Regardless of what our policymakers do, we are looking at a decade of slow growth, high unemployment, and on-again / off-again recessions. The 2008-2009 crisis did not create a garden-variety “business-cycle recession.” It gave us a much more malignant “balance-sheet recession” characterized by a long period of debt reduction.
All of this leads us to the “endgame.” While a person, company, or government can limp along in technical insolvency seemingly indefinitely, at some point lenders lose confidence and raise rates to punitive levels. Eventually, the debt burden simply becomes unsustainable, and there is a day of reckoning. When people or companies have too much debt, they typically default. But when countries have too much debt, they have one of three options:
- They can inflate the debt away.
- They can default on it.
- They can devalue and hurt any foreigners who are holding the debt.
Before we get any deeper into the book, some introductions are necessary. John Mauldin writes one of the widest-read and best-respected e-letters in the world, Thoughts from the Frontline. He is also the author of the 2004 New York Times best-seller "Bull’s Eye Investing", and a well-travelled public speaker. Jonathan Tepper is the editor of Variant Perception, a macroeconomic research firm, and a frequent collaborator with Mr. Mauldin.
On a side note, I had the pleasure of first meeting Mr. Mauldin years ago when I was paying my tuition at the London School of Economics by writing articles for a now-defunct British investment magazine. John was gracious enough to grant me an interview, and we discussed his soon-to-be released first book, "Bull’s Eye Investing."
In that book—which, though now somewhat dated, I still recommend for the wealth of historical research that went into it—Mauldin elaborated on some of the themes he had begun covering during the last years of the dot-com boom. In the wake of the bust he coined the term “Muddle-Through Economy” to describe what he foresaw for the decade to follow. The economy would grow, but given the excesses of the boom that would need to be worked off, it would be at a rate substantially below the long-term trend. He was largely right; growth for the decade of the 2000s was an anemic 1.9%.
In Endgame, Mauldin reiterates this view, arguing that the deleveraging of the financial sector and the fiscal austerity that will eventually be forced on the government will create major headwinds to a robust recovery. Like HS Dent, Mauldin sees significant parallels between contemporary America and post-1980s-bubble Japan, a country he colorfully refers to as “a bug looking for a windshield.”
Endgame is a veritable trip around the world, as Mauldin lays out the uncomfortable choices facing nearly every major country. In this review, I’m going to focus on the comments of the book that overlap with our own research at HS Dent.
All About Deflation
Mauldin is one of the few analysts out there who really “gets” inflation and deflation (Gary Shilling, whose work we reviewed in Part II of the January 2011, HS Dent Forecast is another, as is Robert Prechter). In clear thinking very similar to our own (see page 16 of the February 2009 HS Dent Forecast-pdf) Mauldin differentiates between “good deflation” and “bad deflation.”
The laptop computer that I am using to write this review is an example of good deflation. It costs one-fourth the price of the laptop I used when I interviewed Mr. Mauldin the first time, back in my LSE days, yet is many times faster and more powerful. This is “supply-based” deflation, and it is the result of technological progress and productivity enhancements that boost supply and lower costs to consumers. Free trade is also a major driver of good deflation.
Unfortunately, our economy is currently plagued by “bad deflation,” which is an entirely different animal. Bad deflation is caused from a fall in aggregate demand rather than a rise in supply or a technological breakthrough; this is the deflation of excess capacity. When no one wants to buy your merchandise and you have to lower the price, this sets in motion a vicious cycles of falling demand and falling prices, the likes of which we haven’t seen since the Great Depression.
Suffice it to say, bad deflation is very bad indeed, and the fear of it is what forced Fed Chairman Ben Bernanke to launch his now wildly unpopular quantitative easing campaigns. Mauldin also touches on another one of our favorite subjects of recent years, the velocity of money.
Most contemporary disagreements about inflation and deflation revolve around a fundamental misunderstanding of what money velocity is and how it works. People get money supply. But money velocity is more abstract and harder to pin down. Mauldin explains money velocity with characteristic Texas bluntness: “If you print money but it doesn’t go anywhere, you won’t get inflation.”
That pretty well sums it up. Money velocity is the rate at which a dollar circulates through the economy. It makes no difference to the GDP level or the inflation rate whether you spent $2 on two widgets or we pass the same $1 back and forth buying one widget each from each other.
That is why the Fed’s doubling of the monetary base has had not led to the hyperinflation that many feared. The Fed has made unprecedented levels of credit available, but the banks have failed to lend it out and consumers have shown little interest in wanting to spend it. (As both Mauldin and ourselves have pointed out, this is the fatal flaw in Milton Friedman’s monetarist statement that “inflation is always and everywhere a monetary phenomenon,” indicating that money supply alone determined to what extent we had inflation or deflation. Friedman failed to take into account variations in the velocity of money, which he naively assumed to be constant.)
Don’t expect money velocity to increase much any time soon. The primary driver of both credit creation and money velocity in the 2000s was financial innovation and securitization. With the mortgage market crippled, this money-churning machine broken is for the foreseeable future.
Though he sees deflation being the dominant force for the time being due to the continued deleveraging of the private sector, Mauldin does acknowledge the possibility that the government’s attempts to fight deflation might be too successful and lead to inflation or even hyperinflation. He sees this as being more likely in the United Kingdom and, eventually, Japan rather than the United States, but acknowledges that it is possible here if the Fed loses its independence and acquiesces to an irresponsible Congress: “Hyperinflations are not caused by aggressive central banks; they are caused by irresponsible and profligate legislatures that spend far beyond their means and by accommodative central banks that lend a helping hand to governments.”
Mauldin is more equivocal in his views on deflation than Harry Dent, Gary Shilling, or Robert Prechter. But like the others, he is absolutely correct to emphasize the deflationary effects of debt deleveraging.
It’s Different This Time
We reviewed "This Time Is Different," the ground-breaking work on financial crises, in history by Kenneth Rogoff and Carmen Reinhart, in the April 2010, issue of the HS Dent Forecast, and Mauldin certainly shares our enthusiasm. He dedicated an entire chapter of Endgame to explaining Rogoff and Reinhart’s findings. Specifically, he focuses on a passage that we too found to be insightful:
If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom…. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living. Most of these booms end badly.
This echoes the work of Hyman Minsky, whose Financial Instability Hypothesis has made quite the comeback in recent years. Minsky’s keen insight is that stability inherently breeds instability because a long period of relative calm lulls market participants into a false sense of security and encourages them to take more risk and take on greater debts than they might have otherwise taken. It’s true of banks, as lending policies generally get quite loose after a long period of economic growth, but it’s also true of individuals.
Consider the unintended consequences of falling interest rates. Lower interest rates mean that, all else equal, you can buy a larger, more expensive house for a given monthly payment. Thirty years of falling interest rates led Americans to buy ever bigger and more expensive homes, culminating in the 2000s bubble and subsequent bust that wiped out the home equity of millions of Americans and took down the global financial system.
We've written about Minsky before. His work, sadly, only tends to get remembered after a crisis when it is too late to take its wisdom to heart.
Around the World
While Mauldin’s analysis of the American debt problem is sobering, his comments on Europe are downright frightening. The focus in the financial press has been on the “PIIGS,” the European periphery countries of Portugal, Italy, Ireland, Greece and Spain. The crisis facing these countries is not going away any time soon, but Mauldin points to an enormous risk in tiny Austria that no one else is talking about.
The evolution of a garden-variety recession into what became the Great Depression was triggered, in part, by a bank failure in Austria that created a ripple effect across the global financial system. Ominously, Austria’s banking system again looks very risky.
Due to high interest rates in the Hungarian forint, Hungarian home buyers were very interested in lowering their monthly payments by taking out mortgages dominated in lower-yielding currencies like the Swiss franc. The banks in neighboring Austria were only too happy to help. Sure, it seemed like a good idea at the time. But what about now, when Hungarians find themselves forced to pay back those loans in a depreciated currency?
Given Hungary’s fiscal condition, additional currency depreciation may be inevitable. What happens then? Will Hungarians choose to strategically default en masse, like many of their American brethren in states like Florida?
Only time will tell. But don’t be surprised if the next crisis to roil the European Union starts in Hungary and Austria.
Separately, Mauldin has joined the small but growing body of analysts who see big trouble ahead in the Land Down Under. Sunny Australia, which managed to largely avoid the 2008-2009 meltdown, appears to be in the final stages of a massive housing bubble. By the Economist’s estimates, Australia’s housing market is 63% overvalued. More ominously, more than 30% of homeowners now have interest-only mortgages, and private credit growth has been growing at 20% per year.
This is going to end very badly. Australia is due for a massive housing bust. Aussie bulls would point out that the country currently has low national debt, but as the 2008-2009 crisis showed, this can change in a second if you have to bail out your banking sector and your tax take plummets. Australia will be entering its potential crisis in better fiscal shape than the United States and Europe did, but this may prove to be small consolation when the meltdown hits. Keep a close eye on China, because any slowdown in imports of Aussie raw materials could prove to be the straw that breaks this camel’s back.
A Bug in Search of a Windshield
Mauldin saves some of his best comments for the chapter on Japan and correctly attributes the country’s woes to bad demographics. Mauldin is no stranger to demographic analysis, and he routinely uses population statistics in his books and in his e-letters.
Unfortunately, he falls into the same analytical trap that many others—including academic heavyweights like Ben Bernanke and Jeremy Siegel—fall into. He focuses almost entirely on the supply side of demographic analysis, ignoring what we consider to be the more important demand aspects.
Mauldin is largely correct in pointing out that “There are only two, and only two, ways that you can grow your economy. You can either increase your working age population or increase your productivity.” This is a case of the tail wagging the dog, however.
The post-industrial economy has turned Say’s Law upside down. Supply may or may not create its own demand, but demand certainly creates the incentives to produce more supply. Automation and outsourcing can compensate for lack of human labor; they cannot, however, compensate for a lack of consumers. The economics of the Industrial Revolution were made possible by the promise of ever-increasing population growth. The economist John Hicks openly asked if “Perhaps the whole Industrial Revolution of the last two hundred years has been nothing else but a vast secular boom, largely induced by the unparalleled rise in population.”
Mauldin writes that Japan has been unable to grow its economy in over 17 years because government debt has crowded out productivity-enhancing private investment that could have boosted production. But production really isn’t the point. In the absence of aggregate demand—which Japan’s aging demographics have sapped—new production would simply mean overcapacity and even worse deflation. Still, he is spot on in his analysis of the impending doom of the Japanese bond market. Mauldin writes,
94 percent of all Japanese government bonds (JGBs) have been bought by Japanese. Optimists point to a large pool of Japanese savings. However, that savings pool is already invested in JGBs, so it isn’t the stock of savings that matters but the flow. The flow has been steadily decreasing. Japanese savings rates are now approaching the low that we saw in U.S. savings rates just a few years ago. And this is not due to the Japanese somehow becoming profligate Americans but almost entirely due to demographic necessity.
As Japan’s retirees begin to spend down their savings, the country can no longer depend on its citizens to absorb its massive debts. Because of this, Japan will soon be forced to access the international bond markets for really the first time in modern economic history. International investors are far less likely to lend to Japan at current low rates give that outstanding debt is already 200% of GDP. When rates start to rise, then comes the endgame. Japan will finally rocket out of deflation into a hyperinflationary currency collapse. It won’t be pretty.
What Happens Now?
Mauldin is very clear that, with the possible exception of Japan, whose fate is all but sealed, the endgames are not set in stone. Actual outcomes are path dependent on what decisions are made today. Will we take our medicine now, embrace austerity, and accept lower growth for several years in order to build a better foundation for the future? Or will we bury our heads in the sand and continue to rack up debts that will be horrendous burdens to future generations?
It’s not a question of pain or no pain, but rather a question of how much, when, and taken by whom. We could succumb to the “Argentinean disease” and simply print money until it generates enough inflation to effectively erase our current debts. Or we could take the libertarian “Austrian solution” favored by some in the Tea Party, abolish the Fed, let the banks fail, and embrace massive deflation and high unemployment to purge the system of its excesses.
Neither of these solutions is politically realistic, of course. Mauldin’s preferred solution is what he calls the “glide path,” which would be a 5-6-year plan to gradually hack the deficit back down to lower than the GDP growth rate. This would (hopefully) prevent the bond markets from rebelling and pushing interest rates higher. It won’t be fun to live through, but it would ultimately be much less painful than the alternatives.
In any event, Mauldin essentially reaches the conclusion that we are likely looking at a period of higher-than-normal unemployment, a tepid economy, rising taxes, and lower levels of government service. We can’t realistically grow ourselves out of this one.
We recommend you pick up a copy of Endgame. Given the noise dominating the newswires, it is refreshing to find clear, coherent thinking. Our compliments to Messrs. Mauldin and Tepper on a job well done.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.