Category Archives: Saving & Investment

Illinois And The Tsunami

Apparently the standoff between Governor Rauner and Speaker Madigan continues. As it should. Madigan’s willingness to dispense unfunded largesse to his supporters is largely responsible for the state’s financial woes. Today also the state was ordered by a Federal court to pay its backlog of Medicaid bills, which will be interesting as the state is already cash flow negative.

However the biggest issue is the unfunded state employee pension obligations. This article from Bloomberg contains a nice graphic ostensibly showing the funding levels of most states (no data for California? Really? just check this blog)

These reported funding levels are a cruel joke. These funds continue to assume 7-8% returns, despite the fact that they have not achieved them for years. Just look at the column showing the decline in funding ratio from 2014 to 2015. Not only are the assumptions high, but they are for long-term averages, so that they adjust future return estimates higher to compensate for below-average realized returns. John Hussman’s work shows more or less zero returns for the next 12 years, with the high likelihood that there will be a major drawdown in that period. Drawdowns are lethal to pension funds because the payment of benefits continues, sapping the capital base and making recovery to previous levels nearly impossible.

Pension funds used to invest in bonds. The trustees would meet once a quarter, review the actuarial forecast of liabilities and approve adjustment of the laddered bond portfolio’s maturities to exactly meet the liability schedule. Then there would be lunch and golf. The future returns would be locked in and the contributions needed to fund the bond portfolio would be obtained from the sponsor. Everyone got to sleep at night.

Then Wall Street decided that pension funds had a lot of money, and not enough was being siphoned off into Wall Street pockets. So the sales force went out, armed with charts showing that stocks had historically offered higher returns than bonds. Higher returns mean that less contributions would be needed, so fund sponsors bought the pitch. Yes, stocks have offered higher returns but for a reason – much higher risk. Well, we’ll just assume a long-term average return and surely it will average out. GLWT.

The Future Is Now

Debt pulls demand forward in time. Borrowers use debt to pay for consumption today and commit future income to service the debt.

The amount available for consumption today represents the present value of that committed income, discounted by the prevailing interest rates.

The further that borrowers reach into the future, the more that discount lessens the amount available today. The Fed wants consumption today, so it attempts to induce inflation in order that borrowers are more confident of their future nominal incomes, while holding interest rates low so that the discounting of that income is minimized.

This strategy has sustained consumption in the short term, at the expense of reducing future income available for consumption.

The problem is that the future is now.

As consumption slows, so does production and inflationary pressure. Defaults rise – just look at the subprime auto loans. Yes, defaults eliminate debt – but only at the expense of the creditor who takes an immediate hit to income, charged against net worth or equity capital. Lenders are forced to reduce their assets.  Borrowers find that debt service takes more of their income than they had expected. Purchasing power erodes and deflation sets in. Spending capacity falls even more rapidly and the economy slides into recession and depression.

The larger the accumulation of debt, the longer it takes to purge the financial system and restore it to stability. Debt – credit – is a necessary and healthy part of the economic system. But the economy cannot depend on consumption funded by the continuous growth of debt. Debt must revolve, expanding and contracting within limits proportional to the size of the economy.

And It’s Gone

Jack Ma points out that the US has wasted $14 trillion on wars.

Since the Vietnam war, more than 45 years ago, the US has embarked on a neocon strategy of war in an effort to build a global empire. The result of that strategy has left American infrastructure second rate, its school system in shambles, and its healthcare system a complete and utter joke.

Just imagine what America could’ve done with $14t of investable dollars, instead of waging wars.

Aside from the wars, America spends more than 50% of its discretionary budget on the military, per annum, 16% of its overall budget.

And the neocons are trying to stir up another one, with Russia. Why? For what? Wag The Dog? And that doesn’t even count the other futile wars, like the “War On Drugs.”

Going Out On A Limb

I think the end of this bubble is beginning, as yields spike and the dollar soars:

“Our revels now are ended. These our actors,
As I foretold you, were all spirits and
Are melted into air, into thin air:
And, like the baseless fabric of this vision,
The cloud-capp’d towers, the gorgeous palaces,
The solemn temples, the great globe itself,
Yea, all which it inherit, shall dissolve
And, like this insubstantial pageant faded,
Leave not a rack behind. We are such stuff
As dreams are made on, and our little life
Is rounded with a sleep.”

― William Shakespeare, The Tempest

The economy is not strong. There are 100+ million adults not working (“not in the labor force”) out of a total population of 325 million, to say nothing of the myriad of government employees who are employed, but not contributing any value to the economy.

Consumption is being sustained by debt, both private borrowing and government money-printing. By January 2009, the United States had accumulated $10.6 trillion in debt. The gross national debt – just federal government debt – stands at $19.7 trillion as of the end of FY2016. Spending is on a pace to add another $2.4 trillion this fiscal year (2017), surpassing $21 trillion by next September. Krugman applauds, and of course this is Obama, not Trump. Yet.

Debt-funded consumption in excess of income has crowded out savings and therefore investment. As investment has declined, so, logically enough, productivity growth has fallen (see previous post). Simultaneously, government has been growing, making a lethal cocktail for real household disposable incomes, which have been declining for years. Pensioners who think they are in good shape are not noticing that defined-benefit pension funds are already starting to cut benefits and many, especially state and local government funds, are woefully under-funded. Social Security is in negative cash flow, and drawing on the general tax revenue pot to make up the difference. The stock market is ludicrously over-valued and promises zero or negative returns to pension funds for years to come. As Margaret Thatcher notably said “Socialist governments traditionally do make a financial mess. They always run out of other people’s money. It’s quite a characteristic of them.”

Powerful deflationary forces are being unleashed. The world is awash in oil and efforts to keep the price up will eventually fail. OPEC in aggregate will not cut supply because its governments (as well as the non-OPEC ones) depend on the flow of oil money to stay in power. I expect oil to reach the lower $20s if not below. Most of the world is engaged in a race to the bottom, cutting interest rates to devalue their currencies and boost exports. They are therefore exporting deflation to the US. I expect to see CAD in the 0.60s and the EUR in the 0.80s. Consumer price inflation in the US appears comparatively strong due to the inclusion of OER¹ in the CPI, which is not done elsewhere, and due to the uncontrolled rise in healthcare and education prices, funded by government subsidies and debt. These prices end up being a form of taxation by the 0.01%, who are on the receiving end. The protest vote in the US election should be no surprise.

OER, a completely fictional number to start with, is high as a result of low interest rates financing housing bubbles. These will end as badly as the previous lot. I choose not to be a homeowner, largely because I don’t want to face a huge capital loss.

In short, the economy is a Potemkin village. Things are not as they are made out to be. Even a fractional increase in rates may trigger a deflationary crisis, especially considering the shortage of dollar liquidity outside the US.

¹ OER, Owner’s Equivalent Rent, is weighted about 25% of the CPI basket. It is estimated by a telephone survey of selected homeowners, asking them how much they think it would cost to rent their a property like theirs.It has nothing to do with what it actually costs them to own and live in their properties.  I am not kidding. Now do you think CPI means anything?

Guess What?

Productivity improvement is highly correlated with investment.
cxt9yhsxeaeoo4t

From John Hussman via Twitter

Failure To Thrive

cxo238hweaalwi_

This chart is all you need to see to understand why the economy isn’t growing. Thanks to John Hussman.

So Late We Get Smart

Alan Greenspan, interviewed by Bloomberg Radio, said he was not optimistic about the future: “No. I haven’t been for quite a while. And I won’t be until we can resolve the entitlement programs. Nobody wants to touch it. And that is gradually crowding out capital investment, and that’s crowding out productivity, and it’s crowding out the standards of living where do you want me to go from there.”

Inconceivable

The S&P is back within 5% of its all-time highs and the risk-on mode is in full swing – “Bad news is good news” – as the market relies on the folly of central bankers to flood the world with yet more liquidity. Needless to say, the US recession is well-established at this point – unless of course, your name is Janet.

Having said which, apparently even QE-crazed Kuroda has started to realize that QE does not work. Of course, letting the market work is not an option, so plan B is negative interest rates, which of course means eliminating cash so that everyone can be appropriately punished for saving.

We’re so far off in the weeds that we can’t even see what a functional economy looks like from here, let alone hope to attain one without an intervening catastrophe.

30-year government bond yields.

Country Feb 23/16 Feb 18/16 Jan 30/15
Japan 0.97% 1.02% 1.26%
Germany 0.87% 0.96% 0.996%
USA 2.62% 2.69% 2.25%

The War On Cash

The Keynesian central bankers believe that they can manipulate people into spending their money rather than saving. It is of course, completely insane because saving and investment are the backbone of a healthy economy. But that doesn’t matter to these people, who believe that consumption drives the economy. Therefore the idea of saving is anathema and the consumer must be encouraged to pile on more and more debt.

Their preferred manipulation strategy is to punish “idle” cash by inflating it away – hence the 2% inflation goal. This isn’t happening so now plan B arises – simply make interest rates negative so that “idle” cash simply disappears. They like this less, of course, because, unlike inflation, it is immediately and directly visible. But so be it, they say.

The bottom line is that the government is the enemy of the citizenry as it seizes every opportunity and strategy to strip the economy of saving and investment and suck every available resource into government consumption and vote-buying transfer payments.

Toilet Paper

There’s something special about toilet paper. Perhaps, in addition to the obvious benefits in comfort and hygiene, it has become something of a symbol of civilization. It is widely believed that its inability to deliver adequate quantities of toilet paper triggered the downfall of the Soviet Union. As recently as 2009, the government in Cuba was facing unrest for the same reason. The political upheavals in Venezuela clearly highlight a shortage of toilet paper as a major grievance.

The common element in these situations is not toilet paper, but the government’s belief that it can control the economy to conform to socialist ideals while continuing to grow national wealth, production and employment. The shortage of toilet paper is merely a common, albeit not universal, symptom of the failure of centralized government economic management.

As we come to the end of 2015, we see that this belief in central planning has become widespread despite many failures. Keynesian economists have asserted that they can indeed achieve this nirvana by monetary manipulation, and so elected politicians have turned over the central banks to them. The result has been unprecedented volatility in financial asset prices as the inability to accurately forecast the results of monetary actions leads to wider and wider swings.

Sadly, there is no reason to believe that the Keynesians have learned anything from their failures. John Hussman says:

On the other side of the recklessly speculative advance of recent years is not only the likelihood of brutal market losses, but also tremendous opportunity. I fully expect the S&P 500 to double, and to double again over the coming 10-12 years, and yet I also expect the total return of the S&P 500 over that period to be zero. Both aspects of that expectation are likely because markets move not diagonally but in cycles. How did the S&P 500 trace out a total return of zero between 2000 and the end of 2011? By first losing half its value, then more than doubling, then losing more than half its value, and then doubling again. Across history, extreme valuations have invariably been followed by similar behavior – wide cyclical swings, yet only modest overall returns over the following decade.

Dr. Hussman’s assessment, based on history, is likely to understate the volatility of the outcome as the central banks, led by the Fed, will probably act to amplify the cyclic volatility, rather than dampen it as they should. As far as I can tell, nobody at the Fed has the slightest notion of control system theory. Since it has no reliable economic forecasting mechanism, there is no way for the Fed to look forward. Therefore it can only look backward – the Fed calls this “data-driven.” Control based on such feedback can work, but only when properly designed. The delays in the data and the action of any control inputs the Fed might make are probably too high to make any such control system stable.

The end point must be some sort of global economic revolution as socialism, or at least the form of socialism that requires continuous injections of new money to sustain itself, is finally rejected. Getting to that point will be tough as the beneficiaries of big government and redistribution far outnumber the victims, the workers who actually contribute value to the world’s economies. Navigating this series of economic tempests will be difficult. I remember once buying a copy of “Sail” magazine that purported to provide insight in how to excel in light air. The advice boiled down to “sail fast and avoid the holes.” Right. True, but not helpful. In the same spirit, “buy low and sell high.” Happy New Year.