Investor July 2015

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How to survive the coming market correction!

The current brief recovery trend of the JSE is likely to be over on or about September 2 ahead of a Wall Street correction likely to happen a week later on or about September 11. And given that markets worldwide are now completing one of the longest bull phases in modern history, the downturn is likely to be long and costly.

I know that I am sticking my neck out in making these predictions, but the fact is that analysts all over the world are agreed that a correction is overdue and the only question is when it will happen. But many will nevertheless label me as foolhardy for being as absolute as this. So I need to explain that the artificial intelligence system that I and my team have built in the shape of the ShareFinder 6 computer analysis programme has now reached an accuracy level of 92.95% in the weekly market predictions it makes for my Richard Cluver Predicts column which is published every Friday to subscribing investors. Since ShareFinder has produced these dates, there is thus a better than 9 out of ten chance that, give or take a few days on either side, the declines will occur. The graph composite below shows how ShareFinder envisages these events occurring:


Importantly, the declines are likely to be viewed for a long time as merely very modest short-term declines for ShareFinder suggets that they will be quite gradual, probably only gathering steam months into the bear phase. In fact, hindsight will almost certainly show that the JSE decline actually started back in April this year and to date nobody has yet voiced any particular concern although, to be technically correct, the All Share Index decline between April 24 and July 7 this year was 10 percent which qualifies it as a serious correction. And although the market has been correcting upwards since then, my chart below illustrates that a typical head and shoulders formation is now in place on the Alsi which suggests that a fall of the index below 5080 in the next few days is likely to lead to another pronounced drop.

When I produced this graph below, the green line of ShareFinder’s short-term Fourier projection suggested that it would rebound on August 7 and again on August 14 off the red trend line defining this head and shoulders formation and run upwards until September 28. But note that this September peak is unlikely to be higher than the April 24 high point of the year confirming that the market is now in a bear trend. Thereafter it will rund down making successive lower lows on or about October 27, November 11 and December 18. Importantly, as all technical analysts will affirm, when successive market tops are all lower than the previous ones, a bear market is under way and that is precisely what ShareFinder is now projecting.

Here I should stress that as we move towards these dates, new market data might shift the market peaks marginally to the left or right but the general trend is unlikely to change much. Simply stated, the longest bull market in recent history is now almost certainly over: the party is over!


Bear markets, of course, occur regularly every few years inevitably preceded by two main conditions. Firstly the market must be widely perceived to be expensive.

Secondly there is usually a trigger event. Well markets are historically expensive as illustrated by the Cape Ratio which has only twice in history managed to rise above its current level of 27.1. On the first occasion it peaked at 27.8 in 1929 immediately ahead of the Black Friday Wall Street crash that ushered in the Great Depression. On the second occasion it peaked at 43 in 2000 immediately ahead of the Dot Com crash. For purists seeking an explanation of this ratio, it is a valuation measure usually applied to New York’s S&P500 Index, defined as price divided by the average of ten years of earnings, adjusted for inflation


As to the trigger event, it is almost certainly to be the US Federal Reserve acting to raise interest rates. Each time news commentators have signalled that such a rate hike is imminent, Wall Street has caught a cold. Thus Fed Chairman Janet Yellen has been treading particularly carefully lately in order not to spook the market. But now she has spoken clearly speaking to the US Senate Banking Committee a fortnight ago she said that the U.S. labour market had moved demonstrably closer to a more normal state, offering this as a reason why the central bank is likely to raise short-term interest rates later this year.

So we have a probable date sometime between now and the end of the year. Thus, to make my bear market prediction, all it took was to note ShareFinder’s Fourier projection system which depends upon recurrent market cycle analysis to produce its predictions.

Now, as I explained to readers in last months issue of The Investor, Capital Gains taxation has, in this country made it all but impossible for long-term investors to sell their holdings because of the massive slice of their capital. that the Government would take in the event of such sales. Accordingly they have been obliged to adopt a strategy of diverting a significant portion of income into a capital growth cash fund.

Thus, for example, when they anticipate market downturns such as I have currently predicted, they will use this diverted income to create a cash reserve with which allow them, in times of significant market downturns, to buy high quality blue chip shares which have the joint attributes of a record of steadily-rising dividends over extended periods which have translated into high rates of share price growth.

Prior to the introduction of Capital Gains Taxes, investors anticipating a market downturn would sell the underperformers in their portfolios in order to create this same cash pile but by following this alternative strategy the underperformers tend to become in value terms an ever-shrinking portion of the portfolio: not the most efficient approach but the only practical alternative in the circumstances.

Happily too, as investors have increasingly switched to this latter strategy, the bluest of blue chips have become even bluer and virtually immune to market declines.

Thus, for example, when our ShareFinder Blue Chip Index is subjected to the same computer analysis as the general market indices we get the following projection.

Note that in this construction, the predicted September JSE decline becomes just a modest dip in mid-October before growth is resumed,by another modest correction between mid-February and May 24.


Finally, just a passing word about the ShareFinder projection system which uses artificial intelligence to replicate the dominant wave cycles of the past. To achieve the Blue Chip Index projection above the ShareFinder computers had to analyse the daily price movements of all qualifying shares over the past 20 years. Each successive projection is then compared with what subsequently happens and the analysis parameters are adjusted in order to eliminate any prediction errors that might have occurred in the past. The computers thus become increasingly more accurate in their projections as the years progress and have now achieved an average accuracy rate of 93.27 percent.

Readers queries: What to

do with trust money.

clip_image010Mr L has some Trust Fund money coming up for investment and would like to know what would be the “Responsible” way to invest this

The general (Prudential) rule for responsible investment is one third cash, one third property and one third equities.

For cash read bonds or the money market. For property these days one would generally opt for a property share or a Reit and for shares a Blue Chip.

That said, the impending probability of interest rate hikes means one should avoid bonds at this stage of the cycle and the strong probability of a share market correction suggests that one should avoid these as well while the fortunes of Reits and property mutuals are these days closely allied to the share market and the bond market. Thus the quick answer is that for now you should put your money into the money-market on fairly short call: not more than 90 days so that it is easily accessible when the markets turn in the foreseeable future.

The exception to this rule in recent observation has been the ultra blue chips sector which seems likely to be relatively immune to market corrections. I could provide you with a list of shares that qualify in such circumstances but that is very likely to change as the market corrects itself and so now would not be a good time to do so. However, since you say you previously owned my ShareFinder software, might I suggest that you re-activate this so that you can monitor the market. We always credit previous users with whatever module that previously owned at its currrent value: i.e. if you previously had SF5 we will re-issue a new SF5 at any time.

SA economy: Household

help needed

By Brian Kantor

Faster growth will have to be led by SA consumers. Adding to household indebtedness is the solution, not the problem.

The SA economy added neither jobs nor capital equipment in Q1 2015. The business sector is unlikely to come to the rescue of the economy unless households lead the way forward and prove able and willing to spend more. Growth in household spending growth, that contributes about 60% to GDP, has been trending lower ever since the post-recession recovery of 2010. Though in the latest quarter to be reported, Q1 2015, growth in household consumption spending estimated at an annual rate of 2.8% actually helped, raise rather than depressed GDP, which grew at a very pedestrian 1.3% rate in Q1, 2015. The national income statistics reveal the great reluctance of the corporate sector to spend more on equipment or workers. In Q1 2015 fixed capital expenditure by private businesses declined as did their payrolls.

The statistics on bank lending to the private sector are very consistent with the revealed reluctance of households to spend more and to borrow to the purpose. Yet the banks are lending far more freely to the SA corporate sector at a well over 10% rate of growth.

However this corporate borrowing is not showing up as additional spending on fixed or working capital, that is, to employ more workers.


It would therefore appear that SA businesses are using their strong balance sheets to fund offshore rather than on shore operations. The significant increase in mortgage borrowing by SA corporations, presumably to this end, is noteworthy. By contrast household borrowing from the banks, including mortgage borrowing, has long grown more slowly, in fact declining in recent years when loans are adjusted for inflation. The price of the average house in SA has also been falling in real terms, so discouraging households to borrow or banks to lend to them in a secured way.

Much attention is usually given to the rising debt levels and ratios of households. The rising ratio of SA household indebtedness to disposable incomes is often referred to as a signal of the over indebted state of the average SA household. As may be seen below, this debt ratio increased markedly between 2003 and 2007 when the economy enjoyed something of a boom. This boom was led inevitably by a surge in household consumption spending , funded increasingly with credit, especially mortgage credit, linked to rising house prices of the period.

Also often referred to is the debt service to disposable incomes ratio, which has declined in recent years as interest rates have fallen- presumably a positive influence on spending. But this ratio ignores interest received by households that has fallen with lower interest rates- presumably to the detriment of household spending.


Much less attention unfortunately is paid to the other side of their balance sheet. As we show below the asset side of the SA balance sheet strengthened consistently before and after the meltdown in equity markets in 2008-09. A mixture of good returns in the equity and bond markets and a diminished appetite for debt has seen the household debt to asset ratio fall significantly.


The reluctance of SA households to borrow more and or the banks to provide more credit for them is being maintained despite a marked improvement in the balance

sheets of SA households. Hopefully at some point soon, this balance sheet strength will translate into more household spending and borrowing. These improved balance sheets may well have helped sustain household spending in the face of deteriorating employment and profit prospects in Q1 2015.

As may be seen in the figure above the ratio of household wealth to disposable incomes fell between 1980 and 1996. These were very difficult years of political transition for the SA economy, made all the more difficult by declining metal prices. This wealth ratio has since risen significantly to the peak levels associated with the gold and gold share boom of the 1979-1981. Access by SA companies and individuals to global markets and global capital that came with the transition to democracy has clearly been wealth adding and so helpful to SA wealth owners. The value of their shares, homes and retirement plans has more than kept up with after tax incomes in recent years.



In the figures below, we show the composition of the asset side of the household balance sheet in 2014 and also how the mix of assets has been changing. The largest share of household wealth is held in the form of claims on pension funds and life insurance with ownership of residential buildings following closely in importance. The fastest growing component of household wealth is holdings of other financial assets, investments in shares and bonds mostly via unit trusts, while bank deposits lag well behind in importance.

In the figure below we compare the real, after inflation growth in household assets, in household debts, household consumption expenditure and real household per capita incomes. These growth rates move in much the same direction. More household borrowing is associated with greater wealth, more spending and most importantly, a faster rate of growth in real per capita incomes. This virtuous circle that is initiated by more household spending and more borrowing to the purpose is particularly well illustrated through the boom years of 2003-2007, the only recent period when the SA economy could be described as performing well. Over this five year period,

household assets in real terms increased at an average rate of 11.9% a year, household debts by an astonishing real rate of 15.6% a year, while household consumption spending grew by 5.9% a year on average and household per capita real incomes were up at a welcome average real rate of 3.9% a year. Without the extra credit, all this good stuff could not have happened. So what is not to like about a credit accommodating boon to spending and economic growth?






One possible regret would be that such rapid growth rates cannot be sustained in the absence of an increase in domestic savings as well as of wealth. The ratio of gross

savings to GDP in SA has been in more or less continuous decline since the peak rates realised in 1980 as is shown below.


This declining savings rate has meant a greater dependence on foreign capital inflows to maintain growth rates. Even the slow growth of recent years has had to be accompanied by deficits on the current account of the balance of foreign payments and equilibrating capital inflows that have funded these deficits and more – also adding to foreign exchange reserves.

Given the low rate of domestic savings, South Africans have had to sell more debt to foreign investors and shares to foreign investors. More interest and dividend payments have gone offshore in consequence. But what is not well recognised by those who concern themselves (unnecessarily) with the sustainability of faster growth is that faster economic growth attracts capital and slower growth frightens capital away (Unnecessary because the sustainability of the growth will either be supported by the capital market or will not be, in which case the potential growth will not materialise, leaving nothing to worry about, except slow growth).

In the boom years after 2003 the inflation rate in fact came down as the rand strengthened with inflows of capital. SA enjoyed faster growth and lower inflation until the boom ended with much higher interest rates, imposed by the Reserve Bank, before not after, the Global Financial Crisis frightened capital away.

If SA is to re-enter the virtuous circle of faster growth and supportive capital inflows of the kind enjoyed after 2003, it will have to be accompanied by a renewed appetite for household borrowing and lending. Strong balance sheets may help initiate a recovery in the household credit cycle. Higher short term interest rates will do the opposite. A test of the hypothesis that faster growth in SA can be self sustaining when supported by capital inflows is overdue. Hopefully conditions in global capital markets will become more risk tolerant and more inclined to fund growth in SA. A growth encouraging agenda, initiated by the SA government, would be a much needed further stimulus to raising SA growth rates and attracting foreign investment.

The following article by John Mauldin of course refers to the problems of sluggish US economic growth but one could just as easily substitute South Africa every time US appears for the lessons are the same. RAC


Thoughts from the Frontline: Productivity & Growth

by John Mauldin

Almost everyone wants to be more productive. I include myself in that group – there are lots of ways I could be more productive. When I have conversations with people I think are very productive, they almost always tell me they wish they were more productive. What more could anyone expect from them?

In most cases, they aren’t responding to external demands. No one is cracking a whip over them; they have personal reasons for wanting to produce more. They want their children and grandchildren to produce more, too. It’s almost a cliché in

American culture: when the kids become “productive citizens,” a parent can finally feel that he or she succeeded. Multiply this by millions of families, and the result is economic growth.

Productivity & Growth Productivity is a critical part of the economic growth equation. We track the productivity of entire nations by means of gross domestic product (GDP), the sum total of all the goods and services their people produce. I have some issues with the way we calculate GDP, but it’s the best statistic we have for now.There are two – and only two – ways you can grow your economy. You can either increase your population or increase your productivity. That’s it. The Greek letter delta is the symbol for change. So if you want to change your GDP, you write that as Δ GDP = Δ Population + Δ Productivity

That is, the change (delta) in GDP is equal to the change in population plus the change in productivity. If you are a country facing a population decline (like Japan), then to keep GDP growing you have to increase productivity even more. That is why I have written so much about demographics over the years. Population growth (or the lack thereof) is very important. Russia is facing a very serious problem over the next 20 years that will require either a significant increase in productivity or a high level of immigration to stave off a collapsing economy. Russia’s population has declined by almost 7 million in the last 19 years, to 142 million. UN estimates are that it may shrink by about a third in the next 40 years. But that’s another story for

another letter.

One last economic sidebar. You cannot grow your debt faster than your nominal GDP forever. At some point, the market begins to think that you will not be able to pay your debt back. Think Greece. This is no different from the fact that a family cannot grow its debt faster than its ability to bring in income to pay that debt back. At

some point, you run out of the ability to borrow more money, as lenders “just say no.” As a family’s or a country’s debts grow, the carrying cost or interest expense rises, consuming an ever-larger portion of the budget until a breaking point is eventually reached. While the exact point is a matter for serious debate (and conjecture), there is a level at which debt actually limits the potential growth of an economy.

Paraphrasing Clint Eastwood, a country has to know its limitations.

We are going to hear a lot about growth in the coming presidential election. A lot of people are going to offer formulas, but you can check how realistic they are because GDP growth has just three variables. If you want to increase growth, you have to increase:

• the number of workers, and/or

• the number of hours they work, and/or

• the amount they can produce in an hour.

If you want GDP to grow, you have to make at least one of these factors go up without an offsetting decline in the others. Look at any story of economic progress or collapse anywhere in history, and these three variables will explain it.

Here in the United States, for instance, growth took off in the postwar 1950s but really soared in the ’60s and ’70s as newly “liberated” women entered the workforce, raising our total number of workers. In China over the last two decades, people moved from rural subsistence farming to urban industrial jobs. The number of workers in the overall economy didn’t change overnight, but productivity skyrocketed. Going back further, inventions like the automobile and electricity unlocked tremendous growth by increasing hourly output. Untold thousands of workers went from shoveling horse manure to more advanced occupations.

Shoveling horse manure was honorable work back then. Those workers produced something necessary (clean streets – at least until the next horse came along), but they were capable of doing so much more. We don’t think much about it today, but the average horse produces 9 tons of manure every year. That is about 35 pounds of manure daily, plus 6 to 10 gallons of urine, all of which had to be disposed of. Not to mention the amount of labor it took to feed those horses. Onequarter of agricultural output in 1900 went simply to feed horses.

Henry Ford (and a few others) “killed” all those jobs dealing with horses, freed a lot of our agricultural output to be sold all over the world, and thereby opened the door to better times, economically. But a lot of people had to find new employment.

“Better” for those workers was better for everyone. Affordable transportation sped up everything. The result was an economic boom that lasted through the Roaring ’20s. Millions of people left farms, moved to cities, and found high-paying factory jobs.

Do we have a 21st century breakthrough equivalent to the Model T? You bet we do. When autonomous vehicles are ready for prime time in a few years, millions of taxi and truck drivers will lose their jobs. Instead of one person driving one vehicle, we will have human car wranglers managing entire fleets as they roam through the streets. That human’s hourly productivity will be orders of magnitude higher than that of today’s drivers.

So what will the ex-drivers do for work? We don’t know yet. I’m very confident the economy will find ways to keep them productive, but I can’t say how. But their jobs will go away, just as those who shoveled horse manure lost theirs 100 years ago. The time lag required for a return to full employment will probably be painful, too, both for individuals and for the whole economy. GDP could shrink at first if the reduced hours of unemployed drivers outweigh the higher productivity of the people managing the autonomous car fleets. That irony highlights just one of the problems in how we measure GDP. People and products will still be moved, but since it will cost less to make that happen, we may register a drop in GDP. (More on this measurement problem later.)

GDP growth of an average of 2% over the last 15 years is not impressive compared to what we saw in the late 20th century. Is 2% really the best we can do? And for which parts of the economy?

This is a point on which both optimists and pessimists can be right. Even if aggregate growth is only 2%, some parts of the economy will perform much better as the economy makes its next transformation. I think we will see different tiers of growth. Even today, we see how some businesses embrace change, while others hold fast to old models.

• Companies that “get it” succeed by creating entirely new markets, as Apple did with the iPhone. They can also disrupt old ones, as Uber is doing to the taxi companies.

• At the same time, it will still be possible to have a good business without disrupting anyone. If the economy is growing and/or you serve a growing demographic niche, you can do quite well. Collectively, businesses in the second category will be able to grow only as fast as the economy around them does. Some might steal customers from others, but their aggregate earnings will be a function of population and economic growth.

The same applies to individual workers, and it’s already a 2016 election issue. Jeb Bush caught some heat for this July 8 comment to a New Hampshire newspaper: My aspiration for the country – and I believe we can achieve it – is 4 percent growth as far as the eye can see. Which means we have to be a lot more productive, workforce participation has to rise from its all-time modern lows, means that people need to work longer hours and through their productivity gain more income for their families. That’s the only way we’re going to get out of this rut that we’re in.

Critics zeroed in on “people need to work longer hours,” as if he were calling American workers lazy. It sure wasn’t the best choice of words (what is it about that family and their choice of words?), but economically he is correct. To get anything like consistent 4% growth, America will need more workers who will need, in aggregate, to work more hours, and/or our output per hour will need to rise. All of the above would be best.

(Sidebar: What I think Bush was trying to say is that the number of part-time workers who want full-time jobs is way too high and we need to find more jobs for those part- time workers, not for those of us who are already working more than full-time jobs. In a conversation we had last Monday morning in Denver, Larry Kudlow pointed out that there are still some 6 million workers who are working part-time for economic reasons, meaning they want more hours than they can get. If those workers could get more hours, productivity and GDP would go up.)

Now, getting back to the point that we need to work more hours, that actually seems to be happening:


The average US workday is about 0.2 hours longer than it was in 2005. Yes, I know, twelve minutes isn’t much, but multiply those extra minutes by millions of people working 250 days a year. We’ve added the equivalent of 50 hours (1.2 work weeks) per worker per year. If we were to reduce our hours back to where they were in 2005, the total number of workers would need to rise about 2% in order to keep total hours constant.

That would make a big dent in the unemployment rate, but that’s not what’s happening. The opposite is happening: millions remain unemployed – including millions who work “part-time for economic reasons,” i.e., they can’t find full-time jobs

– even as those who have jobs work longer hours. Why is this? I think the chart above gives us one clue. Notice how the length of our workdays popped higher in 2013–2014. That was when ObamaCare began incentivizing employers to squeeze more out of each full-time worker in order to reduce the impact of increased benefit costs. I’m sure ObamaCare had some influence, but I doubt it explains everything. Something else is happening.

The millions who want to work full-time aren’t just sitting at home. Many who can’t find full-time positions are joining the so-called “gig economy” of part-time and contract labor. Uber drivers are just the tip of the iceberg. It seems as though any business that can replace one full-time worker with two or three part-timers is doing it. This has a positive side – some workers get hours that are more flexible so they can care for children or juggle two jobs – but part-time work can also turn into misery. Many retail chain stores and restaurants now schedule workers with algorithms that try to match staffing with customer traffic. This practice results in ever-changing schedules that negate the flexibility.

The reason for this outcome is that businesses try to optimize the number of hours worked instead of making the hours more productive. The approach makes sense only if you presume human beings are all equally productive, interchangeable parts. We all know that’s not true. However, it is true that many workers’ income is limited by the number of hours they can work. If you are a personal trainer, for instance, you can only do so many one-hour sessions in a day. Furthermore, competition limits the amount you can charge for each session.

Some occupations don’t have these limits. If Stephen King, Larry Ludlum, or Danielle Steele can write a book in 500 or 1000 hours, they can then sell large numbers of books with little additional work. The number of hours in a day doesn’t limit their income from that book. The same is true for many creative occupations: programmers, artists, musicians, athletes, entrepreneurs, etc. Their actual income depends on the quality of their work and the demand for it, not the quantity or the number of hours on the job.

It would be great if every worker could have such a job, but that’s not possible. We will always have “personal service” jobs where productivity has natural limits. If these jobs exist in large enough numbers, they can hold back growth of the whole economy. Nevertheless, more people are working, full time or otherwise, yet we are not seeing much growth. Why not?

Obviously, something is holding back growth. The fact that a leading presidential candidate views 4% growth as aspirational shows how low our expectations have dropped. The US easily outpaced that modest growth in most expansions until the last decade or so. There were periods when we were growing at 5% or 6% or more! The tapering off of GDP growth over the last 15 years is noticeable in the chart below.


Productivity may be part of the answer. Maybe we’re working more but not producing more. This notion supports Robert Gordon’s thesis. Innovations like electricity, jet engines, and computers have done all they can. He thinks we are returning to the much lower growth that prevailed before I’m not that pessimistic; I see innovation everywhere. I truly believe it is going to help everyone – but the thing that puzzles many economists is that all this new productivity that we are supposed to be getting from the wave of innovation coming out of technology is not showing up in the data.

This was actually part of the lead story in the Wall Street Journal this morning, “Silicon Valley Doesn’t Believe U.S. Productivity Is Down.” The article features commentary by Google chief economist Hal Varian: To Mr. Varian and other wealthy brains in the world’s most innovative neighborhood, productivity means giving people and companies tools to do things better and faster. By that measure, there is an explosion under way, thanks to the shiny gadgets, apps and digital geegaws spewing out of Silicon Valley.

Official U.S. figures tell a different story. For a decade, economic output per hour worked – the federal government’s formula for productivity – has barely budged. Over the past two quarters, in fact, it has fallen. Sluggish productivity is raising alarms all the way to Federal Reserve Chairwoman Janet Yellen. Productivity matters, economists point out, because at a 2% annual growth rate, it takes 35 years to double the standard of living; at 1%, it takes 70. Low productivity growth slows the economy and holds down wages.

The 68-year-old Mr. Varian, dressed in a purple hoodie and khaki pants, says the

U.S. doesn’t have a productivity problem, it has a measurement problem, a sound bite shaping up as the gospel according to Silicon Valley. “There is a lack of appreciation for what’s happening in Silicon Valley,” he says, “because we don’t have a good way to measure it.” One measurement problem is that a lot of what originates here is free or nearly free. Take, for example, a recent walk Mr. Varian arranged with friends. To find each other in the sprawling park nearby, he and his pals used an app that tracked their location, allowing them to meet up quickly. The same tool can track the movement of workers in a warehouse, office or shopping mall. “Obviously that’s a productivity enhancement,” Mr. Varian says. “But I doubt that gets measured anywhere.”

Consider the efficiency of hailing a taxi with an app on your mobile phone, or finding someone who will meet you at the airport and rent your car while you’re away, a new service in San Francisco. Add in online tools that instantly translate conversations or help locate organ donors – the list goes on and on. He’s absolutely right; but to politicians and economists focused on budgets and debt and wages, the argument misses the point. The government can tax something only if its value is determined in dollars. Google and Microsoft Word and Dragon NaturallySpeaking and the Internet and a dozen other things that all enhance my productivity really don’t cost all that much. I like to think I’m productive, but putting this letter out doesn’t add to GDP, nor do any of the other tools that I used, except through their modest price. The government gets no increased taxes unless I can figure out a way to make money from my “free” letter model (which, thankfully, we do).

So in a way, I am helping to grow the economy; and if Mr. Varian is right, we might be underestimating our true productivity. But if the economy we can measure in dollars doesn’t grow more than 2%, it is difficult for the government to get more

dollars. If we can’t grow at more than 2%, government debt and deficits become ever more significant. Nominal wages are also affected by GDP growth.

Goods and services move the official US productivity needle only when consumers and businesses pay for them. Anything free, no matter how much it improves everyday life, isn’t included. Google offers us all a very powerful search engine that has made us all more productive. And yes, Google gets a lot of money for that. But the value that Google has added to the world, I believe, far exceeds the revenues that Google gets. That value doesn’t get measured in GDP and certainly doesn’t move the tax revenue needle and seemingly hasn’t been reflected in wages earned by the average worker. Let’s return to the problem of slower growth that I mentioned above. I just saw a fascinating paper from Lakshman Achuthan of the Economic Cycle Research Institute. Looking at past economic expansions, Achuthan and his colleagues found that the current slow-growth expansion is consistent with a long- term trend toward slower growth since the 1970s.

You can see what he means in this chart from JPMorgan.


Quarters with real year-over-year GDP growth greater than 4% were common in the 1970s, 1980s, and 1990s. We’ve now gone more than a decade without one. In fact, with GDP growth running at just 2.9%, the Fed is seriously considering higher interest rates. Achuthan points out how the Fed’s own growth projections are getting steadily lower even as it looks to “normalize” interest rates (i.e., raise them).

Adding all this up, we seem to be on a productivity plateau. Some workers and companies are dramatically more productive now, but they aren’t offsetting stagnation in the rest of the economy. Massive Misallocation of Capital What is holding back productivity growth? I don’t think it is lack of innovation or creativity. Smart people all over the world are inventing amazing things.

I see another culprit (which I admit sets me at odds with mainstream economists): easy money. As we know, the Federal Reserve and other central banks pumped astronomical amounts of liquidity into the global economy since 2008. With interest rates already very low, they started buying assets via their various QE programs. I think history will show that the result is a massive misallocation of capital.

1. With central banks driving down interest rates, savers and investors saw their incomes reduced. The losses they incurred limited their ability to invest in business startups. While we all celebrate Silicon Valley and the venture capital business, the reality is that most small businesses are not started with venture capital but with personal savings and investments or loans from friends and family. When you reduce the amount of money available on Main Street, it should be no surprise that you get fewer new business startups. In fact, for the first time in the history of this country, we are seeing more businesses close than are started. The Federal Reserve would contend that low rates make the cost of money lower, but very few new businesses get started with just bank loans from a small community bank.

I am shocked at the amount of money that banks will lend me today. I truly am. But back in 1977 at the tender age of 28, all I could get was $10,000 for inventory. And I paid 18% interest. Well, there is an example of a bank lending to small business.

Except I later found out they really didn’t. My mother went to them and guaranteed the loan without telling me. Otherwise, I was just some kid with a business idea. It was literally friends and family at the beginning, after all. How many great ideas died in the last decade for lack of funding? I think the answer would startle us. I’ll bet some of them would have boosted productivity enough to get GDP to that 4% Jeb Bush thinks would be wonderful.

2. Instead of going to the people and businesses who could have made best use of it, all that money simply drove asset prices higher – mainly stocks and real estate.

3. Financial engineering became the mantra of the day. It is now cheaper to buy your competition than it is to actually invest in equipment or people and compete with rivals. Or you can borrow money cheaply to buy back your own stock, thus engineering increased profits per share and bonuses for management all around.

4. Meanwhile, the Obama administration and Congress gave us financial regulations (Dodd-Frank) that drove a lot of innovation out of public markets and into Silicon Valley’s private ventures. This is certainly spurring innovation – but innovative people elsewhere still struggle to raise capital. I agree 4% growth would be great, but we ought to see even more in an expansion. That was “normal” just 20–30 years ago. Now it is just a dream.

How do we turn dream into reality? In addition to the better tax and incentive structures combined with the revamping of regulations that I wrote about a month ago in the letter called “Cleaning Out the Attic,” the financial sector needs to do a better job of connecting capital to ideas. Congress did help by passing the JOBS Act, but regulators have greatly diminished its potential impact. We really need to open

clip_image029up the venture market to take advantage of 21st-century technology and the Internet. It is happening, but a lot more slowly than it would if there were clear regulatory guidelines and incentives rather than the constant barrage of regulatory barriers.

Just as Henry Ford destroyed the jobs of manure shovelers and those who manufactured buggies and harnesses, Silicon Valley and tech entrepreneurs everywhere will be destroying jobs as they create whole new categories of industries and businesses that will replace or reform the status quo. Henry Ford is often cited as a model because he employed workers in his factories and paid them well. But he and his competitors employed only a small fraction of the people whose jobs he made obsolete, as high tech continues to do today. Those people had to either create new businesses or wait until an entrepreneur came along with an idea to employ them. If we are truly worried about where the jobs will come from in the future, then we need to make sure that those who want to create and fund new businesses can do so as easily as possible.

The World Bank has created a ranking of countries by how easy it is to start a business in them. The United States is

ranked 46th. I might quibble here or there with some of their stats, but not even being in the top 10 is miserable. If you want to know why we are having a problem with a slow recovery, you might start with that simple statistic. And by the way, those new businesses show up in GDP, productivity, and tax revenues. Up until very recently, net new jobs were almost always a result of new businesses. If you want to know why wages are stagnant, productivity is down, and unemployment is frustrating, you need look no further.

Don’t Bring a Knife to a


by John Mauldin

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. For all intents and purposes, Greece had to surrender its sovereignty and is now a European protectorate. But in the end, a majority of the Greek parliament agreed that was better than holding hands and stepping off the cliff into the abyss. In the wake of all my reading this past week on the topic, and after a lengthy conversation with George Friedman of Stratfor, let me offer some thoughts.

Europe as a free trade zone essentially works. It is not perfect, as no free trade zone is, but it is far better than the alternative. However, the eurozone has been an utter disaster for most of its members. It has been a triumph for Germany. Germany now exports almost 50% of its GDP, with half of that to its fellow European Union members. Germany has prospered with a far weaker currency, the euro than it would have with its deutschmark. The southern members of the eurozone (including France) have suffered with a far stronger currency than they deserve.

George Friedman argues (quite aggressively) that the Germans were bluffing. The idea that Greece might lead the eurozone panics German leaders, since they know that if other members were also to leave, their export market share would begin to erode. I agree with George that there is a two-speed Europe that is trying to make a single monetary policy work for dramatically different economies. If you were to split the eurozone into several different currency zones, the zone that contained Germany would soon see its currency appreciate, perhaps dramatically, against the currency of its southern peers.

The vision of a European Union as something more than a trade zone is one for Euro-romanticists. It’s a political vision, not an economic one. And during the meetings in mid-July, the political reality crushed economic reality. No one really thinks that Greece can repay the debt it has incurred. Greece was once again forced to agree to a deal that will let it to borrow more money that it can’t pay in return for hobbling its economy even further.

Why would Greece do this? Especially after the people voted overwhelmingly not to take a deal that was somewhat better? Because if they simply walked away from the debt and returned to the drachma, then every Greek pension would have to be paid in drachmas. Grexit would almost immediately cut the lifestyle of every person on a pension in half. And whatever we may think about the situation in Greece, Greek pensions are not all that generous.

Greece has to import nearly all of its pharmaceuticals and medical supplies, all of its energy, and most of the bits and pieces needed to run its machinery and businesses. By contrast with Germany’s, Greece’s exports are less than 15% of its economy.

Greece is already at the critical point in the medical arena, with most drug and medical companies already dealing with Greek hospitals on a pay-as-you-go basis. Hospitals are short of the basics such as sutures and bandages, not to mention life- saving drugs.

If Greece left the euro, Greek banks would immediately be completely destroyed. Business would grind to a halt, as there would be no way to roll out a new drachma overnight. There is no mechanism in place to do so. Things would eventually sort themselves out, but for the several months that the transition would would require there would be a real humanitarian crisis in a developed country, a phenomenon unprecedented in post-World War II Europe.

Tsipras, with the political naïveté that only a new politician could muster, came into office thinking the Germans would blink because the threat of the eurozone breaking up would terrify them. He overplayed his hand. Now he is a dead politician walking. Relatively soon there will be a new Greek election. There is no way the Greek economy gets any better over the next few months, and voters will be looking for another option.

Though I have little sympathy for radical socialists like Tsipras, I will admit to feeling sorry for him. He was in a no-win situation. Greek voters do not want to leave the euro, but they don’t want to have to deal with the realities of austerity that is European- (read German-) imposed.

If Tsipras and Syriza actually took Greece out of the euro, there would be a massive voter backlash, because the economic reality on the ground for the year after exit would be quite ugly. No politician who wants to get reelected wants to inflict that kind of pain.

Merkel and team knew Tsipras would have to cave at the end of the day. It is not that Angela Merkel is mean-spirited or wants to make the Greeks suffer. She has her own political realities to contend with. The odd thing is, the majority of German voters think they are the victims. They were innocents who goodheartedly lent Greece money, and now Greece doesn’t want to pay them back.

There was a fascinating op-ed in the New York Times last week by Jacob Soll, a professor of history and accounting at the University of Southern California and the author of The Reckoning: Financial Accountability and the Rise and Fall of Nations. He talks about speaking at a conference in Germany where they were debating the Greek situation. I’m going to quote a little bit more than I usually do from someone else’s essay, because he conveys a serious point really well. He has spent much of the day listening to German economists before he rises to speak and debate on a panel.

…but to hear it from these economists, Germany played no real part in the Greek tragedy. They handed over their money and watched as the Greeks destroyed themselves over the past four years. Now the Greeks deserved what was coming to them.

When I pointed out that the Germans had played a major role in this situation, helping at the very least by insisting on austerity and unsustainable debt over the last three years, doing little to improve accounting standards, and now effectively imposing devastating capital controls, Mr. Enderlein and Mr. Fuest scoffed. When I mentioned that many saw austerity as a new version of the 1919 Versailles Treaty that would bring in a future “chaotic and unreliable” government in Greece – the very kind that Mr. Enderlein warned about in an essay in The Guardian – they countered that they were furious about being compared to Nazis and terrorists.

When I noted that no matter how badly the Greeks had handled their economy, German demands and the possible chaos of a Grexit risked political populism, unrest and social misery, they were unmoved. Debtors who default, they explained, would simply have to suffer, no matter how rough and even unfair the terms of the loans.

There were those who handled their economies well, and took their suffering silently, like Finland and Latvia, they said. In contrast, a country like Greece, where many people don’t pay their taxes, did not seem to merit empathy. It reminded me that in German, debt, “schuld,” also means moral fault or blame.

When the panel split up, German attendees circled me to explain how the Greeks were robbing the Germans. They did not want to be victims anymore. While I certainly accepted their economic points and, indeed, the point that European Union member countries owe Germany so much money that more defaults could sink Germany, it was hard, in Munich at least, to see the Germans as true victims.

Here lies a major cultural disconnect, and also a risk for the Germans. For it seems that their sense of victimization has made them lose their cool, both in negotiations and in their economic assessments. If the Germans are going to lead Europe, they can’t do it as victims.

Admittedly, conferences tend to attract a focused group of attendees and are generally not representative of a population at large; however, the reaction he got is in line with the opinion polls I see coming out of Germany and other northern-tier European countries.

Merkel will not remain popular if she is seen to be caving in to the Greeks. And so she dug in her heels. But at the end of the day she finally had to agree to lend the Greeks more money in order to maintain the appearance of a united Europe.

But the agreement with Greece undermined, if not destroyed, the concept of European unity. Germany clearly dictated what were essentially unconditional surrender terms to Greece. One can be sympathetic to the German position that the Greeks have been profligate, don’t pay their taxes, need significant reforms, and on and on. But that doesn’t take away from the fact that the Germans who lent the money have benefitted from the system. The reality is that the Greeks owe something approaching one-half trillion euros to the rest of Europe. The Germans are going have to pick up about €200 billion of that, give or take.

If Merkel had to deal with a €200 billion loss, her popularity would plunge. And there would be the risk that other countries would decide – perhaps on an emotional basis but decide nonetheless – that they would walk away from their debts owed to Germany as well. Germany is on the hook for multiple trillions of euros, just as I wrote some five years ago. The longer they keep lending money, not just to Greece but to the rest of Europe, the bigger the debt grows. What money are they lending, you ask? They are lending as part of their commitment to the European Central Bank and eurozone banking system and various European financial mechanisms. All that money is one day going to have to be accounted for, or the ECB is simply going to have to print a vast amount of money or guarantee an even larger pool to absorb all the debt.

A fiscal union in Europe will require that nation-states will have to give up their fiscal sovereignty. Try sliding that past voters. You might get a significant number of smaller countries to do that, but can you really imagine France doing it? Seriously? Marine Le Pen is getting 40%-plus of the prospective vote today. Try getting the French to agree to give up to Brussels their ability to control their own budget and see how large her poll numbers get.

My friend Eddy Markus and the rest of his team at ECR Research offered a good summation of where this leaves Europe. (I always make a point of getting Eddy to take me to lunch or dinner when I’m in Amsterdam. He has a way of getting the best tables with the most scenic views in really good restaurants – an excellent talent for an economist to have.) The bold print is from me.

For the moment, Greece may have been saved from the abyss, but the underlying weaknesses of the Eurozone and the EU remain in place. Still, we do not think Europe will disintegrate for the foreseeable future. After all, the EU project is of eminent importance to the European leaders. It has boosted economic growth, there is an extremely low chance of war breaking out between the EU countries, former

communist countries are functioning as democracies, and Europe counts for something around the world. This is not forgotten, and the EU leaders will not easily abandon the project.

On the other hand, the Eurozone and the EU are no longer a byword for unity, prosperity, democracy, solidarity, and mutual respect. In essence, the project should be revamped to stop the rot, but this is unlikely to happen. After all, visionary leaders are lacking, and the sprawling structure of the EU is incredibly complex and often rigid. Reforms are years in the making.

The most likely outcome is that the Eurozone and the EU will continue to muddle on. At the same time, there is a constant threat of disintegration and waning global influence. Europe also needs to narrow the gap between the economic viewpoints in the North and the South of the continent. Not to mention the rise of populism and the problems arising from Germany’s ascendant dominance. Such a climate does not seem to be conducive to euro strength.

A geopolitical analysis of Europe’s future underpins our economists’ opinion that the euro will have a hard time holding its own against the dollar in the medium to long term.

For the next few years and maybe for the remainder of the decade, Europe will indeed continue to muddle on. The European Central Bank will try to paper over whatever problems they have. Greece will again go critical, if not next year, then the year after. If Schäuble is still around, he will again say that the Greeks have to figure out their own financing; and we will have another endless round of meetings with a lot of shouting and finger-pointing as they try to kick the can down the road one more time. That will continue to happen until one country or another finally reaches the endpoint and says, “We are out of here.”

But when it happens, it won’t be a last-minute surprise. Greece taught a lesson to all those who might someday want to leave the euro. If you want to exit, then you have to plan for it. Waiting to the last minute is an absolute, utter, complete, total, (insert your own adjectives and expletives) disaster.

If Tsipras had wanted to do more than bluff, he should have started contacting currency printers about printing his new currency. He should have been making real plans to exit. He should have told the voters that he was prepared to walk away from the euro. Of course, he could not have gotten elected if he had done that.

So he walked into a poker game holding a pair of deuces and tried to bluff his way through. I know the rules of poker, and I have a lot of friends who play poker at a serious level, but I would have a snowball’s chance in Hades of walking into the World Series of Poker and not being blown out of the room. I might get lucky for a few rounds, but luck is not how you win that tournament. And you certainly don’t prevail by trying to bluff your way through. Germany knew that at the end of the day Tsipras was bluffing. And they held all the cards.

Tsipras broke the first rule of politics: don’t bring a knife to a gunfight. This time, politics crushed economics. But my long-term bet is that economics wins. At some point some country is going to break from the herd, and we will once again see a multicurrency Europe. Or somehow countries will agree to give up their fiscal sovereignty, which means their own pensions and benefits will be at risk. Either way, it’s going to be a tough time to be a European politician.


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