Chapter 6
An Overall Assessment of the Current Investing Scene
If all the economists were laid end to end—that’s where they belong.
—Unknown
I’ve painted a pretty glum picture for investors in advanced Western countries. There are so many unknowns. This is the first time in history that all the major central banks have printed high-powered money without restraint. The downside from this is unknown. At the same time, major advanced democratic countries of the world are in fiscal crisis and are undergoing a massive debt deflation. The international monetary system is malfunctioning and has been a major source of global bubbles. The euro is a major source of instability. Unlike in 2008, we have no history to rely on. The outlook is so scary because several quite different scenarios are possible.
The most likely near-term scenario is for further debt deflation in the advanced Western countries, which doesn’t end until the unfunded entitlements and sovereign debts are defaulted on. Global oversupply of manufactured goods and commodities is a second near-term deflationary force. Despite all the money printing, accelerating inflation is not a near-term threat.
But there is one event that could have changed everything. That was the 2012 US presidential and congressional elections. If the fiscal conservatives had swept and along with them supply-side remedies and government spending cuts, then the long-term outlook would have brightened. Well folks, that didn’t happen. Unfortunately, the victory of Obama and the Democrats could bring irreparable economic damage to the United States. The Obama administration and Democratic Senate, with the wind of their reelection at their backs, will favor more government spending, higher taxes, financial repression, Luddite environmentalism, and increasing dependency of underperforming groups on the government. After WWII the US, with its Marshall Plan, Bretton Woods international monetary system, United Nations, and its magnanimous treatment of the war’s losers, put the world back together. Can the US do it again or, as so many have argued, is it a spent force for which bankruptcy is inevitable? Keep in mind that sound long-term reforms could be painful in the short term.
Let’s summarize what seems likely in the coming years.
The Bad News
1. There is a greater-than-average possibility of another major global crash in equity prices. This would be the result of continued debt deflation and economic recession in the advanced Western countries and China. And now, although it sounds partisan, the victory of Obama in the United States.
2. Deflation/disinflation rather than inflation is the investment reality of the near term. Debt deflation and global oversupply of goods and services in a recessionary environment will exert downward pressure on prices.
3. Advanced-country central banks will continue quantitative easing in a futile attempt to revive their economies via high-powered money printing. Macroeconomic demand management has been a failure but is something governments and economists will never give up. The global high-powered money printing is likely to have minimal effect on stimulating aggregate demand until the deleveraging is over.
4. If there is no major demand for credit, the high-powered money created in quantitative easing will just sit in the central banks as excess reserves and inflation will not be a problem. But like a sword of Damocles, it will hang over the global economy.
5. A relative slowdown in China as years of capital misallocation by the state sector will result in a lowering of total factor productivity and economic growth. China as the future engine of global growth is overrated. China’s reliance on exports will be a negative in a global environment of recession and near recession.
6. A near-term continued budgetary crisis will occur in India due to populist spending measures and failure to undertake structural supply-side reforms.
7. There will be a coming massive default on advanced-country government debt and entitlement obligations, default being defined broadly.
8. In Europe, overindebtedness, excesses of socialism, and government involvement in the economy will intersect with the design flaws of the euro, prolonging the euro crisis.
9. Advanced-country governments will raises taxes to avoid default. Investors will be targets.
10. Advanced-country governments will make a concerted effort to impose various forms of financial repression including penalties on holding alternative moneys such as gold and possible restrictions and/or punitive taxes on promising foreign investments in countries not burdened by excess debt.
11. An unfavorable demographic situation will push worker/beneficiary ratios downward.
12. Environmental and water problems will continue, particularly in Asia.
The Better Washington Does, the Worse the Country Does, So Buy Washington, DC, Real Estate?
Americans have always been very proud of their capital city with its expansive parks, monuments, and public buildings. Those things are nice, but think about it. The better Washington does as a city is probably inversely correlated with how well the country does. President Obama campaigned on the idea that he would reduce the influence of lobbyists and insiders in Washington. Ha! In fact, the presence of lobbyists and their fellow travelers in Washington is not a function of presidential speeches but, rather, the size and influence of the government in economic life. If the government is a major decision maker in an industry through tax policies and regulations, then the private sector from that industry has to be in Washington to defend its interests.
The fact is that under Obama the federal government has expanded massively and is likely to expand further. Regulations for the environment, finance, energy, health care—the list goes on. The new regulations have flowed copiously from the bureaucrats’ PCs, and because of Obama’s reelection, they will keep coming. All this has been a bonanza for Washington, DC, whose growth has dramatically outperformed that of the rest of the otherwise sickly US economy. The army of federal workers has grown, the army of lawyers and lobbyists to “enlighten” them has grown, and many firms, including those in the technology and media space, have found it useful to locate in the Washington, DC, area. If the government is the big player in a market, the private sector has to engage the government. It has to be there. According to futurologist Joel Kotkin, “California may have Facebook, Google, and Apple, but Washington has federal agencies, the defense establishment, a growing media sector, and the lobbying industry to feed upon.” According to Kotkin, Washington “thrives as the marketplace for the collusional capitalist state that has been growing for decades . . .”
So since President Obama was reelected, buying Washington real estate might be a good idea.
Mal de muchos, Consuelo de tontos, it is said in Spanish. “The bane of many, the advice of fools.” If the government grows, it is the rest of the country—who don’t live in Washington but pay the taxes—who will be the fools.
1
The Good News and Some Long-Term Trends (Which Are Mostly Good News)
1. There is always the hope that governments would take a turn toward fiscal responsibility. With the reelection of President Obama and the overall loss by conservatives, this hope now becomes dimmer for the United States. I believe the 2012 election was a game changer and the wrong guys won the game.
2. New types of moneys, including gold-backed currencies, will be introduced that would be immune from government debasement. This would be combined with the reorganization of the international monetary system. All of this is post-crisis, of course. So it’s years off.
3. Technological progress will accelerate as a fundamental part of human evolution. This is the driving force behind Schumpeterian creative destruction and productivity increases in advanced countries. Biotechnology, Internet-based technologies, and agriculture are areas of investment interest. Unfortunately, Luddite attitudes by electorates and governments can slow this process.
4. Globalization, which benefits the human race as a whole, will continue, although there will be losers as with technical progress. Still, globalization is a positive sum, not a zero sum game.
5. There will be a major positive shift in the world energy equation whereby technological breakthroughs of fracking and horizontal drilling have opened up vast new potential supplies of natural gas and oil around the world. Dependence on the volatile Middle East will be reduced and the perceived need for unproductive “green” energy investments will be reduced. Energy will not be a constraint on global economic growth longer term. The one caveat here is whether the extreme environmentalist program of the Obama administration can significantly arrest the development of the energy potential of the United States.
6. Economic growth in countries in Asia and Latin America that formerly were classified as underdeveloped will continue.
7. In advanced countries, aging populations will have special needs. There’s a silver lining in every cloud. The ratio of workers to retirees may be becoming less favorable but the geezers will also be a growing market. One example is dietary supplements, which, however useless, may prove to be in great demand from senior citizens seeking eternal life.
The Unknowns
1. When and if will the markets finally deny access to governmental borrowings by the “core” advanced countries (i.e., the United States, Japan, and Germany)? My best guess is that this could happen not far beyond the 2012 elections, as the market senses the entire budget process is more taxes and more spending. I have to admit, however, that there are no signs of this happening yet.
2. What effects will zero-interest-rate policies and quantitative easing have on the allocation of capital? Central bank “price controls” will inevitably have negative fallouts.
3. Will the United States embark on another major war? This could hasten the coming fiscal crisis for the United States and the global financial system. The Iranian situation is particularly worrisome and complicated. Even if hostilities are not initiated by the United States, it is likely the United States will become involved in a major way. To be fair, on this point Obama might be less likely to start a war than Romney, whose high-testosterone demeanor and seeming inflexibility on China were a little unsettling.
4. When will inflation replace the current debt deflation? In my opinion, that day is further off than many think.
5. What will emerge on the other side of the coming crises? Will a renewed emphasis on free-market principles be the result, or will the advanced countries find themselves in an economic death spiral of ever-higher taxes, more regulations, civil unrest, and unfavorable demographics? This question is particularly important for the United States, which has served as the engine of growth and center of innovation for the entire world.
6. Will the East Asian countries abandon or at least modify their mercantilist economic models?
7. Will major wars interrupt the advance of human progress and disrupt the investment environment, as they have so often in the past?
Supply-Side Reforms Must be Enacted
I have made a strong case against overreliance on demand-side management, be it monetarist or Keynesian. Future reforms of the economic systems, outside those in the monetary sphere, should be broadly defined supply-side or structural reforms. Countries that embark on supply-side/structural reforms are long-term buys. The current fiscal austerity reforms coming out of Europe right now involving higher taxes and little meaningful reduction in government or government regulations are not the reforms we are talking about. They are wealth destroyers.
Supply-side/structural reforms would include the following (perhaps after the American elections this becomes an unattainable wish list):
1. Simplification of the tax code and reduction in taxes. A flat tax is the ideal. Austerity programs which increase taxes and their complexity are economy destruction programs.
2. Removal of the myriad of work related, environmental, and gender restrictions on labor. These restrictions vary by country but they are pervasive. Note the adjoining sidebar regarding labor regulations in Italy. These regulations are worse than Ayn Rand’s worst nightmare.
3. On the energy front, particularly in the United States, addressing energy dependency. This would include getting rid of the regulatory barriers inhibiting the production of oil and gas and eliminating the subsidies currently being doled out by the federal government to unpromising and frequently environmentally destructive “alternative” energy sources such as wind power, which reportedly has taken a huge toll on bird populations. The United States with Canada has the potential to be the next Saudi Arabia of energy. But right now, the Obama administration is holding up the creation of new facilities for LNG export, has effectively blocked the Keystone pipeline, which would allow the shipment of Canadian oil to the American Gulf Coast, has greatly slowed the drilling of offshore oil in the Gulf of Mexico, has prevented the drilling for more oil and gas on federal lands, and has prevented the further drilling for oil in Alaska. The Obama administration has carried on a war against conventional energy sources including oil, gas, and coal, which in the United States, thanks to new technologies, are in great abundance. But the United States is not the only offender. Germany, which has been powered very efficiently and safely by nuclear facilities, has now decided to close these nuclear facilities and substitute for them unproven, unreliable, and expensive alternative energy sources. Germany is putting its own economy and that of Europe at risk with this decision.
4. Regarding food, an approach based on science and facts. This approach should prevail over the Luddite approaches based on irrational fears and nonscience. This is particularly true in Europe, where in my opinion the psychological and guilt hangovers from the massacres and genocides of the twentieth century have given Europeans an irrational fear of both technology and any kind of risk. Genetically modified food overall is banned in Europe, despite one study after the other finding no ill health effects. I think the Europeans subconsciously fear that some kind of genetically modified Hitler is going to pop out of a Monsanto corn stalk. I don’t want to be dogmatic about this, but most studies that I am aware of do not show organic produce to be healthier than produce grown by technologically efficient conventional methodologies. I would agree that the organic movement has made a useful contribution in raising sensitivities concerning the excessive use of pesticides. But the world population has now hit seven billion and is likely to add another billion or two before declining birthrates reverse this trend. Technology, including genetically modified food, has dramatically increased agricultural productivity. From what I have read, so-called organic farming has been proven to be far less productive in terms of output per acre. If the world had to live on only organic produce, the acreage that would be need to produce this would probably require the destruction of large amounts of as-yet-untouched wildlife habitats in the world and would dramatically increase the cost of food.
5. On the international front, reduction of tariff and nontariff barriers and a recognition that globalization is part of technological acceleration and offers nonzero sum benefits to all mankind. This, of course, assumes that the international monetary system is not distorted where one or more countries can set their exchange rates below market to encourage exports. This is not the case today, and thus reform of the international monetary system is really a supply-side/structural reform.
6. Regarding health care and finance, market-oriented solutions. The massive regulation-centered approach of the Obama administration promises that the heavy hand of bureaucracy and regulatory minutia will effectively consign to stagnation two major areas of the American economy.
Economic Delusion Italian Style—Mario Monti’s “Growth Decree” versus 40 years of Labor Regulations
Italian Prime Minister Mario Monti has issued a new “growth decree” to revive Italy’s stagnant economy. Among other things, the 185-page plan proposes loans for corporate R&D, tax credits for businesses that hire employees with advanced degrees, and reduced headcounts at select government ministries. It even envisages some privatizations.
Will Monti’s plan solve Italy’s economic problems? Doubtful. Italy, like all the southern European countries, has tied up its businesses and entrepreneurs into a labyrinth of bureaucratic knots. The knots are unbelievably detailed and costly and would discourage any normal person from ever considering becoming an entrepreneur in Italy.
For example according to newspaper reports:
1. The entrepreneur must pay at least two-thirds of his (or her) employees’ social security costs.
2. After employee 16 is hired, it becomes virtually impossible to dismiss any employee.
3. Once employee 11 is hired, the entrepreneur must submit a report to the national authorities outlining possible health and safety hazards to which employees are subjected. This exhaustive report touches on things like work-related stress, gender and racial problems, measures taken to prevent risk, and so on.
4. After employee 16 is hired, then come the unions, and their many representatives, all of whom must be consulted on company decisions.
5. After employee 16 is hired, the next employee must be disabled. (I don’t know if Italians game the system by self-mutilation.)
6. After employee 51 is hired, at least 7 percent of the workers must be disabled.
I could go on. The point is that the social welfare philosophy and resulting regulations that pervade Western Europe—especially the South—constitute an incredible weight on the economy. This weight has been imposed by well-meaning politicians over time who have no appreciation for, nor understanding of, how private businesses or markets work.
Frankly, I cannot see making major investments in Europe until it dawns on Europe how a market economy really works. I am an optimist deep down. I believe one day that the supply-side or structural reforms will be undertaken. Europe, after all, is filled with well-educated, intelligent people. They can’t be stupid forever.
Taxation—Americans versus Everybody Else
In the years to come, we can expect not only increases in taxes but patriotic guilt tax trips from politicians. Don’t pay attention to these. Why should investors feel a special moral responsibility to pay for generally wasteful government spending and debt that they were opposed to in the first place?
An obvious investment strategy for investors everywhere is to move money to jurisdictions in which taxes are low or nonexistent and not likely to rise dramatically. This is easier said than done and depends on the tax regime prevailing in an investor’s home country. Taxation of capital gains and interest income is not consistent across countries.
There are many illegal ways to avoid taxes. This book is not recommending any of these, although it seems very obvious that tax policies in most advanced countries are extremely burdensome and counterproductive in an economic sense. Raising these taxes is the wrong policy. But the law is the law. Tax revenue departments in most countries are becoming more and more aggressive in enforcing their tax laws. The United States is taking a global approach to tax evasion by pressuring other countries to turn in Americans who keep money abroad to avoid American taxes.
Virtually all advanced Western countries tax their resident citizens on income on investments made abroad. However, in most countries if the investor becomes a nonresident of his home country then foreign income is not taxed. So one solution followed by many wealthy investors is to move abroad but retain their home country citizenship.
Americans do not have this option. The United States embraces a global tax policy for individuals whereby Americans are liable for taxes on foreign income whether or not they reside in the United States. Thus, investing and living abroad for Americans does not legally reduce their tax burden. Americans must move abroad and take the extra step of acquiring new citizenship and renouncing their American citizenship. On financial grounds, this step makes a lot of sense for wealthy American investors. Still, this is not a practical option for the majority of American investors and is a complicated technical and legal subject that we will not dwell on further here.
It is also true that most Americans would regard giving up citizenship as unpatriotic and disloyal. If things get really bad, expect this attitude to change. Capital, both financial and human, will go to where they are most wanted. When France under Louis XIV revoked the Edict of Nantes in 1685, talented French Protestants (Huguenots) moved out of France to more hospitable places like England and Holland. A devastating economic blow was dealt to France by this self-destructive act. Similarly, in the late fifteenth century Jews were driven from Spain and Portugal, thus depriving those countries of another valuable and talented group. Will the United States, with punitive taxation, deteriorating educational institutions, and protectionist campaigns against outsourcing drive out its financial and human capital? Come to think of it, will the French President Hollande, with his 75 percent income tax proposal on high earners, once again drive France’s talented people out?
We are already seeing this phenomenon of tax-oriented migration on an internal level in the United States. There has been a continuous move out of people and businesses from high-tax states like California, Illinois, and New York to lower-tax states.
Recent “reforms” in the United States have seen the introduction of burdensome reporting requirements for taxes on Americans with assets abroad and on financial institutions dealing with Americans. Americans may find it difficult in some countries to find financial institutions that will deal with them at all. Longer term, certain financial institutions may decide to special in American customers and their special reporting problems.
Note
1. Joel Kotkin, “The Expanding Wealth of Washington,” Forbes. (March 19, 2012). http://www.forbes.com/sites/joelkotkin/2012/03/19/the-expanding-wealth-of-washington/print/