The Global Depression and Deflation Is Currently Underway!

"The clear and present danger is, instead, that Europe will turn Japanese: that it will slip inexorably into deflation, that by the time the central bankers finally decide to loosen up it will be too late." Paul Krugman, "The Euro: Beware of What you Wish for", Fortune (1998)

Most central bank policy makers, investors, and analysts around the world today are gripped by the worry of declining growth rates, dwindling international commodity prices, high unemployment, and other macroeconomic figures.

The Global Depression and Deflation Is Currently Underway!

However, not many have given much consideration to one economic factor that has the potential to disrupt global economies, shut down economic activities, and become a catalyst for a worldwide depression. We are talking about 'deflation' that if not tamed, could bring global economies to their knees creating a worldwide chaos never seen before in scale or length.

Paul Krugman, the renowned American economist and distinguished Professor of Economics at the Graduate Center of the City University of New York, had forewarned about the threat of deflation for European economies. He suggested that the European Central Bank policy makers need to look into the situation now before it's too late for them to do anything about the situation.

The Eurozone today has well entered into a deflationary phase with other major economies including the US, UK, and Japan slowly heading into the same direction. In Japan and many European economies such Greece, Spain, Bulgaria, Poland, and Sweden, prices have been decreasing gradually for the past decade. This has created a number of problems for the central bank policy makers as they try to find out ways to diffuse the negative effects of deflation such as a slump in economic activity, drop in corporate incomes, reduced wages, and many other problems. What the World can Learn from Japan's Lost Decade (1990-2000)

The impact of the ongoing global deflationary trends on economies can be gauged by what Japan had experienced during the period between 1990 - 2000, which is also known as Japan's lost decade. The collapse of the asset bubble in 1991 heralded a new period of low growth and depressed economic activity. The factors that played a part in Japan's lost decade include availability of credit, unsustainable level of speculation, and low rates of interest.

When the government realized the situation, it took steps that made credit much more difficult to obtain which in turn led to a halt in the economic expansion activity during the 1990s.

Japan was fortunate to come out of the situation unhurt and without experiencing a depression. However, the effects of that period are being felt even today as corporations feel threatened of another deflationary spiral that could eat away at their profits. The situation analysts feel is about repeat in the Western economies, and that includes the US.

Deflationary Trend Could Threaten the Fragile US Economy

Inflation rates in the US is hovering near zero percent level for the past year. The Personal Consumption Expenditure Price Index has stayed well below the Fed's 2% target rate since March 2012. Although, the US economy hasn't entered into a deflationary stage at the moment, the continuous low level inflation despite the fed's rate being at near zero levels for about a decade has increased the possibility that the US economy could also plunge into a deflationary stage similar to that of the Euro zone.

The deflationary trend could turn out to be a big concern for policy makers and investors that may well lead to a global depression. The lingering memories of the 2008 financial crises that had literally rocked the world are still fresh in the minds of most people. That is why it's important for central banks to implement policies to fight the debilitating effects of deflation.

But, the question is how can the central banks combat the current or looming deflation trend? The Japan's lost decade has taught us that trying to contain the possibility of deflation and its negative effects can be difficult for policy makers. Economists have suggested various ways in which the debilitating effects of deflation can be countered.

However, one policy that central banks can use to fight off deflation is what economists call a Negative Interest Rate Policy (NIRP).

NIRP simply refers to refers to a central bank monetary measure where the interest rates are set at a negative value. The policy is implemented to encourage spending, investment, and lending as the savings in the bank incur expenses for the holders. On October 13ths I wrote in detail about NIRP. Then on October 23rd Ron Insana on CNBC talk about it here.

This unconventional policy manipulates the tradeoff between loans and reserves. The end goal of the policy is to prevent banks from leaving the reserves idle and the consumers from hoarding money, which is one of the main causes of deflation, which leads to dampened economic output, decreased demand of goods, increased unemployment, and economic slowdown.

Central banks around the world can use this expansionary policy to combat deflationary trends and boost the economy. Implementing a NIRP policy will force banks to charge their customers for holding the money, instead of paying them for depositing their money into the account. It will also encourage banks to lend money in the accounts to cover up the costs of negative rates.

Has the Negative Rates Policy Been Implemented in the Past?

Despite not being well known or publicized in the media, NIRP has been implemented successfully in the past to combat deflation. The classic example can be given of the Swiss Central Bank that implemented the policy in early 1970s to counter the effects of deflation and also increase currency value.

Most recently, central banks in Denmark and Sweden had also successfully implemented NIRP in their respective countries in 2012 and 2010 respectively. Moreover, the European Central Bank implemented the NIRP last year to curb deflationary trend in the Eurozone.

In theory, manipulating rates through NIRP reduces borrowing costs for the individuals and companies. It results in increased demand for loans that boosts consumer spending and business investment activity. Finance is all about making tradeoffs and decisions. Negative rates will make the decision to leave reserve idle less attractive for investors and financial institutions. Although, the central bank's policy directly affects the private and commercial financial institutions, they are more likely to pass the burden to the consumers.

This cost of hoarding money will be too much for consumers due to which they will invest their money or increase their spending leading to circulation of money in the economy, which leads to increase in corporate profits and individual wages, and boosts employment levels. In essence, the NIRP policy will combat deflation and thereby prevent the potential of global depression knocking at the door once more.

Final Remarks

The possibility of deflation causing another global recession is very real. Central policy makers around the world should realize that deflation has become a global problem that requires instant action. In the past, even the most efficient and robust economies used to struggle in taming inflation rates. In the coming months, most economies around the world, including the US, will have difficulty curbing the effects of deflation.

The fact is that central bank policy makers have largely ignored the possibility of deflation causing havoc in the economy similar to what happened in Japan during its "lost decade". The quantitative easing program that is being used in the US by the Feds to boost economy is not proving effective in raising the inflation rate to its targeted levels. In fact, the inflation level is drifting even lower and is hovering dangerously close to the negative territory.

Blaming the low inflation levels on the low level of oil prices is not justified. Inflation levels were hovering at low levels well before the great plunge in commodity prices. Moreover, low level inflation rates cannot be blamed on muted wage levels. The fact is that unemployment rates have decreased both in the US and the UK in the past few years, but consumer spending has largely remained unmoved.

Taming deflation is necessary if the central banks want to avoid its debilitating effects on the economy. Policies like the Quantitive Easing program used by the Feds may allow easy access to credit, dampen exchange rate, and reduce risks of financial meltdown; but it cannot prevent the possibility of another more severe situation of deflation wreaking havoc on the economy.

The concept of NIRP may seem counter intuitive at first, but it is the only effective way of combating the deflationary trend. The world economy could sink further into a deflationary hole if no action is taken to curb the trend. And the time to start thinking about it is now. Any delay could result in a global economic meltdown that may cause deep financial difficulties for millions of people around the world.

We as employees, business owners, traders and investors are about to embark on a financial journey that couple either cripple your financial future or allow to be more wealthy than you thought possible. The key is going to that your money is position in the proper assets at the right time. Being long and short various assets like stocks, bonds, precious metals, real estate etc.

Follow me as we move through this global economic shift at the Global Financial Reset Wealth System

See you in the markets,
Chris Vermeulen

Our trading partner Chris Vermeulan originally posted this article at CNA Finance

Get our latest FREE eBook "Understanding Options"....Just Click Here!

Europe: Running on Borrowed Time

By John Mauldin 

“I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”

– Romano Prodi, EU Commission president, December 2001

Prodi and the other leaders who forged the euro knew what they were doing. They knew a crisis would develop, as Milton Friedman and many others had predicted. It is not conceivable that these very astute men didn’t realize that creating a monetary union without a fiscal union would bring about an existential crisis. They accepted that eventuality as the price of European unity. But now the payment is coming due, and it is far larger than they probably anticipated.

Time, as the old saying goes, is money. There are lots of ways that equation can work out. We had an interesting example last week. Europe and the eurozone pulled back from the brink by once again figuring out how to postpone the inevitable moment when all and sundry will have to recognize that Greece cannot pay the debt that it owes. In essence they have borrowed time by allowing Greece to borrow more money.

Money, I should add, that, like all the other Greek debt, will not be repaid.

I’ve probably got some 40 articles and 100 pages of commentary on Greece and the eurozone from all sides of the political spectrum in my research stack, and it would be very easy to make this a long letter. But it’s a pleasant summer weekend, and I’m in the mood to write a shorter letter, for which many of my readers may be grateful. Rather than wander deep into the weeds looking at financial indications, however, we are going to explore what I think is a very significant nonfinancial factor that will impact the future of Europe. If it was just money, then Prodi would be right – they could just create new economic policy instruments, whatever the heck those might be. But what we’ve been seeing these last few months is symptomatic of a far deeper problem than can be addressed with just a few trillion euros, give or take.

But first, I’m going to reach out and ask for a little help. I have just signed an agreement with my publisher, Wiley, to do a new book called Investing in an Age of Transformation. I’ve been thinking about this book for many years, and it is finally time to write it. As my longtime readers know, I believe we are entering a period of increasingly profound change, much more transformative than we’ve seen in the past 50 years. And not just technologically but on numerous fronts. There are going to be substantial social implications as well. Imagine the entire 20^th century fast-forwarded and packed into 20 years, and you will get some idea of the immensity of what we face.

Now think about investing in this unfolding era of change. Companies will spring up and disappear faster than ever. Corporations will move into and out of indexes at an increasingly rapid rate, making the whole experience of index investing – which constitutes the bulk of investing, not just for individuals but for pensions and large institutions – obsolete.

Just as we wouldn’t think of relying on the medical technology of the early 20^th century, I’m convinced that we need a significantly new process for investing that doesn’t depend on the concept of indexing created deep in the last century. In an age of exponential change, being wrong in your investment style will no longer mean you simply underperform: you will not merely be wrong; you will be exponentially wrong.

Of course, the flipside is that if you get it right, you will be exponentially right. We will be exploring some new investing concepts in Thoughts from the Frontline as I write the book, since this letter is actually part of my thinking process. I’ve been spending a great deal of time lately exploring new ways of thinking about the markets, different ways to manage risk, and strategies to take advantage of overwhelming change.

This project will be significantly more complex than any book I’ve attempted so far. I’m looking for a few research interns or assistants to help me on various topics. Some topics are technological in nature, and some are investment-oriented. You can be young or old, retired or working in any number of fields; you just have to be passionate about thinking about the future and be able to spend time exploring a topic and going back and forth with me through shared notes and conversations. It’s a plus if you write well. If you are interested in exploring a topic or two, drop me a note at transformation@2000wave.com, along with a resume or a note about your background, plus your area of interest. Now let’s jump to the letter.

The More Things Change

Almost four years ago, in an article on Bloomberg with the headline “Germany Said to Ready Plan to Help Banks If Greece Defaults,” we read this paragraph:

“Greece is ‘on a knife’s edge,’” German Finance Minister Wolfgang Schäuble told lawmakers at a closed-door meeting in Berlin on Sept. 7 [2011], a report in parliament’s bulletin showed yesterday. If the government can’t meet the aid terms, “it’s up to Greece to figure out how to get financing without the euro zone’s help,” he later said in a speech to parliament.

Over the last few weeks he took a similar hard line, offering the possibility that Greece could take a “timeout,” whatever in creation that is, and only the gods know how it could work for five years.
Reports of the final meeting before the agreement with Greece was reached demonstrated that there is little solidarity in the European Union. The Financial Times offered an unusually frank report of the meeting:

After almost nine hours of fruitless discussions on Saturday, a majority of eurozone finance ministers had reached a stark conclusion: Grexit – the exit of Greece from the eurozone – may be the least worst option left.

Michel Sapin, the French finance minister, suggested they just “get it all out and tell one another the truth” to blow off steam. Many in the room seized the opportunity with relish.

Alexander Stubb, the Finnish finance minister, lashed out at the Greeks for being unable to reform for half a century, according to two participants. As recriminations flew, Euclid Tsakalotos, the Greek finance minister, was oddly subdued.

The wrangling culminated when Wolfgang Schäuble, the German finance minister who has advocated a temporary Grexit, told off Mario Draghi, European Central Bank chairman. At one point, Mr Schäuble, feeling he was being patronised, fumed at the ECB head that he was “not an idiot”. The comment was one too many for eurogroup chairman Jeroen Dijsselbloem, who adjourned the meeting until the following morning.

Failing to reach a full accord on Saturday, the eurogroup handed the baton on Sunday to the bloc’s heads of state to begin their own an all night session.”

That meeting ended with Angela Merkel and Alexis Tsipras arguing for 14 hours and giving up. Donald Tusk, the president of the European Council (and former Polish Prime Minister), forced them to sit back down, saying, “Sorry, but there is no way you are leaving this room.”

Essentially, they were arguing over what form of humiliation Greece would be forced to swallow.
To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: Europe: Running on Borrowed Time was originally published at mauldineconomics.com.

Get our latest FREE eBook "Understanding Options"....Just Click Here!

The Cult of Central Banking

By John Mauldin

In today’s Outside the Box, good friend Ben Hunt informs us that we have entered the cult phase of the Golden Age of the Central Banker:

We pray for extraordinary monetary policy accommodation as a sign of our Central Bankers’ love, not because we think the policy will do much of anything to solve our real world economic problems, but because their favor gives us confidence to stay in the market. I mean, does anyone really think that the problem with the Italian economy is that interest rates aren’t low enough? Gosh, if only ECB intervention could get the Italian 10 yr bond down to 1.75% from the current 1.85%, why then we’d be off to the races! 

Really? But God forbid that Mario Draghi doesn’t (finally) put his money where his mouth is and announce a trillion euro sovereign debt purchase plan. That would be a disaster, says Mr. Market. Why? Not because the absence of a debt purchase plan would be terrible for the real economy. That’s not a big deal one way or another. It would be a disaster because it would mean that the Central Bank gods are no longer responding to our prayers.

But, he points out, the cult phase of any human society is a stable phase in the sense that, while change may happen, it will not happen from within:

There is such an unwavering faith in Central Bank control over market outcomes, such a universal assumption of god-  omnipotence within this realm, that any internal market shock is going to be willed away.

However, there is a minor catch: external market risk factors are all screaming red.

I’ve been doing this for a long time, and I can’t remember a time when there was such a gulf between the environmental or exogenous risks to the market and the internal or behavioral dynamics of the market. The market today is Wile E. Coyote wearing his latest purchase from the Acme Company – a miraculous bat-wing costume that prevents the usual plunge into the canyon below by sheer dint of will.

Ben identifies the three most pressing exogenous risks as the “supply shock” of collapsing oil prices, a realigning Greek election, and the realpolitik dynamics of the West vs. Islam and the West vs. Russia. (You or I might want to expand Ben’s list with one or two of our own favorites; but the point is, it’s a big, bad, volatile world out there right now.) Ben admits that it feels a bit weird to have written on all three of his chosen topics a few weeks before each of them appeared on investors’ radar screens. “Call me Cassandra,” says Ben. (Naw, I’ll stay with Ben.)

I wouldn’t want to steal too much of Ben’s thunder here, but I just can’t help sharing with you the punch line to his piece: “The gods always end up disappointing us mere mortals.”  This is one of Ben’s better pieces, and I really commend it to you as something you need to think about.

Before we examine our collective religious delusions (or at least our central banking delusions), let’s have a little fun. My friend Dennis Gartman (who could be the hardest working writer in the business) found this gem and shared it with his readers this morning. It is about the supposed lack of environmental concern of the Boomer generation has. And some of you will read it that way.

But I want those of you who are of a certain age (ahem) to realize just how much your world has changed in the last 50 years. If you are young, yes, we really did all the stuff listed below. I personally experienced every one of the rather long list of activities mentioned by the “little old lady.” Major changes in lifestyle since then? No, not really. But I’ll grand you that things are a good deal more convenient and time-saving today. Now sit back and enjoy.

Checking out at the store, the young cashier suggested to the much older lady that she should bring her own grocery bags, because plastic bags are not good for the environment. The woman apologized to the young girl and explained, "We didn't have this 'green thing' back in my earlier days." The young clerk responded, "That's our problem today. Your generation did not care enough to save our environment for future generations." The older lady said that she was right – her generation didn't have the "green thing" in its day. 

The older lady went on to explain: “Back then, we returned milk bottles, soda bottles and beer bottles to the store. The store sent them back to the plant to be washed and sterilized and refilled, so it could use the same bottles over and over. So they really were recycled. But we didn't have the ‘green thing’ back in our day. 

Grocery stores bagged our groceries in brown paper bags that we reused for numerous things. Most memorable besides household garbage bags was the use of brown paper bags as book covers for our school books. This was to ensure that public property (the books provided for our use by the school) was not defaced by our scribblings. Then we were able to personalize our books on the brown paper bags. But, too bad we didn't do the ‘green thing’ back then. We walked up stairs because we didn't have an escalator in every store and office building. We walked to the grocery store and didn't climb into a 300 horsepower machine every time we had to go two blocks. But you’re right, we didn't have the ‘green thing’ in our day. 

Back then we washed the baby's diapers because we didn't have the throwaway kind. We dried clothes on a line, not in an energy gobbling machine burning up 220 volts. Wind and solar power really did dry our clothes back in the early days. Kids got hand me down clothes from their brothers or sisters (and cousins), not always brand-new clothing. But you’re right, young lady; we didn't have the ‘green thing’ back in our day. Back then we had one TV, or radio, in the house – not a TV in every room. And the TV had a screen the size of a handkerchief [remember them?], not a screen the size of the state of Montana. In the kitchen we blended and stirred by hand because we didn't have electric machines to do everything for us. When we packaged a fragile item to send in the mail, we used wadded up old newspapers to cushion it, not Styrofoam or plastic bubble wrap. Back then, we didn't fire up an engine and burn gasoline just to cut the lawn. We used a push mower that ran on human power. 

We exercised by working, so we didn't need to go to a health club to run on treadmills that operate on electricity.” But you’re right; we didn't have the ‘green thing’ back then. We drank from a fountain when we were thirsty instead of using a cup or a plastic bottle every time we had a drink of water. We refilled writing pens with ink instead of buying a new pen, and we replaced the razor blade in a razor instead of throwing away the whole razor just because the blade got dull. But we didn't have the ‘green thing back then. 

Back then, people took the streetcar or the bus, and kids rode their bikes to school or walked instead of turning their moms into a 24 hour taxi service in the family's $45,000 SUV or van, which cost what a whole house did before the ‘green thing.’ We had one electrical outlet in a room, not an entire bank of sockets to power a dozen appliances. And we didn't need a computerized gadget to receive a signal beamed from satellites 23,000 miles out in space in order to find the nearest burger joint. But, isn't it sad, how the current generation laments how wasteful we old folks were just because we didn't have the ‘green thing’ back then?”

I wonder what our grandchildren will be telling their grandchildren in 50 years… “I remember a time when we actually used combustion engines to drive our cars that belched out dirty gases. We actually had massive electricity generating power plants and wires everywhere to deliver the electricity, rather than the small, efficient home units that produce free electricity for us now. We used something called glasses to help us see. People actually had to carry their communications devices around, and computers were measured in pounds not ounces. We had to do something called “typing” to write; and while we didn’t have to actually go to places called libraries like our grandparents did, we could and did spend all day searching through a disorganized Internet for what we needed. You weren’t connected biologically to your computer, so getting information in and out of it was a drag.

“People actually got sick and died; and though the situation was getting better, billions of people didn’t have enough food at night. People went to big stores to buy what was needed rather than just ordering it or producing it on the spot. We actually threw garbage away in huge resource-consuming “dumps” rather than completely recycling it into new products at the back of the house. It took like forever to get from one point to another. People actually had to “drive” their car rather than just getting in it and telling it where to go. And people died all the time in those cars – they were so dangerous and uncomfortable. In those days you couldn’t even instantly communicate with anybody by just thinking. You had to push buttons on that clumsy communication device you hauled around, and then talk into it; and if you lost it you were out of touch and out of luck. We didn’t even have intelligent personal robots in those days. It was so Stone Age.”

I could go on and on, but you get the drift. The changes in the last 50 years are simply a down payment on the change we’ll see and live in the next 50.

When I think about central banks and markets and try to figure out how to get preserve and grow assets from where we are today to where we will be in 10 years, it can be a rather daunting and sometimes even a depressing task. But then I think about what the world will be like and how much fun my grand kids are going to have, and I get all optimistic and smiling again.

Have a great week. The future is going to turn out just fine.
Your wondering if we will have flying cars analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

Stay Ahead of the Latest Tech News and Investing Trends...

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.

---

“Catch-22”

By Ben Hunt, Salient Partners
Epsilon Theory, Jan. 12, 2015

Four times during the first six days they were assembled and briefed and then sent back. Once, they took off and were flying in formation when the control tower summoned them down. The more it rained, the worse they suffered. The worse they suffered, the more they prayed that it would continue raining. All through the night, men looked at the sky and were saddened by the stars. All through the day, they looked at the bomb line on the big, wobbling easel map of Italy that blew over in the wind and was dragged in under the awning of the intelligence tent every time the rain began. The bomb line was a scarlet band of narrow satin ribbon that delineated the forward most position of the Allied ground forces in every sector of the Italian mainland.

For hours they stared relentlessly at the scarlet ribbon on the map and hated it because it would not move up high enough to encompass the city.

When night fell, they congregated in the darkness with flashlights, continuing their macabre vigil at the bomb line in brooding entreaty as though hoping to move the ribbon up by the collective weight of their sullen prayers. "I really can't believe it," Clevinger exclaimed to Yossarian in a voice rising and falling in protest and wonder. "It's a complete reversion to primitive superstition. They're confusing cause and effect. It makes as much sense as knocking on wood or crossing your fingers. They really believe that we wouldn't have to fly that mission tomorrow if someone would only tiptoe up to the map in the middle of the night and move the bomb line over Bologna. Can you imagine? You and I must be the only rational ones left."

In the middle of the night Yossarian knocked on wood, crossed his fingers, and tiptoed out of his tent to move the bomb line up over Bologna.

― Joseph Heller, “Catch-22” (1961)

A visitor to Niels Bohr's country cottage, noticing a horseshoe hanging on the wall, teased the eminent scientist about this ancient superstition. “Can it be true that you, of all people, believe it will bring you luck?”

“Of course not,” replied Bohr, “but I understand it brings you luck whether you believe it or not.”

― Niels Bohr (1885 – 1962)

Here's an easy way to figure out if you're in a cult: If you're wondering whether you're in a cult, the answer is yes.

― Stephen Colbert, “I Am America (And So Can You!)” (2007)

I won't insult your intelligence by suggesting that you really believe what you just said.

― William F. Buckley Jr. (1925 – 2008)

A new type of superstition has got hold of people's minds, the worship of the state.

― Ludwig von Mises (1881 – 1973)

The cult is not merely a system of signs by which the faith is outwardly expressed; it is the sum total of means by which that faith is created and recreated periodically. Whether the cult consists of physical operations or mental ones, it is always the cult that is efficacious.

― Emile Durkheim, “The Elementary Forms of Religious Life” (1912)

At its best our age is an age of searchers and discoverers, and at its worst, an age that has domesticated despair and learned to live with it happily.

― Flannery O’Connor (1925 – 1964)

Man is certainly stark mad; he cannot make a worm, and yet he will be making gods by dozens.

― Michel de Montaigne (1533 – 1592)

Since man cannot live without miracles, he will provide himself with miracles of his own making. He will believe in witchcraft and sorcery, even though he may otherwise be a heretic, an atheist, and a rebel.

― Fyodor Dostoyevsky, “The Brothers Karamazov” (1880)

One Ring to rule them all; one Ring to find them.
One Ring to bring them all and in the darkness bind them.

― J.R.R. Tolkien, “The Lord of the Rings” (1954)

Nothing’s changed.
I still love you, oh, I still love you. Only slightly, only slightly less Than I used to.

― The Smiths, “Stop Me If You’ve Heard This One Before” (1987)

So much of education, I think, relies on reading the right book at the right time. My first attempt at Catch-22 was in high school, and I was way too young to get much out of it. But fortunately I picked it up again in my late 20’s, after a few experiences with The World As It is, and it’s stuck with me ever since. The power of the novel is first in the recognition of how often we are stymied by Catch-22’s – problems that can’t be solved because the answer violates a condition of the problem. The Army will grant your release request if you’re insane, but to ask for your release proves that you’re not insane. If X and Y, then Z. But X implies not-Y. That’s a Catch-22.

Here’s the Fed’s Catch-22. If the Fed can use extraordinary monetary policy measures to force market risk-taking (the avowed intention of both Zero Interest Rate Policy and Large Scale Asset Purchases) AND the real economy engages in productive risk-taking (small business loan demand, wage increases, business investment for growth, etc.), THEN we have a self-sustaining and robust economic recovery underway. But the Fed’s extraordinary efforts to force market risk-taking and inflate financial assets discourage productive risk-taking in the real economy, both because the Fed’s easy money is used by corporations for non-productive uses (stock buy-backs, anyone?) and because no one is willing to invest ahead of global growth when no one believes that the leading indicator of that growth – the stock market – means what it used to mean.

If X and Y, then Z. But X denies Y. Catch-22.

There’s a Catch-22 for pretty much everyone in the Golden Age of the Central Banker. Are you a Keynesian? Your Y to go along with the Central Bank X is expansionary fiscal policy and deficit spending. Good luck getting that through your polarized Congress or Parliament or whatever if your Central Bank is carrying the anti deflation water and providing enough accommodation to keep your economy from tanking.

Are you a structural reformer? Your Y to go along with the Central Bank X is elimination of bureaucratic red tape and a shrinking of the public sector. Again, good luck with that as extraordinary monetary policy prevents the economic trauma that might give you a chance of passing those reforms through your legislative process.

Here’s the thing. A Catch-22 world is a frustrating, absurd world, a world where we domesticate despair and learn to live with it happily. It’s also a very stable world. And that’s the real message of Heller’s book, as Yossarian gradually recognizes what Catch-22 really IS. There is no Catch-22. It doesn’t exist, at least not in the sense of the bureaucratic regulation that it purports to be. But because everyone believes that it exists, then an entire world of self-regulated pseudo-religious behavior exists around Catch-22. Sound familiar?

We’ve entered a new phase in the Golden Age of the Central Banker – the cult phase, to use the anthropological lingo. We pray for extraordinary monetary policy accommodation as a sign of our Central Bankers’ love, not because we think the policy will do much of anything to solve our real-world economic problems, but because their favor gives us confidence to stay in the market. I mean ... does anyone really think that the problem with the Italian economy is that interest rates aren’t low enough? Gosh, if only ECB intervention could get the Italian 10-yr bond down to 1.75% from the current 1.85%, why then we’d be off to the races! Really? But God forbid that Mario Draghi doesn’t (finally) put his money where his mouth is and announce a trillion euro sovereign debt purchase plan. That would be a disaster, says Mr. Market.

Why? Not because the absence of a debt purchase plan would be terrible for the real economy. That’s not a big deal one way or another. It would be a disaster because it would mean that the Central Bank gods are no longer responding to our prayers. The faith based system that underpins current financial asset price levels would take a body blow. And that would indeed be a disaster.

Monetary policy has become a pure signifier – a totem. It’s useful only in so far as it indicates that the entire edifice of Central Bank faith, both its mental and physical constructs, remains “efficacious”, to use Emile Durkheim’s path breaking sociological analysis of a cult. All of us are Yossarian today, far too rational to think that the totem of a red line on a map actually makes a difference in whether we have to fly a dangerous mission. And yet here we are sneaking out at night to move that line on the map. All of us are Niels Bohr today, way too smart to believe that the totem of a horseshoe actually bring us good luck. And yet here we are keeping that horseshoe up on our wall, because ... well ... you know.

The notion of saying our little market prayers and bowing to our little market talismans is nothing new. “Hey, is that a reverse pennant pattern I see in this stock chart?” “You know, the third year of a Presidential Administration is really good for stocks.” “I thought the CFO’s
body language at the investor conference was very encouraging.” “Well, with the stock trading at less than 10 times cash flow I’m getting paid to wait.” Please. I recognize aspects of myself in all four of these cult statements, and if you’re being honest with yourself I bet you do, too.

 

No, what’s new today is that all of our little faiths have now converged on the Narrative of Central Bank Omnipotence. It’s the One Ring that binds us all.

I loved this headline article in last Wednesday’s Wall Street Journal – “Eurozone Consumer Prices Fall for First Time in Five Years” – a typically breathless piece trumpeting the “specter of deflation” racing across Europe as ... oh-my-god ... December consumer prices were 0.2% lower than they were last December. Buried at the end of paragraph six, though, was this jewel: “Excluding food, energy, and other volatile items, core inflation rose to 0.8%, up a notch from November.” Say what? You mean that if you measure inflation as the US measures inflation, then European consumer prices aren’t going down at all, but are increasing at an accelerating pace?

You mean that the dreadful “specter of deflation” that is “cementing” expectations of massive ECB action is entirely caused by the decline in oil prices, something that from the consumer’s perspective acts like an inflationary tax cut? Ummm ... yep. That’s exactly what I mean. The entire article is an exercise in Narrative creation, facts be damned. The entire article is a wail from a minaret, a paean to the ECB gods, a calling of the faithful to prayer. An entirely successful calling, I might add, as both European and US markets turned after the article appeared, followed by Thursday’s huge move up in both markets.

When I say that a Catch-22 world is a stable world, or that the cult phase of a human society is a stable phase, here’s what I mean: change can happen, but it will not happen from within. For everyone out there waiting for some Minsky Moment, where a debt bubble of some sort ultimately pops from some unexpected internal cause like a massive corporate default, leading to systemic fear and pain in capital markets ... I think you’re going to be waiting for a loooong time. Are there debt bubbles to be popped?

Absolutely. The energy sector, particularly its high yield debt, is Exhibit #1, and I think this could be a monster trade. But is this something that can take down the market? I don’t see it. There is such an unwavering faith in Central Bank control over market outcomes, such a universal assumption of god-like omnipotence within this realm, that any internal market shock is going to be willed away.

So is that it? Is this a brave new world of BTFD market stability? Should we double down on our whack- a-mole volatility strategies? For internal market risks like leverage and debt bubble scares ... yes, I think so. But while the internal market risk factors that I monitor are quite benign, mostly green lights with a little yellow/caution peeking through, the external market risk factors that I monitor are all screaming red. 

These are Epsilon Theory risk factors – political shocks, trade/forex shocks, supply shocks, etc. – and they’ve got my risk antennae quivering like crazy. I’ve been doing this for a long time, and I can’t remember a time when there was such a gulf between the environmental or exogenous risks to the market and the internal or behavioral dynamics of the market. The market today is Wile E. Coyote wearing his latest purchase from the Acme Company – a miraculous bat-wing costume that prevents the usual plunge into the canyon below by sheer dint of will. There’s absolutely nothing internal to Coyote or his bat suit that prevents him from flying around happily forever. It’s only that rock wall that’s about to come into the frame that will change Coyote’s world.

My last three big Epsilon Theory notes – “The Unbearable Over-Determination of Oil”, “Now There’s Something You Don’t See Every Day, Chauncey”, and “The Clash of Civilizations” – have delved into what I think are the most pressing of these environmental or exogenous risks to the market: the “supply shock” of collapsing oil prices, a realigning Greek election, and the realpolitik dynamics of the West vs. Islam and the West vs. Russia. I gotta say, it’s been weird to write about these topics a few weeks before ALL of them come to pass. Call me Cassandra. I stand by everything I wrote in those notes, so no need to repeat all that here, but a short update paragraph on each.

First, Greece. And I’ll keep it very short. Greece is on. This will not be pretty and this will not be easy. Existential Euro doubt will raise its ugly head once again, particularly when Italy imports the Greek political experience.

Second, oil. I get a lot of questions about why oil can’t catch a break, about why it’s stuck down here with a 40 handle as the absurd media Narrative of “global supply glut forever and ever, amen” whacks it on the head day after day after day. And it is an absurd Narrative ... very Heller-esque, in fact ... about as realistic as “Peak Oil” has been over the past decade or two. Here’s the answer: oil is trapped in a positive Narrative feedback loop. Not positive in the sense of it being “good”, whatever that means, but positive in the sense of the dominant oil Narrative amplifying the uber-dominant Central Bank Narrative, and vice versa.

The most common prayer to the Central Banking gods is to save us from deflation, and if oil prices were not falling there would be no deflation anywhere in the world, making the prayer moot. God forbid that oil prices go up and, among other things, push European consumer prices higher. Can’t have that! Otherwise we’d need to find another prayer for the ECB to answer. By finding a role in service to the One Ring of Central Bank Omnipotence, the dominant supply glut oil Narrative has a new lease on life, and until the One Ring is destroyed I don’t see what makes the oil Narrative shift.

Third, the Islamist attack in Paris. Look ... I’ve got a LOT to say about “je suis Charlie”, both the stupefying hypocrisy of how that slogan is being used by a lot of people who should really know better, as well as the central truth of what that slogan says about the Us vs. Them nature of The World As It Is, but both are topics for another day. What I’ll mention here are the direct political repercussions in France.

The National Front, which promotes a policy platform that would make Benito Mussolini beam with pride, would probably have gotten the most votes of any political party in France before the attack. Today I think they’re a shoo-in to have first crack at forming a government whenever new Parliamentary elections are held, and if you don’t recognize that this is 100 times more threatening to the entire European project than the prospects of Syriza forming a government in Greece ... well, I just don’t know what to say.

There’s another thing to keep in mind here in 2015, another reason why selling volatility whenever it spikes up and buying the dip are now, to my way of thinking, picking up pennies in front of a steam roller: the gods always end up disappointing us mere mortals. The cult phase is a stable system on its own terms (a social equilibrium, in the parlance), but it’s rarely what an outsider would consider to be a particularly happy or vibrant system. There’s no way that Draghi can possibly announce a bond buying program that lives up to the hype, not with peripheral sovereign debt trading inside US debt.

There’s no way that the Fed can reverse course and start loosening again, not if forward guidance is to have any meaning (and even the gods have rules they must obey). Yes, I expect our prayers will still be answered, but each time I expect we will ask in louder and louder voices, “Is that all there is?” Yes, we will still love our gods, even as they disappoint us, but we will love them a little less each time they do.

And that’s when the rock wall enters the cartoon frame.

Like Outside the Box?

Sign up today and get each new issue delivered free to your inbox.
It's your opportunity to get the news John Mauldin thinks matters most to your finances.

The article Outside the Box: The Cult of Central Banking was originally published at mauldineconomics.com.

Get our latest FREE eBook "Understanding Options"....Just Click Here!

A Five Year Forecast: Is this a Tsunami Warning?

By John Mauldin

It is the time of the year for forecasts; but rather than do an annual forecast, which is as much a guessing game as anything else (and I am bad at guessing games), I’m going to do a five year forecast to take us to the end of the decade, which I think may be useful for longer term investors. We will focus on events and trends that I think have a high probability, and I’ll state what I think the probabilities are for my forecasts to actually happen. While I could provide several dozen items, I think there are seven major trends that are going to sweep over the globe and that as an investor you need to have on your radar screen. You will need to approach these trends with caution, but they will also provide significant opportunities.

There is a book in here somewhere, but I do not intend to write one today. In fact, my New Year’s resolution is to write shorter letters in 2015. Over the last decade and a half, the letter has tended to get longer. A little more here, a little more there, and pretty soon it just gets to be a bit too much to read in one sitting. That means I need to either be more concise, break up my topics into two sessions or, if further writing is necessary, post the additional work on the website for those interested.

Take a minute to grab our free eBook "Understanding Options" while it's still available.....Just Click Here

So I’m writing today’s letter in that spirit. Each of the major topics we’ll be covering will show up in other letters over the next few months. I would appreciate your feedback and any links to articles and/or data points that you think I should know about regarding these topics.

But first, this is generally the most downloaded letter of the year. I want to invite new readers to become one of my 1 million closest friends by simply entering your email address here. You can follow my work throughout the year, absolutely free (and see how my prognostications are turning out). And if you’re a regular reader, why not send this to a few of your friends and suggest they join you? At the very least, Thoughts from the Frontline should make for some interesting conversations this year. Thanks. Now let’s get on with the forecasting.

Seven Significant Changes for the Next Five Years

Let’s look at what I think are six inexorable trends or waves that will each have a major impact in its own right but that when taken together will amount to a tsunami of change for the global economy.

1. Japan will continue its experiment with the most radical quantitative easing attempted by a major country in the history of the world… and the experiment is getting dangerous. The Bank of Japan is effectively exporting the island nation’s deflation to its trade competitors like Germany, China, and South Korea and inviting a currency war that could shake the world. I’ve been saying this for years now, but the story took a nasty turn on Halloween Day, when the Bank of Japan announced it was greatly expanding and changing the mix of its asset purchases. The results have been downright scary, and a major slide in the JPY/USD exchange rate is almost certain over the next five years. I give it a 90% probability. All this while the population of Japan shrinks before our very eyes.

2. Europe is headed for a crisis at least as severe as the Grexit scare was in 2012 – and for the resulting run-up in interest rates and a sovereign debt scare in the peripheral countries. After all these years of struggle, the structural flaws in the EMU’s design remain; and now major economies like Italy and France are headed for trouble. In the very near future we will finally know the answer to the question, “Is the euro a currency or an experiment?” The changes required to answer that question will be wrenching and horrifically expensive. There are no good answers, only difficult choices about who pays how much and to whom. Again, I see the deepening of the Eurozone crisis as a 90% probability.

3. China is approaching its day of reckoning as it tries to reduce its dependency on debt in its bid for growth, while creating a consumer society. The world is simply not prepared for China to experience an outright “hard landing” or recession, but I think there is a 70% probability that it will do so within the next five years.

And the probability that China will suffer either a hard landing OR a long period of Japanese style stagnation (in the event that the Chinese government is forced to absorb nonperforming loans to prevent a debt crisis) is over 95%. To be sure, it is still quite possible that the Chinese economy will be significantly larger in 2025 (ten years from now) than it is today, but realizing that potential largely depends on President Xi Jinping’s ability to accomplish an extremely difficult task: deleveraging the debt overhang that threatens the country’s MASSIVE financial system while rebalancing the national economy to a more sustainable growth model (either through either a vast expansion of China’s export market or the rapid development of “new economy” sectors like technology, services, and consumption; or both).

This will not be the end of China, which I’m quite bullish on over the very long term, but such transitions are never easy. Even given this rather stark forecast, it is still likely (in my opinion) that the Chinese economy will be 20 to 25% bigger as 2020 opens than it is today; and every other major economy in the world (including the US) would be thrilled to have such growth. At the very least, though, China’s slowdown and rebalancing is going to put pressure on commodity exporters, which are generally emerging markets plus Australia, Canada, and Norway.

4. All of the above will tend to be bullish for the dollar, which will make dollar-denominated debt in emerging market countries more difficult to pay back. And given the amount of debt that has been created in the last few years, it is likely that we’ll see a series of crises in emerging-market countries, along with an uncomfortably high level of risk of setting off an LTCM-style global financial shock.

My colleague Worth Wray spoke about this new era of volatile FX flows and growing risk of capital flight from emerging markets at my Strategic Investor Conference last May, and he has continued to remind us of those risks in recent months (“A Scary Story for Emerging Markets” and “Why the World Needs the US Economy to Struggle”).

Now that Russia has tumbled into a full-fledged currency crisis with serious signs of contagion, Worth’s prediction is already playing out, and I would assign an 80 to 90% probability that it will continue to do so, as a function of (1) the rising US dollar and a reversal in cross border capital flows, (2) falling commodity prices, or (3) both. This massive wave is going to create a lot of opportunities for courageous investors who are ready to surf when countries are cheap.

5. I do not believe that the secular bear market in the United States that I began to describe in 1999 has ended. Secular bull markets simply do not begin from valuations like those we have today. Either we began a secular bull market in 2009, or we have one more major correction in front of us.

Obviously, I think it is the latter. It has been some time since I’ve discussed the difference between secular bull and bear markets and cyclical bull and bear markets, and I will briefly touch on the topic today and go into much more detail in later letters. For US focused investors, this is of major importance. The secular bear is not something to be scared of but simply something to be played. It also offers a great deal of opportunity.

If I am right, then the next major leg down will bring on the end of the secular bear and the beginning of a very long term secular bull. We will all get to be geniuses in the 2020s and perhaps even before the last half of this decade runs out. Won’t that be fun? Let’s call the end of the secular bear a 90% probability in five years and move on.

6. Finally, the voters of the United States are going to have to make a decision about the direction they want to take the country. We can either opt for growth, which will mean a new tax and regulatory regime, or we can double down on the current direction and become Europe and Japan. I’ve traveled to both Europe and Japan, and they’re both pleasant enough places to live, but I wouldn’t want to be a citizen of either Japan or the Eurozone for the rest of this decade. (I particularly love Italy, but it is beginning to resemble a basket case, with last year’s optimistic drive for reforms seemingly stalled.)

However, I would rather live and work and invest in a high-growth country, with opportunities all around me, a country where we reduce income inequality by increasing wealth and opportunities at the lower end of the income scale instead of trying to legislate parity by increasing taxes and imposing government mandated wealth redistribution, which slows growth and squelches opportunity for everyone.

A restructuring of the US tax and regulatory regime does not mean a capitulation to the wealthy, big banks, or big business. Properly conceived and constructed, it will allow the renewal of the middle class and result in higher income for all. Sadly, it is not clear to me that either the Republican or Democratic parties are up to the task of making the difficult political decisions necessary. They each have constituencies that tend to opt for the status quo. But I see hope on both sides of the political spectrum that change is possible. The course they set will give us an idea where we will want to focus our portfolios in the decade of the ’20s. It is a 100% probability that we will have to make a decision. It is less than 50% that we will make the right one – or at least the one that I think is the right one.

7.  We have entered the Age of Transformation. We’re going to see the development of new technologies that will simply astound us – from increasingly capable robots and other applications of AI to huge breakthroughs in biotechnology.

The winners are going to be those who identified the truly transformational technologies early on in their development and invested wisely. While riskier (potentially far riskier) than most of your investments should be, a basket of new-technology stocks should be considered for the growth part of your portfolio. I see the Age of Transformation as a 100% probability.

Just for the record, I also see a continuation of the global deflationary environment and a slowing of the velocity of money until we have some type of resolution concerning sovereign debt. Central banks will continue to try to solve the “crises” I mentioned above with monetary policy, but monetary policy will simply not be enough to stem the tide. Central banks can paddle as hard as they like into the waves of change, but they cannot reverse their powerful flow.

Now, let’s look further at each of the waves that are forming into a potential tsunami.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: A Five-Year Global Financial Forecast: Tsunami Warning was originally published at mauldineconomics.com.

Get our latest FREE eBook "Understanding Options"....Just Click Here!

German Chancellor Merkel Won’t Let Ukraine Get in the Way of Business

By Marin Katusa, Chief Energy Investment Strategist

The Ukraine crisis has moderated for now, but it should have awakened the world to the new “great game” being played in Eastern Europe. Vladimir Putin is positioning Russia to control the global energy trade, knowing that he holds the trump card: Europe’s dependence on Russian oil and gas.

This epic struggle between the US and Russia could change the very nature of the Euro-American trans Atlantic alliance, because Europe is going to have to choose sides.

The numbers in Putin’s OIL = POWER equation are only going to keep getting bigger as Russia’s control and output of energy continues to grow and as Europe’s supply from other sources dwindles—as I outline in my new book, The Colder War. Finland and Hungary get almost all their oil from Russia; Poland more than 75%; Sweden, the Czech Republic, and Belgium about 50%; Germany and the Netherlands, upward of 40%.

Cutting back on energy imports from Russia as a means of pressuring Moscow is hardly in the EU’s best interest.

Germany, the union’s de facto leader, has simply invested too much in its relationship with Putin to sever ties—which is why Chancellor Angela Merkel has blocked any serious sanctions against Russia, or NATO bases in Eastern Europe.

In fact, Germany is moving to normalize its relations with Russia, which means marginalizing the Ukrainian showdown. Ukraine is but a very small part of Moscow’s and Berlin’s plans for the 21^st century. Though the U.S. desperately wants Germany to lean Westward, it has instead been pivoting East. It’s constructing an alliance that will ultimately elbow the US out of Eastern and Central Europe and consign it to the status of peripheral player. (The concept of the “pivot “ in geopolitics was advanced by the celebrated early 20^th century English geographer Halford Mackinder with regard to Russia’s potential to dominate Europe and Asia because it forms a geographical bridge between the two.

Mackinder’s “Heartland Theory” argued that whoever controlled Eurasia would control the world. Such a far flung empire might come into being if Germany were to ally itself with Russia. It’s a doctrine that influenced geopolitical strategists through both World Wars and the Cold War. It was even embraced by the Nazis before Russia became an enemy. And it may still be relevant today—despite the historical animosities between the two countries. After all, the mutually beneficial alliance of a resource-hungry Germany with a resource-rich Russia is a logical one.)

Considering the deepening ties between Russia and Germany in recent years, the real motive for the US’s stoking of unrest in Ukraine may not have been to pull Ukraine out of Russia’s sphere of influence and into the West’s orbit—it may have been primarily intended to drive a wedge between Germany and Russia.

The US almost certainly views the growing trade between them—3,000 German companies have invested heavily in Russia—as a major geopolitical threat to NATO’s health. The much-publicized spying on German politicians by the US and the British—and Germany’s reciprocal surveillance—shows the level of mutual distrust that exists.

If sowing discord between Russia and Germany was America’s goal, the implementation of sanctions might look like mission accomplished. Appearances can be deceptive, though.

Behind the scenes, Germany and Russia maintain a cordial dialogue, made all the easier because Vladimir Putin and Angela Merkel get along well on a personal level. They’re so fluent in each other’s languages that they correct their interpreters. They often confer about the possibility of creating a stable, prosperous and secure Eurasian supercontinent.

Despite the sanctions, German and Russian businessmen are still busy forging closer ties. At a shindig in September for German businesses in the North-East and Russian companies from St. Petersburg, Gerhard Schröder—former German prime minister and president, and friend of Putin—urged his audience to continue to build their energy and raw-material partnership.

Schröder’s close personal relationship with Putin is no secret. He considers the Russian president to be a man of utmost trustworthiness, and his Social Democratic Party has always been wedded to Ostpolitik (German for “new Eastern policy”), which asserts that his country’s strategic interest is to bind Russia into an energy alliance with the EU.

Schröder would have us believe that they never talk politics. Yet in his capacity as chair of the shareholders’ committee of Gazprom’s Nord Stream—the pipeline laid on the Baltic seabed which links Germany directly to Russian gas—he continues to advocate for a German-Russian “agreement.”

That’s a viewpoint Merkel shares. In spite of her public criticism of Putin’s policy toward Ukraine, Merkel has gone out of her way to play down any thought of a new Cold War. She’s on the record as wanting Germany’s “close partnership” with Russia to continue—and she’s convinced it will in the not-so-distant future.

Though Merkel has rejected lifting sanctions against Russia and continues to publicly call on Putin to exert a moderating influence on pro-Russian Ukrainian separatists, it looks like Germany is seeking a reasonable way out. That makes sense, given the disproportionate economic price Germany is paying to keep up appearances of being a loyal US ally.

Politicians in Germany are alert to the potential damage an alienated Russia could inflict on German interests. Corporate Germany is getting the jitters as well, and there are a growing number of dissenting voices in that sector. And anti-American sentiment in Germany—which is reflected in the polls—is putting added pressure on Berlin to pursue a softer line rather than slavishly following Washington’s lead in this geopolitical conflict.
With the eurozone threatened by a triple dip recession, expect Germany and the EU to act in their own interests. Germany has too much invested in Russia to let Ukraine spoil its plans.

As you can see, there’s no greater force controlling the global energy trade today than Russia and Vladimir Putin. But if you understand his role in geopolitics as Marin Katusa does, you’ll know how he’s influencing the flow of the capital in the energy sector—and which companies and projects will benefit and which will lose out.

Of course, the situation is fluid, which is why Marin launched a brand new advisory dedicated to helping investors get out in front of the latest chess moves in this struggle and make a bundle in the process.
It’s called The Colder War Letter. And it’s the perfect complement to Marin’s New York Times best-seller, The Colder War, and the best way to navigate and profit in the fast changing new reality of the energy sector. When you sign up now, you’ll also receive a FREE copy of Marin’s book. Click here for all the details.

The article German Chancellor Merkel Won’t Let Ukraine Get in the Way of Business was originally published at casey research

Get our latest FREE eBook "Understanding Options"....Just Click Here!

World Money Analyst Update on Europe

By John Mauldin

For the last two weeks on Thursdays we have brought you special editions of Outside the Box featuring World Money Analyst Managing Editor Kevin Brekke’s interviews with WMA contributing editors. We heard from Ankur Shah on emerging markets and Alexei Medved on Russia, and this week we wrap up the series with a frank, hard-hitting interview with Dirk Steinhoff, who covers the European and Scandinavian markets for WMA.

Kevin and Dirk are both based in Switzerland, and so they lead off with a discussion of the recent Swiss referendum on immigration. Dirk’s interpretation of the vote, which imposes quotas on the number of foreigners allowed to enter the country, is that it has implications for the entire European Union:

[T]he Swiss people basically decided that they want to control immigration themselves and do not want to give up this control to the centralized administration in Brussels. I think that this is a clear signal to the Swiss government that the Swiss people don’t want to give up more sovereignty and that they would like to see more decentralization in the future.

Which leads Kevin and Dirk to take up the broader issues of the unresolved Eurozone debt crisis, unemployment mess, and the fate of the euro. With EU parliamentary elections coming up in May, there is change in the air! OK, let’s turn it over to Kevin and Dirk for the details.

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

Stay Ahead of the Latest Tech News and Investing Trends...

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.

---

World Money Analyst Update on Europe

World Money Analyst: With me today is Dirk Steinhoff. Dirk is a contributing editor at World Money Analyst and covers the European and Scandinavian markets. Great to have you with us.

Dirk Steinhoff: Thank you very much for having me.

WMA: Seeing that you're in Zurich and I'm in Fribourg, let's start with a look at developments in our own backyard. The Swiss are known for their system of direct democracy via use of the referendum. The recent success of a referendum that will restrict immigration into Switzerland made global headlines. What’s your position on the immigration issue and the consequences of this vote?

Dirk: First of all, I should mention that I was born and raised in Berlin and moved with my family to Switzerland in 2007. One of the main reasons why I decided to leave Germany and come to Switzerland, next to the great Swiss landscape, was the strongly centralized development of the European Union, which reminds me painfully of the political system in the former DDR [communist East Germany].

European politicians live a life that is completely detached from those that don’t belong to this elitist political class. Their decisions are based on distorted experience and lobbyist influence and not on real life experience and independent judgment. The strong, centralized power of Brussels, in combination with the desire to regulate everything in life, increasingly limits personal freedom, limits the development of entrepreneurship (and therefore the creation of non-government-related workplaces), and eliminates local, regional, and national characteristics.

The state is much less dominant in Switzerland, mainly due to its federalist and decentralized political system, which limits the power of the federal government. Due to my own background and my own moral conviction, I personally believe that every human being should be able to live and work wherever he or she wants, as long as they are self-reliant, willing to integrate, and do not become a burden to the community they recently entered.

My interpretation of the referendum is that the Swiss people basically decided that they want to control immigration themselves and do not want to give up this control to the centralized administration in Brussels. I think that this is a clear signal to the Swiss government that the Swiss people don’t want to give up more sovereignty and that they would like to see more decentralization in the future.

It also interesting to note that most of the media in Europe (even Swiss media) were shocked by the outcome of the vote. In sharp contrast, other polls in various European countries actually show that most citizens would have voted similarly to the Swiss, and some by an even higher margin than the outcome of the Swiss vote. I think that in the long run more and more of the European people will ask for the Swiss model of democracy to be implemented in their home countries.

Although the rhetoric used by politicians in Europe might change to the negative in the short term, I do not think that the referendum will have a long-term negative effect on the relations between Switzerland and Brussels. I believe that Brussels has to come to terms with our form of democracy and has to respect our sovereignty, even if they might disagree with some of our decisions.

WMA: The immigration debate is not unique to Switzerland, of course, and is a divisive issue across Europe. This seems to be part of a trend where we've seen a rise in popularity of nationalist and anti-euro parties? What's your view?

Dirk: You are right. The severe criticism of Switzerland because of the outcome of the referendum has eclipsed the fact that many European countries face the same issue. People are not only unhappy with the immigration politics within the EU, they are becoming more EU skeptical in general.

The political parties critical of the European Union – like the UK independence party in Great Britain, the Finns Party (formerly the True Finns) in Finland, the Lega Nord in Italy, the FPÖ in Austria, the AfD in Germany, the French Front Nationale, the Golden Dawn in Greece, and the Party of Freedom in the Netherlands – are gaining popularity. Of course, the reasons for and the scope of their EU criticism vary a lot.

I think this trend can be summed up as follows: the people want to have a voice and be able to decide their own fate! Pretty much everybody in the EU is unhappy about one issue or another. The Southern European countries are unable to cope with the austerity measures, and on the other hand you have a large part of the German population that is simply unwilling to continue financing the complete EU.  I believe this trend will gain momentum, and it will bring some surprises in the elections to the European Parliament in May 2014.
Europe has so many different cultures that centralization just doesn’t work, because there isn’t a one-size-fits-all answer to most issues. The euro is a perfect example of this!

WMA: That's an important point on the euro. With the continued rise of anti-euro sentiment, what is your outlook for the currency? Will the euro survive?

Dirk: I don’t know. There are different scenarios that I can imagine for the euro: strong countries leaving the Eurozone, unwilling to pay for a bottomless pit of EU debt; weak countries leaving the Eurozone in order to be able to devalue their currencies and regain competiveness; or a split into a strong northern euro and a weaker southern euro. Or some combination of these. As you can see, there are many possibilities, and what we will see depends on economic and political developments in European countries over the next several years. In my view, something will happen and we won’t have the same euro in five years time that we have today.

WMA: The adoption of the common currency has limited how individual countries can respond to fiscal stresses. News about the euro debt crisis has been very quiet lately. What is the situation?

Dirk: As you say, there has hardly been any news recently regarding the troubles in the EU, which does not mean that the problems are solved. They are still bubbling under the surface. With the current papering-over and continuation of indebtedness, the need to address the problems, with their inherent negative consequences for most people, has been postponed. Because of that, most of the harsh protest has faded and turned away from the streets and is canalized into the euro-skeptic political parties. And when there have been noteworthy protests, such as last November in French Brittany, media coverage was excluded.
What has changed in the last year? Absolutely nothing fundamentally! So the euro crisis will at some point reappear with all its inevitable consequences.

WMA: You mention France, so let's continue down that path. The small and mid-sized Eurozone countries – Spain, Portugal, Italy, and Greece – are essentially bankrupt as measured by GDP and in receivership by Brussels. Today, there is growing speculation that France, too, is headed for trouble soon. What do you think?

Dirk: I totally agree! They have too much debt, a radical socialist government, and absurd, business-unfriendly regulation. I have several friends who are business owners in France, and they are all contemplating leaving the country and moving their businesses abroad.  The quantity of regulation they have to comply with simply cannot be handled by a normal business, and the labor laws are so strict that no business owner in their right mind wants to take on the risk of employing someone.

Taking into consideration the unhealthy debt levels they have, the unsustainable social programs they offer, and the complete lack of any growth impulses, I have to believe that the French are indeed headed for trouble soon. And, as the second largest economy in the EU, France matters. If France stumbles, the EU is at risk.

WMA: Drawing on your comments about strict labor laws, the unemployment numbers in many EU countries are mind-boggling. You discussed this situation in your recent article for World Money Analyst. Can you talk about this for a minute?

Dirk: As we have seen since 2008, the trillions in newly created fiat money have mainly fueled asset bubbles. However, the real economy has not profited from it, because this money has not been lent to private industry. We are still facing 30% lower money velocity than before 2008 and that means that more than 30% of credit in circulation has disappeared. This is also why the real economy is still going down the drain.

Most jobs have been created within the government or government related entities; and as we all know, these jobs are paid for by the taxpayers and are not a source of production. Therefore, I personally believe the situation in the labor market will further deteriorate, especially among the young generation, below 25; they are going to suffer the most. The current youth unemployment rates in Spain and Italy are just shocking: 58% and 42%, respectively. We are losing a whole generation, and we cannot predict how drastically the damage we are doing to them will play out in the future.

WMA: High and sustained rates of joblessness can lead to frustration and anger by the unemployed that turns to civil unrest and protests. We've seen riots in several EU countries, including France, Greece, and Bosnia. Is that also a real danger for the stronger European countries?

Dirk: Yes, this is a real danger. As soon as the deterioration of people's personal economic situations reaches a certain level they will be on the streets, and that includes the streets of the stronger countries. At the moment, most people still believe that all the debt and all the rescue programs come for free.

WMA: What does this all mean for the outlook for European stocks and bonds?

Dirk: That you have to watch closely what the European Central Bank and governments do. It’s a tricky situation – you don’t want to miss any upside rallies in equities and bonds induced by loose monetary policies. Yet, on the other hand you know the party could end at any time. Risk management is essential.  The day of reckoning can be postponed by governments and central banks much further – as we know from the US and Japan – than common sense would allow for.

WMA: In your opinion, what European countries have the best economic outlook?

Dirk: The countries that have been strong in the past, with competitive industries and with sound current-account and budget balances. Countries like Germany, Austria, Denmark, Sweden, and Norway. And Switzerland.

WMA: As you mentioned above, in May 2014 there will be the EU Parliament election. Will that change anything?

Dirk: The potential increase of parliamentarians that are critical of Europe I mentioned before could intensify tensions within the EU and complicate the functioning of the EU system. But I don’t expect a quick change.

WMA: We must talk about the un-loved Swiss franc. Since Switzerland began intervention in the currency markets to halt the rise of the franc against the euro, the mainstream consensus has it that the franc is doomed. But the performance of the franc against other currencies, in particular the US dollar, has been very strong. What's your take on the Swiss franc going forward?

Dirk: It’s hard to say. In a euro crisis I would expect the Swiss National Bank [the central bank] to remove the floor to the euro. In such a situation the power of the SNB to keep the floor would be simply too small, I think. There are also attempts in Switzerland to once again constitutionally back the Swiss franc by gold. We’ll have to see. The Swiss franc, to me, still belongs to the upper class of paper currencies.

WMA: Do you have any last thoughts for our readers?

Dirk: Globally, we have entered a time when substantial corrections of past misadventures are likely to occur. It’s not the end of the world, but it's worth being prepared.

WMA: I really appreciate your insights on the European markets. Thank you for taking the time to speak with us today.

Dirk: The pleasure was mine.

Like Outside the Box?
 
Sign up today and get each new issue delivered free to your inbox. It's your opportunity to get the news John Mauldin thinks matters most to your finances.

The article Outside the Box: World Money Analyst Update on Europe was originally published at Mauldin Economics

Catch our replay of our wildly popular webinar "Being the Architect of the Big Trade"

Thoughts from the Frontline.....France: On the Edge of the Periphery

By John Mauldin

"The emotional side of me tends to imagine France, like the princess in the fairy stories or the Madonna in the frescoes, as dedicated to an exalted and exceptional destiny. Instinctively I have the feeling that Providence has created her either for complete successes or for exemplary misfortunes. Our country, as it is, surrounded by the others as they are, must aim high and hold itself straight, on pain of mortal danger. In short, to my mind, France cannot be France without greatness.

– Charles de Gaulle, from his memoirs

Recently there have been a spate of horrific train wrecks in the news. Almost inevitably we find out there was human error involved. Almost four years ago I began writing about the coming train wreck that was Europe and specifically Greece. It was clear from the numbers that Greece would have to default, and I thought at the time that Portugal would not be too far behind. Spain and Italy clearly needed massive restructuring. Part of the problem I highlighted was the significant imbalance between exports and imports in all of the above countries.

In the Eurozone there was no mechanism by which exchange rates could be used to balance the labor-cost differentials between the peripheral countries and those of the northern tier. And then there's France. I've been writing in this space for some time that France has the potential to become the next Greece. I've spent a good deal of time this past month reviewing the European situation, and I'm more convinced than ever that France is on its way to becoming the most significant economic train wreck in Europe within the next few years.

We shifted focus at the beginning of the year to Japan because of the real crisis that is brewing there. Over the next few months I will begin to refocus on Europe as that train threatens to go off the track again. And true to form, this wreck will be entirely due to human error, coupled with a large dollop of hubris. This week we will take a brief look at the problems developing in Europe and then do a series of in-depth dives between now and the beginning of winter. The coming European crisis will not show up next week but will start playing in a movie theater near you sometime next year. Today's letter will close with a little speculation on how the developing conflict between France and Germany and the rest of its euro neighbors will play out.

France: On the Edge of the Periphery

 

I think I need first to acknowledge that the market clearly doesn't agree with me. The market for French OATS (Obligations Assimilables du Trésor), their longer-term bonds, sees no risk. The following chart is a comparison of interest rates for much of the developed world, which I reproduce for those who are interested in comparative details. Notice that French rates are lower than those of the US, Canada, and the UK. Now I understand that interest rates are a function of monetary policy, inflation expectations, and the demand for money, which are all related to economic growth, but still….



France's neighbors, Italy and Spain, have rates that are roughly double France's. But as we will see, the underlying economics are not that much different for the three countries, and you can make a good case that France’s trajectory may be the worst.

"No: France Is Not Bankrupt" – Really?

 

We will start with a remarkable example of both hubris and economic ignorance published earlier this year in Le Monde. Under the headline "No: France Is Not Bankrupt," Bruno Moschetto, a professor of economics at the University of Paris I and HEC, made the following case. He apparently wrote this with a straight face. If you are not alone, please try not to giggle out loud and annoy people around you. (Hat tip to my good friend Mike Shedlock.)

No, France is not bankrupt .... The claim is untrue economically and financially. France is not and will not bankrupt because it would then be in a state of insolvency.

A state cannot be bankrupt, in its own currency, to foreigners and residents, since the latter would be invited to meet its debt by an immediate increase in taxation.

In abstract, the state is its citizens, and the citizens are the guarantors of obligations of the state. In the final analysis, "The state is us." To be in a state of suspension of payments, a state would have to be indebted in a foreign currency, unable to deal with foreign currency liabilities in that currency….

Ultimately our leaders have all the financial and political means, through the levying of taxes, to be facing our deadlines in euros. And besides, our lenders regularly renew their confidence, and rates have never been lower.

Four things leap to mind as I read this. First, Professor, saying a country is not bankrupt because it would then be insolvent is kind of like saying your daughter cannot be pregnant because she would then have a baby. Just because something is unthinkable doesn't mean it can't happen.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Don't miss this week's webinar "Advanced Study of the Opening Gap in Crude Oil"