Warning: This Could Be the Start of a Global Banking Crisis

By Justin Spittler

Europe’s banking system is collapsing. Over the past year, shares of Deutsche Bank (DB), Germany’s biggest bank, have plunged 56%. Swiss banking giant Credit Suisse (CS) is down 62% over the same period. Yesterday, both stocks hit record lows.

Dozens of other European bank stocks have also crashed. The Euro STOXX Banks, which tracks 48 of Europe’s largest banks, is down 48% over the past year. This is a major issue. That's because banks are the cornerstone of the financial system. They keep money flowing through the economy. If they’re struggling, it often means the economy is having major problems. Right now, European banks are flashing bright warning signs. That’s not just bad news for Europe—it’s also a serious threat to the rest of the world.

In today’s Dispatch, we’ll show you why Europe’s banking crisis could turn into a global banking crisis. You’ll also learn how to transform this threat into a chance to make big gains.

European banks are struggling to make money..…
Spanish banking giant BBVA’s (BBVA) profits fell 54% last quarter. First quarter profits at Deutsche Bank were down 58%. Swiss bank UBS’s (UBS) profits plunged 64%. European banks are hurting for a couple reasons. One, Europe is growing at the slowest pace in decades. Banks are making fewer loans as a result.

Two, negative interest rates are eating European banks alive. If you’ve been reading the Dispatch, you know negative rates are the latest radical government policy. They basically flip your bank account upside down. Instead of earning interest for keeping money in the bank, you pay the bank to hold your money.

Negative rates are clearly bad for savers. They’re also hurting Europe's biggest banks. That’s because these huge institutions have to pay their “bank,” the European Central Bank (ECB). Today, European banks pay £4 for every £1,000 they store at the ECB for a year. That might not sound like a lot. But it adds up quick when you manage trillions of euros like these banks do.

Last week, investors got another reason to avoid European banks..…
On Thursday, Great Britain voted to leave the European Union (EU), which it’s been in since 1973.
The “Brexit,” as the media is calling it, blindsided investors. As we explained yesterday, the market was expecting Great Britain to stay in EU. The unexpected outcome triggered a global stock market crash.

U.S. stocks had their worst day since August. Japanese stocks had their worst day in five years. European stocks had their biggest decline since the 2008 financial crisis. Friday’s global selloff erased $2.1 trillion in value from global stocks. It was the global stock market’s worst day in history. The panic didn’t die down much over the weekend. By the end of Monday, another $930 billion had disappeared from the global stock market.

European bank stocks were hit the hardest..…
Deutsche Bank plunged 22% between Friday and Monday. Credit Suisse fell 23%. UBS fell 20%. Barclays (BCS) and Royal Bank of Scotland (RBS) each plunged 37%. Both stocks are down more than 57% over the past year. These are gigantic moves in a matter of days. Remember, we’re not talking about small biotech stocks. These are some of the most important financial institutions on the planet.

Government officials are scrambling to contain the crisis..…
Today, the Bank of England (BoE) injected £3.1 billion into Britain’s banking system. It’s pledged to inject as much as £250 billion to stabilize its financial system. The BoE made its cash injection hours after the Bank of Japan (BOJ) pumped $1.5 billion into its banking system. As we'll show you in a second, we don't believe this will end well. That's because this excessive money printing (sometimes called "quantitative easing") doesn't stimulate the economy like governments intend it to.

Credit Suisse says other central banks could soon print more money too. Bloomberg Business reported on Friday:

“Market liquidity and overall liquidity in the U.K. is drying up as we speak in a very rapid way,” said John Woods, chief investment officer for Asia-Pacific at Credit Suisse Private Banking, told Bloomberg TV in Hong Kong. “It’s highly likely that we see monetary easing in a coordinated response” from central banks across the world, he said.

Great Britain is headed for a recession..…
A recession is when an economy shrinks two quarters in a row. Goldman Sachs (GS) says Britain could be in a recession by early 2017. But here’s the thing. We don’t think the BoE will let this happen. That’s because central bankers will do anything, including using reckless, unproven monetary policies, to avoid a recession these days.

Credit rating agency Standard & Poor’s agrees with us. Reuters reported today:

"Brexit is likely to represent a drag of about 1.2 percent of GDP for the UK in 2017," Jean-Michel Six, S&P's chief economist for Europe, the Middle East and Africa told a conference call for investors on Tuesday. "We have a significant slowdown but growth remains positive although obviously in a much more disappointing way. That is because we anticipate a very strong monetary response on the part of the Bank of England, in the form of additional quantitative easing, in the form of a further cut in interest rates," he added.

Bank of America (BAC) and Deutsche Bank also expect the BoE to fire up the printing press again. Bank of America says it could happen as soon as August.

QE won’t help Great Britain’s economy..…
As we told you above, QE doesn’t work. As regular readers know, the Federal Reserve pumped $3.5 trillion into the U.S financial system after the 2008 financial crisis. This massive money printing effort was supposed to juice the economy. But the U.S. is growing at its slowest pace since World War II. QE also failed to jumpstart Japan’s economy, which hasn’t grown in two decades. There’s no reason to think it will work this time.

If you’re nervous about the global financial system, we encourage you to take action today.…
The first thing you should do is own physical gold. Gold is real money. It’s held its value for thousands of years because it has a unique set of attributes: It’s easy to transport, easily divisible, and durable. You can take a gold coin anywhere in the world and folks will immediately recognize its value.

Unlike paper money, central bankers cannot create gold from nothing. It’s the ultimate antidote to crumbling paper currencies. That’s why the price of gold often soars when governments print money. This year, gold is up 24%. It’s trading at the highest price in two years. But it could go much higher as governments continue to run reckless monetary experiments.

If you want big profits from rising gold prices, own gold stocks..…
Dispatch readers know gold miners are leveraged to the price of gold. A small jump in the price of gold can cause gold stocks to surge. Gold’s 24% jump this year has caused GDX, a fund that tracks large gold stocks, to soar 96%. We believe this gold stock rally is just getting started. During the 2000 and 2003 gold bull market, the average gold stock gained 602%. The best ones soared 1,000% or more.

Nick Giambruno, editor of Crisis Investing, has recommended two gold stocks this year..…
He already closed out one of them for a quick double. It surged 103% in 14 months. Nick’s other gold stock is up 30% since March and is still dirt cheap at today's levels. Nick currently rates this stock a "Buy"…and says it could soon start paying a double digit dividend yield if gold keeps rising.

You can learn more about Nick’s gold stock by taking advantage of our special 60%-off sale for Crisis Investing. If you sign up today, you’ll be enrolled in a trial membership, which gives you 90 days risk-free to decide if the service is for you. But we encourage you to act soon. This special offer ends soon, and we likely won’t open this offer again for a long time.

You can learn more about this incredible offer by watching this video presentation. You’ll also learn about an even bigger threat to your wealth than Europe’s banking crisis. As you’ll see, almost no one is talking about this coming crisis. Yet, it could cause millions of Americans to lose their entire life savings. By the end of this video, you’ll know how to protect yourself. And just as importantly, you’ll know how to profit from this coming crisis. Click here to watch this free video.

Chart of the Day

U.S. bank stocks are also headed lower. Today’s chart shows the performance of the Financial Select Sector SPDR ETF (XLF) over the past year. XLF holds 94 major U.S. financial companies including behemoths JPMorgan Chase (JPM), Wells Fargo (WFC), and Bank of America (BAC). You can see XLF is down 11% since last June. While that's not as severe as the near 50% drop in European banks over the same period, it's still a clear sign to stay away.

U.S. banks have many of the same problems as European banks. Like Europe, the U.S. economy is growing at the slowest pace in decades. And while the U.S. economy doesn’t have negative rates yet, Fed Chair Janet Yellen has said they aren’t “off the table” if the U.S. economy runs into trouble. The arrival of negative rates to the U.S. could tip bank stocks into a crisis, just like they have in Europe.

The article Warning: This Could Be the Start of a Global Banking Crisis was originally published at caseyresearch.com.

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How Negative Interest Rates Will Turbocharge the Migrant Crisis

By Nick Giambruno

In the 1989 Batman movie, the Joker (played by Jack Nicholson) showers a crowded Gotham street with free money. In the scene, it looks like it’s raining hundred dollar bills. The people love it. Little do they know, the money is actually a trap. Once the Joker has lured them into the street, he unleashes poisonous gas.

I think the latest gimmick to stimulate the economy is pretty much the same thing. It’s one of the most absurd ideas I’ve heard in a while. And that’s saying something, considering the outrageous schemes our economic luminaries have recently come up with, like..…

• Faking a space alien invasion to help stimulate the economy.
• Minting a trillion dollar coin.
• Negative interest rates.
• Banning physical cash.
• Cash for clunkers.
• Increasing rounds of money printing, euphemistically called “quantitative easing.”

These ideas would be comical if people in power didn’t actually take them seriously. But they do. It’s the same bad medicine the economic witch doctors have been prescribing for years. With a track record like this, it’s hard to imagine they could come up with something even more ridiculous. But they have. This latest gimmick goes well beyond the absurdity of their previous ideas. It’s verifiably insane. And the scariest part is, this dangerous idea is gaining currency. It’s spreading across the world like a smallpox outbreak.

Helicopter Money

Politicians and establishment economists call this scary idea “a basic income.” I call it sheer lunacy. It’s where the government gives you money just because. There’s no requirement to work or even display a willingness to work. You could sit at home all day, watch TV, and still get a check from the government. Simply put, a basic income is “free” money the government hands out to everyone unconditionally. European politicians are heavily pushing this policy.

• Finland wants to pay its citizens around $1,000 a month.
• The Netherlands and the U.K. have also proposed dishing out free money.
• In Switzerland, there’s a proposal to hand out around $2,800 a month to everyone. This one is surprising since the Swiss are generally sensible about money.
• The basic income virus has also infected Canada, which recently announced a pilot program in Ontario.

It’s just a matter of time before the idea gains traction in the U.S. In fact, U.S. central economic planners are already discussing it. You might recall former Fed chair Ben Bernanke’s nickname, “Helicopter Ben.” He got the name after he spoke publicly about using helicopter drops of money to “stimulate” the economy. This is just another flavor of a basic income.

Whether you call it free money, a basic income, or helicopter money, the idea is spreading. It’s the next potion the economic witch doctors will use once their latest scam—negative interest rates—not only fails to cure our economic ailments, but predictably makes them worse. No matter, the idea will be politically popular. Who would protest free money?

And, once a country adopts a basic income, it would be next to impossible to get rid of it until the system collapses under its own weight. Who would vote for a politician that stops (or even slows down) the gravy train? The Joker used free money to lure the people of Gotham to poisonous gas. Now real world politicians are using the same trick. They’re using free money to lure the masses into perpetual dependence on government.

More Problems Ahead for Europe

If Europeans think they have a migrant problem now, just wait until they institute a basic income. It’s obvious what will happen….Once European governments start handing every person thousands of dollars in free money each month (more than many in Africa make in a year), everyone will be scrambling for Europe.

A basic income is a sure recipe for economic disaster and increased cultural tensions. It’s an environment where blowhards and demagogues flourish. Unfortunately, this has happened repeatedly throughout Europe’s history. Once again, it’s going to lead to some very bad things.

I think a basic income will greatly accelerate this recurring trend.

Without a basic income and other welfare benefits, immigrants are usually skilled and the very best of people. But the average European will surely forget that once free money draws in the world’s riffraff. This is why, although the financial effects will be severe, the sociopolitical ones will be much worse.

Here’s the bottom line: All you can do is protect yourself from the consequences of all this stupidity. This is a big reason why I think everyone should own some gold. Gold is the ultimate form of wealth insurance. It’s preserved wealth for thousands of years through every kind of crisis imaginable. It will preserve wealth during the next crisis, too.

Unfortunately, most people have no idea how to prepare for the next economic collapse…..

How will you protect your savings in the event of a crisis? This just released video will show you exactly how. Click here to watch it now.

The article How Negative Interest Rates Will Turbocharge the Migrant Crisis was originally published at caseyresearch.com.

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Muddling Through Shanghai

By John Mauldin

“He who knows when he can fight and when he cannot, will be victorious.”

– Sun Tzu

A couple of weeks ago I was complaining about 47,000 China reports clogging my email. The number now feels like it is well into six figures (perhaps a slight exaggeration). Maybe my memory is going, but there wasn’t nearly as much China talk on the way up. Funny how that works.

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Is China collapsing? I think parts of China are under severe pressure if not outright recession, and clearly the stock market is a disaster. Anyone who bought Shanghai or Shenzhen stocks on margin this year is probably on the brink.

That said, China itself is not collapsing. There are parts of China that are doing just fine, thank you very much. It does have serious problems, though. The Pollyannas and the Cassandras are both wrong. The change in tone in the Financial Times is quite amusing. Their recent hyperbolic, bearish section called “China Tremors” is a case in point. Of the last 30 articles on China on their website, I found less than a handful that were positive on China. My take? China will muddle through, at least for the near term.

China is in transition, a transition that was clearly telegraphed if you have been paying attention. Our recent book on China (A Great Leap Forward?) clearly laid out this new path. Today we are going to talk about this precarious, difficult transition, which may impose profound impacts on much of the rest of the world. This transition is going to change the way global trade has worked in the past. There will be winners and losers.
But first, a brief comment on today’s employment report and how it impacts the need for a rate hike by the Federal Reserve in September. I offer a little different perspective on the coming decision.

To Hike or Not To Hike – That Is the Question

Today’s unemployment report was lackluster, as has been the case for the initial reporting for the last two Augusts. Both were revised significantly upward – August 2012 was eventually revised up 96,000 jobs, while August 2013 saw a final revision upward of 69,000 jobs, and August 2014 saw a final count of +213,000 jobs. Part of the reason for the major revisions is that only some 70% of the potential survey participants actually responded (hat tip Joan McCullough).

Evidently the United States is becoming like Europe, and we are all going on vacation in August. Or at least the department personnel responsible for handling employment figures are. Expect to see significant upward revisions in the coming months, just as July saw another 30,000 added and June saw a plus 14,000.

This report was not so ugly that it would take the breath away from hawks wanting to raise rates or force doves into agreeing to a rate increase. Nothing changed, really. That is illustrated by the two articles below that were side-by-side on the New York Times website within an hour of the release of the report (hat tip Brent Donnelly). Everybody got to see what they wanted to see.

I can’t remember a time when there was such serious disagreement over what the Federal Reserve should do regarding a rate hike. I have been in several groups of analysts and economists in the last few months, and I must confess to being surprised at the split in opinions.

Upon reflection, I think I can actually understand both positions. First, the Fed keeps reiterating that they are “data dependent” – thus the focus on every little bit of data, no matter how trivial. Let me see if I can explain why both sides can feel they are right and then why, to my way of thinking, they are missing the point.

On the side of those who feel that a rate hike should be postponed at the September meeting, it must be remembered that most rate hikes are in anticipation of an economy beginning to pick up speed. The Fed has said they want to see low unemployment, and under the leadership of Bernanke and now Yellen, they have a 2% inflation target. Remember, their congressional mandate is to promote stable prices and full employment.

While unemployment did drop to 5.1%, that is a “soft” unemployment figure. The participation rate is down. The number of part time workers wanting full time jobs is still high. And the new employment trend is not encouraging.

August's gains were well below trend. The average of the previous five months is 211,000; for the previous six before that it was 282,000. The yearly employment gain, 2.1%, is off 0.2 point from the late 2014/early 2015 rate. The private sector gain is 60,000 below the average of the previous six months. (The Liscio Report)

We are not close to 2% inflation; and, frankly, it doesn’t look like we’re going to get there for a while. The economy is, at best, stuck in a low, Muddle Through gear (as I predicted years ago); and getting back to a stable 3% growth rate, let alone the occasional 4–5% that we used to see, seems out of reach. The dollar is strong and getting stronger and is not only holding down inflation but also, anecdotal evidence suggests, slowing down exports in various sectors of the economy.

There were those who argued that a bubble was developing in the stock market, but it appears the stock market is taking care of itself to make sure it doesn’t become overheated. There is no need to pile on to see if we can drive asset prices even lower. Further, we are just in the beginning of a housing recovery. Why raise mortgage rates, etc., at the beginning?

In such an environment, why would you raise rates in order to keep the economy from overheating? The last thing we seem to be doing is overheating, let alone even getting to a slow boil. Instead, we may already be cooling down. If the economy does start to pick up and inflation becomes an issue, we could raise rates then as fast as we would need to. Or so Kocherlakota and his friends on the FOMC say. And thus we should postpone a rate increase until we see a reason for it. Kind of like, don’t shoot till you see the whites of their eyes.

Those who think we should raise rates likewise have an array of data to support their case. GDP grew 3.7% in the second quarter. If you take out the weather related first quarter 2015 GDP figure, GDP growth is running well over 3%. Given the global headwinds currently buffeting economies, that’s about as good as it’s going to get.

This economy has weathered tax increases and the abrupt changes of Obamacare, as well as a significant drop in capital spending related to oil production and has “kept on ticking.” If there is a recession in our near future, as David Rosenberg points out, it would be the first recession ever that did not see consumer spending or employment go down for the count.

We’ve always been able to find negatives in the unemployment rate. Even if unemployment were somehow to ratchet down to less than 200,000 per month, it will be for only two quarters at the most; and it may be that before the end of the year we will be under 5% unemployment. We just set a record for all measures of corporate profits in absolute terms. We finally set a new record for real disposable personal income in July, again in absolute terms. As Jim Smith says,

What all this means is that when the FOMC meets on September 16 and 17, they will be looking at a US economy in which more people are employed than ever before, earning more money than ever before, producing more goods and services than ever before, and with personal consumption expenditures and corporate profits at the highest levels ever seen. If that is not a prescription for finally raising the Fed Funds rate, then I can't imagine what it would take to get them to move. (source)

Despite the significant slowdown in the oil patch, the level of investment in the second quarter was almost 4% higher than last year. Businesses are optimistic. Even given the turmoil in Canada, China, the Eurozone, and the rest of the BRICS, and even though global trade is beginning to fall off a little bit, the US economy seems to be doing quite well in spite of it all.

What else do you need in order to begin to normalize rates? Inflation is under control and according to most Fed economists seems to be ticking higher. Unemployment is moving lower. The economy is doing quite well. If not now, when? How much better do you want things to get before rates are taken back to something close to normal?

I must confess that I personally lean toward the latter argument, but I have a few additional reasons for thinking the Federal Reserve should act in September. As I have presented in previous letters, there are real reasons to think that low interest rates are not only creating malinvestment but also encouraging companies to use financial engineering and to buy their competition rather than purchasing the tools of production and actually competing head on. These behaviors distort an economy over the long term. They frustrate Schumpeter’s forces of creative destruction.

Further, what policy tools does the Federal Reserve still have available if we enter a recession? I admit that doesn’t seem to be a likely possibility today, but there are many potentials for exogenous shocks to the US economy that could cause a recession. Further, in the history of the United States we have never had a period longer than nine years without a recession. This recovery, relatively weak though it is, is getting long in the tooth. Do we want the Fed to confront the next recession with another round of massive quantitative easing as the only policy tool left to deploy? When their own research shows that QE wasn’t very useful and when we can clearly see the distortions caused by QE in emerging markets around the world?

The Federal Reserve is functionally incapable of not feeling the need to “do something” in the midst of a recession. If the only tool they have is further massive quantitative easing, they will use it. Damn the distortions, full speed ahead!

I would not argue for a rapid rate hike. In fact, I would prefer 1/8 of a point at every meeting, rather than the typical quarter point. But there is no reason not to raise a quarter of a point at this meeting, skip a meeting to make sure everybody can take a deep breath, and then raise once more before the end of the year.

I mean, really? Does the Fed think this economy is so fragile that it can’t take a lousy quarter of a point increase in interest rates? The Federal Reserve needs to begin to restock its policy tool chest now. While I personally think we are a long way from ever seeing 5% Fed funds rates again, a 2% rate can probably easily be absorbed if it comes slowly. And that rate would give the Fed some policy tools when, not if, we enter the next recession.

Now, let’s turn back to China.

Repeat After Me: Chinese Stocks Are Not the Chinese Economy

It’s easy to assume that a country’s stock market reflects the condition of its economy, but that is not always the case. Further, what the stock market really does reflect is the consensus estimate of an economy’s future condition. More specifically, stock prices reveal future expectations for corporate profits.

This generally applies to both the United States and China. One key difference, though, is that most American stocks represent companies that seek to make profits. In China, that isn’t necessarily the case. The Chinese stock market includes many state-owned enterprises (SOEs), whose executives answer to bureaucrats in Beijing. The government views them as public policy tools. Everyone is happy if the SOEs make a profit, but profit is not the first priority.

If US stock prices generally tell us more about the future than the present, except in times of serious over- or undervaluation, then Chinese stock prices tell us even less about either. Just as last year’s incredible run-up in Chinese stocks did not signal an economic boom, the ongoing decline does not signal an economic bust. The correlations aren’t just weak, they are nonexistent. China’s official economic data is also questionable and would be so even if GDP were a precise measurement tool. As we discussed last week, it usually isn’t.

It is no stretch to say we are flying blind about China.

Fortunately, we have diligent researchers like Leland Miller of China Beige Book, whose research firm does the hard work of gathering reliable data each quarter from thousands of companies in China and assembling it in comprehensible form. His data shows that China’s economy has actually been in good shape since China stopped acting Chinese last year. But even then, you have to separate the Chinese economy into several categories.

China Good, China Bad, & China Ugly

Among the many letters and reports on China that I received over the last month, I’d like to single out an excellent research note that the team at Gavekal Dragonomics published last week, called “What to Worry About and What Not to in China.” I appreciated this piece, because it really helped me structure my worrying. I dislike spending energy worrying about the wrong things. Further, worrying about the wrong things can be dangerous. It’s when you are paying attention to the wrong things that what you should have been paying attention to jumps up and bites you on the derrière.

In the spirit of the Gavekal note, here is the good side of China. We’ll get to the bad and the ugly below.
Chinese real estate prices will stabilize. We hear a lot about China’s massive infrastructure boom and the resulting “ghost cities.” These aren’t just rumors. The government mandated the construction of entire cities to house the formerly agrarian population as it shifts to industrial jobs. Provincial governments earned as much as 80% of their revenues from land sales. Essentially, this is a process where they take possession of rural land that has very little value in price terms, declare it to be available for development, and can make profits several orders of magnitude greater than their costs. Nice work if you can get it.

The ghost cities will not stay empty forever. They will fill with people over the next few years (in some cases more than a few). The recent housing bubble is more a function of young people wanting to cram into certain popular areas. The broader internal migration will support housing prices even as the bubble areas pop.

It might be helpful to think of the Chinese ghost cities as analogous to the overbuilt condos in Florida. Prices in Florida did in fact collapse, and places were selling for a fraction of their construction cost. I wrote at the time that I thought they would be very good investments, because the number of people wanting to retire to Florida is actually a fairly steadily growing figure. Low taxes, good weather, positive infrastructure, excellent medical care – what’s not to like, other than it’s not Texas? Just saying…..

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The article Thoughts from the Frontline: Muddling Through Shanghai was originally published at mauldineconomics.com.

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By John Mauldin

Two years ago, my friend Mohamed El-Erian and I were on the stage at my Strategic Investment Conference. Naturally we were discussing currencies in the global economy, and I asked him about currency wars. He smiled and said to me, “John, we don’t talk about currency wars in polite circles. More like currency disagreements” (or some word to that effect).

This week I note that he actually uses the words currency war in an essay he wrote for Project Syndicate:

Yet the benefits of the dollar’s rally are far from guaranteed, for both economic and financial reasons. While the US economy is more resilient and agile than its developed counterparts, it is not yet robust enough to be able to adjust smoothly to a significant shift in external demand to other countries. There is also the risk that, given the role of the ECB and the Bank of Japan in shaping their currencies’ performance, such a shift could be characterized as a “currency war” in the US Congress, prompting a retaliatory policy response.

This is a short treatise, but as usual with Mohamed’s writing, it’s very thought provoking. Definitely Outside the Box material.

And for a two-part Outside the Box I want to take the unusual step of including an op-ed piece that you might not have seen, from the Wall Street Journal, called “How to Distort Income Inequality,” by Phil Gramm and Michael Solon. They cite research I’ve seen elsewhere which shows that the work by Thomas Piketty cherry-picks data and ignores total income and especially how taxes distort the data. That is not to say that income inequality does not exist and that we should not be cognizant and concerned, but we need to plan policy based on a firm grasp of reality and not overreact because of some fantasy world created by social provocateur academicians.

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The calls for income redistribution from socialists and liberals based on Piketty’s work are clearly misguided and will further distort income inequality in ways that will only reduce total global productivity and growth.
I’m in New York today at an institutional fund manager conference where I had the privilege of hearing my good friend Ian Bremmer take us around the world on a geopolitical tour. Ian was refreshingly optimistic, or at least sanguine, about most of the world over the next few years. Lots of potential problems, of course, but he thinks everything should turn out fine – with the notable exception of Russia, where he is quite pessimistic.

A shirtless Vladimir Putin was the scariest thing on his geopolitical radar. As he spoke, Russia was clearly putting troops and arms into eastern Ukraine. Why would you do that if you didn’t intend to go further? Ian worried openly about Russia’s extending a land bridge all the way to Crimea and potentially even to Odessa, which is the heart of economic Ukraine, along with the Kiev region. It would basically make Ukraine ungovernable.

I thought Putin’s sadly grim and memorable line that “The United States is prepared to fight Russia to the last Ukrainian” pretty much sums up the potential for a US or NATO response. Putin agreed to a cease-fire and assumed that sanctions would start to be lifted. When there was no movement on sanctions, he pretty much went back to square one. He has clearly turned his economic attention towards China.

Both Ian Bremmer and Mohamed El Erian will be at my Strategic Investment Conference next year, which will again be in San Diego in the spring, April 28-30. Save the dates in your calendar as you do not want to miss what is setting up to be a very special conference. We will get more details to you soon.

It is a very pleasant day here in New York, and I was able to avoid taxis and put in about six miles of pleasant walking. (Sadly, it is supposed to turn cold tomorrow.) I’ve gotten used to getting around in cities and slipping into the flow of things, but there was a time when I felt like the country mouse coming to the city. As I walked past St. Bart’s today I was reminded of an occasion when your humble analyst nearly got himself in serious trouble.

There is a very pleasant little outdoor restaurant at St. Bartholomew’s Episcopal Church, across the street from the side entrance of the Waldorf-Astoria. It was a fabulous day in the spring, and I was having lunch with my good friend Barry Ritholtz. The president (George W.) was in town and staying at the Waldorf. His entourage pulled up and Barry pointed and said, “Look, there’s the president.”

We were at the edge of the restaurant, so I stood up to see if I could see George. The next thing I know, Barry’s hand is on my shoulder roughly pulling me back into my seat. “Sit down!” he barked. I was rather confused – what faux pas I had committed? Barry pointed to two rather menacing, dark-suited figures who were glaring at me from inside the restaurant.

“They were getting ready to shoot you, John! They had their hands inside their coats ready to pull guns. They thought you were going to do something to the president!”

This was New York not too long after 9/11. The memory is fresh even today. Now, I think I would know better than to stand up with the president coming out the side door across the street. But back then I was still just a country boy come to the big city.

Tomorrow night I will have dinner with Barry and Art Cashin and a few other friends at some restaurant which is supposedly famous for a mob shooting back in the day. Art will have stories, I am sure.
It is time to go sing for my supper, and I will try not to keep the guests from enjoying what promises to be a fabulous meal from celebrity chef Cyrille Allannic. After Ian’s speech, I think I will be nothing but sweetness and light, just a harmless economic entertainer. After all, what could possibly go really wrong with the global economy, when you’re being wined and dined at the top of New York? Have a great week.

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

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The Return of the Dollar

By Mohamed El-Erian
Project Syndicate, Nov. 13, 2014

The U.S. dollar is on the move. In the last four months alone, it has soared by more than 7% compared with a basket of more than a dozen global currencies, and by even more against the euro and the Japanese yen. This dollar rally, the result of genuine economic progress and divergent policy developments, could contribute to the “rebalancing” that has long eluded the world economy. But that outcome is far from guaranteed, especially given the related risks of financial instability.

Two major factors are currently working in the dollar’s favor, particularly compared to the euro and the yen. First, the United States is consistently outperforming Europe and Japan in terms of economic growth and dynamism – and will likely continue to do so – owing not only to its economic flexibility and entrepreneurial energy, but also to its more decisive policy action since the start of the global financial crisis.

Second, after a period of alignment, the monetary policies of these three large and systemically important economies are diverging, taking the world economy from a multi-speed trajectory to a multi-track one. Indeed, whereas the US Federal Reserve terminated its large-scale securities purchases, known as “quantitative easing” (QE), last month, the Bank of Japan and the European Central Bank recently announced the expansion of their monetary-stimulus programs. In fact, ECB President Mario Draghi signaled a willingness to expand his institution’s balance sheet by a massive €1 trillion ($1.25 trillion).

With higher US market interest rates attracting additional capital inflows and pushing the dollar even higher, the currency’s revaluation would appear to be just what the doctor ordered when it comes to catalyzing a long-awaited global rebalancing – one that promotes stronger growth and mitigates deflation risk in Europe and Japan. Specifically, an appreciating dollar improves the price competitiveness of European and Japanese companies in the US and other markets, while moderating some of the structural deflationary pressure in the lagging economies by causing import prices to rise.

Yet the benefits of the dollar’s rally are far from guaranteed, for both economic and financial reasons. While the US economy is more resilient and agile than its developed counterparts, it is not yet robust enough to be able to adjust smoothly to a significant shift in external demand to other countries. There is also the risk that, given the role of the ECB and the Bank of Japan in shaping their currencies’ performance, such a shift could be characterized as a “currency war” in the US Congress, prompting a retaliatory policy response.

Furthermore, sudden large currency moves tend to translate into financial-market instability. To be sure, this risk was more acute when a larger number of emerging-economy currencies were pegged to the U.S. dollar, which meant that a significant shift in the dollar’s value would weaken other countries’ balance of payments position and erode their international reserves, thereby undermining their creditworthiness. Today, many of these countries have adopted more flexible exchange-rate regimes, and quite a few retain adequate reserve holdings.

But a new issue risks bringing about a similarly problematic outcome: By repeatedly repressing financial-market volatility over the last few years, central-bank policies have inadvertently encouraged excessive risk-taking, which has pushed many financial-asset prices higher than economic fundamentals warrant. To the extent that continued currency-market volatility spills over into other markets – and it will – the imperative for stronger economic fundamentals to validate asset prices will intensify.

This is not to say that the currency re-alignment that is currently underway is necessarily a problematic development; on the contrary, it has the potential to boost the global economy by supporting the recovery of some of its most challenged components. But the only way to take advantage of the re-alignment’s benefits, without experiencing serious economic disruptions and financial-market volatility, is to introduce complementary growth-enhancing policy adjustments, such as accelerating structural reforms, balancing aggregate demand, and reducing or eliminating debt overhangs.

After all, global growth, at its current level, is inadequate for mere redistribution among countries to work. Overall global GDP needs to increase.

The US dollar’s resurgence, while promising, is only a first step. It is up to governments to ensure that the ongoing currency re-alignment supports a balanced, stable, and sustainable economic recovery. Otherwise, they may find themselves again in the unpleasant business of mitigating financial instability.

How to Distort Income Inequality

By Phil Gramm and Michael Solon
Wall Street Journal, Nov. 11, 2014

The Piketty-Saez data ignore changes in tax law and fail to count noncash compensation and Social Security benefits.

What the hockey-stick portrayal of global temperatures did in bringing a sense of crisis to the issue of global warming is now being replicated in the controversy over income inequality, thanks to a now-famous study by Thomas Piketty and Emmanuel Saez, professors of economics at the Paris School of Economics and the University of California, Berkeley, respectively. Whether the issue is climate change or income inequality, however, problems with the underlying data significantly distort the debate.

The chosen starting point for the most-quoted part of the Piketty-Saez study is 1979. In that year the inflation rate was 13.3%, interest rates were 15.5% and the poverty rate was rising, but economic misery was distributed more equally than in any year since. That misery led to the election of Ronald Reagan, whose economic policies helped usher in 25 years of lower interest rates, lower inflation and high economic growth. But Messrs. Piketty and Saez tell us it was also a period where the rich got richer, the poor got poorer and only a relatively small number of Americans benefited from the economic booms of the Reagan and Clinton years.

If that dark picture doesn’t sound like the country you lived in, that’s because it isn’t. The Piketty-Saez study looked only at pretax cash market income. It did not take into account taxes. It left out noncash compensation such as employer-provided health insurance and pension contributions. It left out Social Security payments, Medicare and Medicaid benefits, and more than 100 other means-tested government programs. Realized capital gains were included, but not the first $500,000 from the sale of one’s home, which is tax-exempt. IRAs and 401(k)s were counted only when the money is taken out in retirement. Finally, the Piketty-Saez data are based on individual tax returns, which ignore, for any given household, the presence of multiple earners.

And now, thanks to a new study in the Southern Economic Journal, we know what the picture looks like when the missing data are filled in. Economists Philip Armour and Richard V. Burkhauser of Cornell University and Jeff Larrimore of Congress’s Joint Committee on Taxation expanded the Piketty-Saez income measure using census data to account for all public and private in-kind benefits, taxes, Social Security payments and household size.

The result is dramatic. The bottom quintile of Americans experienced a 31% increase in income from 1979 to 2007 instead of a 33% decline that is found using a Piketty-Saez market-income measure alone. The income of the second quintile, often referred to as the working class, rose by 32%, not 0.7%. The income of the middle quintile, America’s middle class, increased by 37%, not 2.2%.

By omitting Social Security, Medicare and Medicaid, the Piketty-Saez study renders most older Americans poor when in reality most have above-average incomes. The exclusion of benefits like employer-provided health insurance, retirement benefits (except when actually paid out in retirement) and capital gains on homes misses much of the income and wealth of middle- and upper-middle income families.

Messrs. Piketty and Saez also did not take into consideration the effect that tax policies have on how people report their incomes. This leads to major distortions. The bipartisan tax reform of 1986 lowered the highest personal tax rate to 28% from 50%, but the top corporate-tax rate was reduced only to 34%. There was, therefore, an incentive to restructure businesses from C-Corps to subchapter S corporations, limited liability corporations, partnerships and proprietorships, where the same income would now be taxed only once at a lower, personal rate. As businesses restructured, what had been corporate income poured into personal income-tax receipts.

So Messrs. Piketty and Saez report a 44% increase in the income earned by the top 1% in 1987 and 1988—though this change reflected how income was taxed, not how income had grown. This change in the structure of American businesses alone accounts for roughly one-third of what they portray as the growth in the income share earned by the top 1% of earners over the entire 1979-2012 period.

An equally extraordinary distortion in the data used to measure inequality (the Gini Coefficient) has been discovered by Cornell’s Mr. Burkhauser. In 1992 the Census Bureau changed the Current Population Survey to collect more in-depth data on high-income individuals. This change in survey technique alone, causing a one-time upward shift in the measured income of high-income individuals, is the source of almost 30% of the total growth of inequality in the U.S. since 1979.

Simple statistical errors in the data account for roughly one third of what is now claimed to be a “frightening” increase in income inequality. But the weakness of the case for redistribution does not end there. America is the freest and most dynamic society in history, and freedom and equality of outcome have never coexisted anywhere at any time. Here the innovator, the first mover, the talented and the persistent win out—producing large income inequality. The prizes are unequal because in our system consumers reward people for the value they add. Some can and do add extraordinary value, others can’t or don’t.

How exactly are we poorer because Bill Gates, Warren Buffett and the Walton family are so rich? Mr. Gates became rich by mainstreaming computer power into our lives and in the process made us better off. Mr. Buffett’s genius improves the efficiency of capital allocation and the whole economy benefits. Wal-Mart stretches our buying power and raises the living standards of millions of Americans, especially low-income earners. Rich people don’t “take” a large share of national income, they “bring” it. The beauty of our system is that everybody benefits from the value they bring.

Yes, income is 24% less equally distributed here than in the average of the other 34 member countries of the OECD. But OECD figures show that U.S. per capita GDP is 42% higher, household wealth is 210% higher and median disposable income is 42% higher. How many Americans would give up 42% of their income to see the rich get less?

Vast new fortunes were earned in the 25-year boom that began under Reagan and continued under Clinton. But the income of middle-class Americans rose significantly. These incomes have fallen during the Obama presidency, and not because the rich have gotten richer. They’ve fallen because bad federal policies have yielded the weakest recovery in the postwar history of America.

Yet even as the recovery continues to disappoint, the president increasingly turns to the politics of envy by demanding that the rich pay their “fair share.” The politics of envy may work here as it has worked so often in Latin America and Europe, but the economics of envy is failing in America as it has failed everywhere else.

Mr. Gramm, a former Republican senator from Texas, is a visiting scholar at the American Enterprise Institute. Mr. Solon was a budget adviser to Senate Republican Leader Mitch McConnell and is a partner of US Policy Metrics.

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The article Outside the Box: The Return of the Dollar was originally published at mauldineconomics.com.

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Mark Twain: History Doesn't Repeat Itself....But it Does Rhyme. Gold, Vanderbilt and More

By John Mauldin

“The significant problems that we have created cannot be solved at the level of thinking we were at when we created them.”– Albert Einstein

“Generals are notorious for their tendency to ‘fight the last war’ – by using the strategies and tactics of the past to achieve victory in the present. Indeed, we all do this to some extent. Life's lessons are hard won, and we like to apply them – even when they don't apply. Sadly enough, fighting the last war is often a losing proposition. Conditions change. Objectives change. Strategies change. And you must change. If you don't, you lose.”– Dr. G. Terry Madonna and Dr. Michael Young

“Markets are perpetuating a serious error by acting on the belief that central bankers actually know what they are doing. They do not. Not because they are ill-intentioned but because they are human and subject to the limitations that apply to all human endeavors. If you want proof of their fallibility, simply look at their economic forecasts. Despite their efforts to do so, central banks can’t repeal the business cycle (though they can distort it). While the 2008 financial crisis should have taught them that lesson, it appears to have led them to precisely the opposite conclusion.

“There are limits to knowledge in every field, including the hard sciences, and economics is not a hard science; it is a social science whose knowledge is imprecise, and practitioners’ ability to predict the future is extremely limited. Fed officials are attempting to guide an extremely complex economy with tools of questionable utility, and markets are ignoring their warnings that their ability to manage a positive outcome is highly uncertain. Markets are confusing what they want to happen with what is likely to happen, a common psychological phenomenon. Investors who prosper in the long run will be those who acknowledge the severe limits of economic knowledge and the compelling evidence that trillions of dollars of QE and years of zero interest rates may have saved the system from immediate collapse five years ago but failed to produce sustained economic growth or long-term price stability.”– Michael Lewitt, The Credit Strategist, Nov. 1, 2014

As I predicted months ago in this letter and last year in Code Red, the Japanese have launched another missile in their ongoing currency war, somewhat fittingly on Halloween. Rather than being spooked, the markets saw it as just another round of feel good quantitative easing and climbed to all-time highs on the Dow and S&P 500. The Nikkei soared even more (for good reason). As we will see later in this letter, this is not your father’s quantitative easing. The Japanese, for reasons of their own, will intervene not only in their own equity markets but in foreign equity markets as well, and do so in a size and manner that will be significant. This gambit is going to have ramifications far beyond merely weakening the yen. In this week’s letter we are going to take an in depth look at what the Japanese have done.

It is something of a cliché to quote Mark Twain’s “History doesn’t repeat itself, but it does rhyme.” But it is an appropriate way to kick things off, since we are going to look at the “ancient” history of Mark Twain’s era, and specifically the Panic of 1873. That October saw the beginning of 65 months of recession (certainly longer than our generation’s own Great Recession), which inflicted massive pain on the country. The initial cause was government monetary intervention, but the crisis was deepened by soaring debt and deflation.
As we seek to understand what happened 141 years ago, we’ll revisit the phenomenon of October as a month of negative market surprises. It actually has its roots in the interplay between farming and banking.

The Panic of 1873

Shortly after the Civil War, which saw the enactment of federal fiat money (the “greenback” of that era, issued to finance the war), there was a federal law passed that required rural and agricultural banks to keep 25% of their deposits with certain certified national banks, which were based mainly in New York. The national banks were required to pay interest on those deposits, so they had to put the money out for loans. But because those deposits were “callable” at any time, there was a limit to the types of loans they could do, as long-term loans mismatched assets and liabilities.

The brokers of the New York Stock Exchange were considered an excellent target for such loans. They could use the proceeds of the loans as margin to buy stocks, either for their own trading or on behalf of their clients. As long as the stocks went up – or at the very least as long as the ultimate clients were liquid – there wasn’t a problem for the national banks. Money could be repatriated; or, if necessary, margins could be called in a day. But this was before the era of a central bank, so actual physical dollars (and other physical instruments) were involved as reserves, as was gold. Greenbacks could be used to buy gold, but at a rate that floated. The price of gold could fluctuate significantly from year to year, depending upon the availability of gold and the supply of greenbacks (and of course, market sentiment – which certainly rhymes with our own time).

The driver for October volatility was an annual cycle, an ebb and flow of dollars to and from these rural banks. In the fall when the harvest was ready, the country banks would recall their margin loans in order to pay farmers or loan to merchants to buy crops from farmers and ship them via the railroads. Money would then become tight on Wall Street as the national banks called their loans back in.

This cycle often caused extra volatility, depending on the shortness of loan capital. Margin rates could rise to as much as 1% per day! Of course, this would force speculators to sell their stocks or cover their shorts, but in general it could drive down prices and make margin calls more likely. This monetary tightening often sent stocks into a downward spiral – not unlike the downward pressure that present-day Fed tightening actions have exerted, but in a compressed period of time.

If there was enough leverage in the system, a cascade could result, with stocks dropping 20% very quickly. Since much of Wall Street was involved in railroads, and railroads were nothing if not leveraged loans and capital, falling asset prices would reduce the ability of investors in railroads to find the necessary capital for expansion and maintenance of operations.

This historical pattern no longer explains the present-day vulnerability of markets in October. Perhaps the phenomenon persists simply due to market lore and investor psychology. Like an amputee feeling a twinge in his lost limb, do we still sense the ghosts of crashes past?

(And once more with Mark Twain: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”)

It was in this fall environment that a young Jay Gould decided to manipulate the gold market in the autumn of 1873, creating a further squeeze on the dollar. Not only would he profit off a play in gold, but he thought the move would help him in his quest to take control of the Erie Railroad. Historian Charles R. Morris explains, in a fascinating book called The Tycoons

Gould’s mind ran in labyrinthine channels, and he turned to the gold markets as part of a strategy to improve Erie’s freights. Grain was America’s largest export in 1869. Merchants purchased grain from farmers on credit, shipped it overseas, and paid off the farmers when they received their remittances from abroad. Their debt to the farmers was in greenbacks, but their receipts from abroad came in gold, for the greenback was not legal tender overseas. It could take weeks, or even months, to complete a transaction, so the merchant was exposed to changes in the gold/greenback exchange rate during that time. If gold fell (or the greenback rose), the merchant’s gold proceeds might not cover his greenback debts.

The New York Gold Exchange was created to help merchants protect against that risk. Using the Exchange, a merchant could borrow gold when he made his contract, convert it to greenbacks, and pay off his suppliers right away. Then he would pay off the gold loan when his gold payment came in some weeks later; since it was gold for gold, exchange rates didn’t matter. To protect against default, the Exchange required full cash collateral to borrow gold. But that was an opening for speculations by clever traders like Gould. If a trader bought gold and then immediately lent it, he could finance his purchase with the cash collateral and thereby acquire large positions while using very little of his own cash.

[Note from JM: In the fall there was plenty of demand for gold and a shortage of greenbacks. It was the perfect time if you wanted to create a “corner” on gold.]

Gould reasoned that if he could force up the price of gold, he might improve the Erie’s freight revenues. If gold bought more greenbacks, greenback-priced wheat would look cheaper to overseas buyers, so exports, and freights, would rise. And because of the fledgling status of the new Gold Exchange, gold prices looked eminently manipulable, since only about $20 million in gold was usually available in New York. [Some of his partners in the conspiracy were skeptical because…] The Grant administration, which had just taken office in March, was sitting on $100 million in gold reserves. If gold started suddenly rising, it would hurt merchant importers, who could be expected to clamor for government gold sales.

So Gould went to President Grant’s brother-in-law, Abel Corbin, who liked to brag about his family influence. He set up a meeting with President Grant, at which Gould learned that Grant was cautious about any significant movements in either the gold or the greenback, noting the “fictitiousness about the prosperity of the country and that the bubble might be tapped in one way as well as another.” That was discouraging: popping a bubble meant tighter money and lower gold.

But Gould plunged ahead with his gold buying, including rather sizable amounts for Corbin’s wife (Grant’s wife’s sister), such that each one-dollar rise in gold would generate $11,000 in profits. Corbin arranged further meetings with Grant and discouraged him from selling gold all throughout September.

Gould and his partners initiated a “corner” in the gold market. This was actually legal at the time, and the NY gold market was relatively small compared to the amount of capital it was possible for a large, well-organized cabal to command. True corners were devastating to bears, as they generally borrowed shares or gold to sell short, betting on the fall in price. Just as today, if the price falls too much, then the short seller can buy the stock back and take his losses. But if there is no stock to buy back, if someone has cornered the market, then losses can be severe. Which of course is what today we call a short squeeze.

The short position grew to some $200 million, most of it owed to Gould and his friends. But there was only $20 million worth of gold available to cover the short sales. That gold stock had been borrowed and borrowed and borrowed again. The price of gold rose as Gould’s cabal kept pressing their bet.

But Grant got wind of the move. His wife wrote her sister, demanding to know if the rumor of their involvement was true. Corbin panicked and told Gould he wanted out, with his $100,000+ of profits, of course. Gould promised him his profits if he would just keep quiet.

Then Gould began to unload all his gold positions, even as some of his partners kept right on buying. You have to keep up pretenses, of course. Gould was telling his partners to push the price up to 160, while he was selling through another set of partners.

It is a small irony that Gould also had a contact in the government in Washington (a Mr. Butterfield) who assured him that there was no move to sell gold from DC, even as that contact was personally selling all his gold as fast as he could. Whatever bad you could say about Gould (and there were lots of bad things you could say), his trading instincts were good. He sensed his contact was lying and doubled down on getting out of the trade. In the end, Gould didn’t make any money to speak of and in fact damaged his intention of getting control of the Erie Railroad that fall.

The attempted gold corner didn’t do much harm to the country in and of itself. But when President Grant decided to step in and sell gold, there was massive buying, which sucked a significant quantity of physical dollars out of the market and into the US Treasury at a time when dollars were short. This move was a clumsy precursor to the open-market operations of the Federal Reserve of today, except that those dollars were needed as margin collateral by brokerage companies. No less than 14 New York Stock Exchange brokerages went bankrupt within a few days, not including brokerages that dealt just in gold.

All this happened in the fall, when there were fewer physical dollars to be had.

The price of gold collapsed. Cornelius Vanderbilt, who was often at odds with Jay Gould, had to step into the market (literally – that is, physically, which was rare for him) in order to quell the panic and provide capital, a precursor to J.P. Morgan’s doing the same during the Panic of 1907.

While many today believe the Fed should never have been created, we have not lived through those periods of panics and crashes. And while I think the Fed now acts in ways that are inappropriate (how can 12 FOMC board members purport to fine-tune an economic cycle, let alone solve employment problems?), the one true and proper role of the Fed is to provide liquidity in time of a crisis.

“People Who Live Too Much on Credit”

At the end of the day, it was too much debt that was the problem in 1873. Cornelius Vanderbilt was quoted in the epic book The First Tycoon as saying (emphasis mine)

I’ll tell you what’s the matter – people undertake to do about four times as much business as they can legitimately undertake.… There are a great many worthless railroads started in this country without any means to carry them through. Respectable banking houses in New York, so called, make themselves agents for sale of the bonds of the railroads in question and give a kind of moral guarantee of their genuineness. The bonds soon reach Europe, and the markets of their commercial centres, from the character of the endorsers, are soon flooded with them.… When I have some money I buy railroad stock or something else, but I don’t buy on credit. I pay for what I get. People who live too much on credit generally get brought up with a round turn in the long run. The Wall Street averages ruin many a man there, and is like faro.”

In the wake of Gould’s shenanigans, President Grant came to New York to assess the damage; and eventually his Secretary of the Treasury decided to buy $30 million of bonds in a less clumsy precursor to Federal Reserve open market operations, trying to inject some liquidity back into the markets. This was done largely as a consequence of a conversation with Vanderbilt, who offered to put up $10 million of his own, a vast sum at the time.

But the damage was done. The problem of liquidity was created by too much debt, as Vanderbilt noted. That debt inflated assets, and when those assets fell in price, so did the net worth of the borrowers. Far too much debt had to be worked off, and the asset price crash precipitated a rather deep depression, leaving in its wake far greater devastation than the recent Great Recession did. It took many years for the deleveraging process to work out. Sound familiar?

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

The article Thoughts from the Frontline: Rhyme and Reason was originally published at mauldin economics

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What You and Monica Lewinsky Might Have in Common

By Dennis Miller

Collateral damage can assume many forms—and though some may be more newsworthy than others, the latter are no less real, nor any less frightening.


On Tuesday, controversial radio talk show host Rush Limbaugh called Monica Lewinsky “collateral damage in Hillary Clinton’s war on women,” saying that President Bill Clinton and his wife destroyed the former White House intern “after he got his jollies, after he got his consensual whatevers.”

Last month, Jeremy Grantham, cofounder of GMO, a Boston based asset management firm that oversees $112 billion in client funds, dubbed savers “collateral damage” of quantitative easing and the Federal Reserve’s continued commitment to low interest rates.

Would it be worse to be known as the “president’s mistress” for more than a decade and, as Lewinsky claims, to be unable to find a normal job? Maybe. But it’s no laughing matter either to find yourself penniless in your “golden years.”

Signs of Monetary Collateral Damage Among Seniors

 

The 55-plus crowd accounts for 22% of all bankruptcy filings in the U.S.—up 12% from just 13 years ago—and seniors age 65 and up are the fastest growing population segment seeking bankruptcy protection. Given the wounds bankruptcy inflicts on your credit, reputation, and pride, it’s safe to assume those filing have exhausted all feasible alternatives.

But even seniors in less dire straits are finding it difficult to navigate low interest rate waters. Thirty seven percent of 65 to 74 year olds still had a mortgage or home equity line of credit in 2010, up from 21% in 1989. For those 75 and older, that number jumped from 2% to 21% during the same timeframe—another mark of a debt filled retirement becoming the norm. With an average balance of $9,300 as of 2012, the 65 plus cohort is also carrying more credit card debt than any other age group.

While climbing out of a $9,300 hole isn’t impossible, the national average credit card APR of 15% sure makes it difficult. For those with bad credit, that rate jumps to 22.73%—not quite the same as debtor’s prison, but close.

None of this points to an aging population adjusting its money habits to thrive under the Fed’s low interest rate regime.

Minimize Your Part of Comparative Negligence

 

A quick side note on tort law. Most states have some breed of the comparative negligence rule on the books. This means a jury can reduce the monetary award it awards a tort plaintiff by the percentage of the plaintiff’s fault. Bob’s Pontiac hits Mildred’s Honda, causing Mildred to break her leg. Mildred sues Bob and the jury awards her $100,000, but also finds she was 7% at fault for the accident. Mildred walks with $93,000. (Actually, Mildred walks with $62,000 and her lawyer with $31,000, but I digress.)

Comparative-negligence rules exist because when a bad thing happens, the injured party may be partly responsible. For someone planning for retirement, the bad thing at issue is too much debt and too little savings. Through low interest rates, the Federal Reserve is responsible for X% of the problem.

Though ex-Fed chief Bernanke doesn’t seem to see it that way—in a dinner conversation with hedge fund manager David Einhorn, he asserted that raising interest rates to benefit savers wouldn’t be the right move for the economy because it would require borrowers to pay more for capital. Well, there you have it. And there’s nothing you can do about that X%. You can, however, reduce or eliminate your contribution.
In other words, you don’t have to be collateral damage; you can affect how your life plays out.

Money Lessons from Zen Buddhism

 

This might sound like a “duh” statement, but it bears repeating from time to time. Inheritance windfall from that great-aunt in Des Moines you’d forgotten about aside, there are two ways to eliminate debt and retire well: spend less or make more.

Rising healthcare costs, emergency car repairs, and the like are real impediments to reducing your bills. Costs rooted in attempts to “keep up with the Joneses,” however, are avoidable. Those attempts are also futile. A new, even richer Mr. Jones is always around the bend.

Instead of overspending for show, make like a Buddhist and let go of your attachment to things and your ego about owning them. Spring for that Zen rock garden if you must and start raking.

One of the wealthier men I know drove around for years with a gardening glove as a makeshift cover for his Peugeot’s worn out, stick shift knob. It looked shabby, but this man wasn’t a car guy and had no need to impress. As far as I know, the gardening glove worked just fine until he finally donated the car to charity and happily took his tax deduction. Maintaining your car isn’t overspending, but you catch my drift. Dropping efforts to show off can benefit us all.

That said, keeping up isn’t always about show. You may feel pressure to overspend just to be able to enjoy time with your friends and family. Maybe you can no longer afford the annual Vail ski week with your in laws or the flight to Hawaii for your nephew’s bar mitzvah. Maybe your friends are hosting caviar dinners, but you’re now on a McDonald’s budget and can no longer participate.

Spending less in order to stay within your budget can mean missing out on experiences, not just stuff. If you’re in this camp, there’s no reason to hang your head. As I mentioned above, you can spend less or you can make more. The latter is far more fun.

An Investment Strategy to Prevent You from Becoming Collateral Damage

 

While it’s tempting to start speculating with your retirement money, resist. If you have non-retirement dollars to play with and the constitution to handle it, carefully curated speculative investments can give you a welcome boost. However, if all of your savings is allocated for retirement, just don’t do it.

Unless you’re still working, how, then, can you make more money in a low-interest-rate world? At present, my team of analysts and I recommend investing your retirement dollars via the 50-20-30 approach:

• 50%: Sector diversified equities providing growth and income and a high margin of safety.
• 20%: Investments made for higher yield coupled with appropriate stop losses.
• 30%: Conservative, stable income vehicles.

No single investment should make up more than 5% of your retirement portfolio.

Whether you’re designing your retirement blueprint from scratch or want to apply our 50-20-30 strategy to your existing plan, the Miller’s Money team can help. Each Thursday enjoy exclusive updates on unique investing and retirement topics by signing up for my free weekly newsletter.

Don’t let the Fed’s anti-senior and anti-saver policies unravel your retirement.  

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The article Collateral Damage: What You and Monica Lewinsky Have in Common was originally published at Millers Money

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Listening to the Canary

By Terry Coxon, Senior Economist

During World War II, the British Royal Air Force (RAF) undertook a plan of misdirection to allow a squadron of bombers to approach an exceptionally valuable target in Europe undetected. The target was so heavily guarded that destroying it would require more than the usual degree of surprise.


Although the RAF was equipped to jam the electronic detection of aircraft along the route to the target (a primitive forebear of radar was then in use), they feared that the jamming itself would alert the defending forces. Their solution was to “train” the defending German personnel to believe something that wasn't true. The RAF had a great advantage in undertaking the training: The intended trainees were operating equipment that was novel and far from reliable; and those operators were trying to interpret signals without the help of direct observation, such as actually seeing what they were charged with detecting.

At sunrise on the first day, the RAF broadcast a jamming signal for just a fraction of minute. On the second day, it broadcast a jamming signal for a bit longer than a minute, also around sunrise. On each successive day, it sent the signal for a somewhat longer and longer time, but always starting just before sunrise.

The training continued for nearly three months, and the German radar personnel interpreted the signals their equipment gave them in just the way the British intended. They concluded that their equipment operates poorly in the atmospheric conditions present at sunrise and that the problem grows as the season progresses. That mistaken inference allowed an RAF squadron to fly unnoticed far enough into Europe to destroy the target.

People will get used to almost anything if it goes on for long enough. And the getting-used-to-it process doesn't take long at all if it's something that people don't understand well and that they can't experience directly. They hear about Quantitative Easing and money printing and government deficits, but they never see those things happening in plain view, unlike a car wreck or burnt toast, and they never feel it happening to themselves.

QE has become just a story, and it's been going on for so long that it has no scare value left. That's why so few investors notice that the present situation of the U.S. economy and world investment markets is beyond unusual. The situation is weird, and dangerously so. But we've all gotten used to it.

Here are the four main points of weirdness:

1. The Federal Reserve is still fleeing the ghost of the dot-com bubble. It was so worried that the collapse of the dot-com bubble (beginning in March 2000) would damage the economy that it stepped hard on the monetary accelerator. The growth rate of the M1 money supply jumped from near 0% to near 10%. This had the hoped for result of making the recession that began the following year brief and mild.

2. A nice result, if that had been all. But there was more. Injecting a big dose of money to inoculate the economy against recession set off a bubble in the housing market. Starting in 2003, the Fed began gradually lowering the growth rate of the money supply to cool the rise in housing prices. That, too, produced the intended result; in 2006, housing prices began drifting lower.
   
   But again, there was a further consequence—the financial collapse that began in 2008. This time, the Federal Reserve stomped on the monetary accelerator with both feet, and the growth of the money supply hit a year-over-year rate of 21%. It's still growing rapidly, at an annual rate of 9%.

3. The nonstop expansion of the money supply since 2008 has kept money market interest close to zero. Rates on longer-term debt aren't zero but are extraordinarily low. The ten-year Treasury bond currently yields just 2.7%; that's up from a low of 1.7%.
   
   The flow of new money has been irrigating all financial markets. In the U.S., stocks and bonds tremble at each hint the Fed is going to turn the faucet down just a little. And it's not just US markets that are affected. When credit in the US is ultra cheap, billions are borrowed here and invested elsewhere, all around the world, which pushes up investment prices almost everywhere.

4. US federal debt management is living on borrowed time. The deficit for 2013 was only $600 billion, down from trillion dollar plus levels of recent years. But this less terrible than before figure was achieved only by the grace of extraordinarily low interest rates, which limit the cost of servicing existing government debt. Should interest rates rise, less than terrible will seem like happy times.

Almost no one imagines that the current situation can continue indefinitely. But is there a way for it to end nicely? For most investors, the expectation (or perhaps just the hope) that things can gracefully return to normal rests on confidence that the people in charge, especially the Federal Reserve governors, are really, really smart and know what they're doing. The best minds are on the job.

If the best minds were in charge of designing a bridge, I would expect the bridge to hold up well even in a storm. If the best minds were in charge of designing an airplane, I would expect it to fly reliably. But if the best minds were in charge of something no one really knows how to do, I would be ready for a failure, albeit a failure with superb academic credentials.

Despite all the mathematics that has been spray-painted on it, economics isn't a modern science. It's a primitive science still weighted with cherished beliefs and unproven dogma. It's in about the same stage of development today that medicine was in the 17th century, when the best minds of science were arguing whether the blood circulates through the body or just sits in the veins. Today economists argue whether newly created cash will circulate through the economy or just sit in the hands of the recipients.

Let's look at the puzzle the best minds now face.

If the Federal Reserve were simply to continue on with the money printing that began in 2008, the economy would continue its slow recovery, with unemployment drifting lower and lower. Then the accumulated increase in the money supply would start pushing up the rate of price inflation, and it would push hard. Only a sharp and prolonged slowdown in monetary growth would rein in price inflation. But that would be reflected in much higher interest rates, which would push the federal deficit back above the trillion dollar mark and also push the economy back into recession.

So the Fed is trying something else. They’ve begun the so called taper, which is a slowing of the growth of the money supply. Their hope is that if they go about it with sufficient precision and delicacy, they can head off catastrophic price inflation without undoing the recovery. What is their chance of success?

My unhappy answer is "very low." The reason is that they aren't dealing with a linear system. It's not like trying to squeeze just the right amount of lemon juice into your iced tea. With that task, even if you don't get a perfect result, being a drop or two off the ideal won't produce a bad result. Tinkering with the money supply, on the other hand, is more like disarming a bomb—and going about it according to the current theory as to whether it's the blue wire or the red wire that needs to be cut means a small failure isn’t possible.

Adjusting the growth of the money supply sets off multiple reactions, some of which can come back to bite. Suppose, for example, that the taper proceeds with such a light touch that the U.S. economy doesn't tank. But that won't be the end of the story. Stock and bond markets in most countries have been living on the Fed's money printing. The touch that's light enough for the U.S. markets might pull the props out from under foreign markets—which would have consequences for foreign economies that would feed back into the U.S. through investment losses by U.S. investors, loan defaults against U.S. lenders, and damage to U.S. export markets. With that feedback, even the light touch could turn out not to have been light enough.

To see what the consequences of economic mismanagement can be, and how stealthily disaster can creep up on you, watch the 30 minute documentary, Meltdown America. Witness the harrowing tales of three ordinary people who lived through a crisis, and how their experiences warn of the turmoil that could soon reach the US. Click here to watch it now.

The article Listening to the Canary was originally published at Casey Research

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