An Overview of 2013 - Setting the Scene

There were several driving forces affecting market conditions in year 2012. The year opened on a very strong start. In fact much of the overall market gain in 2012 occurred in the first six weeks of 2012. The rest of the year could best be characterized as one finger nail biting financial crisis followed by another, with a measure of election year political uncertainty thrown in for good measure.

The first crisis was the deteriorating economic conditions in Europe and the inability of governmental policy-makers to develop a constructive program to address it. While never really resolved over the course of the year, it was pushed off center stage by our own home grown financial crisis in the United States that came to be known as the fiscal cliff, and similar to their European counterparts, the inability of our own government political leaders to develop a constructive resolution. In each of these crises some sort of gerrymandering solution was developed; but the underlying problems remain not addressed with sustainable policies. The uncertainty of these circumstances created of great deal of volatility in the investment markets. In each case heightened tension increased the fear level of the markets and caused consequent drops in the markets. In each case, as well, the fears gave way to relief rallies in the markets as some policy was cobbled together to at least temporarily address the issues.

While the markets have started the year strongly, it is inevitable that will see these crises reemerge in 2013. In fact, it is highly likely that we will see a return to the same sort of volatility we experienced in 2012. The United States government has already reached the debt limit allowed by law, and while an agreement was reached with respect to taxes, the only agreement with respect to the mandatory budget cuts, known as sequestration, was to defer them for two months. This means that by March we will see the political and economic tensions again escalate, and market fears and uncertainty increase.

The issues at hand are very significant and marginalizing them into just another economic crisis would be poor judgment. The potential consequences mean there is there is not really no one safe harbor. Cash or bonds, the traditional conservative investments have to also be considered as at risk. Considering cash, in US dollar form, to be conservative would be to not recognize the link between the guarantor of the US dollar, the U.S. government, and the intractable financial problems that have brought it to the financial cliff, or are pushing it to have to continually increase its allowable debt ceiling. Bonds are also at risk as interest rates begin to rise from an unsustainable low interest rate environment, bond values, especially those long-term in nature, will decline in value. Indeed, as the markets have started 2013 strongly, many bonds have declined in value because of interest rate pressures.

One thing that seems to be fairly certain is that crises do resolve themselves, one way, or another. At this point we can only speculate on how that will occur. The worst case scenario would be a total global financial collapse and an ongoing subsequent global depression. While this cannot be dismissed as an impossible event, I see the probability of this as being extremely small. There is a great deal of potential economic vigor and potential growth. At present the main problem is the huge overhang of legacy debt. This is putting a damper on economic expansion and its consequent investment potential. Over-indebtedness is always dealt with by some sort of restructuring. That is what I would expect as a resolution in this case as well. What that restructuring will look like remains to be seen. However, as this process unfolds, we will see the economic vigor and investment potential be released. My take is that 2013 will be a pivotal year in beginning that resolution process. While I expect to see heightened volatility, I also expect to see the investment markets becoming more and more attractive as the year unfolds. As the year unfolds, I will be trying to steer a balanced course between the volatility and the potential longer term opportunities through maintaining well diversified portfolios. 

Diversified Investment Strategy

Investment markets over the last quarter have been driven primarily by uncertainties with respect to outcomes in resolving the debt crisis in Europe. As in the United States, Europe has been having its own political gridlock as to its way forward in the face the potential government insolvencies. Most recently, Greece had been the foremost concern. Having been in a severe recession for several years because of budget cuts required per terms of previous financial bailouts by the other countries of the European Union, Greece had called an election to determine whether or not it would stay in the European Union and adhere to the austere budget required by their financial bailout. The alternative was to leave the European Union and default on billions of Euro’s worth of debt. A good portion of this debt was held by major European banks, as well as some major U.S. banks. The fear was that if Greece defaulted, the fallout would be far reaching perhaps undermining the solvency of major global banks and financial institutions. Greece narrowly voted to remain in the Union, but with a significantly divided parliament. No sooner did this occur, than Spain rose to front and center as a problem area. Spain being one of the largest economies in Europe required a new approach to this entire European issue. Germany and France had been forcefully advocating an austere approach to dealing with the over-indebtedness of the countries in the middle of these financial crises. The problem was that the programs of austerity were also damping growth to make it even more difficult for countries like Greece and Spain to deal with their debt problems. Elections in France changed the leadership from Sarkozy to Hollande who was much more sympathetic to relaxing the programs of austerity and do more to stimulate growth. Only Germany’s Angela Merkel remained as the lone, but powerful voice of the austerity programs, and consequently political gridlock. Most recently, Merkel appears to be relaxing her position and the framework of a structural agreement to deal more comprehensively with the issue emerged. Whether the agreement will accomplish this remains to be seen. It did, however briefly, give hope to the investment markets which reacted very favorably to the news.

To compound the uncertainties and the implications surrounding the European financial crisis, lurking in the background, ready to jump forward at any instant, is the financial and economic situation in the United States. More and more frequently, reports are being aired on the mainstream media of an approaching fiscal cliff the United States will be facing at the end of the year. This refers to the prospect of increased taxes and mandatory federal budgets cuts. The outcome is a result of the political gridlock in the United States and is a default position in the event Congress is not able to reach an alternative agreement. Given the extreme ideological polarization of our Congress, the probabilities seem small that an alternative agreement will be reached. There seems to be a fairly wide economic consensus that this is likely to result in the weakening of the already weak US economy. Moreover, even if an agreement is reached, as in Europe, the fixes seem to do little more than “kick the can down the road” a little further without really developing a sustainable solution to very real structural problems. Needless to say, the situation is very complex, and we could continue for some time to discuss it. All of these uncertainties create a very unstable economic and investment environment. The outward appearance is a great deal of volatility as investors swing from the extremes of fear and hope. The relevant question for us is: what is the best investment strategy in this type of environment? There is no shortage of opinion predicting where the investment markets are headed. They range from catastrophic calamity, to the cusp of a new bull market. For over two decades, on a regular daily basis, I consider countless numbers of these viewpoints. I have come to value some commentary and analysis more than others, and I certainly form my own opinions. I have, however, learned several important lessons over the years. One is that no one has a perfect crystal ball. Another is that the reporting media seems to create its own spin. When things are going relatively well, a general impression is created that happy days will never end, creating a type of euphoria. On the other hand, when events turn toward the negative, it sometimes appears that the end of the world is approaching, creating an atmosphere of fear and panic. It is a well documented that investors over-react to news. For example, Dalbar Inc. is a company which studies investor behavior and analyzes investor market returns. The results of their research consistently show that the average investor earns below average returns. For the twenty years ending 12/31/2010 the S&P 500 Index averaged 9.14% a year. The average equity fund investor earned a market return of only 3.83%. While I cannot absolutely dismiss either of the extreme outcomes from occurring, my observation has been that the fundamental principle of risk management, diversification, should still serve as the foundation for a prudently managed investment portfolio. This does not mean that the portfolio will be resistant to all market downturns, and it does not mean that diversification adjustments should never occur. It does suggest, however, maintaining focus and investment discipline is a critical component of navigating what are sometimes, very stormy seas.

Looking forward, it would be great to say that the worst is behind us. Unfortunately, that does not appear to be the case. It is likely that the global economy and investment environment will get worse before it gets better. It will require patience and fortitude whatever the investment allocation is. The silver lining, however, is that unless you believe the world will be ending as a result of these issues, the foundation of future economic health is being established. Despite the grim shorter term picture, my opinion is that the global economic challenges and issues now being confronted will be worked through and resolved, and that the world will not end.

A Review Primer on the Components of Diversification – if needed

The four broad categories, or asset classes, of investments are cash, bonds, or equities. Included within these categories are such things as real estate, commodities such as energy, food, as well as precious metals. Each has its own particular characteristic strengths and weaknesses, and consequently a prudent risk management approach would not allocate 100% to any one of these asset classes.

If we consider cash, for example money market funds, we recognize that this can provide liquidity and stability, but very little investment gain. It is not without risk. In fact, when interest rates are as low as they are today, the risk is known as purchasing power risk. This means that if you have $100,000 in an account today, and $100,000 in the account one year from now, will the $100,000 one year from now be able to purchase what is can purchase today. If inflation is running at 2.5%, one year from now you will have a guaranteed loss of 2.5% in the purchasing power of your account. Currently, by the government’s statistics, this is around the range inflation is running, other independent analysts believe the real inflation number is higher. And some analysts believe that the future rate of inflation will be significantly higher. This suggests to me that while it makes sense to have a portion of an investment portfolio in cash, or cash-like investments such as a money market, 100% would probably be unbalanced in failing to address the unique risks of cash.

This brings us to bonds. Bonds, in general, have traditionally been considered a conservative investment. This is a broad generalization, and it is important to understand some of the unique characteristics of bonds to appreciate their role in an investment portfolio. An attractive characteristic of bonds is that they pay interest on a regular basis, which is of course if the issuer continues to have the ability to pay. The risk that the issuer may not be able to continue paying the interest, as well as the principal at maturity is known as solvency risk. Depending upon the type of bond this risk can be higher or lower. Historically, government of developed economies had been considered low risk, with the United States having the least solvency risk. Municipal bonds have also been considered safe, conservative investments. These days we hear of the developed country bonds being less safe because of over-indebtedness, as well as municipalities in the United States declaring bankruptcy. Another risk of bonds is known as interest rate risk. This is the risk that if interest rates increase, bonds already owned will decline in value. Some investors say this is not a problem because if they do not sell the bonds until they mature, they expect to receive all of their principal back, as well as the promised interest payments. What these investors neglect to consider is that if interest rates increase, it is usually for a good reason, such as higher inflation. They are stuck with lower interest paying bonds they had previously purchased. The bottom line is that bond can also decline in value, sometimes significantly. In historically low interest rate environments, as we currently have, this risk is elevated. These risk management implications imply that while bonds are an important part of an investment portfolio, they also should not represent 100%, and the portion of an investment portfolio that is in bonds should itself be diversified with respect to the types of bonds and the unique risks for each type.

This brings us to equities, or stocks. As with bonds there are a wide range of offerings, as well as a wide range of approaches to investing in them. They have their own unique set of risks, as well as presenting opportunities. Despite regular variations in value, sometime significantly so, they offer income opportunities through dividend payment, and/or growth opportunities through their increase in value. Needless to say they can also decline in value. With a diversified investment position, for example in fund of utility companies, the main risk seems to be primarily psychological. The belief that, for example, that all of the strongest and largest utility companies in a fund will simple become worthless is placing a disproportionate weight on the occurrence of something with an extremely small probability of happening. Despite periodic declines in value, sometimes having nothing to do the real merit of the investment itself, these funds can pay annual dividends of 4% per year or more. In an environment where interest rates are so low, having some component of a portfolio in equities, or stocks, is part of a well diversified portfolio. One way in which the potential volatility can be managed is by having a smaller percentage.

It is interesting to note that some of the same investors in bonds who claim that it does not matter if the bond declines in value because they intend to hold the bond until maturity, will consider it unacceptable to own a utility fund paying 4% or more because of the potential for it to decline in value.

Nonetheless, each type of investment has its own unique set of risks as well as opportunities. There is no one safe harbor. The best overall way to construct and manage a portfolio is with a diversified selection of different types of investments. In some cases, there will be significant declines in value. Some investors believe it to be possible to time when the declines and when the increases are coming, thereby avoiding declines while riding the increases up. Even if this were consistently possible, and there is reason to doubt this, from a prudent investment decision-making perspective, there needs to be some rational decision-making basis, other than an environment of fear and panic driving the markets. With the outcome of so many hugely impactful global issues pending resolution, trying to respond to these unresolved issues offers little other than randomness as a foundation. This is unacceptable, and argues all the more strongly, for holding a well structured portfolio comprised of cash, bonds and equities despite the volatility, and periodic declines.

The Myth of the American Dream

          The United States of America has long been characterized as the land of opportunity. It was founded upon principles recognizing the inherent worth of each individual as embodied in the lines of the Declaration of Independence stating that “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness”. It was for the ideals and principles underpinning the foundation of the United States of America that tens of thousands of courageous citizens sacrificed so much, including their lives, and the well-being of their families. The idea that if one worked hard and did the right thing, there was the reasonable possibility of creating better economic circumstances and a fulfilling life had made the United States of America an international star, holding out the achievement of the American Dream as a life aspiration. No doubt there are countless stories of many individuals and families who have, and are, realizing the fruits of these ideals. Unfortunately, as this is being written in late 2011, national polls show a growing number of dark clouds over Camelot. A recent PEW Charitable Trust poll[1] showed the largest number of Americans living in multi-generational households in modern history. This has been fueled by poor economic conditions that make living in a multi-generational household a financial lifeline. Other polls show the majority of Americans viewing their elected representatives in historically low esteem.

Some of the ideals represented by the United States of America as the land of opportunity seem to have been transformed into myths. The Brookings Institution is a nonprofit public policy organization based in Washington, DC. They have consistently ranked as the most influential, most quoted, and most trusted think tank. Their mission is to conduct high-quality, independent research and, based on that research, to provide innovative, practical recommendations that advance three broad goals:

·      Strengthen American democracy;
·      Foster the economic and social welfare, security and opportunity of all Americans and
·      Secure a more open, safe, prosperous and cooperative international system.
           Two of their Senior Fellows recently wrote an article[2] for the Washington Post in which they highlighted five myths about America. In their article they state that the idea that Americans enjoy more economic opportunity than people in other countries is contradicted by research showing that children born into a lower-income family in the Nordic countries and the United Kingdom have a greater chance than those in the United States of forming a higher income family when they are adults. They also note a myth that each generation does better than the past generation because men in their 30’s earn 12 percent less than the previous generation. If today’s families have a somewhat higher overall income than prior generations, it is because more family members are working to contribute to the overall income. While immigration and trade may serve as political straw men deserving of blame for the poverty and inequality in the United States, it appears that this too is a myth. The real culprit seems to be the increase in single-parent families that is driving the poverty rate. According to the article, the United States would have a poverty rate 30 percent lower than today if the same percent of single-parent households existed today as in 1970. Clearly, there are some significant blemishes on the American Dream causing a growing amount of social discontent.

       When considered along with a recent Associated Press Report that 1 in 2 Americans, a record number, is now classified as low-income[3], the general prevailing sentiment expressed by small business person Jonathon Smucker, participating is the Occupy Wall Street protest, is probably a fairly accurate representation of the feeling of many Americans when he said:
“Like a lot of Americans, I’m pretty ticked off. It’s not that there are rich people, it’s that the people with a lot of money over the past few decades have rigged the system so that there’s not a fair chance for anyone anymore.”[4]
      While the United States may be a glaring representation of the growing polarization between the have and the have-nots, a survey of world events suggests the increasing social and economic malaise is a global phenomenon.  Anyone interested in trying to plan their future must take notice of this state of affairs and ask themselves what might be responsible for this, as well as where this trajectory may be taking us?

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[1] Pew Charitable Trust, Fighting Poverty in a Bad Economy, Americans Move in with Relatives, Kochhar, Rakesh and Chon, D’Vera, October 3, 2011.

[2] Brookings, Five Myths About Our Land of Opportunity,

http://www.brookings.edu/opinions/2009/1101_opportunity_sawhill_haskins.aspx, Sawhill, Isabel, and Haskins, Ron.

[3] Census Shows 1 in 2 People Are Poor Or Low-Income, Associated Press, Yen, Hope, December 15, 2011.

[4] Pay Gap a $740Bn Threat to US Recovery, Financial Times, Harding, Robin, December 15, 2011.

Cronyism and Capitalism

Today I embark on a new project. I am beginning to write a new book investigating the impact of cronyism on capitalism. In part, I am going to take an experimental approach in posting on-going installments of this work. My hope is that my work will generate some interest in providing commentary and discussion that will affect the evolution of this book. Although I welcome constructive input and the sharing of ideas through discussion, realistically my expectations are that because of having received little commentary on past postings, this will be minimal. Nonetheless, I offer the following initial installment.


From media coverage, it appears that the frequency of new instances of financial indiscretions has been increasing. Additionally, the current global financial turmoil in Europe, a present, and globally in general, calls into question whether there is a systemic issue of commonality from which this state of affairs has emerged. If so, there are a number of ensuing questions whose answers would inform anyone interested in making more effective decisions with regard to the future of themselves, and their families. Note that while the intent of policy-makers, economists, and other social engineering types might be to find solutions for these problems, the intent of this work is not to solve to world’s problems, but rather to illuminate what may actually be going on in the hope that any insight which might be offered will serve as a support to the individual empowerment of the decision making which is more relevant to our lives on a personal scale. In the view of this writer, the magnitude of the issues emerging at a macro scale, and represented through the multiplicity of media coverage sources, and with often wide divergence of expert opinion, serve more to obscure and confuse the importance and relevance of these themes on a personal scale. Even in those instances where opinion appears to be rather uniform, a critical view of the consolidation of control of media sources, whether that is by government or business interests, suggest that the individual seeking more solid guidance as to more effective decision making for the present and future seek an independent, well reasoned, narrative which weaves many of the seemingly disparate global issues into a focused, comprehensible view which has bearing and relevance to our individual lives.

The intent of this work is to examine a theme which appears at the heart of many of the current issues being faced by the global financial system and economy. With capitalism serving as the setting for the current global crises, a common thread seems to be the distortion of effective and efficient use of economic resources through favoritism toward interested parties having access to controlling policy makers. As a consequence, the fundamental principal of access to opportunity via a level playing field is corrupted into a continuing consolidation of wealth and power to those established players with access to the levers of power. Notwithstanding examples of individuals and businesses that have successfully negotiated their own form of success, when viewed system wide, many of the global social disturbances represent some form of example. In the United States we have the Occupy movement, whose general identification differentiates the 99% from the more privileged 1%, or the of the Arab Spring in the Middle East initially precipitated by Mohamed Bouazizi, a Tunisian street vendor who set himself on fire December 17, 2010, as a protest of the confiscation of his wares and the harassment and humiliation that he reported was inflicted on him by a municipal official and her aides, or the large demonstrations in Russia against what are perceived to be unfair elections results in favor of Vladimir Putin’s entrenched power regime.

The idea of favoritism reaches its corrupting embodiment in the concept of crony capitalism. Investopedia, an online reference defines crony capitalism as follows:

A description of capitalist society as being based on the close relationships between businessmen and the state. Instead of success being determined by a free market and the rule of law, the success of a business is dependent on the favoritism that is shown to it by the ruling government in the form of tax breaks, government grants and other incentives.

http://www.investopedia.com/terms/c/cronycapitalism.asp#ixzz1gMQ9GiF7

The Investopedia discussion goes on to describe the difference in viewpoint between those of a capitalist persuasion, and those of a socialist persuasion:

Both socialists and capitalists have been at odds with each other over assigning blame to the opposite group for the rise of crony capitalism. Socialists believe that crony capitalism is the inevitable result of pure capitalism. This belief is supported by their claims that people in power, whether business or government, look to stay in power and the only way to do this is to create networks between government and business that support each other.
On the other hand, capitalists believe that crony capitalism arises from the need of socialist governments to control the state. This requires businesses to operate closely with the government to achieve the greatest success.

For the purpose at hand, the relevant focus appears to be cronyism more than the purported economic operating system chosen. As good arguments can be made for the corrupting effects of cronyism, whether they are grounded in a capitalist, socialist, monarchy, or whatever other economic-social system, we will primarily concern ourselves with examining the effects of cronyism, and its corrosive and destabilizing effects regardless of what system it is based within.

The approach of this work will be to examine specific examples economic malfeasance and crises with an eye toward highlighting potential roots in cronyism. More generally, we will be looking for system wide implications derived from these events, and more specifically, the background question we intend to illuminate is whether or not the individual is facing a “stacked deck” in the outcome of potential decisions they need to be making. If so, are there potential strategic course of action we can elect as individuals if we know we are in a game with a “stacked deck”?

The approach of this work will be to examine specific examples economic malfeasance and crises with an eye toward highlighting potential roots in cronyism. More generally, we will be looking for system wide implications derived from these events, and more specifically, the background question we intend to illuminate is whether or not the individual is facing a “stacked deck” in the outcome of potential decisions they need to be making. If so, are there potential strategic courses of action we can elect as individuals if we know we are in a game with a “stacked deck”?

Creditors of the World Are Not Necessarily Captive to the Debtors

In response to Martin Wolf's article in the Financial Times,  I offer the following commentary.

The conceptual framing of this argument is somewhat misleading. To begin with the phrase indicating a belief by creditors that they will inherit the earth suggests a context for concentrating wealth and power that is more benign than the underlying capitalist and human drive for dominance and control. There are enough examples in human history, and biology, be it modern or ancient, that one does not have to be much an historian to be compelled to believe that a basic survival instinct is to attempt to manage one’s environment so as to better the chances of surviving and thriving. Because of the complex web of relationships there is often some sort of mutual interdependence, sometimes beneficial, sometimes not so much.

The heart of Martin Wolf’s argument seems to suggest that the relationship between creditors and debtors is such that there is some sort of “lock” binding specific sets of creditors and debtors to one another. While perhaps the world cannot trade with Mars, specific parts of the world can rearrange their trading relationships and thier drivers of growth. For example, while no doubt the western developed world does serve an important function in sucking up the exports of China, it is also possible that through a combination of weaning itself from such heavy dependence on an export driven economy by developing its domestic aggregate demand, and shifting its trade relationships to for example Brazil, or even Russia, to meet some of its export needs it can transition from its heavy dependence its current export targets. As to being held captive because of its $3,200bn of currency reserves, it should be keep in mind that it is only held captive as long as the currency reserve exists in its current form. If these reserves begin to be exchanged for foreign equity positions representing control in strategic future resources that China needs, the current foreign reserves cease to be a control on China’s behavior, and rather serve to further concentrate power and wealth in the hands of those with capital.

Is this so different than when the Native Americans in New York sold Manhattan Island for the equivalent of $24 in baubles, or when the Soviet Union dissolved, dispersed shares of ownership of formerly state owned enterprises among the people, only to have aspiring oligarchs acquire and concentrate these assets for controlling interests in exchange for perhaps teh equivalent of a supply of vodka for a short period of time. There are innumerous other examples which can be given wherein the exchange of future earnings capacity (read indebtedness) for a more immediate gratification leads to servitude.

To suggest that because we are all on the same planet, as Martin Wolf does in his argument, the fix to the current capital imbalances are compelled by some notion of constraint by reciprocity is to have blinders hindering one’s vision as to the fuller range of feasible alternatives.

Recapitalize the Banks?

The concern about a Greek default is really more about the contagion effect. The central question is how does one contain the impact arising from a disorderly Greek default. From this follows the discussion about potential bank recapitalization. There are all sorts of sub-plots in the recapitalization schemes, from the moral hazard issue, to the inequity inflicted on those who have been fiscally responsible, to whether or not an effective scheme can really be created to many more. Politicians have been receiving the brunt of criticism because of the perceived lack of leadership in dealing with an extremely complex, and perhaps insoluble by mere mortals problem. I would be one of the last ones to come to the defense of the politicians, however, the political posture of the “deer in the headlights” when facing public outcry to “do something, do anything”, is understandable giving the mutually check-mated position the global financial situation has emerged into.

The idea of recapitalization is lacking unless one can quantify with some reasonable degree of confidence the extent of recapitalization that would be needed to effectively resolve the issues. I have heard plausible figures of up to $2 trillion dollars worth. I have not, however, seen much discussion of potential derivative exposure, and counter party risks which might amplify the amount of fiscal deficiencies,  and the number of systemically important institutions which may be impacted. If there is one thing that the institutional failures of 2008 should have taught us, it is that with the degree and scale of economic and financial integration that currently exists, it is all but impossible to see where the chips may fall, or the ensuing consequences. Moreover, when talking recapitalization, ultimately one is talking about using public money to enable those who, either directly or indirectly, were responsible for egregiously imprudent financial behaviors to retain their private ownership interest with minimal risk of loss. The backlash from this sort of thinking is emerging at the main street level that potentially will threaten governments if it continues. As evidence witness the emerging demonstrations in Greece and on Wall Street, and the rising pervasive discontent among so many of the affected citizenry. Perhaps a more honest and equitable approach to allowing Greece to default, and stabilizing the banking system would be an outright state takeover of those systemically important institutions to give the funding public an equity stake rather than a debt holders stake in future recovery. When looking at the impact of the US TARP program the argument is made that the US actually made money from many of its bailouts. I think, however, that this misses the point, if governments are going to use public money to bailout out private institutions, it should be done with the focus of maximizing the return of the investing public, as well as a policy measure to provide a consequence to those who have acting so financially imprudent, directly, or through agency. It really is time to start acting like responsible adults.

George Soros' European Crisis Solution

If one accepts George Soro’s solution to preventing a second Great Depression, the prognosis is indeed grim. His solution, while in itself conceptually problematic, appears in a pragmatic context to reside in never-never land. The bold steps he presents as necessary conditions to prevent a second Great Depression require the cooperation and coordination which would transcend the polarization and fractionalization of regional narrow self-interest at such a scale that defies observable reality. Moreover, while the conditions he proposes may or may not be necessary, he has not presented a convincing argument that they are sufficient conditions.

A nebulous foundation block of his strategy is to provide time for “Europe to develop a growth strategy, without which the debt problem cannot be solved”. The development of a growth strategy is central to every economic and business interest, as he well knows. The question which must be asked is what the potential drivers would be of any effective growth strategy, what are the competitive and comparative advantages that Europe could bring forth, and what the time frame for implementation would be? If this proposed growth strategy would be a palliative to the “debt problem”, one is assuming a sufficient rate of growth to offset the burden of debt service. Even assuming a growth strategy could be developed; getting a realistic idea of whether the growth rate would be sufficient to counter the demands of debt servicing takes us into the unquantifiable speculative realm. While George Soros is a demonstrably recognized master in the realm of speculation, a no small part has been his ability to be adaptable and flexible as changing conditions warrant. Unfortunately governmental and national policies rarely show the same nimbleness in response to changing realities.

http://blogs.ft.com/the-a-list/2011/09/29/how-to-stop-a-second-great-depression/#axzz1ZHNkRk4j

European Union Debt Crisis

The majority of the global economic discourse these days revolves around a central thesis; too much debt, and burdensome deficits. To some degree, the debt problem contributes to the deficit problem because of the requirements of servicing the debt. The actions of policy makers are decried as lacking in leadership as they stumble around seeking politically acceptable ways to resolve these issues, while at the same time being economically effective in really addressing the issues. The results have been skewed towards being politically acceptable via some form of “kicking the can down the road”. The economic realities suggest the end of the proverbial “road” may be near. The debt issue is more of a global issue than regional issue; or at least global with respect to the indebtedness of the western developed economies. Questions such as whether Greece remains part of the European Union seem a little flat when one considers that regardless of whether Greece is or is not part of the EU, the outcome of resolving this issue in any manner other than some sort of default is unlikely. Because of the integrated scale of connectedness, I doubt anyone, or any institution really fully knows what the unanticipated consequences and effects will be. Consequently, talk of “ring fencing” or containment of these issues smacks more of intellectual arrogance than a sober acceptance of the magnitude of the problem. I suspect that after all the “shucking and jiving” is done what we a headed for, and what seems inevitable, is a global restructuring of monetary regimes with some attempt at a functional global monetary unit, be it a basket of currencies, or for that matter a basket of commodities. Along the same line, it would seem that the only effectively managed way out of this global financial mess will be some sort concerted global effort to inflate away the real value of the debt burden.

Critique of Roger Altman's Financial Times Commentary

Roger Altman, founder and chairman of Evercore Partners and former US deputy Treasury secretary under President Bill Clinton offered commentary in the Financial Times suggesting America and Europe are on the verge of a disastrous recession. While he may be correct, I see several problems in his analysis.

 http://blogs.ft.com/the-a-list/2011/09/21/america-and-europe-are-on-the-verge-of-disastrous-recession/#axzz1YNL9mxwW

Roger Altman’s analysis and proposed resolution to the unfolding European financial debacle leaves much to be desired. Interspersed with a review the ongoing events are a great many hypothetical conjectures followed by conclusions presented as some sort of deterministic inevitability. Moreover, his proposed resolution, when compared to an existing model of what he proposes, does not appear to conclusively lead to a better result.

For example, he asks “How do we know that another recession is approaching?”. A more accurate statement would be “it is probable that another recession is approaching”. The simple fact is that none of us has a perfect crystal ball, and from what I can see there is no deterministic cause and effect mechanism that provides a conclusive outcome. Altman may be right, and then again, he may not be. To assert anything more than a probabilistic conjecture is at best an error of judgment and at worse hyperbole directed at serving some sort of agenda.

Altman follows by asserting that “there is no other credible explanation for the relentless fall in interest rates”. I suspect that there are readers who could provide other explanations. Whether they were credible may be more in the mind of the beholder. This is but one more example of the “in-the-box thinking” that keeps potentially great minds bouncing of the walls of the conceptual framework of worn out economic models. A failure to explore other potential outcomes and ways to reach them is more an indication of intellectual impoverishment than a deterministic economic conclusion.

Altman’s proposed resolution is “A single currency representing 17 separate nations inevitably requires a unified balance sheet behind it and, following that, a form of fiscal union. The time for denying the latter is over.” However, we already have an operating model of many separate governments with a unified balance sheet and some sort of fiscal union; that would be the United States. Clearly the observable evidence shouts out that this remedy is more than a little problematic as well.

Pending Global Financial Crisis

The situation in Europe is very serious. From my research and analysis, my conclusion is that a Greek default is already “baked in”. If this situation were limited to a Greek insolvency, it would probably be manageable by the EU. Unfortunately, there are a number of other European countries that
represent a much larger potential problem because of the size of their economies and banking system, Spain and Italy being among them. I have even heard reports that there are some German and French banks that may have some capital adequacy issues. Fundamentally, the real problem is the potential contagion effect that arises. A number of factors are at work here. One is that bond investors start to demand higher interest rates because of the greater risks they perceive in the markets. This only makes the problem worse because it increases the cost of borrowing specifically for countries like Greece. This in turn, makes their financial situation even more challenging. More generally, it would be reasonable to expect borrowing costs to increase because of greater
demand for scarce capital. So far governing bodies in the European Union such as the European Financial Stability Fund, the International Monetary Fund, etc, have been trying to make capital available, or restructure existing debt. While these efforts have taken a potentially explosive situation and put it on a slower burn, they have not been effective in resolving the issues. As in the
United States, even if a theoretically economic effective solution were possible, political differences interfere with the implementation. In my opinion, there will be sovereign defaults. However, even if we are “only” talking about write downs of loan balances, the question arises of the impact on the banking system’s in the individual countries, and globally. Here we have another aspect of the potential contagion effects because banks and insurance companies throughout the world, including the United States, hold these impaired assets as part of their own investments. Moreover, a major risk factor which is very opaque, is what “derivative” exposure these various institutions hold. Derivatives are complex artificially constructed investments that may magnify greatly the risk on the books of these major financial institutions.

So far, one response of investors has been more what I would call a conditioned reactive response, rather than a response that reflects economic fundamentals. That response has been to migrate toward what are perceived to be “safer” assets. These have included US government bonds and
precious metals. This has helped hold down interest rates of US debt. In my opinion, while some position may be warranted in US Government bonds, the US financial system is on the precipice of a disaster waiting to happen. It should be kept in mind that one of the largest; if not the largest holder of US debt is China. They are increasingly expressing misgivings about the US financial situation. We are also seeing an increasing migration of capital into assets like gold. This would be capital that presumably would have been available for additional debt purchases. Both from the governmental side as well as the banking and financial institution sides have capital adequacy issues.

At this point I do not see much that gives me encouragement of a constructive resolution to these issues. In my opinion, at least for the near to medium term future, we are looking at increasing financial and social turbulence. The historical evidence suggests that the way in which policy makers will focus their efforts will be to try to inflate their way out of extreme over indebtedness by creating more and more money. Ultimately this will probably not work, and if I were to have to speculate, I don’t think it out of the question that within three years there will at least be serious discussions among global policy makers about the creation of new currency regimes.

Since we are in uncharted territory on a global scale, this is a time a great uncertainty in which events could move more or less rapidly depending on what the precipitating factors are. For example, the effects of a major natural disaster, a terrorist act, or who knows what else, are impossible to determine in an already fragile global financial system.

In my opinion, and reflective of the strategy we are currently being guided by, the best defense will be diversification which is targeted toward addressing the realities of the geopolitical and economic environment for the foreseeable future. This doesn’t mean there won’t be some volatility, but the objective is to be better able to weather the storm, retain value, and take advantage of the opportunities that will arise in what appears to be an oncoming global financial crisis.

If Only One Investment Could Be Made

The following is a piece I contributed to the investment website Seeking Alpha:
http://seekingalpha.com/article/213381-just-one-etf-safe-haven-concerns-favor-gold-producers-inflation-or-not?source=email

One of the basic functions of money is as a store of value. If the viability of this function becomes impaired, it is important to consider where economic value will be best preserved, or even increased. When making investment decisions, the objective is, at a minimum, to preserve value, and if we choose wisely, to increase the real value of our net worth. Implicit in the idea of value is what preserves and increases our purchasing power Because of the privileged position the US dollar has held as the reserve currency of the world, the mystique of power and safety has become an assumed fact in the perception of most financial players. In my opinion, it would be an error of judgment to assume that the United States has been divinely exempted from the laws of economics, or that the US dollar has any value other than a faith based presumption of economic entitlement.

There is a growing awareness that a fundamental structural shift has occurred, or is in the process of occurring in the power arrangement of the global economy. Events of recent years should have served as a wakeup call that placing blind faith in institutions such as investment banks, banks, insurance companies and governments is likely to be hazardous to an investor’s financial health. One thing that should be abundantly clear is that financial imprudence at all levels of our society, and throughout the world, has became institutionalized into an acceptable form of conduct. Imprudent lending, and imprudent borrowing, has created a vicious destructive cycle of over-consumption and over-indebtedness. As with many extreme indulgences, when the party is over, we are left with a big hangover and a big cleanup job. Right now the United States in particular, and the world economy, in general, has one gigantic hangover, and a daunting clean up job.

With a trillion dollar plus budget deficit, the United States will need likely need to borrow over $70 billion per month from foreign sources in order to continue funding its operations. The question that must be asked now is: How willing and how able will these foreign funding sources be to continue loaning money to the United States to fund its budget deficit? Many of these countries are having a more difficult financial time themselves in the present financial turbulence. Many of these countries were, prior to this financial turbulence, considering reducing the amount of money being loaned to the United States. In addition, because of this financial crisis the credit worthiness of the United States has deteriorated, and there are alternative places where these countries can deploy their financial resources which may be more directly beneficial to themselves. The conclusion is inescapable that a potential funding crisis will be one of the major consequences of the current attempt to contain this financial crisis.

Governments of the world have made massive commitments toward maintaining financial and economic stability. On a global scale, trillion of dollars have been committed to financial and economic stabilization. Each time a government responds to a financial crisis in an industry, business, another sovereign county, or municipality, the financial hole gets deeper. Looking forward to what pending financial crises of global significance crises are likely to emerge, there is no shortage of candidates. On the front burner is the unfolding European financial meltdown. A prudent view would be to assume that as bad as it looks, it is likely to be much worse when one factors in the amplification effect of derivative positions likely held by systemically important institutions. On the back burners, waiting for their chance to emerge are the rapidly deteriorating conditions of the pension systems, the FDIC, as well as state and local municipalities.

The biggest player is the US Government itself. The trillion dollar plus budget deficit projected indefinitely into the future does not even take into consideration expensive contingencies, which seem to inevitably arise, such as natural and man-made disasters, wars, and other Black Swan events which will necessitate additional funding requirements. How will all the unfunded liabilities and current operating expenses be paid for? One might argue that incurring these expenses is necessary, but there are also consequences.

That there will be increasing insolvency, massive economic displacement, and economic restructuring is appearing to be more and more a given. We are at a global economic watershed point. A recent book, This Time Is Different, by two eminent economists, professors Carmen Reinhart and Kenneth Rogoff, is based upon a compilation and analysis of data looking at government’s financial behavior over the past 800 years. Among their conclusions is a pattern which emerges as a constant. Governments overspend, over borrow, and then default. The two basic methods of default are an outright refusal to pay their debts, or an implicit default. In an implicit default the intent is to debase the currency with the objective of repaying existing indebtedness with a lower value currency, in effect, an attempt to inflate away the real value of a currency.

Given the current operating deficits, as well as future liabilities, the United States is on a trajectory that is financial unsustainable. Considering the position of the US dollar as the reserve currency of the world, the question of default must be addressed by an investor who considers that somehow events occurring in the world matter to the investing results achieved. In my view, an outright default by the United States of its debt is a probability so small as to be insignificant. On the other hand, an implicit default, where the United States attempts to inflate its way out of its financial hole is extremely likely, especially when there is no limit as to how much money the government can create.

If we assume, for purposes of discussion, that this is the direction in which economic history will move, it becomes useful to consider some of the implications of this scenario for asset deployment purposes. While there is a great deal of discussion regarding the demise of the US dollar, it is often followed by consideration of other currencies as a safe harbor refuge. This may be a false sense of security. One of the reasons for the US dollar's problem is the lack of monetary discipline because of the fiat nature of the currency, the same problem exists with other currencies. There appears to be an inherent instability with a fiat monetary system. Consequently, in my opinion, it is a mistake to believe that other currencies might be anything other than a temporary refuge.

It is the consequences that follow which will provide both the hazards, as well as the long term opportunities from an investment and financial planning perspective. It is exactly here that both the risks and the opportunities reside. In my estimation, the outcome of these circumstances will result in escalating interest rates, which is another version of credit availability reduction, and a damper on economic growth. This would be an unacceptable outcome for our government whose interests are critically tied to economic growth. The policy response will be an attempt to create vast amounts of money in order to effectively devalue debt, and consequently the dollar. Current economic policy discussion focuses on a debate as to whether we are looking at a deflationary or inflationary future. In my opinion, while I harbor the view that we will experience a severe hyperinflationary and stagnant economic future, I consider this to be somewhat of a secondary consideration. A more primary consideration, which is, and will continue to shape investor behavior, will be the economic uncertainty and dislocation which arises, whether it is inflationary or deflationary. This economic instability is already creating a greater shift in the view of what is perceived as a more desirable asset class to act a as reserve of reservoir of economic value.

Considering assets which might best retain or increase in value, it is clear that current market behavior suggests there is growing recognition that investors have starting voting with their feet. One investment areas which has highlighted these opportunities is precious metals, in particular gold. The evidence derived from reports of shortages of gold coins to the increase in bullion reserves by central banks such as China, India, Russia, and Saudi Arabia, make a compelling case that we are not witnessing merely a speculative thrust at a trading position, but rather a sustainable shift in perception of an asset that will withstand the rigors of the economic storms we are facing.

Aside from owning gold directly, there are now opportunities with exchange traded funds such as GLD, to take positions that very much mimic the economic characteristics expected of a currency. In my analysis, this provides a compelling reason to expect the demand for gold to continue to increase. It follows that if one expects the demand for gold to increase, the value of those entities which hold reserves of gold, as well as the productive capacity to bring it to market, can be expected to be beneficiaries of these circumstances. It is from that perspective that if I had to choose only one investment, I would select GDX, an ETF of gold miners as my investment of choice.

What Could Go Wrong

One thing I have learned from over twenty years of investment decision making, and corroborated during the experiences of my younger years working in research laboratories, is that no matter how well thought out and rational a position is, it does not necessarily mean that is what is. As a consequence, it is important to examine and identify where the potential risks lie in our expectations. The year 2008 gives provides us with a great opportunity to examine what happened to gold during that time of extreme financial duress.

Deleveraging caused massive indiscriminate selling pressure. Institutions were forced to raise capital to meet their regulatory requirements. At the same time the credit markets froze up, making capital very difficult to acquire. This made the situation even worse. Hedge funds are investments for institutions and very wealthy individuals. They operate by borrowing huge amounts of money using their invested positions of stocks, bonds, and the more esoteric derivative investments as collateral. Some of these funds borrow 30-40 times the amount of actual dollars directly invested in them by their investors. The lenders who provide this money to the hedge funds have lending requirements which require the hedge funds to come up with more money if the value of their investments drops too much. During the financial turmoil, the decline of the investments in these hedge funds forced the hedge fund managers to start selling their investments whether they considered them good investments or not. This amplified the overall selling pressure and made a bad situation even worse. It did not matter whether an investment had merit or not, it was going down, and gold did likewise. It is certainly possible for this to occur again. It should also be noted that GDX seems to trade more like a stock than GLD, hence one might expect higher volatility. One of the only assets which did well in 2008 in comparison was US Treasury debt, due to the perception of safety.

If we fast forward to the emerging European crisis of 2010 and examine market conditions, we can see growing investor perception recognizing gold as a safe harbor. Additionally, the gut reaction of flocking to the US dollar as a safe harbor seems to be becoming somewhat more muted. In my view, I see this as a growing trend that will greatly benefit GDX over time. By the same token, does this suggest to me that it would be appropriate to bet the family farm on this position? Absolutely not! Even if an investor sees merit in my analysis, each individual investor needs to evaluate his own risk tolerance and circumstances to arrive at an appropriate allocation to GDX even if it is the only investment position they are taking.

Financial Meltdown; Part Two?

How fast things can change; in either direction. I studiously try to avoid thinking in short term time frames. It usually leads to sub-optimal, emotionally driven decision making, rather than longer term strategicially driven decision making. Sometimes, however, near horizon events are compelling enough to warrant shorter term tactical changes of direction.

I do not see the global financial system being on the verge of a financial apocalypse, at the present time. Last year, at this time, presented a distinct possibilty that we were. Nonetheless, there are a number of very troubling signs on the near term horizon. One of these is an increasing probabilty of a sovereign debt crisis acting as a catalyst for global financial meltdown part two.

A number of countries and regions, such as China, Brazil and India, appear to be economically strong and gaining traction. In and of itself, this might lead one to believe in the underlying attractiveness of some portion of capital allocation to these regions. I concur in the the underlying premise of longer term opprtunity in theses regions. However, there are a number of factors which temper my longer term view of these opportunites, and their derivative considerations, to warrant shorter term tactical changes.

Among these considerations is the growing potential of sovereign debt crises acting as a catalyst for "Global Financial Meltdown, Part Two". The United States and the European region, in general, are seriously problematic. Several countries, in particular, are at the leading edge of a potential governmental solvency crisis. These are Greece, Spain, Italy, and England. S & P recently lowered the debt worthiness rating of the second largest economy in the world, Japan. Because of the growing deficit problem in our own country, and a Congress that may not be able too deal with it, even if the U.S. Congress were to be functional, it appears that the United States may not be too far behind with respect to a solvency crisis within the next five to ten years. This is but one of a number of signifcant factors which should prompt some additional strategic thinking away froma "full steam ahead", business as usual mentality.

As should be quite evident from our recent experiences of the 2007-2008 global financial meltdown, as people ruah for the exit, even assets which have strong underlying fundamental strength get painted with the same brush of value deterioration as panic sets in. Indeed, from a longer term perspective, these can be rare opportunities for the investor, assuming the emotional, pyschological, time, and financial abilities to withstand the ensuing trauma and economic dislocation.

In my opinion, a more prudent approach would be to err on the side of caution. After the financial market runups from March 2008, it appears to me unreasonable to expect, and improbable to achieve an immediate followup to this. The chances are that if we have really turned the corner with regard to a sustainable economic turnaround, there will be many years of compelling opportunties ahead. On the other hand, if reconsideration of the financial landscape leads one to believe in at least a reasonable prospect of financial meltdown, part two, it would be prudent to consider a more defensive portfolio allocation.

These are soome of hazards of the economic and investment landscape at the present time. It does nott consider unaccounted for contingencies, which seem to always arise in some form or other. It presents a set of risks, as well as a set of opportunities. In my opinion, the best way in which to deal with this environment is to maintain a vigilent and critical view of ongoing events. It is necessary to be responsive, while not over-reactive, as to how they may impact our longer term strategic outlook. It is important to keep in mind is that no one has a perfect crystal ball, and that because of institutionalized imprudence, there really is no safe harbor left. The most effective management will how well potential risks and rewards can be balanced in the midst of growing global economic dislocations and the financial restructuring resulting thereof.

Where Are We Now?

While many of us began this new year with hopes for an economic and financial recovery, unfolding events suggest that we have a ways to go before we are on the other side of this global crisis. The economy has continued to deteriorate with huge job losses, real estate prices continue to plunge, and our major financial institutions and industries continue their financial hemorrhaging. I have been studying and monitoring events with sharply focused attention. Below, I share some thoughts regarding what is currently going on. Hopefully, you will find these thoughts helpful in better understanding this environment.

Current View
Towards the end of 2008 the United States Congress agreed to provide $700 billion to keep the financial system from imminent collapse. The Secretary of the Treasury of the United States, Henry Paulsen, and the nation’s top banker, Ben Bernanke, had testified that the United States was within days of financial collapse. Congress provided for two installments of these bailout funds.

Several months later, we have had an opportunity to get some idea of the effectiveness and efficiency of the use of these funds.

The fallout from the failure of several large financial institutions had caused the global credit markets to freeze, consequently bringing global commerce to an abrupt slowdown. The public presentation of this strategy said the bailout funds were supposed to prop up the remaining mega financial institutions of the United States and stimulate the continuing flow of money, via increased lending, necessary for commerce to continue. How unsurprising that reports now emerging present a somewhat different picture of what was really going on. A recent news article reported that the CEO of a large US bank, as well a recent PBS Frontline presentation, said the bailout funds, TARP money, was essentially forced upon some banks. The apparent reason, which was supposed to be kept quiet, was to provide money for some banks to buy out smaller, weaker banks. Shortly after the TARP funds were distributed, there actually were reports of these types of bank acquisitions occurring. To the extent that this would “privatize” dealing with failing banks, this might make some sense.

One of the ways in which these TARP funds were distributed to the banks was to buy some of their “Troubled” (read toxic) assets. If the government paid a fair price for these assets, injecting money into them would be a fairly clean process. Unfortunately, however, this would not have accomplished the objective of stabilizing the financial system any better than they actually did, as I will explain.

If the government bailout funds purchased these assets for what their actual market value was, the financial system would experience an additional shock beyond what was already occurring. In order to try to make banks appear healthier than they actually were, the government needed to pay more for these assets than they were really worth. Indeed, a recent report by a congressional oversight committee headed by chairwoman Elizabeth Warren, a professor at Harvard, came to the conclusion that of the $350 billion spent on this program, the government overpaid for what it purchased by $78 billion. An additional research report by Goldman Sachs said that the real losses in the financial system will be around $4 trillion by the time this crisis is worked through. This is in the same range as estimates by economist Nouriel Roubini, who has estimated around $3.6 trillion of losses. The last estimate I read as to the already acknowledged losses in the financial system was around $1.1 trillion.

To draw the picture more anecdotally, a commenter to an economic blog, www.nakedcapitalism.com, on February 23, 2009, put it this way:
I have a personal anecdote about Citi and the difficulty of spotting how bad their loans actually are. I'm involved with a $300 million condo-hotel development in the Caribbean. Citi has the whole loan (i.e., they didn't securitize or otherwise sell participations in the loan). Even now, we expect the hotel needs at least another $100 million to finish construction and open (we are no longer under any delusions that more than a handful of buyers will close on the condo portion of the condo-hotel). So, in other words, Citi is $275M into this project, and it's not certain that the completed hotel will even be worth the extra $100M required to complete and open. Hence, one might plausibly value this $275M loan at zero (i.e., a complete write off). I cannot imagine any stress test would uncover what a huge loss is on the way in the next 12 months. In fact, this loan has not even been pawned off to the nonperforming/distressed debt/workout section of Citi because the interest reserves make it "seem" like the loan is still performing, not to mention that completely out of date pro formas make it "seem" like (i) equity will come in to finish the project and (ii) condo sales will pay down a huge part of the principal once construction is complete. This scenario must be present in a large number of Citi loans, especially in their somewhat active foreign development divisions. Citi must be so far from solvent that it's not even funny. Only hyperinflation in the dollar could ever make it possible for the borrowers to pay back some of these loans. I'd bet that the sooner we face reality on some of these loans and just halt future fundings, the less money the taxpayers are going to lose. As it is, it's almost too late. Too bad for the US taxpayer.

This suggests that we may have quite a ways to go before we are on the other side of this crisis. Other emerging areas of troubled assets are the commercial real estate sector, as well as car and credit card debt. In an economy which is continuing to deteriorate it would seem as though these problems will get worse. The new Obama administration’s continuing efforts at intervention has not inspired much of a vote of confidence by the markets as to its probability of success.

Looking Forward
There are several take-aways from all this. There is quite a bit a rot left at the core institutions of our financial system. These banks, insurance companies, and other related institutions, provide the backbone for commerce and economic growth. Sustainable and healthy investment markets require the foundation of a healthy economy. Most fundamentally, however, the ongoing financial crisis highlights the importance of rethinking assumptions about risk.

The belief that major financial institutions such as banks and insurance companies provided the “safest” investments arose from the time when these types of institutions conducted themselves in financially prudent ways. The ongoing massive financial institutional failures we have witnessed over the last year are evidence which refutes this belief in a massive way. Moreover, because of the necessity of the United States government having to bailout these institutions in order to try to save the entire global financial system from collapse, it may call the solvency of the United States government into question.
As a consequence of these ongoing events, the challenge of trying to identify potential financial safe harbors in this environment becomes all the more important. It needs to be recognized that “safety” is relative because there are many types of risks, and consequently no absolutely “safe” investment. However, in my analysis and conclusion, trying to balance out these risks points me to reconfirm my conclusion that investments which have a “real use” value such as energy, food, and utilities, will maintain a baseline of economic value in recessionary times, as well as provided the most accelerating growth opportunities when economic conditions improve. This is not to say that these types of investments will not also experience price volatility. Maintaining sizable positions in a safe money market, both for added stability to portfolio values, as well as to take advantage of future opportunities is an additional defensive measure. Having a modest position in precious metals is intended to provide an additional measure of safety. The challenge of this investment environment is to try to have some exposure to the upside of a possible rapid economic turn-around, as well as to provide downside protection from continuing economic deterioration.

From the personal financial planning strategy perspective, a prudent response to these conditions is to seriously re-examine personal spending and expenses with an eye towards belt-tightening. Because many of us have become accustomed to a living standard which includes discretionary expenses which enhance our lives, this is never a pleasant topic. The other side of the coin, however, is that we may find that may of the things we believe we need as discretionary expenditures do not necessarily add to the quality of our lives, or our health. These are times in which we need to have an adaptive response, where we refocus on the things which are really important and take proactive steps to maintain health and manage stress. The bottom line is, I believe, that we will, at some point, emerge from this crisis wiser, stronger, and with some incredible opportunities looking forward.

Addendum
Banks must be in compliance with certain regulatory requirements. These requirements are intended to ensure a minimal degree of financial strength to protect depositors. A peculiar characteristic of banking system accounting requires that assets be carried in the bank’s accounting records at what is called historic cost. This is what the banks actually paid for these assets. When an asset, such as an investment is sold, the bank accounting record is then adjusted to reflect the actual price at which the asset was sold. This means that if a bank paid $50 million for an investment in some type of sub-prime real estate investment, and it was now worthless, as long as the bank did not sell this investment, it would appear on the banks records as being worth $50 million. Consequently, a very financially sick bank could appear healthy as long as it did not sell, or adjust (called mark to market), its troubled assets.

Reflection and Analysis

A Look Back

Shock, confusion, and fear are probably some words which describe many people’s overall experience of 2008. As difficult and challenging as the year was, it is important to try to make some sense out of what happened, what is happening, and provide some analysis towards a sense of where things are likely to go. To this end, I am offering my thoughts on this subject with the recognition that the complexity and magnitude of world economic events can cloud even the best crystal balls. Having said this, those of you who have read my book, The Emperor’s Clothes, know that I discussed many of the issues of this global financial crisis prior to their occurrences.

The news of the past year has been filled with details of the institutional pillars of American finance, such as Merrill Lynch, Lehman Brothers, Washington Mutual, Fannie Mae, Freddie Mac, and many others, collapsing or being taken over because of pending collapse. This has been followed by the frenzied attempts of the world’s Central Banks, such as the U.S. Federal Reserve Bank, coming up with one scheme after another to try to prevent a complete breakdown of the global financial system. Indeed, while trying to get support from Congress for a $700 billion bailout package to save the U.S. banking and financial system, the chairman of the Federal Reserve Bank, Ben Bernanke, and the U.S. Secretary of Treasury, Hank Paulson, testified before Congress that the U.S. financial system was within days of collapsing.

Massive indiscriminate selling pressure was created as a result of this financial turmoil. These institutions were forced to raise capital to meet their regulatory requirements. At the same time the credit markets froze up, capital very difficult to acquire. This made the situation even worse. Hedge funds are investments for institutions and very wealthy individuals. They operate by borrowing huge amounts of money using their invested positions of stocks, bonds, and more the esoteric derivative investments, as collateral. Some of these funds borrow 30-40 times the amount of actual dollars directly invested in them by their investors. The lenders who provide this money to the hedge funds have lending requirements which require the hedge funds to come up with more money if the value of their investments drops too much. During the financial turmoil, the decline of the investments in these hedge funds forced the hedge fund managers to start selling their investments whether they considered them good investments or not. This amplified the overall selling pressure and made a bad situation even worse.

Today, there appears to be some degree of stabilization from the worst of the turmoil. It will be many years, keeping many scholars employed, trying to sort out the details of what actually happened. The one thing that is abundantly clear is that financial imprudence at all levels of our society, and throughout the world, became institutionalized into an acceptable form of conduct. Imprudent lending, and imprudent borrowing, created a vicious destructive cycle of over-consumption and over-indebtedness. As with many extreme indulgences, when the party is over, we are left with a big hangover and a big cleanup job. Right now the United States in particular, and the world economy, in general, has one gigantic hangover, and a daunting clean up job.

Looking Forward

Currently the governments of the world have made massive commitments toward maintaining financial and economic stability. On a global scale, I have read estimates of up to $7 trillion dollars already committed to various bailout type endeavors. The bailout line also seems to be getting longer each time the government responds to an industry or business in financial crisis. The auto industry is the latest example. Following this bailout, I have read accounts of state and local municipalities, and the commercial real estate industry lining up to be next. When the government starts handing out money, there is no shortage of willing, ready, and potentially deserving takers.

Even if one considers these policies to be necessary to prevent an even more disastrous financial collapse, a number of issues arise which impact what the outcomes are that we can expect. One of these issues is the implementation of these policies. For example, the early reports on the banking system bailouts leave much to be desired as to the accountability of the use of the funds. The reports indicate that many of the recipients of the bailout funds are unable or unwilling to account for their use. Other reports suggest a business as usual attitude for many of these troubled institutions. They seem to feel at liberty to pay huge bonuses and compensation packages, and provide extravagant perks to the very management personnel who contributed to bringing about this disastrous situation. It was only when the spotlight of public opinion focused on some of these issues that public relations considerations brought about a more contrite demeanor in these institutions. This suggests to me that the only thing that has really changed is the public relations campaign.

Another issue, which I refer to as the elephant in the living room is: How are all these bailouts going to be paid for? In addition, the other component of trying to climb out of what is being referred to as the worst financial crisis since the Great Depression, is the massive economic stimulus package being put together by the incoming Obama administration. It may, perhaps, be necessary, but there are also consequences. It is the consequences that, in my opinion, will provide both the hazards, as well as the long term opportunities from an investment and financial planning perspective.

Current discussions of the economic stimulus package lead me to believe that by the time it becomes policy it will have a cost ranging from $1-$2 trillion over a two year period. The funding for this will be added to the operating budget deficit of the United States. Prior to all these bailouts and economic stimulus packages, the United States had already needed to borrow $60-$70 billion per month in foreign money in order to continue funding its operations. Luckily, China, the petrodollar countries, and the other countries accumulating U.S. dollar reserves were doing well and were quite willing to continue lending money to the United States. The question that must be asked now is: How willing and how able are these countries going to be to continue loaning money to the United States to fund its budget deficit?

Many of these countries are having a more difficult financial time themselves in the present financial crisis. Many of these countries were, prior to this financial crisis, considering reducing the amount of money being loaned to the United States. In addition, because of this financial crisis the credit worthiness of the United States has deteriorated, and there are alternative places where these countries can deploy their financial resources which may be more directly beneficial to themselves. The funding requirements of the United States its meet the Budget Deficit needs may rise above $150 billion per month; the conclusion is inescapable of a potential funding crisis as being one of the major consequential fallout of the current attempts to contain this financial crisis.

It is exactly here that both the risks and the opportunities reside. In my estimation, the results of these circumstances will result in escalating interest rates, which is another version of credit availability reduction, and a damper on economic growth. This would be an unacceptable outcome for our government whose interests are critically tied to economic growth. The policy response will be an attempt to create vast amounts of money in order to effectively devalue debt, and consequently the dollar. Current economic policy discussion focuses on the immediate deflationary impact of the global financial crisis. However, I believe we will be seeing a very real potential of rapidly escalating inflation by the later part of 2009.

If we remember that the basic function of money is as a store of value and the viability of this function becomes impaired, it is important to consider where economic value will be best preserved, or even increased. Some of investment areas which I will be scanning for appropriate opportunities will be in areas such as precious metals, as well as real use assets such as energy, food, and materials. The added benefit to these areas, apart from providing a potential defense against some of the forces I discussed, is that when the global economy begins to get through this financial catastrophe, these will be among the things which will be crucial to growth and in consequently high demand, with limited supply.

No Free Lunch

The extraordinary measures being taken by central and governments in an effort to stabilize create markets, and intervene in cases of prospective institutional insolvencies, will result in a huge funding need by these governments. In the United States, the Congressional Budget Office has estimated that the Budget for the United States will exceed $750 billion next year. Other estimates are for a U.S. budget deficit in excess of $1 trillion. This is before possible and probable additional costs for an economic stimulus package, $300-$400 billion, and other funding demands arising from this financial meltdown. Questions which should be of interest are: Where will this funding come from; and what be be the implications of funding these needs?

The United States has had the benefit of foreign sources of capital to meet its need of $60-$70 billion per month. This was prior to this financial meltdown and the new capital funding requirements ensuing. Countries like China, and petro-dollar beneficiaries were accomodating enough, for whatever reason, to meet these needs. If the U.S. budget deficit doubles, while probably not a strictly linear relationship, one might estimate that the capital funding requirements of the United States from foriegn capital sources might rise to $110-$120 billion per month. What would be the willingness, ability, and desirability of foreign capital sources to meet this need?

In the context of a global economic slowdown it would appear that foreign reserves of US $'s would diminish from decreases in exports as well as lower oil prices. This would leave less funds available for re-investment back into U.S. Government debt instruments. One might also expect that as the U.S. financial picture becomes more impaired by its crushing debt burden, potential investors may well look more closely at alternative choices, as well as the redeployment of capital back into their own countries. In any case, this suggests that in order to secure the funding necessary for ongoing operations, the costs, ie interest rates, will be pushed up my market conditions. As the United States and other central banks have become the "bailouters of last resort", who has the ability and willingness to bailout these governments and institutions? I suspect there is no one to do this. If so, this may well make the current financial meltdown look like a picnic on a nice spring day.

If the current operational strategies offered by Central Banks and governments are any indication, we might expect that a high interest rate environment(read impaired credit availability), in a severe recessionary environment would be unacceptable. It would then seem like the strategy of the printing press for the manufacturing of money would be the only feasible choice available. One might then conclude that despite this current period of asset deflation and a strengtening of the dollar, this may well be a period that is relatively short lived.

While there is no free lunch, there may well be soup lines.