Archive for November, 2009|Monthly archive page


In Uncategorized on November 30, 2009 at 20:03

Foreign Bonds Provide Buffer if Dollar Declines


Published: October 28, 2009

AMERICAN investors can buy bonds issued by foreign governments that are designed to provide protection against inflation, but strategists say those bonds are really more of a bet against the dollar

“If you are a U.S. dollar-based investor, the currency fluctuations will overwhelm anything you get from inflation indexing” on the foreign bonds, said Aaron Gurwitz, the head of global investment strategy at Barclays Wealth.

For more than a decade, the United States Treasury has been selling bonds protected from inflation, known as Treasury Inflation-Protected Securities, or TIPS, whose coupon payments are based on changes in the Consumer Price Index. Investors primarily concerned about protecting their purchasing power during retirement should own TIPS, Mr. Gurwitz said.

Some strategists say that owning the foreign bonds — individually in a well-rounded bond portfolio, or through an exchange-traded fund — can be a good way to diversify and add exposure to other currencies.

Brett Hammond, the chief investment strategist at TIAA-CREF, pointed out that global inflation-protected securities, as these bonds are called, typically perform very differently from other asset classes like stocks and commodities — and even other types of bonds.

Owning any type of foreign bonds hedges an individual investor’s portfolio against a decline in the dollar and is especially useful if the portfolio has little exposure to other currencies through investments like foreign stocks. This is true, he said, for investors of any age.

David Darst, the chief investment strategist for the global wealth management group of Morgan Stanley Smith Barney, recommends global inflation-protected securities precisely because they are both a hedge against a decline in the dollar and protection against global inflation.

“It is more of a currency play than an inflation play,” he said. “But to the degree that inflation picks up with a global economic recovery, then you will be getting two hedges.” Morgan Stanley projects the dollar will fall to $1.60 against the euro by the end of 2010, down from about $1.50 now.

Mr. Darst recommends that individual investors hold 3 percent to 4 percent of their total portfolio in inflation-protected bonds. This allocation could be entirely in TIPS or in a combination of TIPS and global inflation-protected securities, he said, depending on what the investor thought of the dollar.

American investors can buy bonds from specific foreign countries through a broker, or investors can own a diverse basket of the bonds by purchasing the SPDR Deutsche Bank International Government Inflation-Protected Bond exchange-traded fund. This fund owns inflation-adjusted bonds from 17 countries, including France, Brazil and South Korea, but not the United States. The bonds are denominated in 14 currencies. At the moment, no comparable traditional mutual fund is available, according to Morningstar.

Scott Burns, the director of exchange-traded fund analysis for Morningstar, recommends owning both the Deutsche Bank fund and the iShares Barclays TIPS Bond Fund, which only owns American TIPS.

He pointed out that a decline in the dollar often coincides with rising inflation. “If the dollar goes down, the Consumer Price Index generally goes up,” he said, because the cost of imported goods increases for American consumers.

For investors who want exposure to foreign currencies but are not interested in inflation-protected bonds, Mr. Burns recommended two funds that own traditional foreign government bonds: the SPDR Barclays Capital International Treasury Bonds fund, which primarily owns bonds issued by developed countries, and the iShares JPMorgan USD Emerging Markets Bond fund. Because inflation has been very low during the recession, many investors have not been focused on inflation-adjusted bonds, which makes it easy to gauge the broad market consensus for inflation: the difference between the interest rates offered for TIPS and for plain Treasury bonds indicates what investors think future inflation will be. At the moment, TIPS prices suggest an average annual inflation rate of 1.6 percent over the next five years and 2.11 percent over the next 10 years.

If inflation is higher than that over 5 to 10 years, the current TIPS bondholders would get a higher return. If inflation fears return, though, those expectations will probably be priced into the TIPS market.

Some investment strategists say that makes this a good time to buy inflation-protected bonds — either TIPS or their foreign counterparts — precisely because the outlook for inflation is relatively benign. “You don’t want to buy flood insurance when the river is already in your living room,” Mr. Burns said.


‘THE JOBS IMPERATIVE, ‘by Paul Krugman in the Times.

In Uncategorized on November 30, 2009 at 15:12

If you’re looking for a job right now, your prospects are terrible. There are six times as many Americans seeking work as there are job openings, and the average duration of unemployment — the time the average job-seeker has spent looking for work — is more than six months, the highest level since the 1930s.

You might think, then, that doing something about the employment situation would be a top policy priority. But now that total financial collapse has been averted, all the urgency seems to have vanished from policy discussion, replaced by a strange passivity. There’s a pervasive sense in Washington that nothing more can or should be done, that we should just wait for the economic recovery to trickle down to workers.


This is wrong and unacceptable.


Yes, the recession is probably over in a technical sense, but that doesn’t mean that full employment is just around the corner. Historically, financial crises have typically been followed not just by severe recessions but by anemic recoveries; it’s usually years before unemployment declines to anything like normal levels. And all indications are that the aftermath of the latest financial crisis is following the usual script. The Federal Reserve, for example, expects unemployment, currently 10.2 percent, to stay above 8 percent — a number that would have been considered disastrous not long ago — until sometime in 2012.


And the damage from sustained high unemployment will last much longer. The long-term unemployed can lose their skills, and even when the economy recovers they tend to have difficulty finding a job, because they’re regarded as poor risks by potential employers. Meanwhile, students who graduate into a poor labor market start their careers at a huge disadvantage — and pay a price in lower earnings for their whole working lives. Failure to act on unemployment isn’t just cruel, it’s short-sighted.


So it’s time for an emergency jobs program.


How is a jobs program different from a second stimulus? It’s a matter of priorities. The 2009 Obama stimulus bill was focused on restoring economic growth. It was, in effect, based on the belief that if you build G.D.P., the jobs will come. That strategy might have worked if the stimulus had been big enough — but it wasn’t. And as a matter of political reality, it’s hard to see how the administration could pass a second stimulus big enough to make up for the original shortfall.


So our best hope now is for a somewhat cheaper program that generates more jobs for the buck. Such a program should shy away from measures, like general tax cuts, that at best lead only indirectly to job creation, with many possible disconnects along the way. Instead, it should consist of measures that more or less directly save or add jobs.


One such measure would be another round of aid to beleaguered state and local governments, which have seen their tax receipts plunge and which, unlike the federal government, can’t borrow to cover a temporary shortfall. More aid would help avoid both a drastic worsening of public services (especially education) and the elimination of hundreds of thousands of jobs.


Meanwhile, the federal government could provide jobs by … providing jobs. It’s time for at least a small-scale version of the New Deal’s Works Progress Administration, one that would offer relatively low-paying (but much better than nothing) public-service employment. There would be accusations that the government was creating make-work jobs, but the W.P.A. left many solid achievements in its wake. And the key point is that direct public employment can create a lot of jobs at relatively low cost. In a proposal to be released today, the Economic Policy Institute, a progressive think tank, argues that spending $40 billion a year for three years on public-service employment would create a million jobs, which sounds about right.


Finally, we can offer businesses direct incentives for employment. It’s probably too late for a job-conserving program, like the highly successful subsidy Germany offered to employers who maintained their work forces. But employers could be encouraged to add workers as the economy expands. The Economic Policy Institute proposes a tax credit for employers who increase their payrolls, which is certainly worth trying.


All of this would cost money, probably several hundred billion dollars, and raise the budget deficit in the short run. But this has to be weighed against the high cost of inaction in the face of a social and economic emergency.


Later this week, President Obama will hold a “jobs summit.” Most of the people I talk to are cynical about the event, and expect the administration to offer no more than symbolic gestures. But it doesn’t have to be that way. Yes, we can create more jobs — and yes, we should.

‘GET READY FOR HALF A RECOVERY,’ by Gretchen Morgenson in the Sunday Times.

In Uncategorized on November 30, 2009 at 01:21

Get Ready for Half a Recovery …..By GRETCHEN MORGENSON

Published: November 28, 2009

A ROBUST economic recovery in 2010 is certainly on most investors’ wish lists as this year draws to a close. A return to prosperity would not only mean an end to our long financial nightmare, but it would also buttress a rebounding stock market, one of 2009’s few bright spots.

The news out of Dubai late last week, however — that its investment company is struggling to meet repayments on some of its $59 billion in debt — reminds us that we are far from finished with a ferocious deleveraging process that began last year. And the weight of debt that still must be worked out is one reason that Ian Shepherdson, chief United States economist at High Frequency Economics, estimates that growth in the United States’ output for 2010 will be no better than 2 percent.

Mr. Shepherdson — whose economic forecasts have been more right than wrong throughout the credit crisis — says that while cost-cutting has produced enviable productivity figures and rising earnings at large companies, continued growth in corporate output will be much harder to come by.

“Looking further ahead, you can’t survive on cost-cutting forever,” he says. “We will have to see decent volume growth but we won’t see that immediately.”

Mr. Shepherdson’s 2 percent estimate for gross domestic product growth next year is roughly half what he would normally expect for a solid economic recovery. And a crucial reason is the fact that bad assets on personal and institutional balance sheets are the equivalent of a ball and chain strapped to the economy, he says.

“You can pick up that ball and walk with it,” he says, “but you have to walk slowly.”

All that debt overhanging consumers and organizations is the pivotal reason we are still seeing a free fall in bank lending. And small businesses, which account for half of all jobs in this country, are taking the brunt of this credit contraction. Smaller banks are especially worried about their own balance sheets and aren’t making loans. This puts small businesses — important engines of growth — squarely on the brink.

INVESTORS may be celebrating data that points to improvements in economic activity — this month, for example, the Institute for Supply Management said manufacturing had expanded for three months in a row. But Mr. Shepherdson worries about what he sees in monthly figures put out by the National Federation of Independent Business, a trade group representing small businesses.

The N.F.I.B. data was far more prescient than that of the I.S.M. in predicting the current recession, which began in December 2007, Mr. Shepherdson says. The N.F.I.B. survey signaled a downturn in the spring of 2007, while I.S.M. studies didn’t point to a recession until after Lehman Brothers failed in September 2008.

In its survey, the N.F.I.B. asks small businesses how easy it is for them to get loans. The most recent data shows that credit tightness peaked earlier this fall — the worst levels in 23 years, Mr. Shepherdson says. Although credit continues to remain troublingly hard for small business to come by, that phenomenon is a largely untold story.

“Wall Street focuses on big companies because they are in the Standard & Poor’s 500, but small businesses are still in a very grim state,” he says. “Small-company activity according to the N.F.I.B. is still at deep recession levels.”

And while small businesses do not make up the big stock indexes, they do contribute significantly to the overall economy. The tens of millions of people who work at small concerns are, after all, customers of those big, high-profile corporations like McDonald’s, Wal-Mart and Whirlpool.

What we all are enduring — and what small businesses, workers and consumers continue to be pummeled by, even as Wall Street wizards jump back into the bonus pool — is the dismantling of the great credit boom of the early 2000s. This necessary but grueling deleveraging began last year and is now in full swing. But it is nowhere near over.

Bank credit outstanding peaked in October 2008 at $7.3 trillion and is now down to $6.72 trillion. Still, Mr. Shepherdson says he thinks that banking-sector loan and lease assets have to fall by an additional $2 trillion. That could take another two years.

“We are in unknown territory here,” he said. “Since the peak in October ’08, bank credit has dropped by 8 percent. That is enormous and it is accelerating. The peak-to-trough drop in the early ’90s was just 1.3 percent and that was enough to scare the pants off the Fed.”

This credit cave-in is the driving force behind the Federal Reserve’s mortgage purchase program, Mr. Shepherdson says. The last thing the central bank wants to see is a decline in the broad-based money supply, because when that happens it usually means a depression is afoot. Money supply didn’t fall in the early 1990s, but it fell by one-quarter during the 1930s.

The Fed’s asset purchase program is therefore not about driving down mortgage rates, Mr. Shepherdson says, but about trying to prevent a collapse in the money supply. When the Fed buys assets it creates deposits, which, in turn, helps offset the credit pullback. If the Fed wasn’t buying mortgages with both hands, Mr. Shepherdson estimates, the money supply would be falling 1 percent a month.

The message amid this gloom, he says, is that the Fed isn’t likely to raise interest rates anytime soon. In fact, he doesn’t anticipate an increase in rates until the spring of 2011.

“I WOULD be astonished if they raised rates in the heart of the credit contraction storm,” Mr. Shepherdson says. “The credit contraction will last for a couple of years and if the Fed is interested in offsetting it, they will have to buy assets through next year.”

Deflating an asset bubble is never fun, and this particular specimen is one for the record books. The binge may have been a blast, but the purge, alas, sure is painful.

‘DOES DUBAI MATTER? ASK IRELAND,’ by Simon Johnson at baselinescenario .com.

In Uncategorized on November 29, 2009 at 23:38

Does Dubai Matter? Ask Ireland

Posted: 28 Nov 2009 05:53 AM PST

Presumably the rulers of Dubai and Abu Dhabi are currently locked in negotiations regarding the exact terms that will be attached to a “bailout” for Dubai World.  We’ll never know the details but if, as seems likely, the final deal involves creditors taking some sort of hit (perhaps getting 75 cents in the dollar, at the end of the day), does that matter?

Dubai probably has around $100bn in total liabilities, if we include off-balance sheet transactions, so total credit losses of $30-50bn need to be assigned.  The direct effects so far seem small.  HSBC leads the pack, in terms of exposure,  but our baseline estimate is a 3 percent loss relative to its equity – not good, but manageable (and the stock already fell 5 percent on the news).  The impact among other financial institutions that lent to Dubai seems fairly spread out and mostly within continental Europe.

Korean construction companies and Ukrainian/Russian steelmakers are also affected by the likely fall off in construction activity, but the broader boom in emerging markets is unlikely to be disrupted.  The repricing of risk so far does not apply significantly to East Asia or Latin America.

However, there is a worrying impact on Ireland.

The credit default swap spreads for Irish banks have widened signficantly — even relative to HSBC, with its direct Dubai involvement.  In part, this is hedge funds betting that others will want to insure against the rising risk of an Irish default, but what’s the connection?

The thinking is that a partial bailout – with creditor losses – for Dubai from Abu Dhabi implies something about how Ireland will be treated within the European Union (and the same reasoning is also more vaguely in the air for Greece).  This may make sense for three reasons.

If Dubai can effectively default or reschedule its debts without disrupting the global economy, then others can do the same.

If Abu Dhabi takes a tough line and doesn’t destabilize markets, others (e.g., the EU) will be tempted to do the same (i.e., for Ireland and Greece).  “No more unconditional bailouts” is an appealing refrain in many capitals.

If the US supports some creditor losses for Dubai (e.g., because of its connections with Iran), this makes it easier to impose losses on creditors elsewhere (even perhaps where IMF programs are in place, such as Eastern Europe).

The main effect will be to strengthen the hand of Ben Bernanke in Fed policymaking discussions – so US interest rates will stay low for a long while.  If financial intermediaries draw the appropriate lessons from Dubai, Ireland, and Greece (and Iceland, the Baltics, Hungary, etc), they will be more careful about extending credit to places that are becoming overexuberant – even when it is cheap to increase debt levels.

But an outbreak of caution and care on the part of our biggest banks (and other investment managers) does not seem likely.

By Simon Johnson

‘WHY I’M AN OPTIMIST,’ by John Mauldin at FrontLineThoughts .com. Great but long read.

In Uncategorized on November 28, 2009 at 23:53

I admit that of late my writings have had a rather dark tone. There are certainly a number of severe long-term problems that we must deal with, and they’re going to serve up a lot of economic pain. But the Thanksgiving weekend with the kids has me in a reflective mood, and one that has only served to underscore my long-term optimism. This week we look at why 2007 will not be the good old days we will yearn for in 20 years, after we briefly visit Dubai and the latest unemployment numbers.


Subprime Dubai


While we in the US spent our Thursday eating turkey and watching football, the rest of the world’s markets went into a downward spiral as Dubai announced it wanted its lenders to give the country a six-month moratorium on some $80-90 billion in debt. This has the potential to be the largest sovereign debt default since Argentina. Somehow this was a shocking development. (How can too much debt and real estate be a problem?) And by markets I mean gold, commodities, oil, stocks, and risk assets everywhere. They all went down. Today the US markets experienced their own sell-off, though not as deeply as the rest of the world.


As I wrote last Friday, the world is now negatively correlated with the dollar, and as money went into the dollar and US treasuries, everything else went down. Vietnam devalues, Greece is looking increasingly risky, Russia wants to devalue some more, the world is still deleveraging, etc. Is this another repeat of 1998, when Russia and the Asian debt crisis tanked the markets?


To get an answer, let’s look at some facts about Dubai. It is one of the Arab Emirates; but unlike its neighbor Abu Dhabi, oil is only about 6% of the economy. While the foundations of the country were built with oil, the country has diversified into finance, real estate, tourism, trading, and manufacturing. It is a small country, with a little under 1.5 million residents, but with less than 20% being natural citizens – the rest are expatriates. The gross domestic product is around US $50 billion.


(Note: and then converting the currency. I found the numbers on various websites and services strangely at wide discrepancies. This seems close to a median number. I think the discrepancy is mostly people confusing the GDP for the United Arab Emirates as a whole, which includes Abu Dhabi, rather than just Dubai.)


Dubai has become a byword for thinking large. The world’s tallest building, underwater hotels, the largest manmade islands (plural), indoor snow skiing in the desert… For links to more information try this from Wikipedia: “The large-scale real estate development projects have led to the construction of some of the tallest skyscrapers and largest projects in the world, such as the Emirates Towers, the Burj Dubai, the Palm Islands and the world’s second tallest, and most expensive hotel, the Burj Al Arab.” The list goes on and on.


UBS suggests that the $80-90 billion in debt may not include rather large off-balance-sheet debt (where have we seen that one?). So, a country with a GDP of $50 billion borrows $100 billion. They build massive projects, which are now among the most expensive real estate in the world. The latest manmade island plans for one million people to buy property there. Seriously. Talk about Field of Dreams.


Then came the credit crunch. Property values dropped by as much as 50%. Sales, say the developers in understatements, have slowed. Seems there was a lot of debt used to speculate on real estate, not to mention buying Barney’s, Las Vegas casinos, banks, etc. And while US banks have little exposure, it seems England has about 50% or so of the debt, with the rest of Europe having the lion’s share of the remainder. Admittedly, the estimates seem to confuse the debt of Dubai with that of Abu Dhabi, so it is hard to know a reliable number, other than that European banks are the most exposed.


Now, here’s the deal. Abu Dhabi has the world’s largest sovereign wealth fund, at over $650 billion. Dubai has a “mere” $15 billion. If they cared to, Abu Dhabi could write a small check and make all the problems disappear. It just seems that they are not ready to do that, at least not yet. Abu Dhabi already got the world’s tallest building on past debt problems.


Construction and real estate were as much as 25% of the economy. Let’s see. Large leverage with maybe $5 billion in interest in a $50 billion economy that is 25% construction? A construction and real estate-driven economy. A real estate bubble. Sound like California, Florida, Spain? How can this be a surprise, except that everyone expected big brother Abu Dhabi to pick up the check?


While Abu Dhabi did advance $5 billion earlier, Dubai is not letting that money out of the country. There are projects to be finished, you understand. From where I sit, this is just rather hard-headed negotiations, a restructuring of who owns what and who will get what assets. It will all settle out. Given the massive losses that world banks have already taken, this is rather small potatoes.


So why the reaction by the markets? Because I think many participants know that the potential for there to be a serious correction is quite real. When anything as relatively small as Dubai spooks the market, it should serve as a warning sign. The world has priced in 5% GDP growth for the US and much of the developed world in the equity and commodity markets. Either we have to get that or the markets are going to have to come back to the reality of what I think is going to be a much lower growth figure.


But in any event, one of the lessons to be learned is that investors should pay attention to where the leverage is. Unsustainable debt trends end in tears. They always do. Spain, Greece, Italy, the UK, and Japan will all have to face major restructuring in the next decade due to leverage. And we in the US will also find that we cannot grow debt at our current levels. Will we pare our debt willingly or be forced to by the market? Either way, it will make for a less than optimal economy over the coming years. Muddle Through, indeed.


More Government Data Fun:

Unemployment Claims Were Not Down


The headlines said that initial claims dropped to 466,000 here in the US, finally falling below 500,000. This was greeted with proclamations of recovery. First, let me say that 466,000 people filing for unemployment is still way too high. That is a lot of people losing their jobs, and when we first crossed over 450,000 a few years ago that level was seen as a sign of recession.


Second, the headline number was a seasonally adjusted number. The actual number was 543,926. What is happening is that we are coming off of wickedly high numbers in 2008 and a seasonal number that was much lower in the preceding years. It is another part of the Statistical Recovery. And this trend is likely to keep on for the rest of the quarter. My friend John Vogel, who analyzes the unemployment numbers for me each week, shows pretty convincingly that the average for this current quarter will be over 500,000 per week on a non-seasonally adjusted basis. This is less than a 10% drop from last year for the same quarter. Job losses are continuing to mount, and we are on our way to an 11%-plus unemployment number by next summer. Statistical Recovery, indeed.


Why I Am Optimistic About the Future


I am optimistic by nature. An entrepreneur friend of mine gave me a term that I have grown to love. She calls it “psychic income.” It’s that bit of hoped-for future income that is in our minds, that drives some of us, inflicted with the entrepreneurial gene, to do the next deal, make the next big plan, scheme yet another scheme to finally hit whatever counts as the big one for each of us. How much better would our life be, how our problems would go away, if only this one thing would come about! It has not yet become real income, yet we live and act as if it is almost real. We can feel it getting ready to happen. It is still in our heads, this psychic income. Yet it is in some ways real for us.


I get my propensity for psychic income naturally. My Less-Than-Sainted Dad lived on psychic income. He was always trying to invent something or launch a new business. He had large ups and downs, and at times we would be now classified as below the poverty line. Not that I knew that as a kid. Mostly, Dad lived in his dreams, though often alcoholic ones, of a better future, but he never gave up. In his mid-70s he was re-inventing the small printing press in his garage, with plans for national production. It was only after we had to take his car from him in his mid-80s that he quit. It was a very sad day. I now know we had not just taken his car, but far more than that: his dreams, his psychic income.


For some, I should note, psychic income is not just about money. It may be about the next promotion or the next big discovery. For some of us, it is just having our ideas accepted and validated in the court of human opinion. It is simply what drives us.


I graduated from seminary in the winter of 1974, entering the workforce in the hard year of 1975. We were coming off a recession, about which I technically knew little. I did know jobs were tight. I was unknowingly faceing another eight years of high unemployment, a tumultuous stock market, rising commodity prices, high inflation, and rising interest rates. Japan was just beginning to be a real force in the world. People were still buying bomb shelters, as Russia was a feared and powerful enemy. As the price of gold rose, there were those who told us the dollar would soon be worthless (the Fed was a problem and the deficit was out of control), and so we needed to buy yet more gold and also a year’s worth of dried food.


Not the best time to start a business; yet within a year or so, I ended up starting my own print brokering business, as jobs were scarce and that is what I knew. I often get letters from readers giving me grief about my rich hedge-fund friends and our fabulous wealth, and how little we relate to the real world. And for some of my rich hedge-fund friends, that may be true (although for most of my friends that is not true). And I am sadly far from rich, although I have dreams.


I remember waking up in the late 70s at 2 AM with a knot in my stomach, because a small bank was in trouble and had called my loan (an amount which now seems so small, but at the time it was all the money in the world). How would I make payroll? Gas and food? I know what it is like to work long hours and live on a very tight budget, with some months being behind on everything, while all the while your family is growing.


But I got lucky, and through a series of events got into the investment publishing field in the early ’80s, then partnered in an investment firm, and then went on my own in 1999. I stuck this letter on the internet in August of 2000, and things just took off.


But how many setbacks, bumpy rides, and false starts have I gone through over the decades? Frankly, I try to forget. But the point is that each of those episodes was another learning opportunity. And I woke up the next morning and started trying to figure it all out.


But it’s not just me, it’ is tens of millions of entrepreneurs and businessmen and women in the US, and hundreds of millions worldwide, that have the same ambitions and drive. Every night we go to sleep on our psychic income, and every day we get up and try to figure out how to turn it into real income. And some of us are talented or lucky (that would be me) enough to make it happen.


Long-time readers know that I think we are in the midst of a secular bear cycle, much like 1966-82. The next decade is likely to produce less than average growth, due to structural problems and the bad choices we have made with personal and government debt. I am perfectly cognizant that unemployment will be over 10% for a protracted time. That is tragic for those unemployed and underemployed. I realize the entire developed world has huge and seemingly insurmountable pension and medical obligations over the next few decades, which we cannot possibly hope to meet. The level of angst that we will live through as we adjust will not be fun.


But the point is, that is just what we do – we live through it. In spite of the problems, we get up every day and figure out how to make it. Would it be better if we could get our act together in (pick a country) and not be forced to adjust because we have come to the end of the line? Yes, I know we will likely have some very tumultuous times ahead of us, making business and investment decisions more than a little difficult.


So what? The future is never easy for all but a few of us, at least not for long. But we figure it out. And that is why in 20 years we will be better off than we are today. Each of us, all over the world, by working out our own visions of psychic income, will make the real world a better place.


The Millennium Wave


Let’s look at some changes we are likely to see over the next few decades. My view is that we have a number of waves of change getting ready to erupt on the world stage. The combination of them is what I call the Millennium Wave, the most significant period of change in human history. And one for which most of us are not yet ready.


Some time next year, we are going to see the three-billionth person get access to the telecosm (phones and internet, etc.). By 2015 it will be five billion people. Within ten years, most of the world will be able to access cheap (I mean really cheap) high-speed wireless broadband at connection rates that dwarf what we now have.


That is going to unleash a wave of creativity and new business that will be staggering. That heretofore hidden genius in Mumbai or Vladivostok or Kisangani will now have the ability to bring his ideas, talent, and energy to change the world in ways we can hardly imagine. When Isaac Watts was inventing the steam engine, there were a handful of engineers who could work with him. Now we throw a staggering number of scientists and engineers at trivial problems, let alone the really big ones.


And because of the internet, the advances of one person soon become known and built upon in a giant dance of collaboration. It is because of this giant dance, this unplanned group effort, that we will all figure out how to make advances in so many ways. (Of course, that is hugely disruptive to businesses that don’t adapt.)


Ever-faster change is what is happening in medicine. None of us in 2030 will want to go back to 2010, which will then seem as barbaric and antiquated as, say, 1975. Within a few years, it will be hard to keep up with the number of human trials of gene therapy and stem cell research. Sadly for the US, most of the tests will be done outside of our borders, but we will still benefit from the results.


I spend some spare study time on stem cell research. It fascinates me. We are now very close to being able to start with your skin cells and grow you a new liver (or whatever). Muscular dystrophy? There are reasons to be very encouraged.


Alzheimer’s disease requires somewhere between 5-7% of total US health-care costs. Defeat that and a large part of our health-care budget is fixed. And it will be first stopped and then cured. Same thing with cancers and all sorts of inflammatory diseases. There is reason to think a company may have found a generic cure for the common flu virus.


A whole new industry is getting ready to be born. And with it new jobs and investment opportunities.


Energy problems? Are we running out of oil? My bet is that in less than 20 years we won’t care. We will be driving electric cars that are far superior to what we have today in every way, from power sources that are not oil-based.


For whatever reason, I seem to run into people who are working on new forms of energy. They are literally working in their garages on novel new ways to produce electric power; and my venture-capital MIT PhD friend says they are for real when I introduce them. And if I know of a handful, there are undoubtably thousands of such people. Not to mention well-funded corporations and startups looking to be the next new thing. Will one or more make it? My bet is that more than one will. We will find ourselves with whole new industries as we rebuild our power grids, not to mention what this will mean for the emerging markets.


What about nanotech? Robotics? Artificial intelligence? Virtual reality? There are whole new industries that are waiting to be born. In 1980 there were few who saw the rise of personal computers, and even fewer who envisioned the internet. Mapping the human genome? Which we can now do for an individual for a few thousand dollars? There are hundreds of new businesses that couldn’t even exist just 20 years ago.


I am not sure where the new jobs will come from, but they will. Just as they did in 1975.


There is, however, one more reason I am optimistic. Sitting around the dinner table, I looked at my kids. I have seven kids, five of whom are adopted. I have two Korean twins, two black kids, a blond, a (sometimes) brunette, and a redhead. They range in age from 15 to 32. It is a rather unique family. My oldest black son is married to a white girl and my middle white son is with a black girl. They both have given me grandsons this year (shades of Obama!). One of my Korean daughters is married to a white young man, and the other is dating an Hispanic. And the oldest (Tiffani) is due with my first granddaughter in less than a month.


And the interesting thing? None of them think any of that is unusual. They accept it as normal. And when I am with their friends, they also see the world in a far different manner than my generation. (That is not to say the trash talk cannot get rather rough at the Mauldin household at times.)


I find great cause for optimism in that. I am not saying we are in a post-racial world. We are not. Every white man in America should have a black son. It would open your eyes to a world we do not normally see. But it is better, far better, than the world I grew up in. And it is getting still better.


My boys play online video games with kids from all over the world. And the kids from around the world get on the internet and see a much wider world than just their local neighborhoods.


Twenty years ago China was seen as a huge military threat. Now we are worried about them not buying our bonds and becoming an economic power. Niall Ferguson writes about “Chimerica” as two countries joined together in an increasingly tight bond. In 20 years, will Iran be our new best friend? I think it might be, and in much less time than that, as an increasingly young and frustrated population demands change, just as they did 30 years ago. Will it be a smooth transition? Highly unlikely. But it will happen, I think.


I look at my kids and their friends. Are they struggling? Sure. They can’t get enough hours, enough salaries, the jobs they want. They now have kids and mortgages. And dreams. Lots of dreams. That is cause for great optimism. It is when the dreams die that it is time to turn pessimistic.


I believe the world of my kids is going to be a far better world in 20 years. Will China and the emerging world be relatively better off? Probably, but who cares? Do I really begrudge the fact that someone is making their part of the world better? In absolute terms, none of my kids will want to come back to 2009, and neither will I. Most of the doom and gloom types (and they seem to be legion) project a straight-line linear future. They see no progress beyond that in their own small worlds. If you go back to 1975 and assume a linear future, the projections were not all that good. Today you can easily come up with a less-than-rosy future if you make the assumption that things in 20 years will roughly look the same as now. But that also assumes there will not be even more billions of people who now have the opportunity to dream up their own psychic income and work to make it happen.


We live in a world of accelerating change. Things are changing at an ever-increasing pace. The world is not linear, it is curved. And we may be at the beginning of the elbow of that curve. If you assume a linear world, you are going to make less-than-optimal choices about your future, whether it is in your job or investments or life in general.


In the end, life is what you make of it. With all our struggles, as we sat around the table, our family was content, just like 100 million families around the country. Are there those who are in dire distress? Homeless? Sick? Of course, and that is tragic for each of them. And those of us who are fortunate need to help those who are not.


We live in the most exciting times in human history. We are on the verge of remarkable changes in so many areas of our world. Yes, some of them are not going to be fun. I see the problems probably more clearly than most.


But am I going to just stop and say, “What’s the use? The Fed is going to make a mess of things. The government is going to run us into debts to big too deal with? We are all getting older, and the stock market is going to crash?”


Even the most diehard bear among us is thinking of ways to improve his personal lot, even if it is only to buy more gold and guns. We all think we can figure it out or at least try to do so. Some of us will get it right and others sadly will not. But it is the collective individual struggles for our own versions of psychic income, the dance of massive collaboration on a scale the world has never witnessed, that will make our world a better place in the next 20 years.


All that being said, while I am an optimist, I am a cautious and hopefully realistic optimist. I do not think the stock market compounds at 10% a year from today’s valuations. I rather doubt the Fed will figure the exact and perfect path in removing its quantitative easing. I doubt we will pursue a path of rational fiscal discipline in 2010 or sadly even by 2012, although I pray we do. I expect my taxes to be much higher in a few years.


But thankfully, I am not limited to only investing in the broad stock market. I have choices. I can be patient and wait for valuations to come my way. I can look for new opportunities. I can plan to make the tax burden as efficient as possible, and try and insulate myself from the volatility that is almost surely in our future – and maybe even figure out a way to prosper from it.


A pessimist never gets in the game. A wild-eyed optimist will suffer the slings and arrows of boom and inevitable bust. Cautious optimism is the correct and most rewarding path. And that, I hope, is what you see when you read my weekly thoughts.


New York and My Own Psychic Income


This week I go to New York to be with Todd Harrison and so many friends at the annual Festivus, put on by the folks from Minyanville. Then the theater on Saturday with Barry and Toni Habib to see Gods of Carnage. Then back home for the rest of the month, turning to book writing and waiting for my granddaughter to appear.


And speaking of psychic income, I remarked to some of the kids the other day that for the first time in my life I have no psychic income. There is no scheme I am working on that will change the world, no dramatic visions of grandeur. Just working on improving what we do in the best ways we can, which should be enough; but for me it is a different feeling. I worried that I was losing my edge, my drive.


“Dad,” said Tiffani, hopefully prophetically, “that just means the best and most exciting thing of all is actually going to happen. Finally.”


I love the future. It is going top be the best thing ever. Have a great week.


Your going to have fun on the ride analyst,


John Mauldin


Copyright 2009 John Mauldin. All Rights Reserved

‘THE WEAK DOLLAR WAS SUPPOSED TO FIX EVERYTHING,’ by Michael Pento , chief economist of Delta Global Advisors..

In Uncategorized on November 28, 2009 at 17:16

The Weak Dollar Was Supposed To Fix Everything

by Michael Pento November 24, 2009

The inflation redux plan from the Federal Reserve and Washington is based on zero interest rates, massive deficits and quantitative easing, which are designed to bring down the value of the U.S. dollar and create inflation. That is the truth, despite promises from Treasury Secretary Geithner that he really means it this time when he says the United States has a strong dollar policy – the irony being, that he says this while concurrently begging the Chinese to allow the dollar to fall vs. the Renminbi. But their hopes placed in a lower dollar are woefully misguided and all that is being accomplished is to put into place the same conditions that brought the global financial system to its knees.


Messrs. Geithner and Ben Bernanke have been successful in bringing down the value of our currency. In fact, many of the negative factors that were in place before the global economic meltdown occurred have returned in full force.


The trade deficit for September surged 18% to $36.5 billion. That gap was the largest since the beginning of 2009 and largely due to imports surging 5.8% to $168.4 billion, which was the biggest increase since 1993. The news must have been greeted with cheers in D.C. After all, the deficit would mean more dollar weakness and signaled the return of the borrowing and spending consumer. But the news also meant that the strategy of balancing trade by destroying the dollar was not based on sound economics. The U.S. dollar fell from 78.5 on the DXY to about 77 during the month of September. In fact, the U.S. dollar has lost more than 16% of its value since March of this year. If a weak dollar discouraged imports and boosted exports, then why did imports surge by the most in 16 years?


Sorry Ben and Tim, the so-called benefits of a falling dollar didn’t materialize as planned. That’s because the inflation you created to bring the dollar down caused the price of goods made in the United States to become more expensive. Therefore, foreign exporters couldn’t really afford to increase the purchase of American made goods even though their currencies strengthened.


The Treasury and the Fed have also been able to bring risk appetites back to 2007 levels. The massive increase in money printing and government guarantees has reduced credit spreads to razor-thin margins. The Libor-OIS spread measures the spread between the London interbank offered rate for dollars over three months and what traders expect the federal funds target rate will be during the term of the contract. The gap fell to 0.10 percentage point this quarter, below the 0.11 percentage point average between December 2001 and July 2007, according to Bloomberg, and substantially below the record high 3.64% in September of 2008.


Likewise, the Ted Spread is back to the “good old days” as well. Last November, the gap between the 3-month Treasury securities and 3-month Libor was 199 basis points. Today, it is just 21 basis points. But the mispricing of risk that helped bring the financial sector down in 2007 and 2008 is not boosting bank lending to private industry. Bank lending is plummeting for the creation of capital goods and new businesses. However, a broad measure of the money supply, Money Zero Maturity, is up 8% year-over-year. That’s because banks are lending to the U. S. government, which is the only insatiable entity for borrowing that still exists.


So the benefits of a crumbling currency have yet to materialize. However, the ravages of pursuing such a flawed policy have started to arrive. The price of oil has soared and gold is setting new highs every day. Credit spreads are indicating that investors are mispricing risk yet again and the ballooning trade deficit indicates that we once again believe we can consume much more than we produce.


The stock market is dancing on top of a $2 trillion monetary base and that latent liquidity has sent commodities higher, while the dollar sinks. My guess is that Wall Street and Washington believes things are getting much better. But I’ve seen this movie already and I don’t like how it ends. As the prints on the consumer price index (CPI) become more and more difficult to ignore, the Fed will be forced to remove the life support provided by their free money policy. When that occurs, we will see the return of economic calamity. And maybe then we will have the courage to finally face and deal with the true problem. News flash to D.C. and Wall Street: It is not the misperception of an overvalued dollar, but rather it is our overriding debt.


Michael Pento is chief economist of Delta Global Advisors.

‘YIELD MATTERS. AND WHERE IT COMES FROM,’ in the Wall St. Journal via

In Uncategorized on November 28, 2009 at 15:11

Yield matters. Not that you’d necessarily know it from where some markets are trading.

For instance, at one point last week, U.S. short-dated Treasury bills were said to have had a negative yield. That’s to say, investors were paying the U.S. government to hold its paper.

And 10-year U.S. Treasury notes are yielding just over 3.3% — exactly the average U.S. inflation rate of the past century. In other words, the expected real return of longish-dated U.S. government paper is broadly the actual return of short-dated U.S. government paper. Which is nothing.

Investors have lately been chasing gold, which is another asset with a negative yield (no earnings, but you’ve got to pay to store the stuff).

OK, so there’s a bit on offer from equities. The S&P 500 index  returns 2.4%. That’s a little more than a percentage point more than equities returned during the peak of the tech and telecom bubble. Yipee. But then again, share buybacks also returned about another percentage point back then, and you don’t hear of too many firms spending their recently hard-accumulated cash on something as silly as shares, do you? So the actual percentage payout to shareholders probably isn’t so different from where it was in the craziest of the go-go days. Not so yipee.

You get a little more return from corporate credit, particularly high-yielding paper, and from emerging markets, but even here the spreads have narrowed considerably since the spring. On the other hand, you could also argue that the additional bits of yield are hardly compensation for historic volatility — never mind the market gyrations of the past couple of years.

Indeed, that’s why yield matters. In a world where wildly fluctuating capital values are the norm, investors would do well to look for a safe source of income. Throw in the risk that trend growth will be considerably lower than it has been in this brave new world of massive government, heavy regulation, deleveraging and general consumer uncertainty and the potential sources of that income shrink.

Bill Gross, head of the giant bond fund Pimco, and Warren Buffett of Berkshire Hathaway  have identified utilities as the best source of that guaranteed flow. They yield two to three times more than the overall market index. And if the upside is strictly limited by regulators, it’s also true their returns are as guaranteed as anything in these crazy markets.

Yield matters. And so does the source of that yield.


In Uncategorized on November 28, 2009 at 04:46

By Mark Felsenthal

WASHINGTON (Reuters) – Federal Reserve Chairman Ben Bernanke said on Friday congressional proposals to audit the Fed and strip it of regulatory powers as part of post-crisis reforms could damage prospects for economic and financial health in the future.

“These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States,” Bernanke wrote in a column posted on the Washington Post’s website.

The rare newspaper column by a Fed chairman comes shortly before Bernanke testifies before a Senate panel on his renomination to serve a second four-year term at the helm of the central bank and answers a series of steps on Capitol Hill that could diminish the central bank’s role.

Lawmakers are angry with the Fed over its emergency bailouts of major financial firms and its failure to prevent the contagion of mortgage delinquencies that crashed the financial system. A proposal to audit the Fed’s monetary policy deliberations won a committee vote recently over the objections of House Financial Services Committee Chairman Barney Frank.

Frank’s Senate counterpart, Banking Committee Chairman Christopher Dodd, is himself the author of a proposal to consign the Fed solely to making decisions about setting benchmark interest rates.

Bernanke, in his column, conceded the Fed had missed some of the riskiest behavior in the lead up to the crisis. But he said the Fed had helped avoid an even more damaging economic meltdown and has stepped up its policing of the financial system.

“The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation,” he said.

Bernanke acknowledged that lawmakers are responding to public anger over the government’s response to the turmoil.

“The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis,” he said.

However, the central bank has moved “aggressively” to fix the problems, Bernanke said. The Fed’s knowledge of complex financial institutions is invaluable in supervising them, he said.

The Fed’s ability to slash interest rates to combat a recession without fueling inflation depends on its political independence he said. Allowing audits of its monetary policy — as proposed legislation would do — would increase the perceived influence of Congress on interest rate decisions, he said.

That, in turn “would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation,” Bernanke wrote.

Frank has said the audit provision is likely to be revisited as legislation winds through both houses of Congress.

Dodd has said his proposal is a starting point for debate.

‘TAXING THE SPECULATORS,’ by Paul Krugman in the N.Y.Times.

In Uncategorized on November 27, 2009 at 19:52

Should we use taxes to deter financial speculation? Yes, say top British officials, who oversee the City of London, one of the world’s two great banking centers. Other European governments agree — and they’re right.

Unfortunately, United States officials — especially Timothy Geithner, the Treasury secretary — are dead set against the proposal. Let’s hope they reconsider: a financial transactions tax is an idea whose time has come.


The dispute began back in August, when Adair Turner, Britain’s top financial regulator, called for a tax on financial transactions as a way to discourage “socially useless” activities. Gordon Brown, the British prime minister, picked up on his proposal, which he presented at the Group of 20 meeting of leading economies this month.


Why is this a good idea? The Turner-Brown proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the Nobel-winning Yale economist. Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.


Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation.


Tobin’s idea went nowhere at the time. Later, much to his dismay, it became a favorite hobbyhorse of the anti-globalization left. But the Turner-Brown proposal, which would apply a “Tobin tax” to all financial transactions — not just those involving foreign currency — is very much in Tobin’s spirit. It would be a trivial expense for long-term investors, but it would deter much of the churning that now takes place in our hyperactive financial markets.


This would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years, there’s broad agreement — I’m tempted to say, agreement on the part of almost everyone not on the financial industry’s payroll — with Mr. Turner’s assertion that a lot of what Wall Street and the City do is “socially useless.” And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What’s not to like?


The main argument made by opponents of a financial transactions tax is that it would be unworkable, because traders would find ways to avoid it. Some also argue that it wouldn’t do anything to deter the socially damaging behavior that caused our current crisis. But neither claim stands up to scrutiny.


On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair. Take, for example, Tobin’s original proposal to tax foreign exchange trades. How can you do this, when currency traders are located all over the world? The answer is, while traders are all over the place, a majority of their transactions are settled — i.e., payment is made — at a single London-based institution. This centralization keeps the cost of transactions low, which is what makes the huge volume of wheeling and dealing possible. It also, however, makes these transactions relatively easy to identify and tax.


What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.


But bad investments aren’t the whole story of the crisis. What turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money.


As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period — often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”


And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis — and could help us avoid a future replay.


Would a Tobin tax solve all our problems? Of course not. But it could be part of the process of shrinking our bloated financial sector. On this, as on other issues, the Obama administration needs to free its mind from Wall Street’s thrall.


‘WHAT ARE THE DOLLAR AND GOLD TELLING US?, ‘ from director of research at Fidelity.

In Uncategorized on November 27, 2009 at 18:56

The rally in gold and the related decline in the dollar have been hard to miss these past few months. What is this telling us about monetary and fiscal policy, and what might an investor do?


The Federal Reserve (Fed) has an incredibly tough job these days. It deserves credit for helping prevent a second Great Depression a year ago, which it did by not only lowering short-term interest rates to near zero but also by expanding the monetary base. But now comes the even harder part: What is the exit strategy? Withdraw the stimulus too soon and the Fed risks triggering another economic relapse, but withdraw too slowly and it risks raising inflationary expectations, not to mention renewed asset bubbles. It’s like threading a needle.


Complicating matters even further is that the same thing is playing out on the fiscal side. Congress responded to the crisis with a huge dose of fiscal stimulus. But when does it stop the cycle of deficit spending? How many years of trillion-dollar deficits will our foreign creditors tolerate? Is the United States inflating its way out of trouble by printing money and debasing its currency, as so many countries have unsuccessfully tried to do throughout history?


These are difficult questions indeed, and there are no clear answers right now. This is why gold is rallying and the dollar is declining: they smell a policy error.


Lessons from the Great Depression

To help understand the choices the Fed is facing, it’s instructive to take a page from past crises, especially the Great Depression. Doing so is especially relevant because Fed Chairman Ben Bernanke is known to be a student of that period in our country’s history. So, if his decisions at the Fed are influenced by what he has learned from the Great Depression, then it’s important for us to know about it as well.


The Great Depression was actually two depressions. It started with World War 1, which essentially bankrupted Europe in the 1920s. Via the Fed, the U.S. lent a helping hand by extending easy money to Europe from around 1925 to 1927. However, in a classic example of the “laws of unintended consequences,” some of this easy money ended up in our own stock market, thus contributing to the massive bubble that burst in 1929. This episode shows that the concept of “moral hazard” is not new. It existed as far back as the 1920s.


When the bubble burst in 1929, it unleashed a wave of deflationary debt deleveraging onto the U.S. economy, much like that which occurred in 2008 after the housing bubble burst. However, during the 1930s the Fed was on the gold standard, which made it impossible to just open up the liquidity spigot like it did last year. In fact, the gold standard acted somewhat like a straight jacket and the Fed actually raised rates for a while, which is obviously the last thing one should be doing during an economic crisis. This policy error undoubtedly contributed to the 87% blood bath in stocks from 1929 to 1932.


Bernanke knows this well, which is probably why he responded with such overwhelming force in the fall of 2008 following the collapse of Lehman. Not only did the Fed lower rates to zero, but it expanded the monetary base. We call this “quantitative easing” or, more simply, “printing money.”


The idea behind quantitative easing is that the Fed creates (out of thin air) excess banking reserves. These reserves end up on the balance sheet of banks, which are then supposed to lend out these new reserves to consumers and businesses. That triggers what is known as the money multiplier, which then expands the money supply and brings the economy back to life, and creates inflation (which under these circumstances is a desired outcome).


The problem in the early 1930s was that the gold standard prevented the Fed from doing this, until Franklin D. Roosevelt (FDR) came into power in 1933. FDR realized that the gold standard was limiting his ability to respond to the crisis, and in April of 1933 he changed it. He did this by making it illegal to own gold. Holders of gold had to turn in their bullion, receiving the stated conversion price of $20/oz. FDR then changed the conversion price to $35/oz., and with the stroke of a pen he increased the money supply and devalued the dollar at the same time. That was the catalyst for a 150% rally in the stock market and several years of very strong economic growth.


Today the Fed doesn’t need to worry about the gold standard. While that gives the Fed more freedom to expand its balance sheet and print money, it also has a consequence. The dollar can go down in value, which is of course what is happening now. And when the dollar goes down, gold goes up. After all, gold is the ultimate currency because unlike a fiat (paper) currency, it is not someone else’s liability. Consequently, it may be useful to view gold less as an inflation barometer and more as a hard currency. This is especially the case because other countries are doing the exact same thing in terms of monetary and fiscal policy.


Inflation or deflation?

So here we are with the printing presses running at full speed. Is that inflationary? Not necessarily, or at least not yet. Printing money is only inflationary if the banks end up lending it out via the above mentioned money multiplier. That isn’t happening right now. This is a liquidity trap, because banks haven’t been increasing their lending. As long as we are stuck with this liquidity trap, the velocity of money will stay low and the risk of deflation will outweigh the risk of inflation.


What if the banks do start lending out some of these excess reserves at some point? After all, that is what banks are supposed to do for a living. If and when that happens, the money multiplier will start multiplying, which could set the stage for both growth and inflation. At that point, it will be important for the Fed to start withdrawing some of this unprecedented stimulus.


To give you a sense of just how high the stakes are, the chart below shows declines in GDP in the bottom panel and the monetary policy response in the top panel. The latter is defined as the ratio of excess banking reserves to required banking reserves (as a proxy for how fast the printing presses are running).





Take a look at the left side and then at the right side of the chart. There is no question that the current degree of policy response relative to the decline in the economy is far greater than that which occurred during the 1930s. Whether the current policy response is excessive or necessary is beside the point right now. The question: How do we get out of this when the time comes?


Gold and dollar are on the move because some investors are wondering whether or not the Fed has the willingness or ability to exit qualitative easing at just the right time and by the right amount. It’s not so much an issue of inflation, as an issue of confidence in our policy makers. In a way, gold is providing a hedge against mismanagement in Washington.


If the Fed is able to thread that needle when the time comes, and that’s a big “if,” then the run-up in gold and the corresponding decline in the dollar could reverse very quickly. If that happens, the dramatic rally in gold will be seen as nothing more than a one-off bubble.


But if the Fed finds itself unable or unwilling to exit when the time comes, especially if at the same time Congress continues to run massive deficits, then the moves in gold and the dollar could still have a long way to go.


What’s an investor to do?

So how do you play this potentially binary outcome?


The immediate impulse might be to buy gold, either physical gold or a gold mutual fund or exchange-traded fund exchange-traded fund (ETF). If you believe we’re headed for a fiscal train wreck, then allocating a small portion to a well-diversified portfolio may make sense. But what if the Fed pulls it off? Then gold could come crashing down. A tough call indeed.


Another option might be to allocate a small portion of your portfolio to stocks and bonds of emerging market countries (like China and India) and natural resource-rich countries (like Brazil, Canada, and Australia). This might buy you two things: geographic and currency diversification. As the dollar falls, the appreciation of foreign currencies can provide an extra boost in return to U.S. investors. That’s because foreign securities are worth more when translated back to dollars.