The Last Chapter

The Last Chapter
September 4, 2010
By John Mauldin


The Last Chapter
Let’s Look at the Rules
Six Impossible Things
Killing the Goose
Home and Then Europe


This week you will get a kind of preview as this week’s letter. I am desperately trying to finish the first draft of my book and am one chapter away from having that draft. I have promised my editor (Debra Englander) that she would see a rough draft next week, and the final version will be delivered on the last day of September. More on that process for those interested at the end of the letter. But this week’s letter will be part of what will probably be the 4th or 5th chapter, where we look at the rules of economics.

There is just so little writing time left that I have to focus on that book for a little bit. I am writing this book with co-author Jonathan Tepper of Variant Perception (who is based in London), a young and very gifted Rhodes scholar with a talent for economic analysis and writing. We each write the first draft of a chapter and then go back and forth until the chapter has been much improved. Alas, gentle reader, you will only get my first draft. You will have to wait for the book to get the new, improved version. But this is the last one I have to write. And Jonathan has done all his initial chapters. We are on the home stretch.

But first, my partners at Altegris Investments have written a White Paper entitled “The New Normal: Implications for Hedge Fund Investing.” It is a very instructive read. If you are in the US and have already signed up for my Accredited Investor letter, you should already have been sent a link or a copy. If not, and you are an accredited investor (basically net worth of $1.5 million or more) and would like to see the paper, or are interested in learning more about how hedge funds, commodity funds, and other absolute-return strategies might fit into your investment portfolio, I suggest you click on and fill out the form, and a professional will get back to you. And if you live outside the US and are interested, I have partners around the world who can work with you, so you can sign up as well. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC. Member FINRA.) And now let’s look at part of a chapter from The End Game.

Let’s Look at the Rules

There are rules in sports. Three strikes and you’re out. You have to make ten yards in four downs to get another first down. You can’t touch the soccer ball with your hands.

Baseball is a confusing game for most non-Americans. There are so many rules and subtleties. I (John) confess to not understanding the rules in soccer, although I am getting better. And forget about understanding hockey.

There are rules in economics as well, they’re just not as well-known. And breaking these rules has consequences for individuals, companies, and countries. Sadly, there is no independent referee who can blow a whistle and stop the game, assess a penalty, and make you obey the rules. There is, however, a market that can decide not to buy your currency or your bonds if you don’t play by the rules.

We are going to look at some of the more important rules in this chapter. But, gentle reader, don’t panic. These rules are fairly easy to understand if we take out the academic jargon often associated with them. And if you “get it” then it is much easier to understand the consequences of what happens when a nation violates the rules, both from a policy perspective and a personal investing point of view.

Also sadly, there is not necessarily an immediate penalty for a violation. As we saw in the last chapter, a country can rock along for a very long time before that Bang! comes along and the flag finally gets thrown. But in the fullness of time, if a country does not correct its misbehavior, the end will be full of weeping and wailing and gnashing of teeth. And a lot of finger pointing – it is always the other side’s fault.

Note that the rules are the same for everyone and every country. These are basically accounting rules known as identity equations. They are like E=MC2 or F=MV (force is equal to mass times velocity). They are just true. If they are not, then a thousand years of accounting is wrong. You may not like what they say, or not like the consequences, but you have to deal with the real world, take it or leave it.

John here: in 1976, as a very young entrepreneur (no one would hire me, so I had to work for myself), I had launched my first business, and my best friend did my taxes. I thought I had sent the IRS more than enough to cover me. Then he came to me with a tax bill that was more money than I had ever seen in one place. I guess the concept that I had to pay the employer’s side of Social Security had escaped my attention in my quest to simply survive, along with all sorts of alternative minimum taxes and other things I had never heard of. Reality can be a real bitch.

The importance of knowing the rules was forcefully driven home. And the rules we will now look at are every bit as important as knowing those tax laws. Even if you don’t know about them, they exist and will eventually come to haunt you (whether you’re an individual, a company, or a nation) if you ignore them.

The Federal Reserve and central banks in general are currently attempting a major and highly experimental operation on the economic body, without benefit of anesthesia. They are testing the theories of four dead white guys: Irving Fisher (representing the classical economists), John Keynes (the Keynesian school), Ludwig von Mises (the Austrian school), and Milton Friedman (the monetarist school). For the most part, the central bankers are Keynesian, with a dollop of monetarist thrown in here and there.

Six Impossible Things

Alice laughed. “There’s no use trying,” she said, “one can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

– From Through the Looking Glass, by Lewis Carroll

Economists and policy makers seem to want to believe impossible things in regard to the debt crisis currently percolating throughout the world. And, believing in them, they are adopting policies that could will well lead to tragedy.

Let’s look at the basic equation that summarizes a nation’s Gross Domestic Product.

GDP = C + I + G + Net Exports (that is, exports minus imports)

Which is to say, the Gross Domestic Product of a country is equal to its total Consumption (personal and business) plus Investments plus Government Spending plus Net Exports. Again, this equation is known as an identity equation: it is true for all countries and times. And it is rather simple in concept but has profound implications.

Let’s examine some of those implications. First, what happens if the C drops? That means that, absent something happening elsewhere in the equation, GDP is going to drop. That circumstance is typically called a recession.

Keynesian economists argue that the correct policy response is to boost the G through fiscal stimulus, allowing consumers and businesses time to adjust and recover, and to gradually remove that stimulus as the economy returns to its normal growth trajectory. And, as an added measure, it helps if the central bank will become more accommodative, with lower interest rates and an “easy-money” policy to give further stimulus to business and consumers. In most places and in most times in recent (as in 60) years, these policies have worked to help bring an economy through a recession.

There are, however, those who argue that such a policy also keeps in place the imbalances that cause the problems (such as ever-increasing growth in consumer borrowing, housing bubbles, etc.), and we’ll return to that argument later in the book; but for now let’s acknowledge that a boost in G provides a temporary boost in GDP. Elsewhere we will show that the boost is indeed temporary, but few will argue that it does make a short-term difference. We believe that the recent stimulus in the US, as an example, did in fact have a temporary effect and kept the US out of what might have been a depression, but not without its own costs. That debt must be repaid.

Again, the idea is to try to offset the effects of a retrenching consumer and business sector and give the overall economy time to recover. The US began to withdraw from the stimulus in the summer of 2010. And sure enough, the economy is slowing down. Only time will tell whether the economy is strong enough to return to a sustainable growth trajectory.

The hope is that with the stimulus you can give a jump-start to consumer final demand. In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. This is the demand for the gross domestic product (GDP) of a country when inventory levels are static.

Remember that for most developed economies consumer spending is a big part of the economy. In a recession, final demand (consumer spending) retreats; therefore the objective of stimulus is to get demand back on track. For economic theories that see final demand as the driving force behind growth, recessions are simply a problem of a lack of consumer spending. Get that back in gear and you the economy moves forward.

Now, in fairness to Keynes, he also asserted that governments should run surpluses in good times, something that most countries have not seemed to be able to do. In our view, one of the main faults of the Bush administration, in conjunction with a profligate Republican Congress, was that they squandered the surpluses that we now need. We will deal with Vice President Cheney’s assertion that “deficits don’t matter” in due course.

Before we go into the other, more profound implications of our equation, let’s visit a few other topics that will give us needed insight into them.

Delta Force

There are two, and only two, ways that you can grow your economy. You can either increase your (working-age) population or increase your productivity. That’s it. There is no magic fairy dust you can sprinkle on an economy to make it grow. To increase GDP you actually have to produce something. That’s why it’s called gross domestic product.

The Greek letter delta (^) is the symbol for change. So if you want to change your GDP you write that as:

^GDP = ^Population + ^Productivity

That is, the change in GDP is equal to the change in population plus the change in productivity. Therefore, and I’m oversimplifying a bit here, a recession is basically a decrease in production (as normally, populations don’t decrease).

Two clear implications: The first is that if you want your economy to grow, you must have an economic environment that is friendly to increasing productivity.

While government can invest in industries in ways that are productive, empirical evidence and the preponderance of academic studies suggest that private companies are better at increasing productivity and producing long-term job growth.

Going to the US for a second, studies show that it is business startups that have produced nearly all the net new jobs over the last 20 years. Let’s look at this analysis by Vivek Wadhwa.[1]

“The Kauffman Foundation has done extensive research on job creation. Kauffman Senior Fellow Tim Kane analyzed a new data set from the U.S. government, called Business Dynamics Statistics, which provides details about the age and employment of businesses started in the U.S. since 1977. What this showed was that startups aren’t just an important contributor to job growth: they’re the only thing. Without startups, there would be no net job growth in the U.S. economy. From 1977 to 2005, existing companies were net job destroyers, losing 1 million net jobs per year. In contrast, new businesses in their first year added an average of 3 million jobs annually.

“When analyzed by company age, the data are even more startling. Gross job creation at startups averaged more than 3 million jobs per year during 1992-2005, four times as high as any other yearly age group. Existing firms in all year groups have gross job losses that are larger than gross job gains.

“Half of the startups go out of business within five years; but overall they are still the ones that lead the charge in employment creation. Kauffman Foundation analyzed the average employment of all firms as they age from year zero (birth) to year five. When a given cohort of startups reaches age five, its employment level is 80 percent of what it was when it began. In 2000, for example, startups created 3,099,639 jobs. By 2005, the surviving firms had a total employment of 2,412,410, or about 78 percent of the number of jobs that existed when these firms were born.

“So we can’t count on the Intels or Microsofts to create employment: we need the entrepreneurs.”

Run through the data from around the world. Where has the vast majority of long-term net new jobs come from, even in China? The private sector. And what is the mother’s milk of the private sector? Money. Investments. Angel investors. Private banking. Private offerings. Public offerings. Loans. Personal savings. Money from friends and family. Borrowing against houses. Credit cards. And anything else that provides capital to business.

(We are reminded of the improbable story of Fred Smith, the founder of FedEx, who early in the history of the company could not make payroll. So he flew to Las Vegas and wagered what little cash they had, and incredibly made enough [$27,000] to keep the company alive. Not exactly orthodox investment banking procedure, but it is illustrative of the crazy, gung-ho nature of some entrepreneurs. Eighty percent of all business startups do not exist after five years (at least in the US). We guess Fred figured he could get better odds in Vegas.)

Want to increase productivity and jobs? The best way it seems, is to encourage private business, and especially startups.

Now let’s go back to our first equation. You remember,

GDP = C + I + G + Net Exports

We will spare you the mathematical rigamarole, but if you play with this equation some, you come up with the following:

Savings = Investments

That is, the savings of consumers and business are what is available for investment in businesses, which grow the economy. But there is a rather large but.

Those savings are also what finances government debt. Unless a central bank elects to print money, government debt must be financed by the private sector. That means, if the fiscal deficit is too large it will crowd out private investment. But as we have seen, private investment is what fuels productivity growth, so if you don’t have enough savings to satisfy private investment needs, you are choking off productivity growth and the creation of new jobs.

Japan is an instructive example. The government debt-to-GDP ratio has risen from 51% in 1990 to over 220% by the end of 2011, absorbing almost all of the rather enormous savings of the Japanese public. And what have they gotten for their largesse? Nominal GDP is where it was 17 years ago, and there have been no net new jobs for two decades. Think about that for a moment. In 1990, many pundits were proclaiming that Japan would overcome the US in the near future. Now they have suffered two lost decades and are on their way to a third as government debt has absorbed whatever capital would have been available to private investment. (See our analysis of Japan further on.)

If you are a country facing a population decline (like Japan), to keep your GDP growing you have to increase your productivity even more. That is why we have so much to say about demographics later in the book. Population growth (or the lack thereof) is very important. Russia is facing a very serious problem over the next 20 years that will require either a significant increase in productivity or large immigration to stave off a collapsing economy. Russia’s population has declined by almost 7 million in the last 19 years, to 142 million. UN estimates are that it may shrink by about a third in the next 40 years. But that’s a story for another book.

Note: We are not against a healthy government sector. But when government becomes too big or absorbs too great a share of private savings, it chokes off productivity and growth. And that hurts job creation. And that is especially true when a government runs large fiscal deficits.

Back to Vice President Cheney’s famous assertion that “deficits don’t matter.” In one sense he is right. Let’s play a thought game.

Suppose we start a business that watches its income grow by $100,000 a year every year. Assuming 5% interest rates, we could borrow $1 million every year and never really encounter a problem, as our income would be growing at twice the rate of debt service. We are running a “deficit” as a business (spending more than we make), but the deficit doesn’t matter, since our profits and productivity increase more than the debt service. In ten years we owe $10 million, but we are making $1 million and could actually pay down the debt in less than ten years if we stopped borrowing so much money.

For that business, deficits don’t matter.

But what if interest rates rose to 10% and our profits dropped in half? Then, Houston, we have a big problem. Now our profits don’t cover the interest payments. In fact, we have to borrow money just to make the interest payments. As long as friendly bankers cooperate, we can survive. And because we were so profitable for so long, they might just keep lending, assuming that things will get back to normal.

But at some point we need to start showing a profit or they will stop making those loans and suggest we sell assets, or even take them from us.

In that case, deficits matter a whole lot.

It is the same for countries. Governments cannot run deficits in excess of the growth in GDP without eventual consequences. As we saw last chapter, things go along well until Bang! bond investors lose confidence in the ability of a government to pay its debt, even if that debt is denominated in a currency the government can print! Bond investors become concerned that the currency will lose its value faster than the interest on the bond will grow. Then interest rates rise, making it even harder for the country to pay back its debt.

We all know about Greece, but let’s look at the US. Our fiscal deficit for 2010 is projected to be about 9% of nominal GDP (now roughly $14.3 trillion), down from 12-13% a short while ago. The Congressional Budget Office currently projects that the deficit will still be $1 trillion in ten years. The Heritage Foundation thinks a more realistic estimate is closer to $2 trillion in just nine years. Either one is very troubling.

Dr. Woody Brock has written a very important paper on why a country cannot grow government debt well above nominal GDP without causing severe disruptions to the overall economic system.[2]

We are going to reproduce just one table from that piece. Note that this was Woody’s worst-case assumption, adding 8% of GDP to the debt each year, and not the 9-12% we are experiencing today. The Congressional Budget Office long-range projections are growing worse with each estimate, and that assumes a very rosy 3% or more growth in the economy for each of the next five years. Under Woody’s scenario, the national debt would rise to $18 trillion by 2015, or well over 100% of GDP. Take some time to study the tables, but note that we are going to focus on 2015 and not the outlier years.

Woody makes the assumption that US debt will grow about $1.5 trillion a year. That means that by 2015, even assuming an average of 2% growth of the economy, the debt-to-GDP ratio would be 110% (or 1.1 in Woody’s table)

And in just another ten years, by 2025, if the deficit were not brought under control, debt-to-GDP would climb to 200%. Note that the Heritage Foundation suggests that, under current budgetary law, the deficit will grow by more than the $1.5 trillion a year that Woody projects, in the not-too-distant future.

The point here is not to predict some future catastrophe but to point out what can happen very quickly if deficits are not brought under control.

It is our contention that long before we ever get to that point (say 2020) the bond market will revolt and interest rates will rise and the results will be very unpleasant.

Killing the Goose

Governments can increase their debt as long as the increase is less than the growth in nominal GDP. It may not be a wise choice to do so, but it does not “kill the goose.” That is why Cheney argued that deficits don’t matter. The deficit he was commenting on was less than the growth in nominal GDP. We assume that he never thought we would see deficits of 12% (worse in some countries). But he should have.

Voters around the world are increasingly worried that governments are not only taxing the goose that lays the golden eggs but risking the very life of the goose. And unchecked deficits do in fact risk the economic life of a country. You can get away with them for a while, but at some point you have to deal with them or risk becoming Greece. Or Argentina.

Let’s look at another serious implication, again using the US as our example.

A $1.5-trillion-dollar yearly increase in the deficit means that someone has to invest that much in Treasury bonds. Let’s look at where the $1.5 trillion might come from. Let’s assume that all of our trade deficit comes back to the US and is invested in US government bonds. That could be as much as $500 billion, although over time that number has been falling. That still leaves $1 trillion that needs to be found to be invested in US government debt (forget about the financing needs for business and consumer loans and mortgages).

$1 trillion is roughly 7% of total US GDP. That is a staggering amount of money. And again, that assumes that foreigners continue to put 100% of their fresh reserves into dollar-denominated assets. That is not a safe assumption, given the recent news stories about how governments are thinking about creating an alternative to the dollar as a reserve currency. (And if we were watching the US run $1.5-trillion deficits, with no realistic plans to cut back, we would be having private talks, too.)

There are only three sources for the needed funds: either an increase in taxes or people increasing savings and putting them into government bonds or the Fed monetizing the debt, or some combination of all three.

Leaving aside the monetization of debt (for a later chapter), using taxes or savings to handle a large fiscal deficit reduces the amount of money available to private investment and therefore curtails the creation of new businesses and limits much-needed increases in productivity. That is the goose we will kill if we don’t deal with our deficit.

It is time to hit the send button, as this letter (and chapter) is getting long. But next week we will pursue this theme. We will see why trade deficits matter, how these problems affect currencies, and why everyone can’t export their way out of the problem at the same time, which may be the most contentious of all future problems.

As Ollie said to Stan (Laurel and Hardy), “Here’s another nice mess you’ve gotten me into!” A nice mess indeed.

Home and Then Europe

I got back from LA yesterday. We went out to look at the new web sites (among a lot of other things). They are coming along very nicely. Tiffani and I are quite excited. New look and feel, but more importantly, a new ability to serve you, with reader forums, audio podcasts, a better search engine, and so much more. It is really coming together. Right now it looks like we will be “live” before the end of the month.

I leave for Europe in about eight days and will be there for two weeks. Amsterdam, Malta, Zurich, Mallorca (with my partners from Absolute Return Partners in London, at Neils Jensen’s fabulous mountain home overlooking the ocean, and joined by Enrique Fynn, my Latin American partner – I can assure you the whole weekend will be strictly business!). Then it’s Copenhagen for open meetings and a dinner with the team from Jyske Bank (Thomas and Lars), and then on to London.

I will be speaking in Houston October 1, at a public forum. You can sign up at

When Tiffani became pregnant, we decided we would just adjust our lives so she could continue working and still be a mother (Dad desperately needs her to run the business!). That means nannies come along on trips, and granddaughter Lively is at the office most days, with some time for Tiffani to be a mother every day. It is working out better than I thought it would, to be honest, and it is huge fun to watch my granddaughter grow up day by day. She sits in on meetings and is absorbing it all!

And raising a kid is a lot different these days. Nine-month-old Lively is in love with a kids’ TV show called Yo Gabba Gabba. She already “dances” to the music and loves the large puppets and songs. I looked over on our flight to LA, and Lively was sitting in Tiffani’s lap, with her baby headphones on (who knew they made special baby headphones?), watching Yo Gabba Gabba on an iPad! Is this a happy baby or what?

For the record, that picture is from an iPhone. The new one is 5 megapixels. And sometime I will write about my iPad. I love it. It is now my favorite toy. I can so see not needing a heavy laptop in the future. The iPad is a game changer. I know other guys are coming out with cool competitive products, and I cheer them on. Apple will have to make this even cooler or lose out. Video chat? Cameras? My phone? Skype or the equivalent? Can we get a decent version of Word? Powerpoint? Excel? Unchain me!

Oh, and coming to an iPhone and iPad near you as soon as we can: the Mauldin apps. Way cool.

Your wondering how it is possible to have so much fun analyst,

[1] Vivek Wadhwa is an entrepreneur turned academic. He is a visiting scholar at the School of Information at UC Berkeley, a senior research associate at Harvard Law School, and director of research at the Center for Entrepreneurship and Research Commercialization at Duke University.

[2] If you have not read Dr. Brock’s paper, or would like to read it again, it is at

John Mauldin
John@frontlinethoughts.comCopyright 2010 John Mauldin. All Rights Reserved

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