Unstable Stability

In a recent talk with Congress, Greenspan warned against Americans becoming too content with the economy, that they need to prepare themselves for the shock of what would happen if those "kind strangers" were to stop supporting us. John Mauldin explores…

"Another G-7 meeting has come and gone. And what has been accomplished? Next to nothing, in my view. The club of the world’s wealthiest nations has punted on the big issues facing the global economy – namely, unprecedented current-account imbalances, currency misalignments, mounting trade tensions, and the liquidity-prone biases of central banks. The G-7’s latest communique is emblematic of the increasingly vacuous rhetoric of globalization. This is a perilous course of inaction for a global economy beset with record imbalances."
(Stephen Roach, Chief Economist, Morgan Stanley)

In his talks to Congress at the end of February, Chairman Greenspan dropped in these words, which did not make the highlight reels, but nonetheless should be listened to:

"People experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency."

The record imbalances, which Roach alluded to, are inherently unstable. They are the proverbial unsustainable trend. Yet things seem to be rocking along just fine. One of America’s finest theoretical economists, Hyman Minsky, gave us this great quote, "Stability is unstable." What he meant by that is that the longer things remain the same, the more we expect them to remain the same and the more complacent we get. Thus, when things actually do change, the shock is much greater. Few have "remained vigilant." The long-term stability of trends is the seedbed for asset and credit bubbles of all types.

While the game can go on for much longer than reason would dictate, there will be an end to it. Will it be the soft landing with nations agreeing to work together to find a sort of Nash equilibrium; or, the hard landing where the "vacuous rhetoric of globalization" masks the reality of each nation going its own way, in a kind of "devil take the hindmost" world?

Game Theory and Economics: The Nash Equilibrium

In game theory, the Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute Nash equilibrium. John Nash, the Nobel laureate in mathematics was featured in the movie "A Beautiful Mind." (Highly recommended, by the way.)

The United States is living, many say, on the kindness of strangers. If it were not for the willingness of Chinese and Japanese central banks, along with their smaller Asian counterparts, to finance our trade deficit, we would be in perilous circumstances. If Asian currencies saw the dollar fall by 33%, they stand to lose over $600 billion in buying power due to their massive $1.8 trillion U.S. dollar reserves. That is a massive amount of confidence.

Yet it works both ways. Exports to the United States alone accounted for about 12% of China’s GDP, and that was up from 9% in 2000. At current growth rates, U.S. imports could be responsible for 20% of China’s GDP by 2008. It may be that China is depending upon the kindness of strangers, in this case U.S. consumers. Other Asian countries have similar, if not as dramatic, dependence upon U.S. consumers. And many of them ship materials to China that eventually find their way to the United States.

The elephant in the world economic room is the now $660 billion U.S. current account deficit. At least $465 billion of that comes from foreign central banks. It is an odd Nash equilibrium. They take our paper, which they know will one day be worth less than it is today, in order to be able to sell us products that keep factories growing. How long can the game continue? In the case of China, it may continue until they have established their own internal equilibrium of jobs for the hundreds of millions of peasants moving from the farms looking for a better life.

Game Theory and Economics: "Senator Stabenow Is an Idiot."

It is not a matter of things staying the same. There is no Nash equilibrium into which the world has settled. We are still "playing the game" and some players may be opting to take advantage of others. The system itself is inherently unstable, as we will see. And if you have trouble understanding how the game is played, then take comfort in the fact that a U.S. Senator, whose staff should know better, clearly does not understand the basics of how the economy works. I quote this from good friend Dennis Gartman:

"Secondly, we are now firmly convinced that Sen. ‘Debbie’ Stabenow (D-Michigan) is an utter and complete idiot. Why mince words, for clarity is what we are after here, and in her questioning of Mr. Greenspan yesterday Sen. Stabenow removed any and all possibilities that she is not an idiot. Taking a page from the manners of H. Ross Perot and waving a piece of paper upon which one of her staff had obviously listed the foreign buyers of U.S. Treasury securities, Sen. Stabenow roared before the television audience and wondered aloud what Mr. Greenspan was going to do about this problem!

"Sen. Stabenow was indignant that so many ‘foreigners’ owned US Treasury securities, and she hoped that Mr. Greenspan would somehow come to his sense and prohibit them from doing so in the future… or at least expose this as a problem that must needs be addressed immediately.

"Mr. Greenspan, visibly torn between laughing aloud at the Senator’s idiocy and between disdain, but summoning up all of the will power necessary to answer her properly, said that he knew of no laws that these ‘foreigners’ had broken; that he knew of nothing he could do to stop them from making investments that they thought were well advised and reasonable; that without their purchases U.S. interest rates might well have been a good deal higher than they are, and that there seems to be no movement on their part to create an untoward market circumstance by selling those securities presently. The only comment he missed making and one we wish he had made is that their purchases are a huge ‘vote of confidence’ in the U.S. economy, not an indictment of same. Sen. Stabenow proved the wisdom of the old aphorism that it is far better to remain silent and thought of as an idiot than to say something and remove all doubts. In her case, there were few doubts before her appearance; now there are none."

There is reason to believe that long term interest rates might be at least 1% higher and perhaps as much as 2% without foreign buying of U.S. government debt. 10-year Treasuries at 6% would mean that 30-year mortgages would be well over 7%. That would create quite a slowdown in housing construction and at least put a lid on the rise in home values, if not reverse the trend. That would certainly slow the economy down.

While it is doubtful the Senator would wish for such an economic slowdown, this illustrates that there are consequences for individual investors to the "international trade game." It is not played in a vacuum.


John Mauldin
for The Daily Reckoning
March 03, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. Bull’s Eye Investing is a must-read road map if you want to avoid the pitfalls of the modern investing landscape…

To order your copy at a discount, see:

Bull’s Eye Investing

Bill is on a plane headed home today…his time in paradise had to end sometime.

We will soldier on – we just won’t be very long-winded…

Yesterday, our favorite government official, Alan Greenspan, issued a grave warning to Congress on the subject of the U.S.’s gigantic budget deficit.

Greenspan said that worry over the budget is obscuring the economic outlook, and that "the consequences for the U.S. economy of doing nothing [about the budget] could be severe."

Since Bush II took office in 2000, the federal budget has swung from a record surplus to a record deficit.

Everyone seems to want to get his or her two-cents in on the budget deficit. At the Academy Awards on Sunday, host Chris Rock said:

"You know, when Bush got into office he had a surplus of money. Now there’s like a $70 trillion dollar deficit. Now, just imagine you worked at the Gap…You’re closing out your register, and you’re $70 trillion dollars short.

"The average person would get in trouble for something like that, right?"

This may be the one time that you could say Alan Greenspan and Chris Rock are on the same page.

More news, from our team at The Rude Awakening…


Eric Fry, reporting from Wall Street:

"Escorted by a well-connected friend, your editor strolled unmolested past the series of velvet ropes that bars the V.I.P. entrance to "Mansion," one of the trendiest nightclubs in Miami’s South Beach…The U.S. capital markets used to be almost as fashionable as Mansion, but something has changed. Mansion is still hot; the U.S. capital markets are not."


Back in Baltimore…

*** We just received this from our commodities expert, Kevin Kerr:

"Commodities and natural resources used to be the butt of jokes and misconceptions. Now they are finally getting the respect they deserve. Traditional investors and advisors are rushing into commodities, hoping to find the high growth that traditional equities no longer deliver.

"But even with the commodities turnaround, there is still one sector of the real asset market that is still taboo to many mainstream investors. I’m talking about the commodity futures markets.

"Resource stocks and stock options are fine for most investors. But they still think that trading in the futures markets is nothing more than gambling.

"And that’s a real mistake. The fact is, traders need to diversify. And if the next several years are as bumpy for stocks and bonds as some analysts expect, commodity futures and options might provide the kind of returns investors need."

*** A note from a reader:

"There I was, watching Alan Greenspan live on TV. Ron Paul began his gold standard question, and, being the bi-metal standard kind of bug that I am, my antennae went straight up, straining for better perfect reception. What was a one-time gold standard proponent going to say to a man essentially calling him an apostate?

"Just then, the CNBC Keynesians cut in, Steve Liesmann began chatting something nonsensical, but quite fervently, at Maria Bartiromo. Ron Paul’s volume immediately shrank into the inaudible range as the sound engineer hit the ‘suppress the truth’ button.

"Later I saw more of the exchange on a different channel. There I learned that Greenspan had simply fibbed his way through. Greenspan lied to me, and I must tell you, I am shocked, SHOCKED, that a government official would think of such a thing.

"If I only had a gold ounce – even a Canadian maple – for every time I have heard these people poo-poo real money, or call the U.S. (which is, I repeat again, A CONSTITUTIONAL REPUBLIC, and NOT) a ‘democracy.’

"I guess I am just going to have to get used to it. After all, most people still haven’t figured out that the lottery is really another form of taxation. It is a graduated tax on stupidity. I wonder how long the social security debate will last before someone spills the awful beans: The whole SS system is a pyramid scheme. And pyramid schemes are illegal. SHHHHH. Mums the word.