Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q4 '05

The Great Debate: Debt Bubble vs This Time is Different

The great debate ongoing in financial circles is this:

On the one hand we have the traditionalists, the real conservatives (not to be confused with Republicans), libertarians and those who generally think that virtue is a desirable pursuit; who say that we have been living beyond our means for far too long; that a debt incurred must and will be paid one way or another, and that we are sooner or later going to have a day of reckoning. The basic position here is that if you create a debt, you must take responsibility for that debt; that our fiscal and monetary policies have been wildly irresponsible if not downright fraudulent; that the mountain of debt we have created is unsustainable and will inevitably cause us great pain, and that we are impoverishing our children and grandchildren in our “live for today” orgy of consumption. (For more detailed information on this position see the Grandfather Economic Report.) This is a pretty simple, straightforward, common sense position. That is its strength, but in the age of spin, that is also its weakness.

On the other hand we have the market cheerleaders and government officials, and an army of paid publicists and pundits who claim that this time is different; that “deficits don’t matter;” that we can continue to run up debt with no horizon in sight, and that we are doing the rest of the countries of the world a favor by borrowing their savings in order to consume their products so they can keep growing their economies. The debt, we are told, will be worked off by “growth,” and unofficially, by devaluation of the dollar. And this will work because we are more intelligent, creative and industrious than the rest of the world, and also conveniently because our dollar is the world’s reserve currency and everyone has to have dollars, so the world will continue to buy them, like it or not. The economic and moral consequences of the fact that we are creating a mountain of debt that we have no intention of repaying are ignored. This position is complex, consisting mainly of clever arguments that in the end amount to “this time is different” and “we can have our free lunch and eat it too.”

In the interest of full disclosure, if it’s not already apparent, I am in the former camp. It is my contention that virtue is not out of style, that the laws of nature have not been repealed and that we will indeed have a day of reckoning.

The primary operating principle of natural law is balance. Natural events and processes swing from one extreme to the opposite within a band of dynamic equilibrium. These extremes, by the way, are not “inefficiencies.” They are the natural rhythms and cycles evident in all natural processes. The meandering path of a river, for example, is not inefficient. It is a natural path, appropriate, responding to and balancing all influences seen and unseen in its sphere of passage. Whether rivers or markets, as any natural phenomenon progresses through time, it moves periodically toward one extreme or another and imbalance is created. Opposing forces manifest to bring that phenomenon back into balance. This is an entirely natural process. It can be observed in all natural phenomena, in markets and in the aggregate of markets, the economy.

If the natural corrective or balancing process of any natural phenomenon is impeded for a long time, eventually the unresolved backlog is balanced all at once in a catastrophic event. The Yellowstone fire of 1988 and the Midwest floods of 1993 are good examples. Our fiscal and monetary policies have worked to prevent recession for decades in just the same way the forest service worked to prevent forest fires and the Army Corps of Engineers dammed the rivers to prevent flooding. The end result of all of these interferences with natural law are, have been and always will be the same – disaster.

There is a corollary to the law of balance, which we can call the reality of personal affinity. The gist of this corollary is that nature, in this case the marketplace, seems to know each one of us individually. Any trader can tell you that it is uncanny how the market seems to know what they are doing…personally! This is felt most acutely when the trader puts himself in a vulnerable position, i.e. does something stupid. Hence the trader’s prayer, “Lord, please let me get out of this trade whole, and I promise I’ll never do it again.” The market is a harsh master, however, and usually the price for indiscretion is pain.

There is no question that America has put itself in a vulnerable position. With our fiscal and monetary policies working for decades to block the natural cleansing and balancing effects of recession, we have created an extreme imbalance. Like a drug addict desperate to avoid the inevitable, we have spent our savings and gone deep into debt, and are currently increasing our debt by record amounts each month. We are dependent on foreigners to continue buying our debt in order to put off the need to bring our spending into balance. We are taking the position that “if I owe you a thousand dollars, that is my problem, but if I owe you a million, it is your problem.” If the world stops buying our debt, then we can no longer afford to buy the world’s products and everyone will suffer. Our position is the economic equivalent of the cold war nuclear strategy called MAD, or mutually assured destruction. MAD worked in our nuclear standoff with the Soviet Union, but just barely. However, the specter of economic calamity does not have quite the same restraining power as the specter of literal annihilation. MAD as an economic strategy is a riverboat gambler’s strategy.

John Mauldin recently ran a series of his free weekly newsletter, Thoughts From the Frontline, devoted to this debate. If you are not already a subscriber I suggest that you sign up. Mauldin does a great job of keeping his readers of informed of the major economic issues, developments and publications. His series on this topic begins with the 11/11/05 issue entitled “It’s Different This Time.” Mauldin has staked out a position he calls “muddle through” which essentially states that we are in a secular bear market and, yes we have major imbalances which are inevitably going to balance themselves in the coming years, but that we will manage to work our way through this rebalancing in an orderly, albeit not necessarily painless manner, without a depression and without economic chaos. Let’s hope he’s right.

Mauldin frames his series around two books that take opposite sides of the argument: Empire of Debt; The Rise of an Epic Financial Crisis by Bill Bonner, CEO of Agora Inc. and Addison Wiggin, publisher of the Daily Reckoning, the title of which gives away their position, and Our Brave New World by Charles and Louis-Vincent Gave and Anatole Kaletsky of GaveKal Research, which takes the position that “this time is different.”

I took the time to read these two books, and they are both highly recommended. In fact, for any serious investor or individual professionally or otherwise concerned about our economic future, these books should be considered required reading.

The GaveKal gang begin their work by acknowledging that “anyone who has spent ten minutes on a trading floor knows that saying ‘things are different this time’ is: 1) the easiest way to get laughed out of a room, 2) the most expensive words ever pronounced, 3) the surest way to lose any credibility…” and that in “arguing that ‘things are different this time,’ we freely admit that we might end up making the wrong conclusions, say silly things and establish relationships where there are none.” Then they spend the rest of their book arguing that this time is different.

The foundation of their argument is that we have entered into a “third wave” post-industrial information based society as described by Alvin Toffler. An essential part of the third wave economy as they see it is the “platform company,” multinationals like Dell Computer and Reebok that outsource their manufacturing to the lowest bidders world wide and keep the fat margin design and marketing for themselves. “The new business model is to produce nowhere, but sell everywhere.” This allows the platform companies to continuously make big profits by adapting quickly to changing conditions, seizing new opportunities as they arise and avoiding getting trapped in non-productive markets.

The platform company business model is dependent on four main elements; free trade, technological progress, recurrent overcapacity in most industries, and the ability to move goods around without difficulty. The problem with this model is that it takes about two seconds to recognize that at least two and maybe all of these elements are dependent on global political stability, avoidance of protectionism, and the probability that the rest of the world is going to allow these platform companies to eat their lunch forever. Already the third world is up in arms over what they see as unfair practices by the advanced nations and their proxies, the platform companies. For the first time, the latest round at the WTO was unable to achieve its agenda because the third world countries consolidated in protest. Even in the U.S., protectionist sentiment is quick to rise whenever economic adversity threatens.

The GaveKal “Brave New World” as they aptly name it comes down to a global economy in which the rich nations continue to get richer by dominating the fat margin design and marketing of products and services while outsourcing the capital intensive low margin, high risk manufacturing to the lowest bidders among the low wage countries. In this model the rich will continue to spend more than they earn and finance their consumption with savings from the poor, and rich country real estate will continue to appreciate because the poor will have no safe place to invest their savings but in the stable rich countries.

“One of the major characteristics of the new cycle…is that ‘those who have, get more’…the poor get richer through falling prices, low interest rates and rising disposable income. The rich get insanely rich by capturing entire markets where the marginal cost of production is zero…Income disparities then grow, but the overall society prospers.”

This will work out for two reasons, they say. First, because our fat margins are allowing us to accumulate wealth faster than we are incurring debt even with the massive trade deficits…“The so-called ‘US debt to the outside world’ can easily be repaid by the sale of US assets to foreigners…As long as the US has assets to sell, then there will be no reason to worry.” Please read those statements again. If this is the basis of our “third wave” global economy then I confess…I’m worried!

Second, the growing debt in the Western world is not a problem, they say, because we have outsourced the volatile high risk part of economy to the poor countries, so our jobs and our balance sheets are more stable and can therefore justify more debt, both at the collective and individual levels!!! “Given the joint collapse in the volatility of the US economy and of US employment…why shouldn’t the US consumer borrow more and consume today instead of tomorrow?” Yes, go ahead. Read that one again, too.

The problem with the first argument is that it is depraved. The problem with the second argument, aside from its moral turpitude, is that it can be likened to the Long Term Capital approach to leverage, and we all know how that worked out.

The bottom line remains always that more debt equals more risk, and the difference between manageable debt and excessive debt is the difference between crisis and catastrophe when something unexpected happens…and something unexpected always happens eventually. Yes, less volatility means you can handle more debt, but what happens if you have exceeded any prudent measure of debt, and suddenly volatility returns from some unexpected source? You’re screwed, that’s what.

You have to give the GaveKal guys credit. They are smart; perhaps too smart for their own good. Their logic is excellent and their arguments elegant. But like many very smart people they tend to get too caught up in their own high flying brilliance and overlook the basics.

Empire of Debt takes the other side of the argument. Rather than focus on the trees of economic minutia and spinning clever arguments for the status quo, Bonner and Evans expose the forest of moral decay, consumption addiction and hubris that have allowed our republic to morph into an empire, and note with considerable historical references the certainty of the end path of empire.

A unique element of the American empire is that we finance our empire through debt. We borrow from our vassal states and from our enemies alike, unlike previous empires. Rome, for example, levied a 10% tax on its vassal states. We instead tax ourselves, a punishing 50% plus all-in, and borrow from everyone else.

A large part of the volume is spent looking at the history and characteristics of empires and empire builders past from a libertarian viewpoint, which is to point out the follies and delusions of same, and to generally debunk the claimed benefits of empires. Also, considerable space is dedicated to the history of the transformation of the American Republic created in 1776 to the American Empire of today and to the coincident development of militarism and bloated bureaucracy. Included is a fascinating history of Ho Chi Minh, the French, and the blind imperial militarism that drew us into Vietnam, including a detailed and rather disturbing play by play of the development of U.S. strategy there.

Most of the book is spent revealing a picture of imperialism -- the thinking and actions of an imperial people. The purpose of this history of imperialism is to lay the groundwork for understanding how and why Americans today believe the absurdities that they do, including:

  • That you can get something for nothing;
  • That we can spend more than we earn forever;
  • That domestic savings and capital investment are no longer necessary;
  • That house prices will go up forever;
  • That the virtues that made America rich and powerful are no longer required to keep it rich and powerful;
  • That the rest of the world will continue to take American IOU’s forever;
  • That “deficits don’t matter;”
  • That the rest of the world wants to be more like America, even if it is forced on them;
  • That America has the most dynamic economy in the world; and
  • That Americans are more intelligent and more creative than the rest of the world.

Bonner and Evans make numerous interesting high level observations including that people come to believe what they need to believe when they need to believe it. “America is an empire; its people must think like imperialists…An imperial people must believe that they deserve to be the imperial power…that their own culture, society, economy, political system, or they themselves are superior to others. It is a vain conceit, but it is so bright and so big it exercises a kind of gravitational pull over the entire society. Soon it has set in motion a whole system of shiny vanities and illusions as distant from the truth as Pluto and as bizarre as Saturn. Americans believe they can get rich by spending someone else’s money. They believe that foreign countries actually want to be invaded and taken over. They believe that they can run up debt forever, and that their debt laden houses are as good as money in the bank.”

The fiscal status of the U.S. is painfully detailed, including the following items.

  • The total value of all assets in America is approximately $50 trillion.
  • Current U.S. debt is 37 trillion.
  • Unpaid liabilities and obligations equal $44 trillion.
  • Add those numbers and we are bankrupt.
  • America pays the direct cost of empire; military budget (over half the global expenditure) and trade deficit combined equal 10% of GDP.
  • Debt service is another 5% of GDP.
  • In 1950 approximately 5% of US government debt was in foreign hands; today that number is close to 50%
  • When Ronald Reagan entered the White House foreign owned US assets were less than 15% of GDP; today they’re over 78% and growing.
  • A dollar from 100 years ago is now worth approximately 4 cents.
  • A dollar from 20 years ago is now worth approximately 50 cents (my addition).
  • The mean value of paper currency is zero, and that is the value to which all paper currencies past have gone, and to which the dollar will eventually go.

The most important part of this book in my opinion is the last chapter, “Subversive Investing,” which begins with a quote from Uncle Remus, “Dere’s dem dat’s smart, an dere’s dem dat’s good,” which is the perfect frame for this debate. The key to this chapter is virtue, something held to be of great value by Americans in generations past and sadly forgotten in public life today. The most important virtue in relation to markets is humility. One can never know what is going to happen tomorrow, let alone next week, month or year, and one can never know whether a given action is going to produce a desirable result. What one can do is humbly rely on the accumulated wisdom of those who have gone before us, learn the lessons of history, stick with the tried and true. In the case of markets we strive to buy cheap and sell dear, and above all to be very cautious in the use of debt and leverage. As for the bigger picture, the economy, it is the failure to humbly heed the wisdom of generations past that has led us to our current situation wherein we have squandered our wealth, become the world’s greatest debtor and have taken to squeezing the poor countries of the world for their savings in order to put off the inevitable in our own society.

In summary, the GaveKal viewpoint is a reflection of the tendency of our economic elite to make economic efficiency the arbiter of the moral and the good. It is the hubris of an epic market top in my opinion, and the failure of the entire argument rests on the practical consequences of this point. However this book is a valuable read. The authors frame numerous issues with great clarity and put forth some interesting ideas that merit further thought and debate. Interestingly enough, one of the final notes of Our Brave New World is a lamentation of the takeover of the money management business by risk managers and accountants, a development that is sure to have long term negative consequences…a sentiment I am certain they share with the authors of Empire of Debt.

But if you only read one book this year, it should be Empire of Debt. I see that it has found its way onto the NY Times bestseller list, and rightly so. This book is grounded in wisdom. It is important for everyone to have a clear perspective on where we stand in historical terms, and it is all too easy to become transfixed by the relentless onslaught of data and spin and to lose perspective. Bonner and Evans do a good job of presenting the long view of where we stand and they do this with great humor, which makes for an enjoyable read.

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