Saturday, March 12, 2011

Recession? Yup. Inflation? Better hope so. Hyperinflation? Better hope not!
You'll need to clear your mind first, but then read this and make up your own mind.
As always, here's one of my favorites: 
John Maudlin’s  Thoughts from the Frontline

A Dose of Inflation
The Characteristics of Hyperinflations
The Problems of Inflation,   
Hyperinflation in the United States?

Europe, New York, La Jolla, Korea, and Recent Media Links

    Bankruptcies of governments have, on the whole, done less harm to mankind than their ability to raise loans. —R. H. Tawney, Religion and the Rise of Capitalism, 1926
   By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. —John Maynard Keynes, Economic Consequences of Peace
   Unemployed men took one or two rucksacks and went from peasant to peasant. They even took the train to favorable locations to get foodstuffs illegally which they sold afterwards in the town at three or fourfold the prices they had paid themselves. First the peasants were happy about the great amount of paper money which rained into their houses for their eggs and butter. . . . However, when they came to town with their full briefcases to buy goods, they discovered to their chagrin that, whereas they had only asked for a fivefold price for their produce, the prices for scythe, hammer and cauldron, which they wanted to buy, had risen by a factor of 50. —Stefan Zweig, The World of Yesterday, 1941

   I have had a lot of questions about my thoughts on inflation and hyperinflation of late, especially in the new “Ask Mauldin” section on www.johnmauldin.com. Unfortunately, the answer is not short and simple. The good news is that my new book has an entire chapter on inflation and hyperinflation, and today, as I fly to La Jolla (more below), I give you that chapter as this week’s letter. The letter will print a little long, as there are a lot of charts. Hopefully it will encourage you to want to read the rest of the book!
   Please note, my co-author (Jonathon Tepper) and I have different views on the subject, for different countries. In some, we consider high (or worse) inflation a serious prospect. In others the opposite is true. There is no one size fits all. And of course our best estimates today are based solely on the facts as we know them – if the facts change, so will our opinions. When we wrote this chapter late last year, it was not obvious that the Fed would purchase 100% of the US debt. We currently assume that will stop. If it does not, then the lessons of this chapter are more important than we would like them to be. Inflation and hyperinflation are choices made by humans. That means there is an element of uncertainty, when logic would dictate there should not be. And also, we start off the chapter a little tongue in cheek (we are NOT really recommending inflation as an answer to debt!).
   Endgame got up to #2 on Amazon yesterday (#1 non-fiction). Thanks to all you faithful readers who bought the book, whether there or at your local bookstores. Maybe this weekend, those of you who procrastinated will help us get to #1! And if you are going to buy some extra books for clients, family, or friends go ahead and do it now! No more procrastination! Go to www.Amazon.com and get clicking!
   I just bought the book myself (really!) on Kindle. I need it on my IPad for reference. It works great! And we are #1 on Kindle! OK, I will only be this aggressive for another month or so, then it’s back into regular e-letter mode, but cut me some slack – books are a big deal for my generation. And I think this one adds some important insights to the national conversations that must be had around the world. Now, let’s jump into the chapter on inflation.
Inflation and Hyperinflation
   In the previous chapter, we looked at deflation. Now let’s look at the opposite: inflation and even hyperinflation. Hyperinflation is an extreme case of inflation and a nightmare for anyone living it.
   We know that the world is drowning in too much debt, and it is unlikely that households and governments everywhere will be able to pay down that debt. Doing so in some cases is impossible, and in other cases it will condemn people to many hard years of labor to be debt-free. Inflation, by comparison, appears to be the easy way out for many policy makers.
   Companies and households typically deal with excessive debt by defaulting; countries overwhelmingly usually deal with excessive debt by inflating it away. While debt is fixed, prices and wages can go up, making the total debt burden smaller. People can’t increase prices and wages through inflation, but governments can create inflation, and they’ve been pretty good at it over the years. Inflation, debt monetization, and currency debasement are not new. They have been used for the past few thousand years as means to get rid of debt. In fact, they work pretty well.
   The average person thinks that inflation comes from printing money. There is some truth to this, and indeed the most vivid images of hyperinflation are of printed German reichsmarks being burned for heat in the 1920s or Hungarian pengös being swept up in the streets in 1945.
   You don’t even have to go that far back to see hyperinflation and how brilliantly it works at eliminating debt. Let’s look at the example of Brazil, which is one of the world’s most recent examples of hyperinflation. This happened within our lifetimes. In the late 1980s and 1990s, it very successfully got rid of most of its debt.
   Today, Brazil has very little debt, as it has all been inflated away. Its economy is booming, people trust the central bank, and the country is a success story. Much like the United States had high inflation in the 1970s and then got a diligent central banker like Paul Volcker, in Brazil a new government came in, beat inflation, produced strong real GDP growth, and set the stage for one of the greatest economic success stories of the past two decades. Indeed, the same could be said of other countries like Turkey that had hyperinflation, devaluation, and then found monetary and fiscal rectitude.
   In 1993, Brazilian inflation was roughly 2,000 percent. Only four years later, in 1997 it was 7 percent. Almost as if by magic, the debt disappeared. Imagine if the United States increased its money supply, which is currently $900 billion, by a factor of 10,000 times, as Brazil did between 1991 and 1996. We would have 9 quadrillion U.S. dollars on the Fed’s balance sheet. That is a lot of zeros. It would also mean that our current debt of 13 trillion would be chump change. A critic of this strategy for getting rid of our debt could point out that no one would lend to us again if we did that. Hardly. Investors, sadly, have very short memories. Markets always forgive default and inflation. Just look at Brazil, Bolivia, and Russia today. Foreigners are delighted to invest in these countries.
   Endgame is not complicated under inflation and hyperinflation. Deflation is not inevitable. Money printing and monetization of government debt work when real growth fails. It has worked in countless emerging market economies (Zimbabwe, Ukraine, Tajikistan, Taiwan, Brazil, etc.). We could even use it in the United States to get rid of all our debts. It would take a few years, and then we could get a new central banker like Volcker to kill inflation. We could then be a real success story like Brazil.
   Honestly, recommending hyperinflation is tongue in cheek. But now even serious economists are recommending inflation as a solution. Given the powerful deflationary forces in the world, inflation will stay low in the near term. This gives some comfort to mainstream economists who think we can create inflation to solve the debt problem in the short run. The International Monetary Fund’s top economist, Olivier Blanchard, has argued that central banks should target a higher inflation rate than they do at present to avoid the possibility of deflation. Economists like Paul Krugman, a Nobel Prize winner, and Blanchard argue that central banks should raise their inflation targets to as high as 4 percent. Paul McCulley argues that central banks should be “responsibly irresponsible.” There are, however, problems with inflation as a policy tool.
   In this chapter, we’ll examine inflation and hyperinflation, what they are, how they’re different, and how hyperinflation ends. As a quick aside, that is why we expect the current attempts by the Fed at quantitative easing 2 to be probably ineffective: $600 billion is not all that much in the grand scheme of things. Now, if they start talking $6 trillion, that would get our attention.
A Dose of Inflation
   In the previous chapter, we discussed why the current crisis presents the real risk of deflation if monetary velocity falls and does not rise. However, there are many reasons to believe that we will not see deflation. The major mistake that deflationists now make is their focus on spare capacity. Central bankers and most economists assume that because of the huge deleveraging we’re seeing, governments can print money and borrow like crazy without provoking inflation because of slack in productive capacity created by the recession.
   The severity of the recession means that they are wrong. During a normal downturn, production slows, but spare capacity isn’t destroyed, and it is able to create extra supply when demand returns. A severe credit squeeze, though, does lasting structural damage, as the evaporation of bank lending destroys firms’ longer-term ability to produce at given levels. People who think inflation isn’t possible point to high unemployment in the United States, the United Kingdom, and Europe. But as we’ve shown earlier in this book, many of the unemployed in the developed world are unskilled or will be unemployed long enough that their skills will be totally rusty and, hence, they will be unemployable. The slack, in other word is imaginary.
   According to a major study by Athanasios Orphanides, now central banker in Cyprus, the “ex-post revisions of the output gap are of the same order of magnitude as the output gap itself, that these ex post revisions are highly persistent and that real-time estimates tend to be severely biased around business cycle turning points, when the cost of policy induced errors due to incorrect measurement is at its greatest. . . . The bulk of the problem is due to the pervasive unreliability of end-of-sample estimates of the trend in output.”
   The English translation is: Economists and central bankers are very, very bad at estimating output gaps. No surprise there!
   The output gap is often subject to considerable measurement error, and it is often revised because of revisions to real GDP and to estimates of the economy’s underlying rate of productivity growth. So output gap estimates and capacity utilization estimates are almost worthless in real time. Not only are they worthless but also revisions turn out to be bigger even than the output gap itself. (As we’ve written before, anyone can make mistakes, but it takes an expert with a computer to really foul things up.)
   Even Federal Reserve governors understand the problem. As Charles Plosser of the Philadelphia Federal Reserve has noted, “The data uncertainties are not just theoretical curiosities. They have caused actual problems when policy has been based on mis-measured gaps, resulting in unnecessary economic instability. A particularly poignant example is the Great Inflation of the 1970s in the U.S. [emphasis added].”
   I have written before that when you become a Federal Reserve Bank governor, you are taken into a back room and are given a DNA transplant that makes you viscerally and at all times opposed to deflation. Modern central bankers are much happier with inflation. They’re pretty good at producing it, in fact.
   Figure 8.1 shows U.S. inflation historically, going back to the late 1600s. (How economic historians know what prices were centuries ago always amazes us, but that is the story for another fascinating book.) As you can see from Figure 8.1, when the United States and the rest of the world used a gold standard, periods of inflation alternated with periods of deflation. On average, the price level didn’t go anywhere. One year’s inflation was usually canceled out by the next year’s deflation. But if you look to the right on the chart, you see that suddenly we don’t get deflation anymore. After the Bretton Woods Agreement in 1948, when the world moved to a dollar standard only nominally backed by gold,
and then after 1971, when the United States no longer made the dollar exchangeable for gold, something happened: We only got inflation. Figure 8.1 shows that inflation is the norm in a world of paper currencies. Central banks and governments have an inflationary bias. They can regulate monetary policy much more easily when interest rates are positive, so they prefer always to have some inflation in the system. In fact, there are very, very few examples of deflation after 1948 or 1971.
   In the previous chapter, we looked at the elements of deflation. Deflation can happen right after banking crises and property busts. It happened, for example, after the Japanese bubble burst and as the Japanese banks started going bust. It also happened after the housing bubble burst in Hong Kong in 1997, the banking bust in Ireland in 2008, and the Baltics after their housing bust in 2008. These examples are the only examples we know of deflation after 1971. Almost all of these cases happened because the countries had given up control of their monetary policy. Hong Kong, Ireland, and the Baltics did not control their own money supply. They operated pegs that fixed their exchange rate to the U.S. dollar or the euro (in Ireland’s case, it was in fact already inside the euro). Japan is the one and only case of deflation in a country that is not pegged to another currency or in a currency union.
   As Reinhart and Rogoff have shown us, the typical pattern is for banking crises to lead to sovereign defaults and for sovereign defaults to lead to inflation.
BANKING CRISIS (leads to) DEFAULT (which leads to) INFLATION
   The simple explanation is that banking crises unleash powerful deflationary forces of deleveraging and falling monetary velocity. In this environment, people, corporations, and eventually governments are unable to pay their debts and default. Government defaults typically lead foreigners to sell the local currency, and you get a currency devaluation. A devaluation makes prices for imported goods more expensive and leads to inflation. At the same time, governments and central banks fight the downturn with more expansive monetary policies, which leads to higher inflation.
   The previous paragraph is a highly simplified (or if you’re an economist, it is a highly stylized) version of what typically happens. But it is accurate. Figure 8.2, by Reinhart and Rogoff, captures very well how inflation typically follows external defaults, which typically follow banking crises. It is easy to see why this is the case. Every week, you can read a very respectable professor recommending monetizing deficits and having a free lunch. If only the world worked that way.
 The following was written by Ricardo Caballero, a brilliant professor at MIT:
   “What we need is a fiscal expansion (e.g. a temporary and large cut of sales taxes) that does not raise public debt in equal amount. This can be done with a ‘helicopter drop’ targeted at the Treasury. That is, a monetary gift from the Fed to the Treasury.
   “Critics may argue that this is simply voodoo accounting, as it is still the case that the consolidated balance sheet of the government, which includes the Fed, has incurred a liability. But this argument misses the point that the economy is in liquidity-trap range, and once this happens the system becomes willing to absorb unlimited amounts of money. In this context, by changing the composition of the liabilities of the consolidated public sector in the direction of money, the government gets a sort of ‘free lunch.’”
   Of course, in Professor Caballero’s defense, he argues that we should have a mechanism to drain this liquidity from the system, but realistically, would the Treasury or the Fed have the wisdom to do it? Inflation doesn’t work as a policy response for many reasons. The reason inflation only makes things worse is probably best shown by looking at extreme examples, where the ravages of inflation are clearest and most evident. We will look at hyperinflations, which is a lot of fun for the reader, but not much fun if you’ve lived through hyperinflation.
The Characteristics of Hyperinflations
   Just as Reinhart and Rogoff wrote the book on banking and debt crises, there is one book that is the bible on hyperinflations. Professor Peter Bernholz, from the University of Basel, has written Monetary Regimes and Inflation, which provides an overview of every inflationary episode that has ever happened, and he explains the origins and characteristics of hyperinflation. It is well worth your time if you are interested in the mechanics of hyperinflation.
   As Professor Bernholz points out, you can get inflationary episodes without printing money. Under the Greeks and Romans, rulers often made gold and silver coins smaller or put bad coins into circulation to debase their currency. However, true hyperinflation only happens with paper currencies.5 As you can see from Table 8.1, almost all hyperinflations have happened in the twentieth century. (Note: he wrote the book before the episode in Zimbabwe.) The only hyperinflation prior to the twentieth century was during the French Revolution, when the French monetary regime, too, was based on the paper money standard. We don’t have very long-term inflation data for most countries, but as you can see in the case of the United Kingdom, where we have historical data, inflation was




 

relatively stable for about 600 years. It was only after the United Kingdom moved toward paper money that inflation has really taken off. Unfortunately, this is true of every country with a paper currency (see Figure 8.3). Interestingly, after countries abandoned the gold standard, there are more cases of hyperinflation than deflation. Figure 8.3 shows inflation, but we need to distinguish between inflation and hyperinflation. Many countries have high inflation, but hyperinflation is a very special case in which money grows greater than 50 percent from one month to the next. When money starts growing that quickly, the numbers become truly astronomical. To give you a sense of just how crazy inflation can get once it gets going, Figure 8.4 shows inflation in Weimar Germany. You can see that toward the end of 1923, inflation was growing at 16 million percent per year.
   What kinds of prices does 16 million percent inflation give you? The highest-value banknote issued by the Weimar government’s Reichsbank had a face value of 100 trillion marks (100,000,000,000,000; 100 billion on the log scale).6 At the height of the inflation, one U.S. dollar was worth 4 trillion German marks. One of the firms printing these notes submitted an invoice for the work to the Reichsbank for 32,776,899,763,734,490,417.05 (3.28 x 1019, or 33 quintillion) marks.











 









   What causes such a spectacular increase in prices? Bernholz has explained the process very elegantly. He argues that governments have a bias toward inflation. The evidence doesn’t disagree with him. The only thing that limits a government’s desire for inflation is an independent central bank. After looking at inflation across all countries and analyzing all hyperinflationary episodes, the lessons are the following:
   *Metallic standards like gold or silver show no or a much smaller inflationary tendency than discretionary paper money standards.
   *Paper money standards with central banks independent of political authorities are less inflation-based than those with dependent central banks.
   *Currencies based on discretionary paper standards and bound by a regime of a fixed exchange rate to currencies, which either enjoy a metallic standard or, with a discretionary paper money standard, an independent central bank, show also a smaller tendency toward inflation, whether their central banks are independent or not.
   Bernholz examined 12 of the 29 hyperinflationary episodes where significant data exist. Every hyperinflation looked the same. “Hyperinflations are always caused by public budget deficits which are largely financed by money creation.” But even more interestingly, Bernholz identified the level at which hyperinflations can start. He concluded that “the figures demonstrate clearly that deficits amounting to 40 percent or more of expenditures cannot be maintained. They lead to high inflation and hyperinflations. . . .” Interestingly, even lower levels of government deficits can cause inflation. For example, 20 percent deficits were behind all but four cases of hyperinflation.
   Stay with us here, because this is an important point. Most analysts quote government deficits as a percentage of GDP. They’ll say, “The United States has a government deficit of 10 percent of GDP.” While this measure makes some sense, it doesn’t tell you how big the deficit is relative to expenditures. The deficit may be 10 percent of the size of the U.S. economy; currently the U.S. deficit is over 30 percent of all government spending. That is a big difference.
   Figure 8.5 shows the level of deficits relative to expenditures before hyperinflationary periods.
   Interestingly, currently Japan and the United States are not far from levels that have preceded hyperinflations. The big difference between Japan or the United States and countries that have experienced hyperinflations is that the central banks are not monetizing most of the deficit. If they were to do that, then we would be one step away from paying quadrillions of dollars for a stamp or a sandwich (see Figure 8.6). It is extremely important to note Bernholz’s conclusion. 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.
   What are the implications for the present day? Fiscal liabilities are the real threat that will lead to higher inflation, if central banks continue to monetize government liabilities. In the case of a monetization, governments with independently authorized central banks disavow the overly convenient slippery slope option of paying their bills by printing new currency. A government must pay down its liabilities with currency already in circulation or else finance deficits by issuing new bonds and selling them to the public or to their central bank to acquire the necessary money. For the bonds to end up in the central bank, it must conduct an open market purchase. This action increases the monetary base through the money creation process. This process of financing government spending is called monetizing the debt. Monetizing debt is thus a two-step process where the government issues debt to finance its spending and the central bank purchases the debt from the public. The public is left with an increased supply of base money.
   Although now with quantitative easing (QE2), some would argue that the United States is on such a path. Mohamed El-Erian writes:
   “The unfortunate conclusion is that QE2 will be of limited success in sustaining high growth and job creation in the US, and will complicate life for many other countries. With domestic outcomes again falling short of policy expectations, it is just a matter of time until the Fed will be expected to do even more. And this means Wednesday’s QE2 announcement is unlikely to be the end of unusual Fed policy activism.”
   Do we think the Fed will abandon its responsibility to control inflation and resort to total monetization of U.S. debt? No. But in the attempt to get mild inflation, it is possible the controlled fire they hope to kindle could get out of control, forcing them to act to take back the excess reserves and bring about a recession, as did Volcker. Let’s hope it does not come to that.
   If inflation is the cure for too much debt, as we suggested earlier in our tongue-in-cheek example of Brazil, why is it that high inflation and eventually hyperinflation made things worse? Governments have to spend money all year round, but typically they collect tax revenues at the end of the year. So the value of the government’s revenue in real terms is constantly diminished until the money is spent. Indeed, plugging a hole with inflation merely makes the hole bigger. Digging yourself deeper in an inflationary situation is what economists call the Tanzi effect, after the economist who discovered it.
   Hyperinflations are all very similar. At first, bad money drives out the good. Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them. This is called Gresham’s law: Bad money drives out good money.
   In modern hyperinflations where gold coins don’t exist, people begin to barter and exchange goods and services to avoid having to use devalued paper. Then, if they can get their hands on a foreign currency that is perceived to be hard and unlikely to lose its value, like dollars or deutschmarks, they will start to use the foreign currency. At first, they’ll use the foreign currency as a unit of account to settle wages and price negotiations, then as a means of exchange, and finally as a store of value. Once enough people use the hard currency, Gresham’s law reverses itself and hyperinflations come full circle. The good foreign money drives out the bad, and the inflating currency becomes totally worthless. This is called Their’s law.
   This happened in Argentina. If you are buying a home, you literally come to the closing with large bags of physical U.S. dollars. One side counts the cash while the other checks the paperwork.
   The consequences to this pattern are dreadful. Hyperinflation completely destroys the purchasing power of private and public savings. No one wants to hold paper money, so it leads to excessive consumption and the hoarding of real assets. Investors face uncertainty and refuse to invest, unemployment skyrockets, and savings flee the country. The best-performing stock market in 2008 was Zimbabwe, which offered people a way to hedge their currency risks, even as their economy plummeted.
The Problems of Inflation
   It’s tempting to think that highly indebted countries can inflate their way out of their fiscal problems. Inflation would erode the real value of debt. Debts are fixed, while workers, companies, and governments could earn higher income as wages and prices could be indexed to inflation. The main drawback of high inflation or hyperinflation is that most people become poorer through reduced real income. If we look at the real incomes, we can see that periods of high inflation, for example in the late seventies and in the last few years, have led to negative real wages. On the other hand, periods of disinflation and deflation have led to periods of positive real wage growth. Simply put, prices go up faster than wages, so the things you need to buy tend to go up faster in price than your salary (see Figure 8.7).







    There are three main problems with trying to use inflation to get rid of the value of real debt. Investors would recognize even a stealth inflation policy and quickly push up yields. Many governments around the world have tied pensions and salaries to inflation measures, so increases in government spending would rise with inflation. Nearly half of federal outlays are linked to inflation, so higher inflation means higher deficits. Social Security, which represents about 25 percent of federal spending outlays, is officially indexed, and Medicare and Medicaid are unofficially indexed. Indeed, over the period 2009 to 2020, the Congressional Budget Office (CBO) estimates that these three programs will account for 72 percent of the growth in total federal outlays and about the same share of the growth in debt. If anything, CBO’s assumptions may be conservative, as they are required under current law to assume a sharp cutback in physician reimbursement payments under the Medicare program. Those cuts have been delayed every year since 2003. Any increase in inflation will erode the value of existing debt, but it will make deficits much larger going forward and even possibly increase the real burden of debt as a percentage of GDP. The CBO estimates that if inflation is 1 percentage point higher over the next decade than the rate CBO has projected, budget deficits during those years would be roughly $700 billion larger.
Hyperinflation in the United States?
   Congress likes spending more than a drunken sailor on shore leave, and the Federal Reserve sees the answer to any problem as providing more liquidity. Given this unfortunate dynamic, what is the likelihood that the United States will suffer from higher inflation and hyperinflation? Who better to answer the question than the world’s foremost expert on hyperinflation? Given all the fiscal problems and the monetary response, Bernholz sees many potential problems, but he currently sees no danger in the United States:
   “But does this mean that inflation may evolve into a hyperinflation in the United States? I believe not. Though it is true that budget deficits with government expenditures covered by 40 percent or more through credits have historically led to hyperinflation, it has been stressed in Monetary Regimes and Inflation that it is not only the size of these credits but also their composition that is important. This is noted in the book, thus:
   “‘It will be demonstrated by looking at 12 hyperinflations that they have all been caused by the financing of huge budget deficits through money creation” [emphasis added]. This expresses the fact that only credit extended directly or indirectly by the monetary authorities to the government leads to the creation of money, that is, an increase of the monetary base. This is not true for borrowings taken up in the capital markets if they are not resold to the Fed. Looking from this perspective at the U.S. deficit, by far not all of the credits borrowed by the government were financed by the Fed.
   ‘According to preliminary and rough estimates, not 40 percent but “only” about 13 percent of U.S. expenditures are presently financed this way. Moreover, in discussing this problem it has to be taken into account that about two-thirds of dollar bills are estimated to circulate abroad. This—together with the fact that incredibly huge holdings of dollar assets are owned especially by the central banks of China, India, and the Gulf States—may pose other and later dangers. But these dangers will be, except for a return of the dollar bills and a purchase of foreign-owned dollar assets by the Fed, of a different nature. Inflation may rise more or less strongly during the next years, but there is presently no danger of a hyperinflation in the United States.’”
   Bernholz is likely being far too generous to the Fed and Congress. He is not counting more than $700 billion worth of mortgage bonds by Fannie and Freddie that the Fed bought with money it printed. Arguably, if other central banks had not been dumping their mortgage-backed securities, the Fed would have monetized 100 percent of the U.S. deficit through Treasury purchases. Interestingly, the only country in the world that currently fits the bill for hyperinflation is the United Kingdom, where 100 percent of the budget deficit was monetized by the central bank. Unsurprisingly, ever since, inflation in the United Kingdom has consistently overshot the Bank of England’s own forecasts. Apparently, they don’t see a connection.
   While it is unlikely that the United States, Japan, or any other country will soon enter hyperinflation, the situation could change in the future if any of the central banks were to lose their independence or continue to coordinate their actions with their treasuries. Central banks have lost a lot of independence through quantitative easing. They may say they are keeping an arm’s length from the legislature and the Treasury, but few are fooled. Central banks in the United Kingdom, Europe, and the United States are now effectively working alongside the Treasury to pump money into the economy, so far with limited results due to the massive deleveraging in the private sector. They may continue to try this on a greater scale, and the larger the scale, the greater the need for coordination and the less the independence. If we go into a downturn, we hope central banks will be wise enough not to monetize government debt in any fiscal crisis. Sadly, they probably will. The Federal Reserve has made spectacular mistakes over the past few decades. Under Alan Greenspan, the Fed’s only solution to any problem was to provide more liquidity. To a man who only has a hammer, everything looks like a nail. Under Bernanke, the Federal Reserve effectively monetized government debt and monetized mortgage bonds held by quasi-government entities like Fannie Mae and Freddie Mac.
   If we go into another downturn, will the Fed use its hammer again and provide more liquidity by monetizing even greater quantities of government liabilities? We hope not. Debt deflation is a terrible thing, but hyperinflation is even worse. We must remain vigilant that central banks maintain their independence.
+++++++++++++++++++
   What are we predicting for the US and your country? That’s all in the following chapters. Go to www.amazon.com to get your own personal guidebook to the coming few years.

Europe, New York, La Jolla, Korea, and Recent Media Links
   I did a lot of TV last week, which of course got rescheduled as the week progressed. Two short (5-minute) interviews, with Liz Claman on Fox and Dylan Ratigan on MSNBC. Very different questions. I like the challenges. They are at http://www.foxbusiness.com/on-air/closing-bell/index.html#/v/4578867/steps-to-getting-the-us-fiscal-house-in-order/?playlist_id=87063  and http://www.msnbc.msn.com/id/31510813/#41995013.
   Next Saturday I am off to Europe. We are working on a book “launch” party with my co-author, Jonathan Tepper, in London on Monday Happy Hour in the City area. Drop me a note for details. And I will be on CNBC Squawkbox as guest host in London (I love that gig; lots of fun, smart anchors!). Then Malta, Milan (a public speech), and Zurich and home.
   I am on my way to La Jolla for my good friend Jon Sundt’s birthday party tonight (his 50th!) which will be a hoot. Keb’ Mo’, for you blues guys, will be the entertainment (lots of his stuff on YouTube). I love it. Jon has had a very impressive run for only 50 years, and I want to honor his life. Not just his work life, but his efforts in drug education for our kids, and as a great father, are an inspiration. To many more years of partnership, my friend!
   It looks like I will be going to Korea in mid-May. I look forward to going for the first time to the country from which I have two adopted children. My twin daughters are a true joy in my life. And I will be in NYC April 4-6 (that is the plan for now!) doing media for the book and some research.

   Have a great week.
   Your happy so far with the book launch analyst,
   John Mauldin  John@FrontlineThoughts.com

   Copyright 2011 John Mauldin. All Rights Reserved



Monday, September 27, 2010

Pushing a String

Once again I must bring you John Mauldin's "Thoughts from the Frontline Weekly Newsletter. 
I truly hope you all go to www.frontlinethoughts.com/learnmore and sign up for your own copy, you will look forward to reading it every Saturday morning as much as I do

by John Mauldin
September 24, 2010

   This week the Fed altered their end-of-meeting statement by just a few words, but those words have a lot of meaning. It seems they are paving the way to a new round of quantitative easing (QE2), if in their opinion the situation warrants it. A trillion dollars of new money could soon be injected into the system. Tonight we explore some of the implications of a new round of QE. Let's put our speculation hats on, gentle reader, as we are moving into uncharted territory. There are no maps, just theories, and they don't all agree

     Let's Shift the Focus
   The Fed issued the usual statement at the end of their meeting this week, and Fed watchers poured over the words, looking carefully for any sign of change in Fed policy. The consensus seems to be that the most important change was the statement concerning inflation, the first such change in over a year.
   "Measures of inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."
   The next (and only other real) change was:
   "The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate." (my emphasis)
   Translation: inflation may be getting too low, but don't worry, we are on the job.
   One of my laugh lines in my speeches (I don't have that many) is: "When you are appointed to the Federal Reserve they take you into a back room and do a DNA change on you. After that, you are viscerally and genetically opposed to deflation."
   Bernanke made his famous helicopter speech about not allowing deflation to happen back in 2002. He happily assured us that the Fed has many tools to fight deflation and that it won't happen here. Of course, he also told us the subprime problem would be contained, but I am sure that we have to give him a bit of slack - we all miss a few, including your humble analyst. (Well, I didn't miss the subprime thingie. Nailed that one.)
   Anyway, the Fed seems to be setting us up for another round of quantitative easing. That is Fed speak for buying a few trillion or so dollars of government debt and injecting said cash into the economy.
   Before we get into the wisdom of such a move, let's look at what might prompt them to do so. This is where we get into speculation.
   Recessions are by definition deflationary, but if we go into recession when inflation is already as low as it is, the Fed will be behind the curve. But telling us they are going to start easing because they are worried about a recession is not a good recipe for a positive market reaction.
   So? Why not just say that they are worried about the lack of inflation, "at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." That way they are not fighting a weak economy but rather something that everyone understands, i.e., deflation.
   I agree with David Greenlaw from Morgan Stanley. He writes:
   "Growth data still take precedence. The change in the inflation language, while important, does not, in our view, signal an elevated emphasis on the incoming inflation data itself as a possible trigger for asset purchases. To be sure, the inflation data do matter, but the growth indicators matter more because, from the Fed's perspective, the pace of growth in economic activity is a leading indicator of inflation. Here is a key excerpt from Bernanke's Jackson Hole speech that helps explain the perceived link between growth and inflation:
   " '...the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.' " (emphasis added)
   The key driver for whether the Fed enters into another round of quantitative easing, likely to be in the trillions, is the growth in the US economy. If we are above 1.5-2%, I think they will hesitate, for reasons I go into below. If we drop below 1% and it looks like we are getting weaker, then they are likely to act. A slide into recession would bring about deflation. As noted, they are viscerally opposed to deflation.
  
     An Invitation to an Inflation Party
   The question in my mind is whether a few trillion dollars spent purchasing government debt would do the trick. What if they sent out invitations to an inflation party and nobody came? Let's look at some data points.
   The Fed purchased $1.25 trillion in mortgage assets last year. The theory was that injecting money into the economy would cause banks to take that money and lend it, jump-starting the economy and bringing us back into a normal recovery. Let's see how the lending part went. Here are a few graphs from the St. Louis Fed FRED database.
   The first is "Bank Credit of All Commercial Banks." Please note that the straight upward line in the middle of 2010 is an accounting change. Without that the trend would still be down.

 image001
   Then we have "Total Consumer Credit Outstanding." That had been growing steadily for 65 years until this last recession.

image002

   Next we have "Commercial and Industrial Loans at All Commercial Banks."

image003

      We could look at total residential mortgages (down); credit card debt (down); and commercial mortgages (down). The list goes on.

   Sidebar from Greg Weldon:
   "Also, the value of Commercial Property Loans classified as Special Servicing (restructured and-or- extended) rose to a NEW HIGH, pegged at 11.74% of all CMBS, as evidenced in the chart below."

image004
   No wonder commercial mortgages are down.
   So, what happened to the trillion-plus dollars? It doesn't look like it went into bank lending. As it turns out, it went back onto the balance sheet of the Federal Reserve. Banks put it back into the Fed. There are several ways you can measure this with the FRED database, but one way is to look at "Reserve Balances with Federal Reserve Banks, Not Adjusted for Changes in Reserve Requirements."

image005

   If banks are not lending now, with what seems like lots of reserves, then what is to make us think that another $2 trillion in QE will make them feel like they have too much money in their vaults?
   If it is because they don't have enough capital, then adding liquidity to the system will not help that. If it is because they don't feel they have creditworthy customers, do we really want banks to lower their standards? Isn't that what got us into trouble last time? If it is because businesses don't want to borrow all that much because of the uncertain times, will easy money make that any better? As someone said, "I don't need more credit, I just need more customers."
   How much of an impact would $2 trillion in QE give us? Not much, according to former Fed governor Larry Meyer, who, according to Morgan Stanley, "...maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running 'what if?' simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be 'high-end estimates'.
   "Some probability of a resumption of asset purchases is already priced in, and thus a full 50bp response in Treasuries is unlikely. Moreover, a model such as Meyer's is based on normal historical relationships and therefore assumes that the typical transmission mechanisms are working. For example, a drop in Treasury yields would lower borrowing costs for consumers and businesses, helping to stimulate consumption, business investment and housing. But there is good reason to believe that the transmission mechanism is at least partially broken at present, and thus the pass-through benefit to the economy associated with a small decline in Treasury yields (relative to current levels) would likely be infinitesimal." (Morgan Stanley)
   That is not much bang for the buck, so to speak, but it would be pointing a gun with a very big bang at the valuation of the dollar. If QE were attempted on that scale, it would not be good for the dollar. My call for the pound and the euro to go to parity with the dollar would be out the window for some time, and maybe for good.
   Now, if the strategy is to lower the dollar, then QE might make some sense; but of course no one would admit to that, not when we are accusing other countries of manipulating their currencies (as in China). No, we would just be fighting deflation. The fact that the dollar dropped would just be a coincidence, a necessary but sad thing in the important fight against deflation. (Please note tongue firmly in cheek. Not you, of course, but some other readers sometimes miss my sarcasm.)
   Of course, not all agree that a lower dollar would necessarily be a bad thing. Ambrose Evans-Pritchard, writing in the London Telegraph, concludes a column in where he notes that there is a lot of opposition to QE2 from some fairly significant economic luminaries, and that:
   "Dr Bernanke said in November 2002 that Japan had the economic instruments to pull itself out of malaise but failed to do so. 'Political deadlock' and a cacophony of views over the right policy had prevented action. He insisted that a central bank had 'most definitely' not run out of ammo once rates were zero, and retained 'considerable power to expand economic activity'.
   "Yet eight years later, the US is in such 'deadlock'. Worse, Fed officials now say 'the ball is in the fiscal court', arguing that budget policy should do more to 'complement' the Fed's existing stimulus. Oh no!
   "This is the worst possible prescription. What is needed is fiscal austerity (slowly) before debt spirals out of control, offset by easy money or real QE for as long as it takes. This formula rescued Britain from disaster in 1931-1933 and 1992-1994.
   "Damn the rest of the world if they object. They have been free-loading off US demand for too long. A weaker dollar will force the mercantilists to face some hard truths. So keep those helicopters well-oiled and on standby."
   Hmmmm. If everyone else wants to devalue their currency, should we play along? Can you say buy some more gold?
   But back to the inflation party invitation. If the economy is recovering, QE is not needed. Note that the US economy in the current quarter may be doing better than last. And if you looked at the bank lending charts I presented above, an optimist could note that it looks like we might be seeing a bottom forming and even some increase in lending. Perhaps we have turned the corner. Again, the banks have plenty of reserves, so another $2 trillion is not needed.
   But what if they went ahead and threw $1-2 trillion against the wall? If it showed up back at the Federal Reserve, it would only serve to show that the Fed does not have the tools it needs, or would have to be really willing to monetize debt. It would be Keynes' "liquidity trap" or what Fisher called debt deflation. Neither are good.
   That's called pushing on a string. If the markets sensed that, it would not be pretty.
   The Fed has been buying government debt for several months, taking the money from the mortgages that are being amortized and buying the debt. Let's maybe see how that works out before we bring out the big guns. Just a thought.
   I agree with Allan Meltzer, a historian of the US central bank:
   " 'We don't have a monetary problem, we have 1 trillion or more in excess reserves, so it's literally stupid to say we're going to add another trillion to that,' Meltzer, a professor at Carnegie Mellon University in Pittsburgh, said today in an interview on Bloomberg Television's 'InBusiness With Margaret Brennan.'
   " 'One of the major mistakes that the Fed makes all the time is too much concentration on the short-term,' said Meltzer, author of a history of the Fed. 'Aiming at that is just a fool's game.' " (Business Week)
   That being said, we live in a world where we need to act in terms of what will be rather than what should be. And if the economy continues to weaken, I think it is likely the Fed will act preemptively and start QE2. So the next few months of economic data are very important.
   And even more important is whether Congress will extend the Bush tax cuts at least until the economy is growing respectably, when they come back for the lame duck session in November. Not extending them would be a policy mistake bigger than QE2, and might force even more precipitous action. We do live in interesting times.
   Your ready to be in his own bed for a week analyst,

     John Mauldin
         John@FrontLineThoughts.com

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Monday, September 20, 2010

With Certainty

It is only certain that uncertainty rules . . .

It really doesn't make a whole lot of difference if we are in the first part of a double dip recession or close to the bottom of a single dip; the US economic recovery will be very, VERY slow compared to what the country has been used to after past recessions.

   The recovery won't really get under way until the real estate market gets back on track. Today, the estimate is that we have more than a year’s supply of homes on the market. That is, a year's supply of what used to be a year's supply in the good (read, "of course the beanstalk grows to the moon, stupid") old days. In today's market it is two or three times that amount. Then there is the shadow inventory (those are the houses that the banks will wind up owning when this all shakes out, and which they will then dump on the market.) that will be, at least, another 12 months added. So you see, in real terms it may be 4, 5, 6 or even seven years before things get back to some semblance of "normal" in the residential real estate market. Oh yes, we are just now beginning to feel the slump in the commercial real estate market. That bit of bad news has yet to be figured into the sound bites of the Political Wonks.
   The American Consumer is not as stupid as most political and financial pundits are. Those of us who live in the real world, that is East of Riverside, CA, and west of the Hudson River, excluding that part of the heartland which lies inside "Beltway"; have a much better understanding where the economy is, and where it is going than those inside the Beltway, on Wall Street, or the nuts of the West.
   Consumers have become Savers and are saving all they can, at least those who have a job are. Job or no job, there are few who are spending on anything which isn't necessary, so retail sales aren't going to pull us out of the doldrums. Small businesses, the major creators of jobs, aren't going to do anything that uses cash because they don't know what "money grabbing/money costing" Sisyphean Load Washington will pile on their backs next.
   Maybe the Tea Partiers and their associated groups will get Washington's attention and stop the ridiculous taxing and spending spree before it is too late. The only certainties are these:
  • Unless things turn around, the U.S. will be relegated to Third World Status by the time my Grandson graduates from collage and has to go to India or China to find a job.
  • Until entrepreneurs are free to carry on business without fear of retribution from Washington, we will continue with 10% plus unemployment.
  • Without reducing the exponentially increasing size and cost of government, that’s all governments, Federal, State and Local, to somewhere under 5 % of GDP, we will continue to be a debtor nation.
   Maybe it wouldn’t be so bad. I wonder how Mexico would treat US illegals streaming into their country looking for a job?

My Take
Dave Skibowski

Sunday, August 8, 2010

Another Bailout ? ! ? ! ?

   Gonna Print More Money

   "Main Street may be about to get its own gigantic bailout. Rumors are running wild from Washington to Wall Street that the Obama administration is about to order government-controlled lenders Fannie Mae and Freddie Mac to forgive a portion of the mortgage debt of millions of Americans who owe more than what their homes are worth. An estimated 15 million U.S. mortgages - one in five - are underwater with negative equity of some $800 billion. Recall that on Christmas Eve 2009, the Treasury Department waived a $400 billion limit on financial assistance to Fannie and Freddie, pledging unlimited help. The actual vehicle for the bailout could be the Bush-era Home Affordable Refinance Program, or HARP, a sister program to Obama's loan-modification effort. HARP was just extended through June 30, 2011.    "The move, if it happens, would be a stunning political and economic bombshell, less than 100 days before a midterm election in which Democrats are currently expected to suffer massive, if not historic losses. The key date to watch is August 17, when the Treasury Department holds a much-hyped meeting on the future of Fannie and Freddie."

   Rumors are just that. But James Pethokoukis is a serious journalist with a solid pedigree and a long list of inside contacts, which you can see at the link below.

   I hope this is just a rumor. Seriously. You want to tax everyone including renters (about 35% of us) to help pay for mortgages for people who entered knowingly into a business transaction that sadly did not end well? I truly feel sorry for them. I have several very good (and responsible) friends who are in trouble, and I understand the issues. They just bought at the wrong time. But what about my investment in a start-up that failed? People who are behind on credit cards? If you bought a new car, you are underwater the moment you drive the car off the lot. Help for those? Where does it end? Hundreds of billions of debt that our children will have to pay?

   You can read the whole blog if you have adult beverages or blood-pressure medicine nearby.
http://blogs.reuters.com/james-pethokoukis/2010/08/05/an-august-surprise-from-obama/

Friday, July 30, 2010

Wealth in America was in our homes

We won't be well till we get it back

     Whose Got A Centrifuge?
   The “Fair Weather-All Is Well” prognosticators are spin, spin, spinning away like a mama orb spider in a new location. In fact, if they get much more bad news to spin into good, they may need a centrifuge. The 2nd Quarter advance GDP report came out this morning only 0.10% lower than projected. However, the revised data for earlier periods presents some real cause for alarm. 1st Quarter GDP numbers were adjusted upward a full 1%. That made the 1st Quarter look pretty good. But boy, that switched the 2nd Quarter numbers from OK to bad, if not dismal. To add to the turmoil, the 2009 GDP was dropped from a -2.4% to a 2.6% loss, the 2008 was lowered from +0.4% to unchanged, and the 2007 was dropped 0.2%. All worse than we were told.

What this means is the economy has not been growing as fast (I use that term with trepidation) as claimed, and we are not in nearly as good shape as the Administration pundits claim. I question whether even this poor news will be enough to wake up the markets, and make the “rah, Rah, RAHers” understand that until the housing market quits bouncing along on the bottom (if it is even at the bottom) and the consumers leave the sidelines and start to spend, the economy is going nowhere. We need businesses to start creating jobs, but no businessperson in there right mind would go on a hiring binge, or even think about it with a future so clouded by tax increases, healthcare uncertainties, and banks that won’t lend. Why wont the banks lend? Because they don’t know what sucker punch the administration will throw at them next.

     The Gains Are Not Sustainable
   The gains the equity markets have been enjoying have been fueled by positive corporate earnings. Problem is those earnings have been predicated on massive cost cutting by companies. They’re reducing costs and slicing R & D budgets, preparing for the draconian increase in regulatory costs that will start hitting next year. 2010 hasn’t been fun, but 2011 just may be horrendous. Even Bernanke is pushing full recovery off till 2015 or 2016

     How Long Till Recovery?
   The last two years have seen America’s wealth peeled away like the skin of an onion. The constant flow of double-talk and even lies from inside the Beltway has both businesses and the consumer confused. Wealth in America was in our homes. This fact seems to have come as a surprise to the Beltway insiders and even the geniuses on Wall Street. It is going to take several years to recover from the excesses of the past few, and the government is doing everything in it’s power to push the date of full recovery farther down the time line.

That's My Take.
Dave Skibowski

Thursday, July 29, 2010

Running through a minefield, backwards

The U.S. is upside down, but in reality, the E.U. is worse. Here is another article Via John Mauldin’s Outside the Box newsletter at InvestorsInsight.com to give you some more perspective on the worlds economy.

John's intro . . .
   Now, I offer you a very intriguing essay by those friendly guys from Bedlam Asset Management in London. They argue that Belgium's sovereign debt should be suspect, and is the country that could be a "sleeper" problem. This is a very interesting read, with a lot of history. It is not too long and very interesting. Enjoy. (www.bedlamplc.com)
   Your thinking sovereign debt is the biggest bubble of all analyst,
   John Mauldin

Farewell Flanonia?
   The last issue concentrated on sure sovereign default by Greece, Spain and Portugal - partly due to hopeless economic numbers but more because of various 'soft' issues. For, just as the numbers in a company's balance sheet theoretically provide all that is required to understand and value it, the reality is that squishy issues, such as the quality of management, staff morale or even simple luck can make a mockery of these numbers. Part I also emphasised the futility of gnawing at the bone of the de facto bankruptcy of these three countries. Backward looking investment never makes money; better surely to recognise the sovereign default cycle has further to go, and so spend time identifying the next unexpected candidate.
   On the numbers alone, the most likely casualties are the UK and US in that order, but both have good odds of escaping. Many hard issues help. In America, one such is the dollar's currently irreplaceable role as the world's reserve currency. In the UK, the relatively excellent debt duration (i.e. it is spread over many years rather than near-term) is a plus. Each also has good soft issues: the market likes the new British government's tax and slash policies so is a willing buyer of UK debt, whilst the Asian central banks have so many US bonds they simply self destruct if they refuse to keep buying.
   The standout surprise candidate for sovereign default by end-2012 is Belgium. A decent country; civilised, at peace, wealthy and globally competitive in several areas. Moreover, first glance at the numbers gives no particular reason to expect Belgium to default. Its potential financial problems have been on the radar screen for so long that we have grown used to them, rather like those many parents who fail to recognise the repulsiveness of their offspring. With net government debt of €400bn, it is hardly a huge world borrower in absolute terms. Yet default could occur almost entirely by accident and the ripples be far greater than its size warrants, because of its position as the de facto federal capital of the EU. Belgium's hastening car crash is not in current bond prices or exchange rates.
   The glue has dissolved There are five reasons why Belgium has hung together for the last 180 years: Britain, God, the King, fear and most importantly, money. Before addressing these, it is necessary to understand why Belgium exists at all. When in 1815 Britain was the Big Beluga after the battle of Waterloo, it wanted a buffer state to contain France. The easy solution was to give the area now known as Belgium to one of its staunchest allies, Holland. Unfortunately, King William I of the now-renamed United Netherlands was not, even according to Dutch history books, the smartest primate in the zoo, and he suffered from the diplomatic skills of a water buffalo. Holland (or the Kingdom of the Netherlands to give it its official name) had a long history of Calvinism. This was unpopular with the newly acquired Dutch and French Catholic subjects alike. Moreover, by deliberately ensuring the French were under-represented in all parts of government, yet overtaxed, the embers of resentment smouldered. These grew hotter in 1823 after an attempt to make Dutch the official language for the whole population. Surprisingly, full rebellion was ignited by the staging of a sentimental patriotic opera in Brussels in 1830. The crowds poured out of the theatre and went on the rampage. As Britain still wanted a buffer state, and was still the world superpower, it quickly moved to ensure the creation of a new country called Belgium, uniting Flanders and Wallonia (hence Flanonia might have been more appropriate).
   The people, having suddenly been rebranded, opted for a French king. Britain growled, ever mindful of France's latent imperial ambitions, thus a minor German duke's second son was chosen instead. After nine years' skirmishing, as Holland held onto a few strong points, and a minor invasion by France, Holland withdrew to sulk.
   The Dutch king's alienation of his many Dutch speaking but Catholic subjects in Belgium united them with their French counterparts, providing a powerful glue to hold society together well into the late twentieth century. Now, like most of Western Europe, society has rapidly turned secular. In 1967, 43% of the population attended Catholic mass every Sunday. By 1998 (the last year in which the Roman Catholic Church produced data) this was down to 11%. It is estimated to have fallen by 0.5% p.a. ever since, possibly accelerating given the latest sex-scandal investigations. (The Bishop of Bruges confessed to an unpleasant 20-year history and resigned; the police then raided and sealed off the Archbishop's palace, also the national catholic HQ on similar charges. The investigation continues.)
   In line with this trend, reverence for the monarchy has also waned, although most of the country's kings have done a good job given they have forever walked the high wire over ferocious political and linguistic divisions. Little needs to be said of the fear quotient. Belgium has suffered from three highly aggressive neighbours: Germany, France and the Netherlands. It was a popular sport for each to routinely stomp all over the area. They have all changed their ways. Leaving aside a lack of clout, the British are now wholly ignorant of how or why they created Belgium at all.
   The language chasm Belgium is a federation of three states: Flanders in the North, where Dutch (Flemish) is spoken by the native Flemings; Wallonia in the South where the official language is French; and thirdly the all-important region of Brussels. This is surrounded by Flanders although the majority of the region speaks French. The linguistic divide is well-known, but this is not of the Mandarin vs. Cantonese or Castilian vs. Catalan spat variety. It is aggressive. Ten metres either side of the official linguistic border, the other language does not exist. Municipalities can and often do insist official documents and meetings only take place in their local language. This draconian legal divide was foolishly legislated into place in 1980 and has become more intolerant every since. Belgian politics are so culturally divided that all 12 of the major parties break down on linguistic lines and cannot stand in the other language area.
   A shifting balance of power Post-independence the balance of power shifted to the French speakers. The richer Flemish Belgians were highly dependent on Holland's colonial trade and capital. Post independence, this stagnated and so they concentrated on successfully out-breeding the French over the next 150 years. Meanwhile the French speaking south boomed. The development of iron, steel, coal and heavy industry - funded by French, and to a lesser extent German, capital and supplied by the major mineral deposits nearby - put all the financial and industrial power into Walloon hands. Like their previous masters in Holland, this was gradually abused. Almost all higher education was in French; plump political posts always went to French-speakers.
   Meanwhile, the Flemish-speakers developed into a distinct but majority underclass. By the early 1970s, the wheel had again turned. Today, 75% of GDP is accounted for by the service sector as industry withers. The majority Flemings now sit in the financial chairs and have not hesitated to embark on a little light payback, such as splitting up key universities into Flemish and French speaking sections from 1968 onwards. The relative wealth of the Flemings is simply overwhelming. Their income per head is 118% of the EU average - the French-speakers 85%. Per capita productivity is 20% higher. They make up over 70% of the skilled labour force. French unemployment is twice that of the Flemish speakers.
   Per capita, subsidies for French speakers are 50% more than for the Flemish. In short, Flanders funds and props up Wallonia.
   This has not been lost on the ever chaotic voting system. Recent headlines have screamed that the independence parties have taken over. A slight exaggeration. True, the Flemish speaking, free market and pro-independence Vlaams Belang (VB) party won the most seats in the 150- member lower house, with an increase from 17 to 27 (in line with the wealth divide, the second largest party with 26 seats is the French-speaking Socialist "welfare" party). But this does not ensure separation, even though in those areas where it was allowed to stand, VB and its sympathisers won over 40% of the votes. Belgian law requires that at least four of the 12 "major" parties (seven Flemish and five French) form a government with at least one from each state. Hence, once again various caretakers are manning the desk. There is no elected government.
   The most heated and longest debates in parliament concern two issues: language superiority and the French speakers demanding, and to date getting, an ever greater and disproportionate share of the welfare pie. Up north, not surprisingly this is unpopular. The result is net government borrowing equal to 100% of GDP. Not quite as bad as Greece and a few other miscreants, but add a budget deficit of 6% of GDP and a too-high a structural deficit, and Belgium is in the top fifth of over-borrowed nations globally, a position it has steadfastly maintained for the last 30 years. It has even been worse. Throughout most of the late 1980s and 1990s net government debt averaged 114% of GDP.
   As with several Mediterranean countries, Belgium was a huge beneficiary of joining the euro (it was the first to do so) because the implicit German guarantee allowed heavy borrowing at much lower interest rates. Before joining the euro zone, general government net interest payments in 1992 absorbed a whopping 10.3% of GDP. In 2009, even after the collapse and necessary bailing out of its banks, especially the big two of Fortis and Dexia, interest payments were only 3.6%.
   Follow the money High debt and gradual linguistic separation have been a constant for 30 years. The recent elections confirm the trend of accelerating separatism. Yet these are likely to morph faster than expected into a financial problem because of Brussels.
   Much to the dislike of most politicians across Europe, Brussels is the de facto Federal Capital. A small city; and only 1.1m people live within the "Brussels region". It is wealthy, with income per head 233% above the EU average. Moreover, despite being only a tenth of the Belgian population, it accounts for over a fifth of GDP. The reasons are well-known. Since the early 1950s treaties presaging the European Union, money has poured into Brussels. The EU Commission alone employs 25,000 people, the EU parliament another 7,000. There are over 10,000 registered lobbyists and more diplomats and countries represented in Brussels than in Washington. Then there are 1,200 accredited journalists (which may explain why expenditure on expenses accounts alone was €800m in Brussels in 2009). Just for direct running costs (i.e. rentals and electricity), the EU pumps $1bn into Brussels every year. Yet this money fountain is not only the EU. 40% of the population comes from outside Belgium, as it is headquarters to a range of other organisations which have developed into an administrative cluster. The better known includes groups like NATO, where Brussels is the European HQ with 5,000 employees. The range includes the weird, such as the heavily funded, big employing World Customs Organisation or EURATOM.
   All these foreigners, usually funded by their overseas governments, are amongst the very highest earners in Europe, creating a major multiplier effect on schools, restaurants, cleaners, auto sales or house building. Originally majority Flemish-speaking, now most locally born Brussels residents speak French, the result of policies introduced when they were at the top of the economic tree. Yet Flemings - residents and commuters - still dominate the better paid and skilled jobs, hence Brussels is the only part of Belgium where both languages must co-exist by law. Some local French speaking politicians have been muttering darkly about doing to Flanders what Flanders wants to do to Wallonia, i.e. spin out of Flanders or even Belgium itself. This is because the money spigot is about to jam.
   Turning off the taps As the third richest region in Europe (after Luxembourg and London) it could in theory exist as a wealthy city-state cum federal capital, but such a dream is a chimera. Derided eurocrats live a life apart. Even Brussels-born residents who benefit from their largesse often complain that the many organisations have created rich ghettos from which they are excluded. That these eurocrats are out of touch has been demonstrated both by pay and expenses enough to make a third world dictator blink, and recent demands for pay rises.
   There is a commonsense test to apply to the financial future of Brussels. Most European countries are net recipients of aid from the EU. Of the minority putting money in, Germany dominates. Other small contributors such as Scandinavia or the UK are co-joined triplets with Germany. Forced to slash their own capital, social, and welfare budgets following the financial crash, they will not put more into Brussels. It is a matter of time before each country decides to reduce its net or gross cheques written out to various Brussels organisations; hence the second most important engine of Belgium's economy (after the wider economy of Flanders) suffers its first ever post-war squeeze. This means it has less largesse to spread around - particularly in Wallonia
   Moreover, Brussels is no longer so logical a geographic centre for a federal capital since the EU expanded eastwards. This has not been lost on the Germans (Brussels' most significant honey provider). Its press and politicians have suggested for example that NATO be moved from a largely neutral country with minimal military capability to one with a little more vim, such as Germany. France would murder to get its hands on more EU institutions. Even the UK, ever-equivocal about what it really wants form the EU, and outside the euro zone, would like a few pointless but foreign funded pork barrels like EURATOM. Such major political changes will take time. Turning off the money spigot is easier and will happen sooner.
   How it plays out? What is evolving in Belgium is old news. The problem now, as for divorcing couples, is how to divide up the assets, or more precisely in Belgium's case, its sovereign debt. It is noteworthy that the government is chary in producing full data on how much Brussels and Flanders subsidise the minority Walloons, but roughly speaking the national debt should probably be split about 35:65 Dutch:French. Yet relatively poor Wallonia simply could not service nearly €260bn of national debt (€175,000 per person in employment). Meanwhile, wealthy Flanders would emerge with a budget surplus, a minute structural deficit and debt to GDP the lower than any EU nation outside of Scandinavia. The imperative for Flanders, along with the scope for argument, is clear.
   There is a growing risk of a faster than expected dissolution of Belgium which will result in sovereign default; this is based on a belief in the inability of the individual nations within the euro zone, let alone the EU institutions themselves, to realise that as nations unravel, speed is of the essence. To repeat, the net €400bn national debt is chicken feed - less than half the loss racked up by America's AIG in 2007-8. And in wealthier times, the dream then shared by most of its members, of a politically united Europe would have ensured a quick bailout led by Germany. Mrs Merkel has already discovered that small cash subsidies to the profligate, such as Greece, are very expensive electorally. So foot dragging and evasion are sure to be the political order of the day. As the divorce commences, little is gained in double guessing the next phase. Whether Flanders goes alone as a fabulously rich small state or joins up with Holland (now the religious issue is moribund) is a moot point. Equally, whether France chooses to absorb Wallonia into greater France (Sarkozy's wild card to escape likely electoral defenestration?) or to subsidise Wallonia as a client state again, is also an unknown. On every topic, there is no agreement on how these regions should evolve, nor who is responsible for the debts, further ensuring delay.
   Investment conclusions If markets have re-learned one lesson recently, it is that small events have disproportionate results. Belgium ranks as the world's 20th economy by size, accounting for 0.8% of world GDP. Greece before the fall was No. 28, with 0.6%; its problems continue to shake markets, both because they were unexpected and because of the risk of a domino effect. So too would be the problem with Belgium. It is yet another reason why government bonds are toxic and why at some stage their yields will blow out, thus capital values fall.
   Obviously, not holding Belgian shares on a medium term basis is sensible unless valuation work has fully taken account of these unexpected risks (clients have zero exposure). Once again the euro would fall and the German export machine boom. Equity markets would rattle around for a while but then absorb the key lesson. For Belgium is yet another example, as if one was needed, that the supply of government bonds over coming years will continue to soar to unprecedented levels even. All commodity prices tumble when the supply is perceived as infinite. Meanwhile, equities would benefit.


      Regards 
      Bedlam Asset Management plc