by John Mauldin, Frontline Thoughts
This week I offer a main course, a veritable piece de resistance, for Outside the Box readers, from my friend Rich Yamarone. Rich is Chief Economist for Bloomberg and one really sharp talent. He helps write Bloomberg Brief: Economics, a daily notebook that comes out every business morning with an all-encompassing view of what's happening and will happen.
I have been on stage with him several times recently and have spent even more time with him over dinners. He keeps reminding me to pay attention to the slow-motion slowdown and eventual (he says) recession that is coming right here to the US. He thinks ten-year bond rates could scare 0.5% (not a typo!) if/when both Europe and China have a simultaneous crisis and the US is seen as a real – and perhaps the last – safe haven (to which I would add: besides gold). Certainly 1% on the ten-year and 2% on the 30-year will be on offer in such a scenario.
I asked him to give us a brief tour, based on some of the graphs in his latest presentation, and it arrived today. If you like, you can subscribe to their regular research by going to bloombergbriefs.com/economics.
But we can't ignore Europe entirely, so for an appetizer I offer this small note from Rob Arnott, founder of Research Affiliates (you may know them as the Fundamental Index guys) and manager of the extremely popular (for good reason) All-Asset Fund at PIMCO. Rob will be with me in about a week in Italy, and I look forward to great evenings over Italian food with friends and family.
Here, Rob looks into the future (something he does with great success in his funds) and walks us backward in time. But I will let him tell his story and then we'll get on to the main course. Quoting:
"On another topic, one of my favorite games as an asset manager is to look past current travails and ask what *must* happen in the years ahead. Then we can turn attention to working backwards, identifying the intervening "path of least resistance." Sometimes, this is *way* more powerful than looking at the near-term decision tree and working forwards.
"The EZ travails lend themselves elegantly to this treatment. What will happen in the months ahead? No one really knows. What will happen in the years ahead? Nations addicted to debt-financed consumption will have to balance their books. All of Europe (and the US and Japan) will be spending no more (or very little more) than their tax receipts, a few years hence. Why? Because – as with any family – debt-financed consumption is ultimately unsustainable.
"Likewise, some years hence, entitlements will need to be on a pay-as-we-go basis, give or take a little wiggle room, in order to not crowd out all other forms of spending. Debt service will need to be part of the nations' spending, crowding out other forms of spending; a 'primary surplus' will be irrelevant.
"When will this transition take place? It's impossible for the status quo to continue more than a few years, though Japan shows that debt-financed government spending can persist far longer than most observers might suppose. And it's impossible for status quo to persist after the capital markets begin looking these few years ahead, which telescopes this transition into the coming handful of years. The more a nation relies on foreign investors to fund its spending, the faster this cliff arrives.
"So, working backwards from these inevitabilities ...
· "Since government spending roughly equals tax receipts, less interest payments, collecting more in taxes is a very dubious path by which to arrive at balance.
· "This leaves us with spending cuts. Entitlement spending roughly equals tax receipts attached to the entitlements. So the same logic applies: entitlement spending will be cut. Age of eligibility, means testing, and rationing are the paths of least resistance; but this will require an evisceration of the public sector and empowering of the private sector, which will in turn require a stark liberalization of regulatory and employment law.
· "*Or* there will be a collapse of GDP, as public spending drops without allowing the private sector to pick up the slack. Increasing global pressure for financial transparency, to facilitate tax collection, will become the norm.
"As we move back closer to the present, the near-term implications are less clear.
· "Nothing in this end-point *requires* that countries leave the EZ. Greece can simply slash public-worker salaries or head count to be fully covered by tax receipts. Likewise, Spain, Italy, Portugal, France (!).
· "If any country does exit, its banking sector must rebuild from scratch. The domino effect here is obvious: countries exiting en masse becomes a possibility. Italy and France are not assured to remain in the EZ in this circumstance. So, it's implausible that one, and only one, country exits.
· "All of this means that EZ exits may prove to be too messy to be allowed to happen, in which case defaulting countries will simply default, then cut spending to balance their budgets ... and then move on, with sharply diminished public sectors and GDP."
And back with John. It all sounds so simple when he explains it. But we will lurch from crisis to crisis in Europe, and then Japan will enter the picture in a big way. Hopefully we in the US can learn a lesson and deal proactively with our very similar problems, about which I will write this week.
And now I have to go to my next meeting, although it will be a pleasant one over a low-cholesterol dinner. Have a great week. The next time you hear from me I will be in Madrid on my way to Italy. So adios and ciao for now.
Your ready for a little downtime and conversation analyst,
John Mauldin, Editor
Outside the Box
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