Joe B., Oliver Wendell Holmes, Sr. & Mike Dooley
April 1, 2012
David R. Kotok
Dear reader: My friend Joe B. has experienced some of the world’s exigencies. He thinks about them in the context of being a former Bostonian, and he said a few things at our last lunch together. His words caused me to reflect on the teaching of an earlier Bostonian. I originally sought a quote from the famous son, but as readers will see, I ended up with the father. We will dedicate this commentary to Joe B., who set me on the course for today’s comments.
“The mind, once expanded to the dimensions of larger ideas, never returns to its original size.” Oliver Wendell Holmes, Sr.
Holmes, Sr. lived in the century before World War I. He preceded central banks like the Federal Reserve and European Central Bank. He didn’t know there would be an International Monetary Fund. In his time, he was a thinker, author, physician, poet. His son was the famous Supreme Court Justice.
Fast forward. The new idea is to take the government-institutional official sector coalition and empower it when there is a financial crisis. This approach is at work in the Eurozone, the UK, the US, and a growing number of other venues. The new idea is to crush the private sector and to keep the official sector in the game for a prolonged period.
This “idea shift” is a distinguishing feature of the recent crisis period that started in 2007-2008. The old idea was that the official sector would intervene, rebalance the system, and then exit. The old idea was to get the private sector back in the game quickly. The old idea was to recover the official money and then let the market resume its functions of pricing and clearing and providing capital.
The old idea is dead.
At our GIC conference in Paris, during the second-day roundtable, Mike Dooley brilliantly demonstrated the difference between the new idea and the old idea. He dissected the transaction in the Greece restructuring. His slides are available on the GIC website, www.interdependence.org .
We pause for slide viewing.
Please note: The rest of this commentary will assume that the reader spent ten minutes on those slides and has now returned to our reflections. If you haven’t done so, you will have missed one great learning opportunity.
“The official sector seems to be the clear winner,” says Mike Dooley. In our view, that is the triumph of the new idea over the old idea. The lesson from Oliver Wendell Holmes, Sr. is that the minds of officialdom have now been expanded and cannot return to their original boundaries.
Investors who look at the post-Lehman world through the lenses of the private sector-oriented old idea are puzzled. They expect outcomes that do not occur. They measure risk by the size of the official response. They anticipate that the huge sums mentioned by officialdom will yield the results of higher interest rates and more inflation and weakening currency values. In fact, that may eventually come to pass, but it will take a while. The new idea has to run its course before those things will happen. Inflation, weak currency, spiking interest rates are the outcomes of the old-idea framework.
In the new-idea realm, officialdom is in the game for a long time. This is true for Greece. It will need more subsidies. It will be offered that assistance through negotiations under strenuous terms. Such is the power of officialdom. Greece will have little choice, since the alternative of leaving the Eurozone will always appear to be worse. That process will continue for years unless a new Greek government repudiates the decisions of the previous ones and a new political crisis undermines the official European coalition.
Notice how there is no room in this process for a rapid return to the private sector. The private sector is limited and will remain so until the new idea has completed its development phase. Then and only then can a newer version of the old idea commence. Private-sector expansion in Greece requires officialdom to permit it. To do that the political forces must change from the present ones.
We expect the same new-idea process to unfold in Portugal and Spain. The sequence that leads to it is already underway. There is ongoing debate about Italy, since it is in the “too big to fail” category. So far the Monti-led technocrats have maintained power while implementing a changeover to the new idea.
In the US we have experience with the new idea in housing finance. GSE-based mortgages have been the result. It is nearly five years since the first ripple appeared in the Fannie-Freddie mortgage pond. Where are we with officialdom? You take the inventory and be the judge.
In the US, the new-idea framework is now focused on our national healthcare policy. The successors to Justice Oliver Wendell Holmes, Jr. are deliberating. For a perspective, consider that housing is a large part of the United States in economic terms. Now consider that healthcare is bigger. It is about 18% of our GDP. This Supreme Court decision is monumental. It comes down to the debate over officialdom vs. private domain.
“The great thing in the world is not so much where we stand, as in what direction we are moving,” said Holmes, Sr.
In the mature economies of the world, movement is away from the private sector. Movement is toward global and regional officialdom. The players are known by their acronyms, like ESM, EFSF. IMF, or GSE. We live with a consortium of acronyms, funded by central banks and governments. They represent the power of the new idea as it becomes institutionalized.
What does this bode for investors?
We think there is a good period and then a bad period. We are currently in the good period, which is defined by massive liquidity injection from officialdom. $4 trillion of global (G-4 countries) excess reserves in the banking system is a marvelous tonic.
The bad period will evolve as officialdom begins to confront resistance from the citizenry and when the old idea outcomes start to appear. That lies ahead. Signs of it are visible in the civil strife in countries where the new idea is being deployed.
Holmes Sr. warned us: “Beware how you take away hope from another human being.” Investors must carefully observe when officialdom suppresses hope with power. Investors’ capital spent on hope in this uphill fight to preserve hope will be lost. Ask the private holders of Greek debt if you need proof. Ask the holders of Fannie preferred.
The new idea of officialdom is operation and control by a central group of people. They are quite different from the old-idea folks, who are dispersed and whose time is ending. Holmes Sr. warned of the risks implied by this tension. He said, “Between two groups of people who want to make inconsistent kinds of worlds, I see no remedy but force.”
We discussed this when I visited with the Tuesday lunch group. The debate was friendly and intense. Varied viewpoints let to no conclusion other than to continue the debate.
Then my Tuesday lunch-group friend and client, Joe B., reminded me that I must always end with an investment policy statement. “What does this mean for my portfolio?” he asks. So, Joe, we will dedicate these closing thoughts to you.
Joe, we are still fully invested in the US stock market ETF accounts. And we have positions in the energy sector and believe they must be maintained for all the strategic reasons we know. Believe it or not, we are overweight healthcare. And regional banks. And homebuilders. Our new book, Bear to Bull with ETFs, is soon to be released. It will describe some of these sector decisions and how we made them.
We expect a mild, single-digit percent correction and then a higher level of stock prices by the end of the year. The bull market started on October 3, 2011. It is probably only half over.
We are gradually reducing durations in the bond arena, and we are tactically hedging spreads where we can do it. We expect officialdom’s commitment to very low interest rates to persist for a while. That is part of new-idea application.
Joe, enjoy the tonic of liquidity as long as it lasts. And enjoy the libation that accompanied lunch. We are monitoring the punchbowl. We are prepared to change this strategic direction at any time.
David R. Kotok, Chairman and Chief Investment Officer