Missing Pieces in John Mauldin's 'The End Game'
Elliot R. Morss
September 16, 2010
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Introduction
John Mauldin, a leading economic blogger, is writing a book to be published shortly by Wiley, The End Game. The book will discuss the global economy and alternative policies to move the world forward. He recently published a draft chapter on his Frontline Weekly Newsletter. I read it, and it got me thinking about missing pieces.
1. Mauldin says:
A $1.5-trillion-dollar yearly increase in the national debt means that someone has to invest that much in Treasury bonds.
Treasury bonds? How about bills and notes? OK, Mauldin was using “bonds” as shorthand for all Treasury debt. How about the debt incurred by Federal agencies? OK. Quibbles, being too literal.
But here is something that is not a quibble: the Federal Reserve “deficits”. Take a look at Table 1. Mauldin does talk of “monetizing the debt” – converting Treasury debt into currency - but the Fed did a lot more.
Table 1. – Federal Reserve Assets and Liabilities (year end, in billions)
Item 2007 2008 2009
Total financial assets 951.3 2,270.6 2,267.2
Total agency and GSE-backed securities 0.0 19.7 1,068.3
Treasury securities 740.6 475.9 776.6
Bank Loans 48.6 589.5 96.6
AIG Assets 0.0 111.9 85.9
Term Asset-Backed Securities Loan Facility (TALF) 0.0 0.0 47.5
Foreign currencies 24.0 553.7 10.3
Commercial Paper Funding Facility (AMLF) 0.0 348.7 9.4
Other Assets 138.0 171.2 172.7
Total financial liabilities 932.8 2,249.6 2,241.6
Depository institution reserves 75.8 917.7 1,031.9
Deposits and currency 792.1 1,220.3 1,102.7
Other Liabilities 65.0 111.5 106.9
Source: Federal Reserve Flow of Funds
In 2008, the Fed ran a “deficit” (change in liabilities) of $1.3 trillion. How?
* By monetizing some Treasury debt;
* Creating bank reserves, and
* Buying AIG (AIG) and other bad assets.
$1.3 trillion is a lot, just about the same as the Treasury deficits in 2009 and 2010. Of course, there are some assets to offset these liabilities. Consider this Fed deficit against the Troubled Assets Relief Program (TARP). TARP was capped at $475 billion in the financial reform bill ( morssglobalfinance.com ). Just as with the Fed’s deficit, there are some assets to offset its liabilities. But there is a big difference: TARP had to be approved by Congress and signed by the President. The Fed’s activities only have to be approved by its Board.
2. Mauldin says he will discuss monetizing the debt in a later chapter on inflation. I have not seen that chapter, but the automatic association of the Fed buying Treasury debt with inflation is common and not always correct. As Table 1 indicates, the Fed “monetized” $300.7 billion ($776.6 - $475.9) of Treasury debt in 2009. Inflation? Hardly. With a capacity utilization rate around 70% and a panicked world desperate for dollar-denominated assets, the dollar got stronger. In an earlier article ( morssglobalfinance.com ), I pointed out there are two sources of inflation (a weaker dollar).
* The first source: aggregate domestic demand is greater than what can be produced (most definitely not the case in the US now).
* The second source: the global supply of dollars exceeds the global demand (not currently the case).
In short, the Fed buying Treasury debt (debt monetization) does not automatically cause inflation.
3. Mauldin asserts that bigger government leads to slower growth. He claims he will demonstrate this in his book empirically by showing that countries with lower government expenditures to GDP ratios grow more rapidly than countries with higher ratios. I suggest that if you want to focus on one ration to explain growth, try the total investment to GDP ratio. China’s investment/GDP ratio is 45%, higher than any major country in the world. And look at its growth rate.
4. Mauldin has an extended discussion of trade deficits, government debt, and private debt in his draft chapter. And we certainly hear a lot about the US trade and current account deficits in the daily press. But how about Net Financial Flows appearing in the US Capital Account? Ever heard of it? It provides critical data if you want to understand what has and will happen to the dollar. Table 2 provides the data....
Table 2. – US Current Account/Net Financial Flows (in billions)
Item 2006 2007 2008 2009
Current Account, net -803 -718 -669 -378
--------------------------------------------------------------
Net Financial Flows (inflows (+), outflows (-)
809 638 578 216
--------------------------------------------------------------
US Investors Abroad -1,286 -1,476 156 -140
US government 5 -22 -530 541
US private -1,293 -1,453 691 -630
Direct investment -245 -414 -351 -269
Foreign securities -365 -367 198 -208
Other -681 -673 839 -205
Foreign Investors in the United States
2,065 2,108 455 306
Foreign governments 488 481 551 450
US government securities 428 270 591 441
Other Foreign government 60 211 -41 9
Private foreign investors in the United States
1,577 1,627 -96 -144
Direct investment 243 271 328 135
US Treasury securities -58 67 161 23
Private securities 683 605 -166 0
US currency 2 -11 29 13
Other Private 707 694 -448 -314
Financial Derivatives, net
30 6 -33 51
Source: US Bureau of Economic Analysis
The financial flows are large. Note that in 2006 the net financial inflows ($809 billion) more than offset the current account deficit ($803 billion). Not the case since then. The Table has three primary sections: US Investors abroad, Foreign Investors in the US, and Financial Derivatives. When the US government or the private sector invests abroad, global dollar holdings increase putting pressure on the dollar. The opposite holds when foreign governments or the private sector invests in the US.
The 2008 panic is seen in the numbers. Americans sold foreign securities and foreigners sold their US equities in favor of Treasuries.
Note Foreign Governments’ purchases of US government securities: down in 2007 ($270 billion) but back up in 2008 and 2009. The leading purchasers were China and Japan. They want to keep the dollar strong.
In 2008 and 2009, it appears the bloom came off the rose for foreigners in terms of US equities – they sold $166 billion in the 2008 panic and did not return in 2009. American investors on the other hand, increased their purchases of foreign equities in 2009.
In Table 3, I have consolidated data from Table 2 on private investors. It provides the net of US private investments abroad and private foreign investments in the US.
Table 3 – Private Net Financial Flows (in billions)
Item 2006 2007 2008 2009
Private net 286 173 590 -826
Direct Investment -2 -143 -23 -134
Securities 260 306 193 -185
Other 28 10 420 -507
The numbers are scary. If Americans keep investing overseas as I have been recommending and foreigners are reluctant to invest in the US….
And take a look at the last row in Table 2. If the speculators smell a weaker dollar, they will make it happen.
Investment Implications
I have been arguing that investors should get out of dollar-denominated assets since May 2009. If these numbers don’t convince you to do so, nothing will. My specific suggestions have not changed since my last article on the subject.
Conclusion
I like Mauldin, he makes me think. But in his latest chapter draft, there are a few missing pieces.
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