern world literally almost everywhere, now that the United States has become so much more like Europe and Japan have long been. As such, the U.S. has taken on Europe’s economic growth rates, too.
And this leads directly to our second point driven home in the chatter about Greece this week:
(2) Liquidity and solvency problems are very different, yet people – including the willfully ignorant policy elites – do not apprehend this, yet; but soon, they all will. The multiple rounds of national plebiscites, summit meetings, central bank interventions, and alphabet-soup list of backstop (i.e., bail-out) facilities all point toward easing debt obligations, more generous pay-back schedules, and guaranteeing perpetual liquidity to the economic system, as if that is the major deficiency of the moment. Certainly there is a grain of truth in this assertion, too: after all, “everybody knows” that short term interbank credit markets “seize up” when the banks’ financial health, including true asset valuation, dries up.
But as the great Walter Bagehot long ago taught, there is a seminal difference in back-stopping banks which are well-capitalized and sound but temporarily mismatched in asset and liability maturities, and bailing out recalcitrant institutions whose capital base has been depleted, even if not yet marked to market, thanks to stupid managerial practices or lending decisions. Over at Atlantic Capital Management of Florida, our friend Jeff Snider has written prolifically about this topic, and sounded alarm about the opacity of (and hence phony public posture about) the balance sheet health of Eurozone banks, particularly those in Spain. There is a big difference, asserts Mr. Snider correctly, between the trading books of financial institutions and their longer term balance sheet assets, many of which are carried at values having no basis in current reality.
To say this simply, there is no way Mr. Bagehot would approve of the modern bastardization of his principles of sound central banking, that have conflated liquidity and solvency – and thereby actually contributed to further destruction of scarce capital. Or to say it colloquially, throwing good money after bad makes little sense as sound policy, regardless of current suffering in Greece or Spain. And further, these bail-out policies in the end, in toto, carry little prospect for ultimate success on a profit-and-loss basis, nor do they promise a quick end to current agonies.
Which brings to a third lesson of late, for investors:
(3) The Eurozone torpor, years in the making, will take years to unravel. As Jack Welch is famous for saying, “Don’t kid yourself” about life’s challenges or circumstances, if you want to succeed and prosper. All the recent summit meetings and votes and ECB actions have one thing in common: they lead to a false hope that somehow problems will get resolved, or a path to stability restored, in the wake of the event or announcement. Quickly after the event, as will surely happen here, the depth of the current problems, forced upon innocent Europeans by generations of beguiling public spending and cradle-to-grave promises of comfort – that have finally surfaced in the brutality of an immovable currency at the individual country level – will once again be made manifest, and fears will again come to dominate the temporary relief.
For the reality is, linking the two items above, the EU’s (Keynesian) public spending profligacy has led to so many roosting chickens now – the waste and inefficiencies have been considerable, at the cost of restraint of entrepreneurial and job-creating energies. And secondly, the Eurozone has a fundamental solvency problem, not one of liquidity: it is lack of capital, and not lack of demand, that plagues southern Europe most acutely. The refusal to recognize the losses that have occurred, to downsize the out-sized public sectors there, to allow capital and resources to flow into more capable hands than those of the Eurocrats’ crony friends, et al. all portend years of reckoning, lurching from crisis to stillborn solution back to crisis.
These three major “lessons” – or, really, reminders – in the wake of the Greek vote have several implications for investors:
- The EUR/USD (€/$) exchange rate is sure to change, perhaps dramatically. There are two countervailing forces here, and those investors who discern the correct play between them will reap benefits. The United States is of course running a chronic, and massive, current account deficit, huge budget deficits, and now lives with an exploded Federal Reserve balance sheet. In the fiat money era, the dollar’s “market share” in international transactions as the preferred reserve currency has fallen from around 91% of all trading volume to 63% or so, and bilateral trading (such as between China and Japan) may avoid the dollar altogether more in the future.
- All of this portends a lower dollar moving forward, particularly against the euro. But on the other hand, the euro faces tremendous pressures due to the area’s own collective (and massive) fiscal imbalances, devolving agonies in the PIIGS countries, potentially destabilizing exits, and threats of a vacuum in pro-growth political leadership, as is on display now in Hollande’s France. The ECB’s balance sheet is also more than likely to get far bigger than its current €3 trillion, already gargantuan-size. There already is and will be pressure from political quarters to purposefully devalue the dollar. Might the EUR outpace the USD in a race to the bottom, in the years ahead? This seems to us more likely, especially if continued global turmoil props up demand for dollars. But in any case, the prudent path ahead is one of caution: there are bargains now in European equities, to be sure, but they should be evaluated on a case-by-case basis, and with currency risk in mind.
- Absent a major change in U.S. economic policy, long sideways movements in U.S. equity markets are in store here. Does this negate the logic of those who argue for a fair value of the S&P 500 at, say, 1600, based on overly-deflated market valuations in the uber-productive U.S. corporate sector? On the one hand, reasonable underlying math for earnings expansion, currently north of $100 for the S&P, along with 2.5% or so growth in U.S. GDP, certainly allows for the possibility of a 15-20% move up for U.S. equities. This would be reinforced with the eventuality of improved fiscal policies in the United States in 2013.
- But candidly, there are too many headwinds at the moment, and too much uncertainty, to feel confident about such a bet. While it is true that the extraordinary level of fear around the globe makes all dollar-denominated assets somewhat of a “safe haven” for international hot money flows, and further, the huge bubble in U.S. bonds should direct some investment into U.S. equities for a while longer, the reality is, the U.S. economy, let alone global sources of instability, is in a fundamentally unsound position itself at the moment; that is to say, the correlation of forces, policy and otherwise, for sustained expansion of equity values are absent. This more than anything else is the reason for a compression in U.S. price/earnings ratios below their historic mean, and it seems to us there is no reason to believe a move up that would stick, based on fundamentals, is likely anytime soon. (Having said that, we again reiterate that if policy changed, the strong relative capital base, as well as institutional supports to growth here in the U.S., would certainly cause one to amend a bias for caution at the moment. Economist John Rutledge loves to point out that total U.S. assets amount to, now, about $195 trillion; whereas all total debts, public and private, are around 315% of GDP, or $50 billion or so. While this excludes unfunded future entitlement liabilities, it nonetheless shows that the U.S. has a reservoir of resources to get control of its fiscal challenges at the moment, if the political will is summoned – that Europe or Japan certainly does not have.)
- There will be surprises in the play-out of the evolving resolution to the Eurozone’s torpor. The biggest one (and most intriguing) in our view that may occur, aside from Greece somehow remaining inside the Eurozone – we see its exit as highly likely, and probably forced when capitulation comes on the debt loads there and an end to patience – is that Germany would decide to leave. It seems unlikely now, and certainly Chancellor Merkel, Finance Minister Wolfgang Schäuble, Bundesbank President Jens Weidmann and all the relevant players there are signaling intent to preserve the Eurozone as is (and Germany’s de facto leadership). But doing this will certainly involve German backstop of periphery debt, and transfer of German wealth to debtor countries.
It is certainly possible, therefore, that at some point, centrifugal political forces in Germany pull the Federal Republic away from the Eurozone. There would be costs and benefits in this eventuality, the biggest costs being a hammering of German export industries, loss of German assets in shaky Eurozone banks, and potential expropriation of German wealth elsewhere in Europe. But the considerable upside gains of being free from a never-ending bailout sinkhole and the transfer of wealth it represents (not unlike the years of slower growth involved in absorbing the former East Germany), and the preference for bailing out fellow Germans over lazy southern Europeans, may force the hand of the political class in Germany. And from a macro-perspective, such an outcome may in fact be ultimately salutary for the economy as a whole, as it would force a much quicker “mark-t0-market” of Eurozone financial assets and debt; that is to say, it would increase the amplitude, but shorten the wavelength, of recessionary forces in Europe, not unlike ripping a Band-Aid swiftly off of sensitive skin. It would permit a quicker return to sustainable growth in all of Europe (albeit after perhaps a mini-depression across the continent), and hence does carry a logic of its own.
Summary: Is Global Recession in Store? Let the Buyer Beware, When It Comes to Global Investing Nowadays
Does the foregoing description of challenges in Europe and the United States guarantee a new global recession? Here in 2012, will the United States and China follow Europe and Japan down a path to zero or negative growth?
We continue to believe the U.S. economy is stronger than the data show, or than the pessimists fear. Nothing is inevitable, although we concede that the U.S. GDP growth rate, which increased at an historic average of 3.3% per annum across the 20th century, but is only 1.9% in this one, is now burdened for the future and consigned to lower levels for many years to come. The higher burden of debt in the U.S., coupled with lack of international dynamism, seems to assure this – and it can only mean slower-growing asset prices for U.S. equities, which until recently had increased in value by over +7% per year since 1926.
But what all this adds up to are years of elevated uncertainty for investors, and a concomitant level of volatility in the U.S. and global economies. What we are living through now is the New Normal, as PIMCO executives call it. Even a dramatic inflection in U.S. policy, last seen here in the Economic Recovery and Tax Act of 1981, would still take at least a few years to become effective – the nervous times are not going away anytime soon. In such an environment, cash itself must be viewed as an asset to be actively managed in a portfolio, and may well at times carry a positive return in this new era. And happily, there will be investment opportunities even in moribund economies such as in Europe, due to the uneven nature of volatility as it plays out.
The key to recovery, for us, is the same as it was back in the dark days of 1980-82, per the landmark legislation mentioned above. And this is true even though the situation today is in some respects very different, although the one core commonality – the destruction of trillions in capital value across the U.S. economy thanks to monetary instability and fiscal profligacy – is the same in form, if not in origin or degree. But the policy intent of the 1981 ERTA legislation, as President Reagan described it, was a strong dollar, a capital friendly business climate that induced equity investment here, and fiscal prudence in the form of a reduced government footprint in the economy on the way to a balanced budget in a low-tax regime.
This is what is needed now, and as it happens, such a policy mix produces the economic signaling trifecta that provides evidence of a recapitalizing economy on the mend in a sustainable way: rising equity markets, a strong dollar, and a falling gold price, all simultaneously. The world’s economic torpor in the 1980s was largely eradicated after the United States once again took up the mantle of global economic leadership and employed this formula for a return to prosperity: there is no reason that history cannot again repeat itself. And in that event, Europe and Japan, and China too, would all benefit greatly over time.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
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