GMO

White PaPer
July 2010

Is Austerity the Road to Ruin?
James Montier

et me share with you one of my guilty secrets: I occasionally indulge in the dark art of macroeconomics. I don’t try to forecast the future (that would be truly pointless), but I do think that understanding the macro backdrop can, on occasion, help inform the investment process. For instance, those who understood the impact of a bursting credit bubble stayed well clear of the value trap opportunities offered in financial stocks during 2008. Those who focused purely on the bottom-up tended to plow in and repent at leisure, as the deteriorating fundamentals generated a permanent loss of capital. So why share this confession now? I think we are seeing a very worrying trend around the world: the rise of the Austerians. This breed is the latest incarnation of what used to be called the deficit hawks, a group set upon reducing what it sees as the government’s profligate spending. The power of the paradox of thrift The Austerians either ignore or dismiss the paradox of thrift. This paradox (which appears first in the Fable of the Bees1) was popularized by John Maynard Keynes in The General Theory of Employment, Interest and Money. He wrote: For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption
1

L

on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment. In essence, the paradox of thrift is a fallacy of composition. Whilst it may be perfectly rational for one household (or section of the economy) to save more, if everyone tries to save more, total income is lowered. If you aren’t spending, then neither are the people who depend upon you for their source of income. Firms won’t invest if there is no demand for their products, and we end up in a nasty downward spiral. An alternative presentation was provided by my good friend, Rob Parenteau, in one of John Mauldin’s “Outside the Box”2 columns earlier this year. Parenteau reminds us that: Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0 This makes it clear that it is impossible for all sectors to net save at the same time. As Parenteau notes, this isn’t a theory, it is an accounting identity. If this is wrong, then so are hundreds of years of double-entry bookkeeping.
2

“As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error.” Bernard Mandeville, The Fable of Bees: or, Private Vices, Publick Benefits, 1714.

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/ archive/2010/03/09/the-european-union-trap.aspx

He creates a useful map to think about the paradox of thrift (Exhibit 1). The diagram rearranges the equation above such that: Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance The 45-degree line marks the points where the current account balance is equal to the fiscal balance, and thus the private sector balance must be zero. To the left of this line, the current account balance is less than the fiscal balance, and the domestic private sector is deficit spending. To the right, the current account balance is greater than the fiscal balance, and the domestic private sector is running a financial surplus (net saving). As Parenteau points out, “The financial balance map forces us to recognize that changes in one sector's financial balance cannot be viewed in isolation, as is the current fashion. If a nation wishes to run a persistent fiscal surplus and thereby pay down government debt, it needs to run an even larger trade surplus, or else the domestic private sector will be left stuck in a persistent deficit spending mode.” This framework also highlights one of the great ironies of the Austerian’s approach. If a fiscal surplus is pursued, and the domestic private sector is stuck in deficit spending Exhibit 1

mode, then the financial fragility of the economy is likely to increase, raising the probability that more fiscal spending will be needed in the future. The lessons of history In early 2009, Christina Romer, Chair of the Council of Economic Advisers, gave a speech laying out six lessons from the Great Depression.3 Lesson I: Small fiscal expansion has only small effects. Lesson II: Monetary expansion can help to heal an economy even when interest rates are near zero. Lesson III: Beware of cutting back on stimulus too soon. Lesson IV: Financial recovery and real recovery go together. Lesson V: Worldwide expansionary policy shares the burdens and the benefits of recovery. Lesson VI: The Great Depression did eventually end. Of relevance to our current concerns are Lessons III and V. The huge monetary expansion caused by the U.S. leaving
3

The Great Depression is the subject in which Romer made her professional name. Full text at: http://www.econ-pol.unisi.it/fiorito/c.romer_rec09.pdf

Exhibit 1 Domestic Balances Map 3 Sector Financial Private Sector Financial Balance = Current Account Balance – Fiscal Balance
Domestic Private Sector Financial Balance = Current Account Balance - Fiscal Balance

3 Sector Financial Balances Map

Fiscal Surplus DPS Deficit DPS Deficit DPS Surplus

Current Account Deficit

Current Account Surplus

DPS Deficit Domestic Private Sector Financial Balance = 0% DPS Surplus DPS Surplus Fiscal Deficit
Source: Parenteau (2010)

GMO

2

Is Austerity the Road to Ruin? – July 2010

Source: Parenteau (2010)

the Gold Standard seems to have produced remarkable results in terms of real growth: the U.S. economy grew by 11% in 1934, 9% in 1935, and 13% in 1936 in real terms! This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately 2.5% of GDP. Monetary policy was also tightened. As Romer notes, “… the Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937… taking the wrong turn in 1937 effectively added two years to the Depression.” Lesson V is also of marked interest as the Austerians seem to have gained a higher degree of influence in Europe (including the U.K.) than they have currently in the U.S.

share the hallmark of being adjustments occurring in small, open economies with weak currencies at a time of generally healthy global growth. These are about as far removed as one can imagine from the circumstances that the world faces currently. If the examples of history are ignored (as is all too often the case) then policy error is likely to be a serious source of deflationary pressure. This is the last thing a debtladen economy needs, especially a debt-laden economy that is teetering on the brink of deflation anyway. But that doesn’t mean that policy makers won’t try to tighten. Indeed, one of the world’s worst economists and a paragon of orthodox belief, Alan Greenspan, opined in a recent Wall Street Journal OpEd that “an urgency to rein in budget deficits” is “none too soon.” Did you need more evidence that this was a really bad idea!?!

Japan provides us with another example of the unerring ability of policy makers to snatch recession from the jaws of recovery. Time and time again in the post bubble Exhibit 3 period, the Japanese policy makers have beaten an Exhibit 3 incipient recovery over the head with overly aggressive G7 Inflation (YoY, %) – No margin for error tightening measures. Most relevant for the Austerians 14 was the experience in 1997, when the authorities raised the consumption tax by 2% and plunged the economy 12 10 back into a recession. Exhibit 2 Japan: Exhibit 2 A prima facie case against premature tightening (YoY, %)
8 6 4 2 0 -2 -4 -6 -8 -10 Q1- 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Consumption tax increase

8 6 4 2 0 -2 Jan-1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: Datastream

Source: Datastream

One can understand the pressure being placed upon policy makers. They are caught between a rock and a hard place. On one side, the Austerians and the (albeit invisible) bond vigilantes argue that unless governments act, there will be sovereign debt crises left, right, and center. On the other side, the Keynesians (like me) argue that tightening will lead to a relapse into recession. In an effort to find some common ground between the warring factions, Olivier Blanchard and Carlo Cottarelli5 have suggested the following Ten Commandments for fiscal adjustment in developed economies:

In fact, Alesina and Ardagna4 examined 107 fiscal retrenchments in the OECD countries between 1970 and 2007. A mere 26 of them occur with growth, whilst the others are all deflationary. The minority essentially
4

Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spending,” 2009; forthcoming in Tax Policy and the Economy, available at: http://www.economics.harvard.edu/faculty/alesina/recently_published_alesina

5

Blanchard and Cottarelli, “Ten Commandments for Fiscal Adjustment in Advanced Economies,” 2010, http://blog-imfdirect.imf.org/2010/06/24/ ten-commandments-for-fiscal-adjustment-in-advanced-economies/

Is Austerity the Road to Ruin? – July 2010

3

GMO

Commandment I: You shall have a credible mediumterm fiscal plan with a visible anchor (in terms of either an average pace of adjustment, or of a fiscal target to be achieved within four to five years). Commandment II: You shall not front-load your fiscal adjustment, unless financing needs require it. Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its stabilization at post-crisis levels. Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong potential growth. Commandment V: You shall pass early pension and health care reforms as current trends are unsustainable. Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be equitable. Commandment VII: You shall implement wide reforms to boost potential growth. Commandment VIII: You shall strengthen your fiscal institutions. Commandment IX: You shall properly coordinate monetary and fiscal policy. Commandment X: You shall coordinate your policies with other countries.
Many of these suggestions seem sensible to me. However, ultimately and thankfully, policy making is beyond my pay grade. I just have to work out what all of this means for portfolios (more on this later, I promise). Deflation, the route to inflation If the Austerians and their ilk win the day, we may see some short-term deflationary pressures and, as noted above, they will be even more dangerous than they were previously because we are starting with no margin of safety in terms of the inflation rate. However, the U.S. at least has a central banker who seems to understand the risk. Despite his complicity in getting us into this mess in the first place, Ben Bernanke has shown he understands the risks that deflation poses, especially in a debt-laden economy, and believes that he has sufficient tools to prevent deflation from gaining traction in the economy (even with rates at zero). Indeed, he has given speeches where he has laid out a menu of policy options in the event of deflation risk.

First on the menu was aggressive currency depreciation; second was the introduction of an inflation target; third was money-financed transfers (effectively, tax cuts financed by printing money); and, finally, quantitative and qualitative easing. Ergo, the “good news” arising from an Austerian victory would be the rapid arrival of QE II.6 Thus any short-term deflation will ultimately lead to long-term inflation pressures. The portfolio implications – the quest for robustness A flight path that contains short-term deflation and long-term inflation suggests the need for portfolios that are robust. Indeed, robustness is a much neglected trait in portfolio construction. In the past, I have often talked about the need to consider cheap insurance in circumstances where we simply don’t know the outcome of events. One of the better definitions of risk that I’ve come across is that more things can happen than will happen. The distribution of possible future outcomes is wider than the ex post singularity of history. Thus, one can seek to construct portfolios that are protected under a number of different possible scenarios. In accordance with our 7-year forecasts, we generally think that bonds are a lousy investment – although possibly not as a speculation. Ben Graham said, “An investment operation is one which, upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”7 Judged from a long-term perspective in which inflation must be a concern, bonds look exceptionally unattractive. However, if deflationary pressure builds as a result of the Austerians, then bonds could well be a good speculation. How does a long-term value manager like GMO deal with this conundrum? Generally, we simply can’t bring ourselves to own bonds at the yields on offer in most markets today. However, that doesn’t mean we are ignoring the short-term risks. So whilst we are generally inclined to be short nominal duration across portfolios (as suggested by the 7-year forecasts), we have been adding nominal duration. How can one add nominal duration when bonds are overpriced? Doesn’t this imply that we are betraying our value investing credentials?
6 7

Quantitative Easing II. Graham and Dodd, Security Analysis, McGraw-Hill, 1934.

GMO

4

Is Austerity the Road to Ruin? – July 2010

Thankfully, no. There are a couple of bond markets that are still essentially at fair value (based on our measures): Australia and New Zealand both offer government bonds that look to be fairly priced. Are we happy about buying fair-priced bonds? Of course not. We are happy only when we buy cheap assets. However, these fair-priced bonds provide us with some useful insurance, without

which our portfolios would be exposed to intensifying short-term deflation pressure. If deflation does arise, most likely we will be on the look-out for longer-term insurance against inflation. Ultimately, I suspect that is where we will end up. (And remember, the time to purchase insurance is when no else wants it as it’s likely to be cheap.)

Exhibit 4 Exhibit 4a GMO 7-Year Asset Class Return Forecasts
As of June 30, 2010
Stocks
12%
Annual Real Return Over 7 Years 10.3% 9.1%
1.8% 3.7%

-Expected Value Added

-Real Return (Asset Class Index)

Bonds

Other

10% 8% 6% 4% 2% 0% -2%
4.7%
1.8%

7.2%
2.3%

6.5 % Long-term Historical U.S. Equity Return
5.1%

7.5%
1.5%

5.2%
2.3% 6.6%

2.9%
1.8% 1.1%

7.3% 4.9%

2.9%

6.0%

2.9%

2.9%

1.0%
0.9%3 0.1%

0.9% -0.8%

0.1%

1.4%
2.2% 0.9%3 0.5%

1.0%
1.4%2 -0.4%

U.S. U.S. equities equities (large cap) (small cap)

U.S. High Int'l. equities Int'l. equities Equities Quality (large cap) (small cap) (emerging)

U.S. Bonds Int'l. Bonds Bonds (gov't.) (gov't.) (emerging)

Bonds (inflation indexed)

U.S. treasury (30 days to 2 yrs.)

Managed Timber

±6.5

±7.0

±6.0

±6.5

±7.0

±10.5

±4.0

±4.0

±8.5

±1.5

±1.5

±5.5

Estimated Range of 7-Year Annualized Returns
Note: These charts represents real return forecasts1 for several asset classes and an estimate of net value expected to be added from active management. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above.
1

2 3

Real returns — long-term inflation assumption: 2.5% per year. Alpha transported from management of global equities. Alpha transported from management of global bonds.

Mr. Montier is a member of GMO’s asset allocation team. He is the author of several books including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioural Investing.
Disclaimer: The views expressed herein are those of James Montier and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Copyright © 2010 by GMO LLC. All rights reserved.

Is Austerity the Road to Ruin? – July 2010

5

GMO