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Back to the Future Recession
1 4/24/09
MV=PQFinancial Innovation: The Round Trip2010-11: Back to the Future RecessionThe Fed at the CrossroadsHow Did We Get It So Wrong?The Trend Is Not Your Friend When It EndsOrlando, Naples, Cleveland, and GrandkidsBy John Mauldin
This week we look at the second half of my speech from a few weeks ago at my annualStrategic Investment Conference in La Jolla. If you have not read the first part, you can review itatwww.frontlinethoughts.com. The first few paragraphs are a repeat from last week, to give ussome context. Please note that this is somewhat edited from the original, and I have added a fewideas. You can also go there to sign up to get this letter sent to you free each week.
MV=PQ
Okay, when you become a central banker, you are taken into a back room and they do aDNA change on you. You are henceforth and forever genetically incapable of allowing deflationon your watch. It becomes the first and foremost thought on your mind: deflation, we can’t haveit.MV=PQ. This is an important equation, right up there with E=MC
. M (money or thesupply of money) times V (velocity – which is how fast the money goes through the system – if you have seven kids it goes faster than if you have one) is equal to P (the price of money in termsof inflation or deflation) times Q (roughly standing for the Quantity of production, or GDP)So what happens is, if we increase the supply of money and velocity stays the same, andif GDP does not grow, that means we’ll have inflation, because this equation always balances.But if you reduce velocity (which is happening today) and if you don’t increase the supply of money, you are going to see deflation. We are watching, for reasons we’ll get into in a minute,the velocity of money slow. People are getting nervous, they are not borrowing as much, eitherbecause they can’t or the animal spirits that Keynes talked about are not quite there.To fight this deflation (which we saw in this week’s Producer and Consumer PriceIndexes) the Fed is going to print money. A few thoughts on that. The Fed has announced theyintend to print $300 billion (quantitative easing, they call it). That is different than buyingmortgages and securitized credit card debt – that money (credit) already exists.When they just print the money and buy Treasuries, as with the $300 billion announced,they can sop that up pretty easily if they find themselves facing inflation down the road. But thatproblem is a long way off.Sports fans, $300 billion is just a down payment on the “quantitative easing” they willeventually need to do. They can’t announce what they are really going to do or the market would
 
Back to the Future Recession
2 4/24/09throw up. But we are going to get quarterly or semi-annual announcements, saying, we are goingto do another $300 billion here, another $500 billion there. Pretty soon it will be a really largetotal number.When we first started out with TALF and everything, it was a couple hundred billion, andnow we just throw the word
trillions
around and it just drips off of our tongues and we don’teven think about it. A trillion is a lot. It’s a big number. And the total guarantees and backupsand all this stuff we are into – I saw an estimate of $10-12 trillion. That’s a lot of money.Understand, the Fed is going to keep pumping money until we get inflation. You cancount on it. I don’t know what that number is; I’m guessing maybe as much as $2 trillion. I’veseen various studies. Ray Dalio of Bridgewater thinks it’s about $1.5 trillion. It’s some very bignumber way beyond $300 billion, and they are going to keep at it until we get inflation.Side point: what happens if the $300 billion they put in the system comes back to theFed’s books because banks don’t put it into the Libor market because they are worried aboutcredit risks? It does absolutely nothing for the money supply. Okay? It’s like, goes here, goesback there – it doesn’t help us. The Fed has somehow got to get it into the financial system.They’ve got to figure out how to create some movement.Will it create an asset bubble in stocks again? I don’t know, it could. Dennis [Gartman]talked about being nervous yesterday. I would be nervous about stock markets both on the longside, as I think we are in a bear market rally, but also there is real risk in being short. BillFleckenstein will be here tonight. He is a very famous short trader. He closed a short fund acouple of months ago. He says he doesn’t have as many good opportunities, and basically he’sscared of being short with so much stimulus coming in. So it’s going to work, at least in terms of reflation, but the question is, when? A year? Two years?
Financial Innovation: The Round Trip
Financial innovation is one of the drivers of the velocity of money. We started inapproximately 1991 creating the first securitizations and CDOs. It was done at Merrill Lynch, if Iremember right. But they started getting copied, and then we went into warp speed, creating allkinds of new CDOs and SIVs that invested in loans, securitized mortgage debt – most of whichwas rated AAA – banks loans, credit card debt, etc. Without thinking about it, we created ashadow banking system that funded a huge chunk of our total credit markets. It was outside thebailiwick of the normal regulatory authorities.Then in 2007 we began to destroy the shadow banking system. If it was working so well,why did we do that? Because they mismatched their liabilities and assets. They were borrowingshort-term and lending long-term, and doing it highly leveraged. They were buying up long-termassets at 4-5-6%, some (or most) of them rated AAA. Then they were selling commercial paperat 1% or 2% – so you get a 2-3% profit spread.A 2-3% spread doesn’t really make you anything, you’re not really excited about that; sosince we’re dealing with AAA investments that everyone believes to be absolutely safe, let’s
 
Back to the Future Recession
3 4/24/09leverage it up 6-7-8 times. Now you’re talking a 20% return. Now you’re talking about makingmoney, real money. And I should note that we were also talking real commissions and monsterbonuses.I think one other side note needs to be made here. In hindsight, we can now look back and wonder what the investment banks were thinking. They “must” have known they werepushing bad paper into the system.But their behavior tells us they didn’t know. If they really believed they were, therewould not have been so much of the toxic debt left on their books. Bear Stearns launched verylarge funds to buy this debt at obscene leverages and sold it to their best customers. At leastsome people in management thought there was real value in these securities, which just goes toshow how lax or ignored the risk managers were in all parts of the financial industry.Then it all began to implode, because people started paying attention to some of theassets on the balance sheets of the various SIVs and CDOs and suspected they might not beworth what they had originally thought. You have subprime mortgages in your SpecialInvestment Vehicle? Hey, I’m not going to buy your commercial paper. Suddenly, thecommercial paper market simply imploded. This was the start of the banking crisis.So we started taking the innovation of securitizations off the table. The innovation thathad driven the velocity to new highs was now slowly being pulled off. So, velocity slows down,and it’s continuing to slow down with each passing month.Let’s survey the economic landscape. We have an unstable economy. Housing doesn’tbottom until 2011 or 2012, unless, as I wrote the other day, we give immigrants a green card tocome here. We need the immigrants anyway. We need smart immigrants. By the way, I’ve neverhad as much response to my letter, both positive and negative. It ran about 60/40 for. Many of the “against” were people outside of the US, saying why are you trying to take our best, we needthem. I suppose there is a certain logic to that, but if we could pull a million homes off themarket, it would solve a big part of the US credit crisis right now, not to mention, we would havepeople putting money into our system and it wouldn’t cost taxpayers anything.But back to the current scene. Consumer spending is slowing, and it’s going to slow foryears as savings increase. At one time we were savings 7-8-10% of our incomes, back in theearly ’80s. We grew from 63% of the economy being consumer spending, to 71% in 2006. Weare going back to the mid –to low 60s in terms of the percentage of consumer spending in GDP.We are not doing it all at once, it’s going to take years; but, gentle reader, it’s the blue screen of death! We are hitting the reset button.Economists have a term for this process. It’s called rationalization. We have too manystores to sell “stuff,” all sorts of stuff. Too many malls. We have too many factories to build toomany cars, too many plants to build too many widgets for an economy where 65% of GDP isconsumer spending. When we built all that capacity it was for an economy in which consumerspending was 71%; and because we were enthusiastic and believed we would grow at 3%forever, we probably built it for 73% or 74%.
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