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  by Dennis M.
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Past Commentaries

Current Commentary, Review and Outlook
October 29, 2010

To my Clients, Friends & Observers:

Research firm Capital Economics (London, Toronto, Singapore) held their annual conference in Boston last week. Chairman Roger Bootle presided with several of his excellent economic specialists. The theme was the question “How can the world economy get out of this mess?” Briefly, the answer offered was that the recession was the result of reduced demand. It was completely man-made and could be completely un-made by reversing the strong reluctance to spend by countries with strong finances, by reducing public debt, strengthening consumers, and pressuring banks to lend.

The world, according to Mr. Bootle, is divided between those who want to spend but can’t and those who can spend but won’t. In Germany trade and budget surpluses are virtue; in China they are the road to growth. Both have large surpluses and undervalued or weak currencies. In Germany real consumer spending has grown less than 5% since 1999. That’s not annualized, that’s for the entire 10 year period. In China, with the strongest GDP growth on the planet, the percentage of national income going to the consumer is actually declining, going instead to state-owned industries. The other big surpluses and reluctant spenders are the oil producers. The price of oil would have to drop to $20 a barrel to bring the oil producers into current account balance.

What the Western world could do is increase “quantitative easing” (the new euphemism for “printing money” or monetizing debt), take measures to boost demand in countries with surpluses, create supply-side reforms to encourage private sector investment, and put pressure on the emerging markets with large surpluses to expand domestic demand and revalue.

All the prescriptions for improving the economy – what the Fed can or should do, what Congress should do, how to encourage spending, how to fix trade imbalances – all these things are stimuli meant to encourage production and manufacturing. They are not fixes by themselves. The Fed, Congress, the President cannot fix anything. They cannot create any private sector jobs. Government produces nothing and that is as it should be. Apart from the specific tasks given in the Constitution, like delivering the mail and providing for the common defense, the federal government can only tax and transfer. The only thing that will restore the economic growth and create jobs is growth in manufacturing and production. America must produce more here at home.
What the emerging/developing world could do is increase spending by commodity producers, reduce commodity prices so that income is transferred to those who will spend it, and expand domestic demand in emerging Asia and revalue exchange rates helped by higher demand in Latin America, Turkey and Russia. But China particularly, because of sheer size and growth rate, holds the key. Mr. Bootle describes three fazes of “China shock:” 1) low production costs leading to disinflation in the West; 2) huge trade imbalances and cheap finance for Western consumers sowing seeds of an economic bubble; and 3) China becoming the spender of first resort (because nobody else can).

Immediately following the conference I had lunch with my former research assistant, Sara, who after achieving her MBA at American International College (where I was her finance professor) got a law degree at New England Law School. Sara is the daughter of parents who are significant members of the Communist Party in China. Her father is a powerful judge at the central government level. She has established her own firm in Boston, has a partner and four other lawyers that she directs, and a beautiful baby boy. She has recently become an American citizen, an event that appalls her parents because China does not allow dual citizenship, but delights Sara because now she can vote. Sara loves America and has embraced all the best this country offers. She is a model of what the ideal immigrant is, past, present and future. She is a real contributor who cherishes the great freedom of Opportunity.

I shared with Sara my notes from the conference. It is her opinion that the culture of the Chinese is to save, not spend, and this will not easily change. She is not surprised that the greater portion of national income goes to state-owned industries.

China, despite its growth rate and trade surplus and massive accumulation of dollar denominated assets, i.e. U.S. Treasury securities, is creating its own bubble by not floating or revaluing its currency. To sell off its U.S. assets or even to cease buying Treasuries would cause a serious devaluation. It begs the question, who is more hooked, the U.S. on Chinese goods or the Chinese on U.S. bonds? The longer the yuan remains cheap the worse will be the eventual correction.
To keep perspective, it is worth noting that China is ranked 102nd in per capita income (CIA World Factbook) right behind Turkmenistan. Yet the savings rate approaches 50%. I’ve often argued in these commentaries that importing products manufactured by laborers paid at 10% of the rate of domestic workers may be free trade but it’s not fair trade. It’s just plain dumping.

The U.S. shouldn’t hesitate to protect against this dumping. The knee-jerk reaction of free-traders is to cite the Smoot-Hawley trade tariffs of 1933 which exacerbated the Depression. This is true, Smoot-Hawley was a disaster, particularly for the U.S., but U.S. in the 1930’s was what China is today, the worlds’ leading manufacturer and exporter. China would have to be naive to enact 50% tariffs against imports. Exports would suffer disproportionately from the subsequent retaliation. For the U.S., with its endlessly ballooning trade deficit, some strong corrective action is imperative.

Capital Economics forecasts now through 2012: GDP growth 8%+ in China, 2%+ in the U.S. and 1% in the EZ (Eurozone); inflation 2% to 3% in China, 1% declining to 0 in U.S; .3% in EZ.

Quantitative easing is not a serious inflationary threat and policy makers retain an anti-inflationary bias. Forecast for interest rates is flat, no change for the next two years at least and a ten year Treasury yield of 2.5%.

  2010 2011 2012
S&P 500 1100 1050 1050
$/Euro 1.40 1.00 1.00
Oil/brl $80 $60 $60

I concur with their deflationary outlook and am expecting several years of slow growth and struggling. That is not all bad if our portfolios are generating real returns of 5%, we are still growing and protecting our purchasing power. I think their expectations for the S&P 500 are severely understated. A 25% drop in the price of oil would be a significant catalyst to earnings.


If there is a laboratory to test what government overreaching and overspending does to a culture, it’s Argentina. In 2001 Argentina defaulted on $95 billion of its sovereign debt, expelling it from global capital markets. In other words, the rest of the world would no longer lend money to Argentina; there was no longer a market for Argentine bonds outside of Argentina. This triggered a currency devaluation of approximately 75%. Since 1991 the Argentine peso had been fixed to the dollar, every one peso was convertible to one dollar. Now the exchange rate is almost four pesos per dollar. A dollar goes a long way for an American tourist.

In 2005 President Nestor Kirchner offered creditors 30 cents on the dollar to redeem the debt. Most balked and did not accept. The succeeding president, Christina Fernandez de Kirchner, Nestor’s wife, recently oversaw another debt-swap offer. $18 billion remained unredeemed since the 2005 settlement and the current offer has redeemed another $8.5 billion of that. The debt swap deal closed May 14 and has been extended twice to retail investors. It did not go well.

Neil Shearing of Capital Economics has identified “the structural problems that currently blot the outlook for Argentina,” including “a toxic mix of ultra loose monetary and fiscal policies, rising inflation and a heavily managed exchange rate.” A return to global capital markets would be beneficial as would greater “transparency of government policy and projections as well as the quality of official data.” We could use some of that here in the U.S.A.

This is what happens to a nation when its bonds go bad. At once the money’s not as good either. Interest rates, the cost of borrowing, go up. Argentine 2015 maturities yield over 12% and are denominated in dollars. The net effect is an enormous drag on economic activity. The populace is poorer, without understanding why. The public debt is 49% of GDP, and GDP shrunk 2.5% in 2009. Inflation is now in the teens and rising. (Information from the CIA Worldbook) Argentina was one of the wealthiest of nations a century ago. Crushing debt constricts economic choices and the effects are painfully obvious.

In May I spent 10 days in Argentina and my impression was of an economy dependent on Brazil for growth, otherwise out of gas and down at the heel. It was a clear picture of what happens when populist politics trumps fiscal sanity.


The shots that have caused so many financial casualties were the various and bogus derivatives and unfunded credit default swaps fired around the globe by greedy American investment bankers. At their compensation level stupidity is no excuse. Where there was ignorance it was deliberate. As the casualties mount it is constructive to look at the wounds and the repairs. Greece was exposed as a society so corrupt that its government had become irrelevant. Actual self-government was effectuated by a protocol of payoffs, lies, bribing, cheating, short-changing, and political favoritism. Severe, painful austerity had to be enforced in order for Greece to qualify for financial aid (loans) from the EU. Public employees violently protested.

Drastic fiscal austerity has spread rapidly to Spain, Ireland, England, Portugal and most recently – and again violently – to France. Even in Germany, the great engine of the Eurozone, Angela Merkel expresses concern.

But across the pond, America seems blissfully unaware, whistling past the graveyard, tiptoeing around unfunded pension obligations, continuously expanding government expenditures and public debts. During economic expansion the public sector expands. During economic recession the public sector expands. What will it take to get budgets in balance? It will not be economic growth. That is off the table for the foreseeable future. What process then and when will the process start? These debts will be paid. There is not even a hint of potential austerity coming from Washington, or Boston, or Albany or Sacramento. There are only two states in the Union which municipal bonds are without speculation, Tennessee and Texas.

A GDP expanding at 2% a year will not make a dent in the unemployment rate which is officially 9.6% but actually closer to 17% including those who have given up looking. We will need growth greater than 3.5% a year for several years to get the rate below 9% and a growth greater than 5% for several years to get unemployment back to 7%. That is not in any forecasts that I’m reading.

The Wall Street Journal reported a few weeks ago that there is a great deal of insider trading in publicly traded securities by Congressional staffs. Insider trading is not a crime in Congress. Congress specifically exempts itself from compliance with the laws it imposes on the rest of us.

Is it any wonder most of our representatives become millionaires?

Kind regards,

Dennis M. O’Connor