This week I had the privilege of being on the same panel with
former Comptroller General David Walker and former Majority Leader
(and presidential candidate) Richard Gephardt. A Democrat to the
left of me and a self-declared nonpartisan to the right, stuck in
the middle and not knowing where the unrehearsed conversation would
take us. As it turned out, to a very interesting conclusion, which
is the topic of this week's letter. By way of introduction to those
not familiar with them, David M. Walker (born 1951) served as
United States Comptroller General from 1998 to 2008, and is now the
Founder and CEO of the Comeback America Initiative. Gephardt served
in Congress for 28 years, was House Majority Leader from 1989 to
1995 and Minority Leader from 1995 to 2003, running for president
in 1988 and 2004.
The Recent GDP Numbers - A Real Statistical Recovery
Now, before we get into our panel discussion (and the meeting
afterward), let me comment on the recent GDP number. This is what
Moody's Analytics told us:
"Real GDP grew 3.2% at an annualized pace in the fourth
quarter of 2010. This was below the consensus estimate for
3.6% growth and was an improvement from the 2.6% pace in the
third quarter. Private inventories were an enormous drag on
growth, subtracting 3.7 percentage points; this bodes very
well for the near-term outlook and means that current demand
is very strong. Consumer spending, investment and trade were
all positives for growth in the fourth quarter; government
was a slight negative. The economy will see very strong
growth in 2011 as the tax and spending deal passed in
December stimulates demand and the labor market picks up,
creating a self-sustaining expansion."
This 3.2% followed a 1.7% in the second quarter and a 2.6% in
the third quarter. The trend is your friend.
Well, maybe not so much. That inventory number seemed odd to me,
and looking into it with Lacy Hunt, it turns out there is more than
the headline number. For some of you, this is going to be a little
like "inside baseball;" but the way they calculate the GDP number
can have some odd effects every now and then. And this quarter the
effect was way more than normal. This is going to be somewhat
counterintuitive, but hang in there with me as I try to make it
You remember our old friendly equation:
GDP = C + I + G + (Net Exports) or
Gross Domestic Product is the combination of domestic
Consumption (both consumer and business) plus Investments plus
Government Expenditure plus Net Exports (exports minus imports).
This latter category has been negative for quite some time, as
imports, especially oil, have been larger than exports.
Now to get Real GDP (actual GDP after inflation) you have to
take away the effects of inflation / deflation. This is done by the
use of a deflator built in for each category. But the deflator for
exports / imports is a little tricky at times.
Moody's correctly noted that "private inventories were an
enormous drag on growth" and concluded that this was a good thing,
in that they assumed that meant inventories went down and thus
inventory rebuilding in future quarters will add to GDP growth. And
that is where you have to look at the numbers, and there we find
our anomaly. There really wasn't that big a drop in inventories. It
was in large part in the statistics, not in the warehouse.
Oil in the 4
quarter rose from roughly $81 to $89, or about 10%. On an
annualized basis, this is 40%. Inventory investment is equal to the
change in book value of the inventories, minus what is known as the
IVA, or inventory valuation adjustment, which is used to correct
for prices going up or down. Because the value of oil rose and thus
cost more to acquire, the accounting requires that you reduce the
value of the current inventories. Thus "real" imports fell at a 13%
annual rate. Why? Because the deflator rose by 19%, largely because
of the rise in the price of oil.
I know, I know, I just wrote that because the price of oil went
up, the "real" value of imports went down, as well as inventories.
Some of you are getting economic whiplash right about now.
If oil were to go back down this quarter by the same amount,
that "growth" could be wiped out. There is no conspiracy here. It
is just a statistical necessity, like hedonic measurements, and it
is all very clear in the fine print; but when there are wide swings
in oil prices over a quarter, and because our imports of oil are so
large, you can get these odd accounting factoids. Which the
gunslingers on TV (and elsewhere) miss in their urge to be the
first to get out a bullish statement!
How much did it change things? Lacy thinks by anywhere from 0.5%
to 1%. That means GDP is still a positive number, but there is not
a "3" handle at the beginning of it. In the grand scheme of things,
no big deal, as it will balance out over the coming quarters and
years. But I just wanted to point out (once again) that you have to
take some of the numbers we get from our government with a few
grains of salt. That's the key takeaway here. And they CERTAINLY
should not be traded upon. (Anybody who trades on the employment
numbers deserves what they get, which is usually a loss.)
Consumer Spending Rose? Where Was the Income?
The really surprising number you saw the talking heads on TV
mention was the growth of consumer spending, at 4.4%. Is the US
consumer back? After all, real final sales rose by 7.1%, a number
not seen since 1984 and Ronald Reagan. But real income rose a
paltry 1.7%. Where did the money that was spent come from? Savings
dropped a rather large 0.5% for the quarter. That was part of it.
And I can't find the link, but there was an unusual drawdown of
money market and investment accounts last quarter, somewhere around
1.5%, if I remember correctly. (David Walker remembered that
article as well.) That would just about cover it. But that is not a
good thing and is certainly not sustainable.
Let's see what good friend David Rosenberg has to say about
"Even with the Q4 bounce, real final sales have managed to
eke out a barely more than 2% annual gain since the recession
ended, whereas what is normal at this stage of the cycle is a
trend much closer to 4%. Welcome to the new normal.
"There is no doubt that there will be rejoicing in
Mudville because real GDP did manage to finally hit a new
all-time high in Q4. The recession losses in output have been
reversed (though what that means for the 7 million jobs that
have to be recouped is another matter). But, before you
uncork the champagne, just consider what it has taken just to
get the economy back to where it was three years ago:
· The funds rate moved down from 4.5% to zero.
· The Fed's balance sheet expanded by more than 1.5
· The printing of M2 money supply of around 1 trillion
dollars (the illusion of prosperity).
· Expansion of federal government debt of 4.8 trillion
"All this heavy lifting just to take the economy back to
where it was in the fourth quarter of 2007. As they rejoice
in Mudville, the memory is conjured up of Billy Joel
bellowing out those famous words 'Is that all you get for
"With that being said, the bulls have the upper hand as
they have since late August. At this point, the best advice
we can give is to remind everyone that we entered 2010 with a
5% real GDP print in our hands. Back then, the most dangerous
thing anyone could have done was extrapolate that performance
through the winter, spring and summer months, when air
pockets in the economic data surfaced, as Fed and federal
government stimulus faded, and the equity market rode a wild
roller coaster ride until Ben reclaimed his helicopter
A Bubble in Complacency
Thursday put me in an introspective mood. It was the annual
Tiger 21 conference, and the room held about 150 or so
very-high-net-worth participants. The lunch session was Greta van
Sustern interviewing Newt Gingrich. And yes, from what I heard he
is going to run. I am glad about that, because he will raise the
intellectual heft of the debate. I am nothing if not a political
realist, having been involved in a lot of campaigns. I know the
issues surrounding Newt. But far more important is that we have an
honest national conversation that is a few notches above what we
got in 2008. We so need more than sound bites and posturing. We
need actual plans. There are several people I hope will run on the
GOP side, as I think they bring something to the discussion. I will
interject a few comments from Newt below.
As noted above, I did not have any real idea where we were going
with the panel. Clearly, Leader Gephardt was a pro-union,
card-carrying Democrat, but he was very obviously concerned about
the direction of the country and is very up on the issues. You
don't run for president twice without having some personal "mojo."
David Walker has been running around the country for three years
telling people that we are on an unsustainable path. I have a book
coming out in a month talking about the next and coming crisis
(some of which has been the subject matter of this letter).
There was surprising agreement among us (surprising to me, at
least). The gist of it is this (and if you have been paying
attention this is no surprise):
We (the US) are on an unsustainable path. As Walker noted,
cutting the budget (spending) by a few hundred billion dollars does
not get us to sustainability. Going back to the 2007 budget level
would be helpful but not sufficient.
Did you see the CBO (the more or less independent Congressional
Budget Office) estimates of the deficit that came out this week?
The CBO said the fiscal 2011 deficit will hit $1.48 trillion, up
from last August's $1.07 trillion estimate. Other estimates, not
forced to use unrealistic assumptions, are much higher.
And the real world? It is a whole lot uglier. From my friend
Bill King at
The King Report:
"The following tables from the US Treasury for January 21,
2011 (Friday) and January 22, 2010 (Saturday) show the public
debt of the US Treasury has increased from $17.422 trillion
to $20.713 trillion, a surge of almost $3.3 trillion in one
year. So, the official budget deficit doesn't tell the real
US debt story. Please note that the current US 'Public Debt
Issues' is 44.75% higher than the $14.3 trillion debt limit
because it includes bailouts, Fannie Mae, Freddie Mac,
student loans and other off-balance sheet funding.
The simple answer is that no possible resolution of the fiscal
deficit that gets us to sustainability (which logic defines as
below-nominal GDP, although surpluses would be nice) can be done
without real cuts to Medicare entitlements or increased taxes or
Yes, there is a lot of waste in the medical system. Gingrich
pointed out that American Express (
) has about 0.3% fraud and Medicare had 13%. That is a hundred
billion or so. American Express runs a real-time system and
Medicare is still on paper. He listed other things that can be
done. But back to our plot line of controlling the fiscal
We located the problem. There is about 30% of the electorate
that is mad at Obama and the Democrats for not getting a
single-payer, full health-care program. They want nothing less than
Then there is the 30% or so that are mad about increased taxes,
runaway spending, and budget deficits. They will likely punish any
Republican who even utters the word "increase" in the same sentence
with taxes, unless they are talking about those bad tax-and-spend
Right now, neither side seems willing to compromise. Obama has
punted on coming up with any real solutions. Offering to freeze
spending at today's level is a joke. It is like one of my kids
getting my credit card, spending a ridiculous amount of money, and
then saying, "Ok, Dad, if you'll give me the card again I promise I
won't spend more than that!"
But the GOP is saying they want to cut spending around the edges
of the budget without dealing with the real elephants in the room,
Social Security and Medicare. They have some plans that get us
closer, but none that David or I could see that gets us there.
What happens if someone talks about real adjustments to the
entitlement programs, or tax increases? Look at what happened to
the Deficit Commission and their reports. They were dead on
arrival. I thought they had some interesting ideas.
It is hard to get to a real compromise with that level of
conversation. But what the three of us on the panel did agree on is
that if a compromise is not reached, the end result looks like
My points were that much of Europe is getting ready to give us a
real crisis, sooner rather than later. Great Britain is headed for
what looks like a recession and further problems. Japan, as I am
wont to say, is a bug in search of a windshield. We are going to
get some great real-time lessons on what happens when you don't
deal with a problem in time. The longer you wait, the worse the
results will be when you are forced to deal with the issues.
The lack of compromise is going to run head on into a bond
market that will force one, or raise rates until there is truly a
crisis of biblical proportions. If you think high rates were bad in
the '70s (and they were, trust me!), think what they would be like
in a deflationary environment.
For that is what would happen. We would fall into a severe
recession, and recessions are by definition deflationary. And
depending on how late we are in getting our act together, it could
be worse than a recession. We could drag the whole world down.
Leader Gephardt spoke to the fact that it will take politicians
essentially violating what they feel are their core views, for the
good (and survival) of the nation. He thinks that there are enough
leaders who get it now that a compromise is possible, although he
noted that Obama is going to have to back off on some of his main
issues. Newt said flat out that he did not think a compromise was
possible, as he did not think Obama would reverse. Let's call
Walker a skeptical optimist. I think it is 2013 before we get the
real changes. I just see a bubble in complacency. The market is
going up, so all must be right with the world.
If we don't get those real changes, we will need to start
thinking the unthinkable.
Can we last until 2013? Most likely, as we are going to see some
cosmetic changes and that should encourage the bond market. But as
our leaders watch the problems of the rest of the developed world
increase then, depending on what they do, they could cut us a much
shorter leash. We are approaching the Endgame. I worry that we
could go much beyond that point without serious volatility and
And that is why the GOP primary is so important. There is not
going to be much of a debate, if any, in the Democratic primary.
Obama will coast to the nomination. All the real debate will be on
the Republican side. And that is why we need "idea leaders" to step
forward. Philosophy is all well and good, but we are getting ready
to encounter a potentially very difficult bond market. There is
hope that we can avoid the real hitting of the wall that I think is
going to be Japan's fate, but it will take some real solutions to
problems, not just words. I want to see budgets. What do you cut?
Do you raise taxes? Can we take this opportunity (let no crisis go
to waste!) to actually reform the tax code? Maybe move to more of a
consumption-based tax? Tax less of the things we need and want
(like jobs, exports, and savings!) and more of the things we have
less need of? Just a thought. Can we get a thought leader on the
debate platform to offer a real restructuring? And make a solid
case for it? Actually get the American people to focus on the
crisis that is coming if we don't act? (Not to mention those pesky
wars, energy policy, the environment, etc. etc.)
Is there a compromise out there? Should there be one? That is
the conversation we will have to have.
This national conversation will be the most important in my
lifetime (I don't say that lightly). Not just because of whom we
elect, but because the bond market vigilantes will be paying
attention to what we are saying. If they see the same old rhetoric,
we will be in for a very bumpy ride.
John Mauldin is president of Millennium Wave Advisors, LLC, a
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Sentiment Update: Slight Decline, But Still