Our Brave New World, Part II
This week we are continuing our multi-week series centering on a debate that began when Bill Bonner joined John Mauldin and the gentlemen from GaveKal Research for dinner. It is one of the most important debates of this era, as not only does the outcome of the debate touch every part of our investment lives, but it also affects the very social and political worlds we live in.
For readers in the middle of this conversation, we are in a series on the debate held at a London restaurant between Charles and Louis-Vincent Gave (father and son) and Bill Bonner. The Gaves openly declared that "This time it’s different," much to Bill’s amusement. We all know that it almost never, ever is. They make their argument in a book called "Our Brave New World."
The next thing that GaveKal argues is that monetary policy no longer works like it used to. "In the wake of the Asian Crisis, lower rates are more stimulative to supply than demand while it used to be that lower rates were more stimulative to demand."
This is a subtle argument, but part of an overall theme that we are in a deflationary world. Bonner would agree, but where he sees a negative aspect of deflation, they see a deflationary boom. Readers of Gary Shilling would recognize this position. Shilling has maintained for years that we will enter a period of what he calls good deflation.
At its roots, a deflationary boom exists when supply is structurally ahead of demand. Prices drop, and in a classic world, when prices drop, demand rises, thus stimulating even more supply.
Our Brave New World: The Job of Central Bankers
This, they point out, makes it easy for central bankers, if you assume the job of central bankers is to keep inflation under control. They do not have to worry about the supply side of the inflation model. Inflation can be created by not enough supply to meet demand. But when there is always "more stuff" coming into the market, inflation does not result from supply side problems.
That means that central bankers need only worry about the demand side of the equation causing inflation. Thus, raising rates will lower demand, taking away the demand driven inflation. If they need to stimulate demand, as they wanted to in 2001-02, they simply lower rates. But here is the GaveKal twist:
"In terms of managing demand, the Fed may have overdone the demand stimulation in 2001-04, but an important lesson was learned: low rates not only stimulate consumption in the US, but capacity expansion abroad even more. For a while, we get a window where demand surges (i.e.: US housing cycle, energy) and people believe we have entered an inflationary boom. For a brief period, it appears that demand has caught up with supply. But, monetary demand stimulation at the core also creates supply stimulation at the periphery. And while this is going on, investment in capacity looks like demand.
"At some point however, the rise in commodity and house prices we have witnessed in recent years will likely be viewed more as a reflection of capacity growth around the world, not true demand.
"Because low rates are a reflection of the deflationary backdrop, not the cause, the Fed simply can not lean into demand too hard by raising rates aggressively; otherwise they risk a real deflationary bust. The Fed thus has to raise rates gingerly and talk tough – walk hard, but carry a small stick. And since prices don’t structurally take off, core inflation measures around the world stay tame.
"Whatever central bankers want to do, they cannot change the reality that supply is in excess of demand. So the complexion of activity is decent volume growth but muted prices. This likely means that the next time the Fed has to lower rates aggressively, the curve won’t be as steep as the last go around. In our old MV=PQ framework, when curves are steep, currencies fall, and deficits widen, companies can monetize higher prices. Income statements are inflation pass-throughs. However, investors usually don’t like to pay a lot for that (which is why multiples have fallen over the last few years).
Our Brave New World: The Crutch of Price
"Today, those forces are in reverse. Companies cannot rely on the crutch of price; companies have to monetize volumes. This is much harder to do; and investors are willing to pay a premium (i.e.: Apple) for companies that can do it."
By "rely on the crutch of price," GaveKal means that companies simply cannot raise prices to increase profits. They have to sell more "stuff" at lower prices to increase total profits.
This is the chicken-and-egg analogy, but an important distinction. Yes, the Fed did want to stimulate demand when they lowered rates. But they also made cheap money (with the help of other central banks, and especially Japan) available WORLDWIDE for increasing production. Thus, China has some 1,000 ball bearing companies when it needs, maybe, 10. Each day, the managers of those 1,000 companies wake up trying to figure out how to get to be big enough to be one of the 10 who will survive. And that means growing even more capacity, which is not really needed. They do this by borrowing money, getting foreign investment, offering lever lower prices, etc. And since rates are low and the money is easy to come by, they have every incentive to do so.
It is the same for chips and copper wire and appliances and, well, just about everything. And the developed world responds by letting the developing world (not just China!!!) do the low profit manufacturing and keeps the profitable design and marketing parts of the business. And this results in a trade deficit.
We shall see that Bonner, et al, do not like the dollar asset standard. Good old gold is what we need as a basis for money. Yet GaveKal not only asserts that a dollar asset standard is developing, but that it is superior to gold. Quite simply, they argue that since gold cannot grow at a fast enough pace to maintain global growth, it has to be replaced, otherwise we revert to a world where consumers lose and governments dominate by their power of controlling gold flows. Now, let’s turn to page 109 in our hymnbook and let them explain how they see their Brave New World developing:
"If we assume that a new part of the world is getting richer (China, India, Russia, Brazil, etc.), then we should probably assume that some entrepreneurs in those countries are making it big. This assumption is not a stretch; there is enough anecdotal evidence to support it (if you doubt that some new entrepreneurs are making it big, go to the Louis Vuitton store in Shanghai on a weekend). If we further assume that, in the countries getting richer, we will start to witness the emergence of institutional savings (pension funds, mutual funds, family offices, etc.), then we should expect big ‘savings flows’ from the rapidly growing developing world into the Western world.
"In simple words, the emerging markets’ newly rich will feel like investing a part of their newly created wealth in regions of the world where property rights are well protected and where there is a rule of law. The excess trade balances earned by the ‘industrial world’ have, in fact, little choice but to be reinvested in the assets of the ‘creative world’. The pension funds of the ‘industrial world’ will buy the companies which give their countries work. The successful individuals in the ‘industrial world’ will also buy real estate in the ‘creative world’ (because it also happens to be the ‘fun world’).
Our Brave New World: The Two Parts of Balance of Payments
"This implies that the assets in the ‘creative world,’ and especially the prestige assets will always border on the overvalued. Similarly, given the ability to change a producer if he becomes a little bit too demanding, asset prices in the industrial world will remain a little bit undervalued at all times…Which brings us to the following point: balance of payments consists of two parts:
"1. The Capital Balance: if the above holds true, that part will always be positive for countries with well developed financial markets.
"2. The Current Account: since the two parts add to zero (by construction) it means that the current account in countries with well developed financial markets (US, UK, HK etc.) should always be in deficit, and massively so…
"Taking this a step further, we can assume that, as a result of the constant capital flows, the countries with a well-developed capital market will have an overvalued currency and a very low level of long rates. Which in turn leads to robust real estate markets (see chapter 8) and higher asset prices.
"We call this ‘the dollar asset standard’. Basically, diversified and safe assets in the Western world replace gold as the standard of value in the eyes of new savers in Asia, Latin America or Eastern Europe.
"The first implication of this new ‘dollar asset standard’ is that overvalued currencies, combined with a low cost of money (i.e. low barriers to entry), will prevent anybody in the ‘developed financial market world’ from making any money in industrial goods. In turn, this development will ultimately force companies in the developed financial market world to move to the ‘platform company’ business model, specializing in design and in marketing, and letting someone else produce the goods.
"But this is where it gets interesting: once they make the switch to the ‘platform company’ model, a number of companies will likely realize that they should domicile their research and marketing activities in countries with low marginal tax rates, both for their shareholders and their employees.
"To some extent, this has already happened in the financial industry. On any given day, the biggest foreign net buyer or seller of US Treasuries is the Caribbean Islands. Now needless to say, the Caribbean islanders are not amongst the world’s largest investors; but the hedge funds domiciled there most definitely are. So the ‘efficiency capital’ of the world, which used to be domiciled in big investment banks in the world’s financial centers (whether London, New York, Frankfurt, Tokyo…) has now re-domiciled itself in hedge funds whose legal structures are in the Caymans, Bermuda, the British Virgin Islands etc. The tax revenue on the ‘efficiency capital’ is now lost for the US, the UK and others…and there is little they can do to gain it back.
"And it’s not just in finance that this is happening. Hong Kong Land, a property developer is incorporated in Bermuda. Electronic Arts, one of the world’s biggest video game designers is incorporated in the Caymans…. As an increasing number of companies move to the ‘platform-company’ model, it is likely that the top talent will want to work, or at least be taxed, in low tax environments. This will lead to a collapse in tax receipts in countries that do not adjust to this new model. In the new world towards which we are rapidly moving, income taxes will becoming increasingly voluntary and governments will have to get their pound of flesh through property and consumption taxes instead. This should lead to more efficient (i.e. downsized) governments all over the Western World. The platform companies might end up killing off the Welfare State."
This sounds like James Dale Davidson and Lord Rees-Mogg in their important book written a few years back called The Sovereign Individual, although GaveKal comes to the same end from a different road.
And it is an idea to which I subscribe, though for different reasons. It will not just be the pressure from platform companies wanting to avoid taxes that will precipitate that change. I would make the argument that the current generation (in nearly every country in the developed world) and our forebears have written a check in the names of our children, which they will not be able to pay. By this I mean our social security and pension programs. And if they cannot pay it, they won’t. The social contract between generations and governments is going to be re-written in the next 20 years.
We live in interesting times.
for The Daily Reckoning
November 29, 2005
P.S. Today, we concluded the GaveKal arguments in Our Brave New World. Next week, we will turn to Empire of Debt, looking at Bill’s and Addison’s arguments.
Then I will share my view on the topic. It will surprise no one that I think the truth is somewhere in the middle. Things are in fact different, yet we will have to find a balance. That a balance and a squaring of the balance sheet may come from new and different forces than in the past will make things seem both different and the same. It is a rhyme, not a repeat. It is Muddle Through, not a depression, soft or otherwise.
John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, is due out in December.
Another day, another dollar.
Today’s dollar ain’t what it used to be. It ain’t even what it used to be yesterday. We have a hunch it ain’t what it will be tomorrow, either.
Yesterday, the dollar fell against the euro and the yen. Don’t be alarmed, dear reader; the small rise in foreign currencies was nothing important. The news from Europe is that traders are betting that the European Central Bank will raise rates, and/or that the U.S. Central Bank will stop raising them.
More important was the news from Washington and Asia. In this morning’s trading in Asia, gold jumped over $500 an ounce. It is almost twice as expensive as it was when we recommended it to you more than five years ago. A double in five years? What’s so great about that, you’re probably wondering. Google went from $85 to $428 (yesterday) in a matter of months.
It is not pride that causes us to remind you of gold’s rise, but modesty. We have good reason to be humble. We know nothing of the future, and very little of the past. But what we do know is that every other time mankind has tried to replace gold with paper, people ended up craving gold more than ever. We see no reason why the present experiment should produce a different result.
The latest numbers issuing from Washington reinforced our faith in the customary outcome. George W. Bush will go down in history not as a great war president, we predict, but as a great debt president. In his few years in office, the feds have borrowed more than $1.05 trillion from foreign governments and banks. This is more than all the rest of the nation’s administrations put together, since 1776 to 2000.
Last month, the U.S. national debt passed the $8 trillion mark. This year’s budget deficit alone, added $319 billion to the country’s obligations. While we do not know what the future will bring, nevertheless we can put two and two together. According to the government’s own accountants, deficits will rise to $873 billion per year within 10 years. Two years more and they will be at $1 trillion per year, with a national debt edging up to $20 trillion. By 2017, annual deficits are supposed to reach $2 trillion per year.
These figures are not hard to come up with. You merely project current population and income trends into the future…along with already-legislated boondoggles, such as health and retirement programs. You end up with big numbers.
You also end up with a national currency that has question marks all over it. Eventually, those questions will be answered. Already, since being cut loose from gold, the dollar has lost more than half its purchasing power. It is bound to lose a lot more.
The price of gold will go over $1,000 an ounce, says Newmont. Maybe so.
More news from the pundits at The Rude Awakening…
James Boric, reporting from Charm City:
"Joel Greenblatt is not famous…He is merely rich.
"Last week, I discovered why he is so rich. My discovery could easily put a few extra dollar bills in your pocket as well…Maybe even millions of dollar bills."
Bill Bonner, back in London with more views…
*** Yesterday’s decline in the dollar was laid to the housing industry. Fewer bricks and less mortar were sold last month than analysts had hoped for. Buyers were so scarce that inventories rose to a 19-year high.
On the other hand, the piles that did sell, sold for high prices. Go figure. The median house sold for 17% more than a year ago – the biggest increase in 26 years.
Obviously, something’s gotta give. Inventories and prices cannot rise together for very long. We will take a wild guess: prices will go down before inventories do.
*** The noted empire scholar, Professor Niall Ferguson, despite being on a book deadline himself, had these kind words to say about our book: "[Empire of Debt] is a book that is certainly asking the right question about America’s fiscally over-stretched empire."
*** As you may know, before Thanksgiving we sent 537 copies of Empire of Debt to the scalawags in Washington. And then, we asked readers to call or e-mail their representatives to make sure they got the books and read the introduction (at least!).
"A reporter from Smart Money magazine got wind of our plot," writes Addison. "’What did you expect to happen next?’ she asked me this morning."
Hmmmn. That’s a good question.
As of this morning, we’ve received six form letters and one holiday card back. Most of the form letters read something like this one from Senator Mark Pryor:
"Mr. Addison Wiggin
Angora Financial (sic)
808 St. Paul Street
Baltimore, Maryland 21202
"Dear Mr. Wiggin:
"Just a note to thank you for sending me a copy of your book Empire of Debt: The Rise of an Epic Financial Crisis. I certainly appreciate your thoughtfulness and am looking forward to reading it.
"Thank you, again.
"Sincerely, Mark Pryor"
Curiously, the phrase: "I appreciate your thoughtfulness and am looking forward to reading it" appears almost verbatim in several letters.
*** One representative from Michigan writes: "Thank you for your generous gift you sent to me. The book, Empire of Debt, will make a nice addition to my collection."
But a Senator from Wisconsin warns us that he has adopted his state’s code of ethics prohibiting him any gifts because of his public position. In lieu of accepting the gift, he will put it on public display in his office, "as property of the State of Wisconsin for the enjoyment of visiting Wisconsin residents."
Public apology: We certainly did not intend to get the gentleman from Michigan in trouble for accepting gifts.
*** Finally, Addison G. "Joe" Wilson, representative from South Carolina, took the time to hand scribble a note: "I particularly like your first name!"
*** Old friends came by to visit over the Thanksgiving holiday.
"You probably should sell that farm you have," said our friend. "Northern Virginia has gotten so crowded and expensive that people are coming over to Maryland, to our area, to buy places. And they’ve got a lot of money to spend."
We did a calculation. We bought our farm, about a half-hour from Washington, DC, in 1984. We paid only about $200,000 for the land. Then, we invested as much as $300,000 in the place, building a house, barns and so forth.
Anne Arundel County has a remarkable program wherein they pay landowners not to sell their property to developers. We had no intention of selling, so we were happy to take the money – about as much as we had paid for the land in the first place. In terms of today’s gold price, this leaves us with about 600 ounces worth invested. But our friend tells us that we could sell the place – even subject to the no-development restrictions – for $2 million.
"You have to be kidding," we protested. The place is just something we cobbled together as best we could, when we had no money to speak of. It is behind an old church that burned down and a property that has become a junkyard. Even as a farm, it’s pathetic.It’s too hilly. We just keep goats on it in order to qualify for a lower property tax rate."
"Well…things have gone crazy. It’s out in the country. Your house is very pretty. Yes, it’s kind of funky. But you have 100 acres. Places like that are hard to find."
Converted to gold, the place has a market value of 4,000 ounces. In other words, in constant gold terms, the place has appreciated more than 600% in the last 20 years. And yet, it has no more real value (or utility) than it had before. Less even…we have been away for more than 10 years. The property has been maintained, but not improved. And all around, the surrounding county has been developed with houses, highways, and shopping malls all over the place…making it less attractive to us.
"We really should sell the place," we said to Elizabeth.
"Well, from an investment perspective, you’re certainly right. It seems ridiculous that anyone would pay that kind of money. We should take advantage of it. But that’s our family home – our permanent home. You built much of it yourself. And yes, you’re not the greatest builder in the world…and I’m sure we’ve learned enough now to put in plumbing that doesn’t freeze every year…and I’m sure you will never again design a solar-heated kitchen where we either roast or freeze…and those windows never worked right…and that heat pump heating system was a disaster from the first day…but I love that motto that you had carved over the front door – what was it?"
‘"Hic Domus…Haec Patria Est,’ It’s from Virgil. It means, ‘this is our home; this is our country’"
"Yes, how could you think of selling that? Besides, where will we go…after you retire, I mean. Where will we live?"
"Well, there’s always Argentina."
"Stop right there…I don’t want to hear any more. I don’t want to sell."