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Author: howardroark Big red star, 1000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 20224  
Subject: Re: depressing Date: 6/5/2010 8:30 PM
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hr, I'll ask. What did you think of Klarman's concerns listed below? And obviously Einhorn's complimentary piece in the NYT Op-Ed? More important, what do think investors should do? I think one of my greatest strengths as an investor has been to ignore macro events (well, except for 2009, but i had auction note issues) but the drumbeat of this stuff seems to get every louder. thoughts?

Okay, just promise not to take me seriously. I once predicted Sam Militello would make the Hall of Fame. These conversations have a habit of turning unproductive, but what the hell. It's a little easier to talk about Einhorn's article because Klarman's concerns are either similar or not specific enough to discuss.

I agree with Einhorn that US Government finances are an important concern. I would focus less on the current cash-accounting deficit and more on the fiscal gap, or the present value of expected future tax receipts less the present cost of expected future spending. Looked at like this, the recent growth of the budget deficit, while meaningful, is still small relative to entitlement promises, and so it isn’t particularly big news on that front (though neither is it irrelevant). In both cases, the fiscal gap is mostly determined by projections about taxation, productivity, and spending. Despite these multiple levers, spending expectations in particular, which includes both future entitlements and the recent stimulus-infused increases in outlays, will almost certainly have to be reduced given reasonable estimates of the fiscal gap and productivity. A reasonable range of outlooks based on in-place taxing and spending policies seem to point toward a shortfall. And I further agree with Einhorn that there are reasons to worry that the Government might procrastinate when faced with implementing this sort of unseemly austerity, but also that procrastination straight through a highly disruptive consequence is not inevitable. I don’t think it would take a miracle to see a combination of spending plan reductions, productivity and effective taxation changes that would reverse the apparent NPV shortfall before any dire consequences arrive. Nor does it seem like a layup. Then again, my intuition on public choice stuff often seems to suck.

I also agree with Einhorn’s second point that it is almost impossible to know when a fiscal gap might come to roost, given that capital markets have the ability to accelerate the consequences by simply fearing that the fiscal gap exists. If we passed a Constitutional Amendment tomorrow pledging to build a replica of Mount Rushmore on Mars depicting the entire 1983 New York Arrows team between 2030-2035 at a cost of $25 trillion, the bond market wouldn’t wait until it showed up in the budget to panic. When might the capital markets believe that the US Government has an NPV shortfall? Who knows. The recent deficits and downturn don’t help, nor would any impression that its contingent liabilities have recently increased (e.g. that it is more likely today to bail out Citigroup or XYZ municipality if it failed than it was X years ago). But the entitlements still seem to dominate. As investors, we’ve seen plenty of examples where markets go from credulous to skeptical. One day, bond holders might think cable companies with years of capex spending plans and negative FCF have enough expected present value to cover current debt; the next they might wake up cranky and change their mind because their neighbor got Direct TV. We do live in a world where expectations matter. It is a very difficult question to ask whether there actually is a fiscal gap (because the "is" depends on a lot of "ifs," i.e. will spending be reduced, can the tax base be effectively increased, will productivity growth mitigate the gap), and an even more difficult question to ask if the markets will act as if there is one.

I don’t much agree with Einhorn’s warning that the current rating agency structure is an important threat to accelerate these capital market whims via a conventional downgrade death spiral. If we get to the point where the ratings agencies are going to downgrading the USG such that people expect imminent RBC requirements for holding Treasuries, I suspect it will be sometime after the market cascade has already occurred, like about halfway through one of those “Life after People” specials on the Discovery Channel. One sure way to lose your precious issuer-pays model is to downgrade Uncle Sam to single A. I can’t help but wonder if Einhorn threw this warning in because he has recently been focused on his antipathy for the current credit ratings duopoly as opposed to really seeing it as a likely outcome; an antipathy I can definitely understand, incidentally. Someone more cynical might say he is talking his book, but because I mostly agree with him on the underlying issue I’ll just say he has the scattershot fervor of a true believer here.

I also agree with Einhorn that attempted government solution to this potential fiscal shortfall (or its anticipation) might result in inflation. It wouldn’t exactly be historically unprecedented for a fiat issuer to find that creating money is a less politically painful way to address a fiscal shortfall than spending cuts and tax increases. More to the point, a market discounting material default risk would likely also be discounting coincident inflation, with possible self-fulfilling, immediate consequences unless effectively countered by the Government and the Fed.

Overall, I think these risks are legitimate and have been for some time, but are only moderately increased (in the US) by the recent deficit increase. Then again, we have seen as investors that it’s not uncommon for negative surprises in the present day to have an outsized impact on market perception, even if it reflects a fairly moderate portion of the overall value picture. People weren’t talking much about Greece last July (and the marketing wasn’t discounting a ton of risk in their bonds), but they already had an uncompetitive wage structure, an inability to devalue, and an apparent long term fiscal shortfall.

On the other hand, I disagree with almost all of his comments about the Fed. I don’t think there is any evidence that the recent round of “money printing” has given Bernanke leave from Quantity Theory. I think Bernanke is pretty well aware that the sharp decline in AD has invoked terrifically unusual circumstances, such as the ability to blow up the monetary base like a balloon without inducing inflation. It seems almost silly to claim he doesn’t recognize the times as unusual and will now assume that he can apply as loose a monetary policy as he likes in more typical times.

In fact, I think Einhorn is totally wrong that we even have easy money, as correctly defined, let alone that misleading inflation statistics are hiding the effects of the actual inflation this easy money is supposedly causing. Yes, 0% overnight rates and a $2 trillion monetary base with a whiff of quantitative easing thrown in seems like absurdly easy money, but these are all crappy indicators of whether money is easy or tight. It’s like counting the number of free vaccinations given out by the government as a measure of whether its current healthcare policy is socially expansive or stingy. Does it matter whether there’s an epidemic broken out at the time? If anything, Bernanke has been less “easy” than expected (mostly because he has avoided setting an inflation or price level target), given that he was maybe the world’s foremost proponent of the importance of avoiding AD declines and of the near omnipotence of the central bank (like Japan) to avoid liquidity traps. I don’t think the Fed or Bernanke in particular has shown even a whiff of indifference to the risks of inflation despite the strange superficial monetary markers of our current world, and nothing Einhorn wrote about that issue made much sense to me. In fact, to the extent that a fiscal shortfall presents inherent inflation risks, I don’t think any of those risks has much likelihood of being exacerbated by the current FOMC or Bernanke. I don’t see it as particularly likely that the Fed will precipitate inflation by engaging in unduly easy monetary policy with some kind of general eye to heading off these fiscal concerns before they arise.

On the other hand, all the earlier concerns Einhorn cites are likewise not fixable by the Fed (without inducing inflation). It's possible that constituents of the Fed change to render it a more independent, near term risk, but probably not anytime soon. The real inflation risks created by the market starting to believe the US Government is in a position of fiscal shortfall is completely independent of recent central bank actions. The ways to "evaluate" those risks are from four very-easy-to-handicap levers: What does public choice theory and our infinite understand of human behavior tell us about the likelihood of reducing spending policies and promises before the two minute warning hits? What is the political likelihood and economic consequence from attempting to increase the revenue base through various tax-increasing policies? What will productivity growth look like for the next few decades? And -- the easiest -- what will capital markets think the answers to these three questions will be over the next few years? Once you answer those gimmes, you are qualified to call up Goldman, buy one of those popular swaptions (after a brief rectal exam to assure you are a reliable enough counterparty for them to accept your up front cash payment) and write a letter with a lot of graphs in it.
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