If you’ve ever wondered how we’ve come to see America’s economic, social and moral decline, Angelo Codevilla’s insightful essay, published in the American Spectator a few days ago, illustrates how the pieces fit together. It’s rather lengthy, but well worth the time to read!

A brief summary is below… do make sure to read the full article: America’s Ruling Class – And the Perils of Revolution.

In the past the upper crust was diverse, drawing its wealth and status from various sources (industrialists, financiers, landowners, oilmen, etc).

“Few had much contact with government, and “bureaucrat” was a dirty word for all. So was “social engineering.” Nor had the schools and universities that formed yesterday’s upper crust imposed a single orthodoxy about the origins of man, about American history, and about how America should be governed. All that has changed.

Today’s ruling class, from Boston to San Diego, was formed by an educational system that exposed them to the same ideas and gave them remarkably uniform guidance, as well as tastes and habits. These amount to a social canon of judgments about good and evil, complete with secular sacred history, sins (against minorities and the environment), and saints. Using the right words and avoiding the wrong ones when referring to such matters – speaking the “in” language – serves as a badge of identity.”

No matter what their profession or income, today’s ruling elite (progressive Democrats and Republicans alike) climbed up via government channels and public money. As the author explains, professional position, money or academic achievement do not secure a membership in the ruling class – what is essential is an absolute commitment to the progressive doctrines and willingness to fit in.

The ruling class believes in its own intellectual and moral superiority and considers the rest of Americans “retrograde, racist, and dysfunctional unless properly constrained”.  As the more enlightened human beings, the elite see it as their task to improve the lesser mortals, which is where social engineering comes in.

Mr. Codevilla traces the beginnings of the progressive era to Woodrow Wilson, “the first American statesman to argue that the Founders had done badly by depriving the U.S. government of the power to reshape American society.” The progressives, while looking down on the American people, were sympathetic to Soviet Russia as well as, in many cases, to Fascist Italy and Nazi Germany.

And the elite have demonstrated contempt for ordinary Americans ever since (see Obama’s remark of ‘clinging to God and guns’ as typical of their inferiority), and have ruled based on the presumption that they, the enlightened ones, know best what the people need.

“Americans think it justice to spend the money they earn to satisfy their private desires even though the ruling class knows that justice lies in improving the community and the planet.”

And so the political elite, via taxation and intrusive regulations, strive to ‘improve’ the American people, and redirect them to tasks more worthy than those they choose for themselves.

Naturally their solution to all matters is a larger and more powerful government, allowing them to reward political support with jobs, contracts, handouts. Hence we see the continuous drive to redistribution, regulation of every aspect of life and business, opaque laws that benefit some and ruin others (in accordance to their political support), patent disregard for the Constitution, and discretionary powers of officeholders.  The ruling class has become the arbiter or wealth and poverty.

“But it surely increases the number of people dependent on the ruling class, and teaches Americans that satisfying that class is a surer way of making a living than producing goods and services that people want to buy.”

Not content with control over people’s economic lives, the elite use further lessons out of the Marxist handbook: indoctrination in schools and colleges, attack on religion and values, destruction of traditional family and marriage. All to fulfill their god-like mandate to ‘improve’ those who are beneath them.

“The ruling class is keener to reform the American people’s family and spiritual lives than their economic and civic ones. In no other areas is the ruling class’s self-definition so definite, its contempt for opposition so patent, its Kulturkampf so open. It believes that the Christian family (and the Orthodox Jewish one too) is rooted in and perpetuates the ignorance commonly called religion, divisive social prejudices, and repressive gender roles, that it is the greatest barrier to human progress because it looks to its very particular interest – often defined as mere coherence against outsiders who most often know better. Thus the family prevents its members from playing their proper roles in social reform. Worst of all, it reproduces itself.”

The war waged against marriage by the government, academia and media has produced the desired results: decline of the traditional family (and its replacement with the state), new ‘progressive’ family models, single motherhood – creating millions of faithful liberal voters largely dependent on government services.

Schools, aside from weapons of social engineering, serve as indoctrination institutes set to undermine the authority of parents and instill children with progressive ideals and statist worldview. (See also link at the bottom of this post.)

“Consensus among the right people is the only standard of truth. Facts and logic matter only insofar as proper authority acknowledges them.”

The ruling class’s main characteristic is its dislike for (the rest of) America, its condescending, patronizing attitude and dismissal of the American people’s moral, spiritual and intellectual values.

“Seldom does a Democratic official or member of the ruling class speak on public affairs without reiterating the litany of his class’s claim to authority, contrasting it with opponents who are either uninformed, stupid, racist, shills for business, violent, fundamentalist, or all of the above.”

Mr. Codevilla then goes on to describe what he, for the lack of a better word, calls the country class. They come from all walks of life, but are united in their core values and their desire to rule themselves rather than be ruled by others.

“The ruling class wears on its sleeve the view that the rest of Americans are racist, greedy, and above all stupid. The country class is ever more convinced that our rulers are corrupt, malevolent, and inept. The rulers want the ruled to shut up and obey. The ruled want self-governance.”

The clash, Mr. Codevilla recognizes, is certain to come. But what might be the outcome of this new revolution? See the full text of this must-read essay here.

———–

And speaking of education being misused for social engineering purposes, here are the details of a shocking recent study.

Links to interesting articles I have read over the past few days that you might also enjoy…

Remember: In 1930, They Didn’t Know It Was “The Great Depression” Yet

China in Africa – Beijing Does Deals, Not Gifts

The Fallacy of a Drilling Moratorium

All You Need to Know About Public Sector Work (A whistleblower’s shocking account)

The Complete History Of European Sovereign Defaults From 1340-1939

Could Super Solar Flares Take Us Back to 5,000 BC?

Here’s Why You Shouldn’t Listen to Equity Analysts

… and here (if you need further evidence)

What’s The Point of Macro?

China’s Death Grip on Rare Earth Metals

Obama – The Caudillo President

The Green Jobs Myth

Welcome to the Insane Asylum or: How We Learned to Stop Worrying and Love the Big Lie

After having suffered the worst May since 1940 (Dow), equities have continued their sell-off into early June, amidst concerns about spreading European debt crisis, Chinese tightening and fading US recovery. The rally off the March 2009 lows was driven by liquidity, stimulus and improving economic and earnings data, particularly in the US. Now that government stimulus starts to taper off the question is whether economic growth has become self sustaining or not.

A natural slowing in the second half of the year has been expected. However, concerns about a double dip recession now appear to be growing, given the sovereign debt crisis and contagion risks in the eurozone and Europe’s impact on the global economy as countries start implementing austerity measures. Add concerns about Chinese tightening to cool an overheating economy and rampant real estate speculation, plus a weakening recovery in the US… the picture is not pretty.

In the US leading economic indicators have started turning over. The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index has gone negative for the first time in over a year, falling to 123.2 from 124 the week before – the lowest level since July 2009. The ECRI WLI has historically been a good predictor of US economic activity, so its downturn is pointing toward a significant slowing in economic growth in the coming months. The Conference Board’s LEI for the US peaked in March.

China has taken steps to cool growth. China’s LEI (leading economic index) peaked last fall, Chinese PMIs are weakening and property market activity has been declining in response to the authorities’ measures to curb speculation. The worry is how much the world’s growth engine will now slow down; so far the economy remains very resilient (exports jumped 48.5% in May). However, the Shanghai Composite index is off nearly 30%, indicating weaker global growth prospects.

May saw the largest slump in commodity prices since Lehman’s collapse, pointing to potentially disappointing global economic growth. The Journal of Commerce Industrial Price Commodity Smoothed Price Index plunged 57% last month, the most since October 2008. Copper price broke down to a new 7-month low, before a bounce this week.

For now the global business cycle expansion appears intact but growth is starting to soften. A mid-cycle slowdown is not so unusual; however, it’s not immediately clear whether we should expect a normal moderation or indeed a double dip recession.

According to the yield curve a recession is not likely. Having correctly called past recessions when it inverted (short rates higher than long rates), the yield curve presently sees the risk of a recession in the next 12 months or so as near zero.

Buy on dips? Maybe not this time …

So, has the recent panic in the financial markets been overdone? The global economy and financial system are still fragile and vulnerable to further shocks, and confidence is fast evaporating. This is no time for complacency – things could get very ugly very fast.

On top of everything else, policy shock (including US financial regulatory reform outcome) is an additional risk investors have to consider. As is often the case, the authorities have been adding to the uncertainty by increasingly erratic moves (chaotic ECB actions, Germany’s ban of naked short selling of some financial stocks and eurozone sovereign bonds and CDS – likely to be further extended, etc). Such actions are counterproductive; they only heighten volatility, increasing the cost of capital and reducing liquidity.

May proved catastrophic for most assets, including equities, commodities (except gold), the euro. The winners have been the US dollar and Treasuries, reflecting a flight to safety as well as a symptom of a deflationary trend. (Money supply is falling at a pace not seen since the early 1930s!)

Markets went into June very oversold, so the relief rally currently underway was expected, and indeed could last a little longer. However it is unlikely to be more than a short term bounce. The S&P has now closed below its 200 day moving average for 16 consecutive sessions – a clear sign of trend change. Although we can’t yet be 100% certain that this is indeed something far more worrisome than a standard correction, there are signs that the trend has turned negative. Until there is more clarity it may be wise not to buy this market – you will likely be able to pick up most assets at much lower valuations late in the year.

It is true that the market has already priced in plenty of bad news – assuming the global recovery remains intact and there is no contagion from Europe; however, that scenario is increasingly looking too optimistic. Considered there is still a great deal of complacency, the bulls could be in for a nasty shock in the coming weeks and months.

Credit crunch is back!

Furthermore, there is good reason to believe this sell-off is different from the previous ones we have seen since March 2009 – the action in the credit markets. We have not witnessed significant deterioration and widening of credit spreads since the start of the rally – until several weeks ago. This is a fundamental change and a sign that the credit crisis is returning.

Credit is the early warning sign; equities lag deterioration in credit conditions. Decline in commodity and equity prices, and ultimately in economic growth, are a result of weakness in the credit markets. It would be foolish to overlook that the current correction has indeed a differentiating characteristics to it; do pay attention to the funding markets.

The European sovereign debt crisis is not going anywhere, and global credit conditions have been worsening. Cost of credit is rising and credit availability declining, which is affecting the funding needs of corporations worldwide. The economic fallout is only just starting to become apparent.

And it’s not only Europe. Higher cost of capital is also noticeable in the US and emerging markets where corporate debt spreads have been rising and debt issuance slowing. Funding markets are seizing up and capital is becoming more expensive, a consequence of which will be a squeeze in profits and slowdown in global growth.

Credit clearly continues to point to further stress ahead. Some disturbing signs that we may be witnessing the beginning of credit crisis 2.0:

Widening eurozone government bond spreads: yield spreads between German bunds and Club Med bonds have resumed their widening trend in recent weeks and in some cases became wider than before Europe’s mega bailout package was announced (although they tightened somewhat this week). And it’s not just the PIGS’s creditworthiness that has been deteriorating; we have seen huge spikes in CDS spreads on Eastern European sovereign debt and even that of France, Austria, UK and Germany over the last month.

European bank CDS have surged, indicating rising stress in the banking system, loss of confidence and growing risk aversion. It means sharply higher borrowing costs for banks. (European banks have raised less from the capital markets in the past six weeks than in any year since 1995.) Some smaller banks have been reported to be completely shut out of the credit markets. Even more troubling is that some of the world’s largest banks in Spain, Germany and France are now becoming infected. The Markit iTraxx Financial Index of CDS on 25 European banks and insurers soared to the highest level since March 2009 (before improving somewhat this week).

The LIBOR-OIS spread has widened significantly in recent weeks (now standing at 32.4bps). Equally, the TED spread has been deteriorating and is now at 47, up more than 300% in the last three months.

LIBOR-OIS and TED reflect the health of (and perceived credit risk in) the interbank lending markets. They are gauges of financial strength or weakness of banks. A rising spread shows that banks are unsure of the creditworthiness of other banks, hence charging higher interest rates to compensate for greater risk. Due to the European debt crisis counterparty risk is increasing and banks are reluctant to lend to each other once again.

Eurozone banks have been parking record sums in the European Central Bank’s deposit facility. Use of the facility, which pays an interest rate of just 0.25%, reached a new high of 364.6 billion euros (higher level than after the Lehman collapse) – a further sign that banks don’t trust each other’s creditworthiness, opting to instead deposit funds with the ECB.

The uncertainty is also rocking the corporate debt markets. May was the worst month for corporate bond sales for over a decade. Issuance of high-yield company debt nearly halted amid new signs that Europe’s sovereign debt crisis may be spreading; investment grade companies are also finding it more difficult to issue bonds. Both High Yield and Investment Grade spreads have soared in recent weeks.

There has also been substantial deterioration in the US Commercial Paper market (short-term IOUs), which contracted to its lowest level since 1999. Debt outstanding dropped, after six straight weeks of decline, to the lowest level on record as companies pared back on tapping short-term funding.

The European contagion impact and lack of liquidity is being felt in the emerging markets as well. New bond issuance of Brazilian companies halted for a sixth straight week, the longest stretch in 14 months, as Europe’s debt crisis drove up borrowing costs and caused a surge in volatility.

This worrying credit contraction is eerily reminiscent of the situation in summer 2007. Investors are fleeing all but the safest government securities. Poor liquidity and vanishing risk tolerance could see consumers contract, businesses stop hiring and investing and economic activity coming to a halt.

The prospects aren’t so good. A recent ECB forecast (Financial Stability Review, May 2010) that eurozone’s financial institutions may have to write off 195 billion euros of bad debts by 2011 – on top of the 238 billion already accounted for – confirmed fears about the fragility of the financial system.

Deflation and double-dip recession?

Meanwhile, the economic picture in Europe is not encouraging.

On the positive side, European core has been surprising with strong economic data; German manufacturing and exports are booming – exports to non-euro area have now surpassed the pre-Lehman bankruptcy peak (a weaker euro will only supercharge this growth), Germany’s PMIs are at a four year high; IFO Expectations Index is at its highest level since mid 2007.

On the other hand, Greece is insolvent and will unlikely avoid debt restructuring/default, which poses a massive risk for the European banking system. (Could Spain and Portugal also turn out to be insolvent in the end?) The hope is that Europe has bought sufficient time to stabilize the rest of the eurozone before a Greek debt restructuring.

The question is whether the European sovereign debt crisis could bring down Europe’s banking system, causing a collapse in confidence and economic activity similar to the fallout of Lehman in September 2008. It’s too early to tell, but a bank run (and a capital strike against eurozone investments) is looking increasingly more plausible.

(Of course European banks are already in a precarious shape, having made much less progress on writedowns and rebuilding of equity than US banks. They will also have to refinance some 800 billion euros in long-term debt by the end of 2012, and bank borrowing has already suffered a major blow because of sovereign risks – see notes above on deterioration in the credit markets.)

It’s not just the ultimate value of their government bond holdings the banks have to worry about. The deficit reduction and austerity programs much of Europe is embarking on are a step in the right direction but will inevitably kill consumption, investment and growth in the short to medium term. A long and painful deflation and severe recession in the periphery would appear unavoidable. (Defaults down the road are still a likely scenario.)

The fiscal retrenchment under way will see incomes in a number of eurozone countries beginning to fall in nominal terms; this will undermine the ability of households and businesses to service their debts, leading to a surge in private sector loan losses at European banks. Credit growth will also further contract as banks – already burdened with the until recently thought safe government bond holdings – will become even more reluctant to lend to riskier private sector borrowers.

Lack of credit will further reduce investment, job creation and economic growth. Slower growth and lower tax receipts will make it even more difficult for the periphery to get their debts under control. And, slower economic growth will create further problems for the banks, causing higher loan losses as highly indebted eurozone households and companies default on their loans. A vicious feedback loop.

A double dip recession in parts of the eurozone should, on itself, not have a disastrous impact on US and Asian economies, although some industries are companies will be more heavily exposed to diminishing European revenues (Europe is China’s largest export market). However, a potential collapse of the European banking system would undoubtedly have catastrophic consequences for the global financial markets, plunging the world back into recession.

And this time policy makers and central bankers would have little ammunition left to support the economy; interest rates are already at or near zero and there is (for now) little appetite for several more trillions worth of stimuli. That might change, of course, after a severe deflationary period, financial collapse, recession/depression; the Fed, ECB and other central banks and governments would then undoubtedly embark on quantitative easing and stimuli on a never before seen scale.

Deflation followed by hyperinflation, anyone?

Links to interesting articles I have read over the past few days that you might also enjoy…

Fiscal Crises and Imperial Collapse (Niall Ferguson) – video presentation

Barney Frank Proven to Be a Liar and a Fraud!

Using Behavioral Finance to Better Understand the Psychology of Investors

Scientists Create Artificial Life: World First as Craig Venter Makes Designer Microbe from Scratch!

Fantastic Presentation on Human Cognitive Biases

Federal Debt As A Percent Of GDP – By President

Beware the Muni-Bond Bubble

The US Government Is About To Get Hit With ‘The Perfect Storm’ Of Debt

The Road to Serfdom (F. Hayek) – free download & a must read!

After months of optimism and growing complacency last week brought a sudden reversal of market sentiment. Optimism was replaced by worry and fear. Confidence was erased, despite a 110 billion euro EU/IMF bailout package for Greece and good US economic data; fear of a sovereign debt meltdown in Europe contributed to Tuesday’s and Wednesday’s sell-off, culminating in Thursday’s bloodbath. The Dow plunged nearly 1,000 points – the largest intraday decline on record – only to recover much of the loss minutes later. Even so, equities suffered their worst session since February 2009, with all major US indices ending the day down by more than 3%.

Escalating concerns of spreading European sovereign debt crisis, aided by images of murderous riots in Greece (casting further doubt of Greece’s ability to implement proposed austerity measures), provided the catalyst for the panic sell-off. Although some believe a trading error or technical glitch may have helped on the downside, the fact is the market was already very weak before the mid-afternoon plunge. The sell-off was, it appears, driven by good old fear.

More selling on Friday – despite better than expected US nonfarm payrolls report – reinforced the growing sense of panic. Both the Dow and the S&P 500 posted the largest weekly losses since March 2009 (DJIA fell by 5.7%, S&P was down 6.4% and the Nasdaq 8%), erasing all gains for the year. As fear spiked, so did the VIX (Chicago Board Options Exchange Volatility Index); it jumped by 86% – the largest weekly increase ever in its 20 year history. In a flight from risky assets the yen, dollar and gold were the best performers.

The EU/IMF providing just a short-term patch for Greece and no solution for other peripherals, financial markets remained unimpressed. Spreads in European sovereigns continued to blow out; the euro sliding further. There have also been increased concerns about European banks, which (as of end of 2009) hold claims of $193 billion on Greece and more than $1 trillion on Portugal, Ireland and Spain. Libor (the interbank lending rate) rose sharply as banks became increasingly suspicious of each other’s exposure to European peripheral sovereign debt.

The slide in the euro, soaring bond yields and global markets’ reaction to the crisis finally led eurozone governments to lay out a set of measures to safeguard the financial stability of the euro area. Last weekend they vaguely committed to additional fiscal consolidation and reform of the Stability and Growth Pact to ensure fiscal sustainability in the region.

As of Monday morning European leaders agreed on providing a massive rescue package of 750 billion euros ($960 billion) to eurozone countries in an effort to stop the sovereign debt crisis and contagion. Eurozone governments pledged 440 billion euros in new loans and guarantees and 60 billion under an existing lending program, with an additional 250 billion to come from the IMF.

The most dramatic intervention came with the announcement that the ECB (European Central Bank) would buy euro area public and private debt. The dollar swap line with the Fed has also been reactivated.

Yesterday’s rescue package averted an immediate crisis and will likely buy Europe some time to allow real fiscal adjustments to take place. However, while it helps eurozone sovereigns with near term financing, it does not fix the longer term debt and solvency problems.

Ultimately, Greece’s problem is not just one of liquidity but also solvency, so the country will still likely have to resort to debt restructuring (which has now been postponed). Without the option of currency devaluation, Greece must go through severe debt deflation. Incomes and tax revenues will plunge. The vicious circle of falling nominal GDP and rising debt/GDP ratio can only be stopped when growth resumes – which will be difficult without devaluation. Solvency risks will not go away anytime soon.

The euro currency downtrend will most likely continue. We may not be far away from a point when the ECB starts printing and effectively monetizing eurozone debt. Concerns of longer term viability of the single currency will also stay as peripheral economies sink deeper into debt deflation.

European periphery facing severe austerity programs and prolonged recessions will not only kill EU’s growth for the foreseeable future but also impact global demand that will go down just as the cyclical recovery is starting to face headwinds.

Where next for the markets?

Peripheral spreads have rallied spectacularly, retracing 50-75% of their widening since the end of March within just a few hours. However, this extreme narrowing is unlikely to be sustained unless the ECB continues buying peripheral debt. European, US and global equity markets also responded positively with a huge rally yesterday.

Last week’s Greek debt fallout provided a perfect trigger for corrective action – we were certainly due for one after the steep rally off the March 2009 lows. Bullish sentiment had reached levels consistent with short term tops (Investors Intelligence survey of investment advisers – a measure of the crowd’s sentiment – reported last Wednesday that 56% of advisers were bullish – the highest level since the 2007 market peak); equities and commodities were overbought. The amount of cash as a percentage of total assets at equity mutual funds was at a record low. Insider sales were at extremely high levels compared to insider buying.

At the moment it’s premature to say whether the sell-off is over; we could be seeing a relief rally, the correction could reassert itself and last for a few weeks. However, given the strong momentum from the March 2009 lows, decent valuations and good upside breadth the cyclical bull market certainly appears to be intact. The markets are bound to remain volatile for a while though.

The following chart shows the spike and subsequent decline in the VIX – also known as Wall Street’s ‘fear index’. A few weeks ago it was at 18 month lows, indicating high investor confidence (and complacency). As we’ve moved from optimism to fear and dread last week volatility rocketed, only to fall back after Monday’s eurozone bailout news.

(The VIX is a measure of the implied volatility of S&P 500 Index options. A low value indicates expected stability in the markets; a high value means expected turmoil. So the VIX tends to exhibit a strong negative correlation with equity prices.)

Another sentiment indicator, the equity put/call ratio, was also very stretched by the end of April, indicating extreme bullish sentiment. As optimism turned into fear the put/call ratio spiked up.

A look at April breadth measures also signaled an imminent correction as over 90% of S&P500 stocks traded above 50 day moving average. We dropped to oversold territory last week, before bouncing back somewhat.

As risk aversion grows US equities could benefit from a flight of capital from Europe; though it will more likely continue to flow into bonds. Importantly, the US economy is improving on all metrics.

We are now seeing a starting recovery in the labor market, based on the payrolls numbers as well as Household Survey employment data. Last Friday’s US nonfarm payrolls surprised to the upside with 290,000 jobs added in April – much better than the anticipated 180,000, with the March number revised upward to 230,000. However, the unemployment rate increased to 9.9% from 9.7% due to a surge in the workforce. (Also, census hiring added 66,000 jobs to the April number.)

There is no doubt about the strong recovery in US manufacturing, as witnessed by ISM data (at 60.4% as of April). The manufacturing sector expanded for the eighth consecutive month to its highest level since July 2004. The pace of new orders was very strong and employment within the sector continued to grow.

Consumer spending has been rising (albeit at the expense of the savings rate). Retail sales rose above expectations in April, for the fifth time in the last six months.

Despite positive US data investors remain skeptical about the health of the economic expansion. At present the consensus is for subdued economic growth; that might end up proving to be too conservative.

Short term interest rates are at their multi-decade lows. Even if rates were to start rising faster than expected, the environment will stay very stimulative for a long time. Low interest rates provide a subsidy to income, profits and economic growth.

Whereas liquidity has been the main driver of the stock market rally until now, the next phase will likely be spurred by growth and profits, with performance depending on expanding economy. Low rates, strengthening business activity and strong balance sheet conditions will drive earnings growth. (Earnings have been very positive, beating expectations in most cases. Expectations of S&P 500 operating earnings are in the region of $80-84 by the end of 2010.)

If economic growth is decent and rates stay low, profits will likely keep surprising on the upside. Of course better economic growth, employment growth and improving corporate profitability will eventually see a rise in interest rates. That alone is, however, not automatically negative for stocks. It is generally only when interest rates start to exceed the nominal GDP growth that the economy slows down. The yield curve also has to become inverted for a cyclical equity bear market to be triggered. Historically, cyclical bear markets were triggered when the yield curve became inverted at a level that was higher than the nominal GDP growth. We are nowhere near that point.

The cyclical bull market has further to go, although the pace of price gains is likely to be much slower, given the steep rally off the March 2009 lows. Most retail investors have not yet moved into equities and are sitting on the sidelines. Yet there is little reason to believe that they will not do so again once confidence in the rally becomes more widespread. Optimism should increase as evidence accumulates on the strength and durability of the economic expansion.

US fundamentals look good for now: leading indicators of growth remain strong, rates are extremely low, earnings are beating expectations, valuations are reasonable.

Equities are relatively cheap on 1-2 year forward valuations (PE of 14 and 12, respectively). Global equities valuations are also attractive at 12M forward consensus earnings multiple of 13. Emerging markets trade on a 12M forward P/E of 12, although they have, over the last two decades, grown earnings at an annual rate of 22% vs. 12% in developed markets, as well as having lower leverage and higher economic growth. Equities are also cheap relative to bonds (as per dividend yield/bond yield ratio).

Retail investors have been net sellers of equities since March 2009. The total allocation to equities by the US household sector is well below long term average. Global bond funds posted inflows of $83.5 billion this year, equity funds saw inflows of only $7 billion. Since the trough of March 2009 US equity funds inflows came to $40 billion compared to bond funds inflows of $360 billion. Retail investors have so far not participated in the rally – retail equity funds saw net outflows of $82 billion since March 2009 (though in March 2010 retail have been modest net buyers). Institutional equity funds have seen modest net inflows since March 2009. (Data from EPFR Global and Credit Suisse.)

Central banks will likely continue to flood the system with liquidity whenever deemed necessary, and the Fed will keep short term rates in real terms (inflation adjusted) below zero for a very long period of time – all of which is positive for equities. And, as noted, there is plenty of cash available from investors who have missed the rally and are still sitting on the sidelines.

I believe the cyclical bull market (i.e. rally within the secular bear that started in 2000) will go on for a while, so any 10-20% corrections may be seen as a buying opportunity for select equities.

There are of course a number of medium to long term concerns.

The situation in parts of the eurozone will remain precarious. Austerity measures will plunge the periphery into a deep and prolonged recession, while bailouts will come at the expense of the productive European economies, all dragging down demand. Europe will buy less US goods, and with the euro likely close to or at parity to the dollar US companies won’t be able to compete with European exporters. This could well slow down US growth by late 2010 and 2011. (Tax hikes will also kick in next year.)

China is tightening in an attempt to slow down its economy, amidst concerns of overheating and housing bubbles. (The Shanghai Composite Index has broken below its key 200-day moving average – a possible precursor of what’s to come in other markets?) Brazil and India (and much of the rest of the developing world) are raising interest rates to fight inflation.

Concerns also remain about US regulatory changes, including financial reform.

The US housing market is a weak spot that needs monitoring. Although prices are stabilizing, the overall picture remains worrying, in particular due to the massive amount of unsold overhang remaining in the system. On the positive side, house price to income ratio is now close to a 40-year low and yields on low-end properties are, according to Credit Suisse research, over 8% – the highest on record relative to 30-year mortgage rate.

And there are still some $6.5 trillion of excess leverage in the developed economies, which will end up reducing growth. Government bond funding will also become more of a problem in the next few years, and not just in Europe. Economies won’t be able to simply grow their way out of fiscal indebtedness. In order to stabilize government debt to GDP fiscal policy will have to be tightened significantly (in the US, UK, Japan, much of the eurozone), which will be extremely challenging both politically and economically. We are still heading toward sovereign defaults a few years from now.

If we are lucky, we may have another 12-18 months before things start getting ugly again.

I think most Americans would agree taxes are heading higher. Yet, curiously, most may not care. (A Gallup survey shows 45% of Americans are happy with their tax rates and 3% believe them to be too low.) In fact, I suspect a significant portion of the population may welcome the tax increases with hardly concealed joy.

How is that possible, you ask?

The explanation is as simple as it is disturbing. For nearly half of US households taxes are simply somebody else’s problem. Approximately 47% pay no federal income taxes at all! (Data from Tax Policy Center for 2009.)

That’s right: nearly half of Americans qualified for enough credits and deductions to fully eliminate their tax liability, or had too low incomes to start with. (According to Deloitte, credits for low- and middle-income families have risen so much that a family with two children making $50,000 a year will owe no federal income tax.)

Half the country is happy with tax policies… well, they should be if they pay no taxes in the first place! These are the people who, more often than not, support higher marginal tax rates, for that simply means someone else will have to pay for their ever growing entitlements.

It is a sign of our hypocritical era that the cry of making taxes more ‘fair’ – meaning of course robbing higher earners blind so that lower earners need to pay nothing – has now been almost universally accepted.

But how on earth can one talk of fairness?

Consider this: the top 1% of Americans pay 40% of federal income taxes, the top 5% pay over 60%… while the bottom 50% pay less than 3%! (Data from the Congressional Budget Office, latest available tax burden release, 2006.)

Half the population is getting something for nothing, and they call this fairness?

As is always the case with expanding welfare states, generous entitlements are paid for by everyone except the actual beneficiaries.

There is nothing fair about redistributing incomes, much less on such a massive scale. There is no fairness in the government penalizing someone for working harder than others. (Not to mention it is unsustainable over a longer term – you will run out of wealthy people to tax.)

Now can you see the fundamental problem here? 40% of American households paid 86% of total federal tax liabilities. However, when it comes to deciding how the government should spend that money, they are outnumbered by the 60% who paid just 14% of taxes.

Is it any wonder that government spending is out of control and the US is coming close to fully adopting European-style socialism? The majority of voters decide on how to use other people’s money – why would they want any spending cuts?

The Congressional Budget Office data also shows that higher earners are paying a larger share of total federal taxes than ever before (as far back as tax burden data goes, to 1979).  

According to the IRS, in 1987 the top 5% of earners paid 43.26% of all federal income taxes; today, that group pays more than 60% of the tax burden – despite bringing in just 37% of the income. By contrast, the share of taxes paid by the bottom 50% of taxpayers – who bring home 12% of the income – has gradually fallen to less than 3%.

Higher earners have, over time, been forced to fund an increasing share of the federal government and fast growing entitlement programs. Meanwhile, according to the Tax Foundation, 60% of Americans consume more in government services than they pay in taxes, and the benefits extended to this group have been steadily increasing.

And yet the likes of Mr. Obama continue to tell us the wealthy aren’t paying their ‘fair share’!

Hence the $650 billion or so in tax hikes and new taxes that will be imposed on higher earners over the next decade will hardly be of concern to the vast majority of Americans. This is a short-sighted view, but then most people aren’t programmed to think of long term consequences. Given the immediate benefits for oneself, who will spare any thought on the negative impact on the economy and future job creation?

Which of course explains the shift toward statism and socialism at a certain stage of mass democracy. (Not for nothing did John Adams, the 2nd President of the USA, say that “there never was a democracy yet that did not commit suicide”, and did James Madison and other Founding Fathers believe that individual rights must be protected from the “tyranny of the majority”. They understood that without checks and balances the propertyless majority would tyrannically tax away the property of the minority.)

The state has clearly become far too big and in the process has made the majority of the electorate dependent on hand-outs, with the result that voting for the necessary medicine will now be virtually impossible.

The massive deficits, unprecedented debts and out of control entitlement programs (as well as demographic trends) leave few options – drastic spending cuts or significant tax hikes (or a combination of the two).

According to a recent Goldman Sachs study (based on budgetary data for 24 OECD economies covering 35 years from 1975), there is only one effective way to reduce debt and sustain future economic growth: imposing budget expenditure cuts across the board. On the other hand, increasing taxes to compensate for a higher budget has proved very damaging to future growth.

While cutting spending would be of most benefit to the country’s prosperity and future, it simply won’t happen on any meaningful scale. When the majority of the electorate has no interest in giving up their entitlements, political leaders will always take the path of least resistance and penalize those voters who, being a minority, don’t present a sufficient threat to their political careers.

And so, on top of all the existing, technically bankrupt federal programs, the Obama administration created a new health care entitlement, to be paid for, as usual, by everyone except those who will benefit. (Detailed overview of associated taxes further below.)

The problem is the US – along with much of Europe – is on a wholly unsustainable budget path, with unprecedented public spending (largely paid for by borrowing and money printing). In the absence of Americans rejecting the expanding welfare and entitlement state, taxes will have to rise much beyond the scheduled increases. Unless, that is, the administration finds some other – miraculous – way to reduce the enormous amounts of debt it continues to pile up.

A recent study by the nonpartisan Tax Policy Center calculated that to reduce the federal budget deficit to a sustainable 3% of GDP, the government would have to find some $500 billion each year – in new revenue (or spending cuts). To get that amount via tax increases on the top two brackets (families with over $209,000 in taxable income) the rates would have to go from the current 33% and 35% to 72.4% and 76.8%.

You didn’t think socialism comes cheaply, did you?

The truth is, no matter how much marginal income tax rates will rise, they cannot realistically be taken high enough to fill the fiscal hole. A broader based tax or a consumption tax is therefore likely to be on the horizon in the coming years.

Speculation about a value-added-tax (VAT) is already ripe. Former Fed Chairman Paul Volcker, among others, has called for VAT to be considered in light of the massive deficits. VAT is a national sales tax applied at each stage of production and collected by businesses (meaning additional bookkeeping and costs). It’s difficult for anyone to escape the tax since it’s included in the price of products and services you buy. (In Europe VAT rates range from 15-22%.)

VAT, apart from being a convenient way to pay for ObamaCare, has other advantages as well. It would allow (via increasing rates) for funding of a continued expansion of government, and as such would undoubtedly permanently open up the floodgates of public spending.

But while VAT is (for now) just a speculation, the tax increases starting next year are very real. Below you’ll find an overview of tax hikes and new taxes to be imposed on (better-off) Americans in 2011-2018.

2011 – tax hikes (tax cuts expiry) on higher income and capital income

First there is the expiry of the Bush tax cuts at the beginning of next year. The highest tax bracket will move from 35% to 39.6% and the 33% bracket will rise to 36%. The estate tax will also revert to 55%, with an exemption of $1 million (unless Congress reinstates the 2009 rules of 45% federal rate and $3.5 million exemption).

Importantly for investors, the capital gains rate is set to rise to 20%, up from 15% now. Dividends, currently taxed at 15%, will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% (unless Congress enacts a proposal for a top dividend tax rate of 20%).

While most of these increases appear to only target wealthier Americans, they are also damaging to small businesses. (According to IRS data, some 26 million small business employers file under the individual income tax code and so will be subjected to much higher taxation.) This, along with the onerous new health care burdens, will certainly not help small businesses hire more people.

On top of the tax cuts reversal, Obama’s health care ‘reform’ brings a number of new taxes and tax increases (2011-18) aimed at financing part of the new spending. For obvious reasons most of the tax hikes will start in 2013, after the election year. (Some ObamaCare related taxes go into effect in 2011, however, these will affect drug makers and importers.)

2013 – increase in payroll tax + new tax on investment income

From the beginning of 2013 higher-income taxpayers will be hit with a tax increase on wages as well as an entirely new levy on investments.

Medicare payroll tax will rise by 0.9% from 1.45% to 2.35% – a gigantic 62% increase – on wages above $200,000 for individuals and $250,000 for married couples filing jointly.

In addition to that, and for the first time ever, Medicare taxes will be extended to investment income. A brand new 3.8% tax will be imposed on the falsely called ‘unearned’ income – dividends, capital gains, interest, rents and other investment income – for individuals making more than $200,000 a year and couples making more than $250,000.

(A 2.3% excise tax on sale of medical devices also goes into effect in 2013.)

2014 – penalties for lack of insurance

2014 is when the health coverage goes into effect, and the requirement begins for everyone to have health insurance. (The government will provide subsidies for lower and middle income groups.) If you don’t want health insurance, tough; you’ll pay penalties – $695/p.a., further rising in 2016.

Medicaid (the federal-state program for the poor) will expand to all Americans with incomes of up to 133% of federal poverty level; since this could bankrupt the states they might start electing out of Medicaid. (More than a dozen states have already filed lawsuits over the constitutionality of the burden imposed by Obama’s bill.)

Subsidies (tax credits of up to 50% of employer’s contribution) for small businesses (up to 10 employees) will provide for coverage increase. Penalties will be imposed on employers with over 50 employees who don’t provide ‘affordable’ coverage (note – affordable as deemed by government bureaucrats); they will be fined $2,000 a year per employee, excluding the first 30.

(The health insurance industry will also start paying annual fees; $8 billion in 2014, rising in subsequent years.)

2016 – steep rise in penalties for uninsured

Penalties for those who don’t carry coverage will rise to 2.5% of their taxable income or $695/p.a. – whichever is higher.

Not to mention, a mammoth bureaucracy will be created thanks to ObamaCare (see here the astonishing list of all the new boards, commissions and agencies the bill gave birth to). The government will also hire an estimated 16,000 IRS agents to harass and audit individuals and individual businesses to check for compliance. (I suppose Mr. Obama would expect us to applaud this convenient new job creation scheme?!)

2018 – tax on high value plans

An excise tax of 40% will be imposed on health care plans with premiums exceeding $10,200 (individual coverage) and $27,500 (family coverage).

Investors hardest hit

Apart from higher-income taxpayers being disproportionately targeted as a revenue source, policy is now clearly taking the path of increased taxation of passive income. In fact investors and higher earners will bear all the burden of ObamaCare (without getting any of the benefits).

Let’s look again at the massive new taxes Obama assaulted investors with, as well as the likely impact.

Those with income from stocks, real estate or other investments are expected to contribute a giant share of the costs of health care expansion. (I suppose we’re seeing a theme here… from the continuing witch-hunt on the financial sector to the increasingly investor-hostile environment.)

Aside of the income tax and payroll tax hikes detailed above, there are three specific developments penalizing investors: increase in capital gains tax from 15% to 20% (2011), increase in dividend tax (to either 20% or as high as 39.6% – see further below; 2011), and the new additional 3.8% tax on all ‘unearned’ income (2013).

What exactly will be subject to the 3.8% tax? Dividends, interest, annuities, royalties, rents, as well as capital gains (minus deductions properly allocatable to such income). Basically, all income and gains derived from a ‘passive activity’ count as investment income. (Note that income and gains from an investment fund, even if the fund is classified as a ‘trader’ for tax purposes, will be subject to the tax.) Tax-exempt interest income and distributions from tax-qualified retirement plans, including IRAs and Roth IRAs, are not to be included in investment income.

Capital gains, currently taxed at 15%, will therefore be subject to a 23.8% tax (20% after expiry of the Bush tax cuts + 3.8% in new tax).

Dividend income (currently taxed at 15%) will be particularly hard hit. In 2011 dividends will be taxed as ordinary income, with the top rate scheduled to rise to 39.6% from 35%. With the additional 3.8% Medicare tax dividend tax will go as high as 43.4% in 2013. Obama has proposed a top dividend tax rate of 20%; if Congress enacts the proposal, the top tax rate for dividends would rise to ‘only’ 23.8% at the beginning of 2013.

Impact on investment and investors’ behavior

Overall, some $409 billion in additional taxes will be snatched from investors in order to pay for big government socialism. What will be the likely impact on investment?

Essentially, investment income (capital gains, dividends) will be worth less to investors once the tax hikes/new taxes go into force than it is today. It is feasible that it could revalue the entire stock market lower.

Credit Suisse in a recent (April 2010) report estimates that a 10% rise in dividend and capital gains tax in the US would take about 7% off the fair value of the equity markets (assuming that 30% of the market is owned by tax-exempt funds and foreigners and the higher tax rates will apply for 15 years).

The 2011 capital gains tax increase could also prompt investors to liquidate holdings this year, ahead of the increase.

In addition, we may see shifts in investors’ behavior, in particular if dividend tax goes up by nearly 200%. Investors will certainly take that into consideration when making decisions; as a result they could shy away from dividend stocks and focus on those they perceive as having greater potential to appreciate.

More generally, the new taxes will discourage investment, making it more difficult for companies to bounce back after the recession. On top of that, as noted earlier, most small businesses pay the individual income tax, and the rate hike will have a negative impact on expansion and hiring. (Mr. Obama of course sees small business owners not as job and wealth creators but as rich exploiters who must pay yet more onerous taxes so that those who don’t pay any can enjoy still further entitlements.)

Add higher income taxes for the most productive Americans and higher payroll taxes, and it becomes clear that the Obama administration is penalizing those who have worked hard, saved, and invested, while rewarding and indulging the less able, unproductive and lazy. Classic Marxist class warfare… blaming the productive and enterprising for all of society’s ills, which can naturally only be ‘fixed’ by redistribution of unprecedented scale.

We will not need to wait too long to see the outcome. Significant tax increases can only reduce economic growth, for they take away people’s incentives to work, save, and invest. (They also encourage tax avoidance, thereby defeating the purpose of the tax increases.) Capital will be allocated to where it can avoid (some of) the taxes instead of where it would be most productive for the economy.

“When people who earn more than the average have their ‘surplus’ or the greater part of it seized from them in taxes, and when people who earn less than the average have the deficiency, or the greater part of it, turned over to them in hand-outs and doles, the production of all must sharply decline, for the energetic and able lose their incentive to produce more than the average and the slothful and unskilled lose their incentive to improve their condition.”

(Henry Hazlitt)

I will not even take into consideration increases in other taxes at federal, state and city levels, including corporate tax hike proposals, a likely consumption tax on energy (as part of climate change legislation) and possibly a value added tax.

And in the unlikely case you still believe Mr. Obama’s socialist propaganda on how the ‘rich’ aren’t paying their ‘fair share’, please review the statistical data at the beginning of this article. Not only do higher-earners pay a fair share, they are being robbed blind. (Brief recap – the top 5% earn 37% of income yet pay nearly 61% of all federal income taxes, while the lower 50% earn 12% of income and pay less than 3% of taxes. And that is before any of the coming tax hikes on the better-off!)

How did we get to this sorry state?

Consider that in 1913 the top rate of income tax was just 7%! Not only have taxes gotten more progressive and excessive, there has also been a staggering increase in related bureaucracy. The number of pages in the tax code has increased by 16,775% in the past century.

Taxes are, however, only a side issue. What should really concern us is how, within a relatively short period of time, the US went from a limited government, free enterprise, individual liberty valuing regime (of the Founders) to big government statism and finally the progressive socialism of today. The people, once freedom loving and self-reliant, have carelessly traded their liberties and responsibilities for entitlements and handouts.

Government programs and welfare only make people less reliant on themselves and more dependent on the state, which in turn prompts an ever increasing size of government, until one inevitably ends up with socialism.

The dependency mindset is now almost as prevalent among Americans as has long been the case in much of Europe. The productive sector that adds value to society is sucked dry by the parasitic state bureaucracy, the able and hard working are penalized for their success; as a result the whole society ends up much poorer. (Not to mention the terrifying and impoverishing public debt burden left to the next generations.)

Of course all this happens in the name of ‘fairness’ and ‘equality’.

Yet redistribution has nothing to do with fairness and everything to do with envy and theft. Such action gains, thanks to majority rule, a seal of legitimacy, but it really is no better than common robbery.

The fact is today the vast majority of people feel entitled to the property of others. They demand that it be taken away from them through taxation, so that (some of) it can be given to those they deem to be ‘in need’ – i.e. those who have less but of course feel entitled to have more.

Forcibly taking other people’s money would in other circumstances be considered criminal, yet this mass criminality is rationalized on the grounds of democracy, will of the people, political mandates, etc. Progressive taxation appeals to the masses who, more often than not, have a desire to pull down the minority of the most productive, talented, enterprising (and as a result more successful). Progressive policies in general are just a mean to an end; the end being an envy-based redistribution.

Unfortunately once a certain stage of statism or progressive socialism is reached it is nearly impossible to reverse. Once a voting majority pays no income tax and benefits from entitlements, the productive and enterprising minority is doomed. The majority will continue to vote away the rights of others, and call it the will of the people.

This is the tyranny of democracy the Founding Fathers had warned against. They did not intend for the state to guarantee everyone’s well-being and provide support against every possible obstacle. They would be horrified at the idea of divesting some people of their properties for the advancement of others in society. And yet today that is exactly what much of the population expects – to be taken care of by the government, be given something for nothing – all at the expense of those who stand on their own two feet and attain things by hard work.

One can work and produce goods or services that others want to pay for, or one can steal (or give the government a mandate to loot on their behalf). It is human nature to take the path of least resistance, which explains why most believe it is perfectly acceptable to plunder others rather than obtain what they desire by their own efforts and sweat. Naturally they will always find a justification for such action; hence it is deemed a matter of fairness for a minority to subsidize the majority who are perceived as disadvantaged in one way or the other (never less apt, less willing or simply lazy).

This socialist disease has now infected much of the fabric of the society. And it’s not just the liberals who prefer the state to make life-governing decisions for them. According to information from the 2008 American National Election Study about spending priorities, the majority of self-identified conservatives isn’t really in favor of cutting spending on most government programs either.

Of course anyone who disagrees with this entitlement mentality is labeled uncaring, uncharitable, lacking social conscience, or worse. The notion that unless we let the state do everything for us we are ‘bad’ persons is now so prevalent that few dare to mention the choices that must be made. How many in public office take up the cause for limited government and hence severe cuts to welfare and the public sector (including eliminating millions of counterproductive public jobs, bureaucracies, regulations, entitlement programs, etc)?

And yet far from unfair or uncaring, that is the only viable path to safeguarding America’s economic future.

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At the outset it must be said that, regardless of the day to day fluctuations of financial news, we are entering into unprecedented territory. What may be construed as long term planning may well be categorically different than medium term common sense.

The increases in the total federal debt outstanding are off of all known scales that we have a historical measure to compare against. In essence, the catastrophic toxic products that nearly imploded out financial system haven’t exactly vanished, as the chart below will make clear. As in a very large shell game, much of this highly problematic material has been shifted off of private books and on to public books.

One of five possibilities will ensure, or some politically expedient combination of the five.

1.    default on the debt (very low probability)
2.    debase the currency (high probability)
3.    massively curtail public spending (one can only cut so far)
4.    raise taxes (count on this one)
5.    experience such massive technological change that we can innovate our way past it

Chances are excellent that our political class will engineer a mixture of currency debasement/inflation, spending cuts, tax increases, and pray for a technological breakthrough. In other words, as for long term prospects, even if we do have a respectable recovery from the lows, as the folks at the Bank Credit Analyst are predicting, we will remain burdened with exceptional social, fiscal, and taxation problems, riding on top of demographic changes, that cannot be waved away with any known magic wand.

E-Commerce sales remain a relatively small component of the entire US economy, however we feel that they are a worthy leading indicator on one hand, and also a sign of the ways in which the consumer is moving away from the higher overhead brick-and-mortar economy to the more customized, flexible, and more deflationary economy of mobile capital and business structures.

Fascinatingly, real retail and food service sales are only about four times bigger that e-commerce sales at this point, and real storefront sales are quickly being overtaken by internet commerce. The difference obviously remains sufficiently great that one will not displace the other overnight. Having said that, e-commerce has advanced with remarkable alacrity, and the implications cannot be ignored. Soon the competitive dynamic of algorithmic pricing will displace and undercut a significant amount of that traditionally associated with face to face commerce. And that impact is likely to be disinflationary if not deflationary.

The employment cost indices make instructive viewing. Whether we look at the manufacturing, service, or private industry indices YoY, we see punishing deceleration in wage and salary gains, in line with earnings fall-offs through 2009. The great question that faces us on many levels is whether an inflationary surge that might well appear as a result of unsustainable debt will be, or could be, an effective index for private sector wage gains and sustainable retail price gains.

In the inventory to sales ratio we see a similar process of “inventory deleveraging” which is by no means merely a product of the last downturn; this is a structural change that clearly demonstrates the US economy moving closer to a just-in-time, lean run model. The move toward e-commerce suggests that this structural change will also reduce many job descriptions as the relationship between the consumer (don’t forget, this mythical being, in toto, accounts for about 70% of the US economy) and the seller removes one or more traditional layers of distribution and marketing.

So where does the estimable Robert Shiller and his cyclically adjusted price/earnings ratio fit into this picture? We tend to see the CAPE index, as it is sometimes known, as a kind of long term fair value estimator. Shiller ingeniously has taken the average of the previous 10 years of earnings as the denominator (hence the “cyclical” part) and compares his adjusted price to this long term measure of earnings capacity, instead of simply a quarter by quarter comparison of price to earnings.

We have made a minor, but we feel useful adjustment to Dr. Shiller’s calculation by instead computing the rolling ten year median earnings value and then drawing a line one standard deviation above the mean of the CAPE series and another line one standard deviation below the mean. We feel that this is a good estimate of the long term fair value band, or we might say, the not-emotionally-driven-by-panic-or-euphoria band.

We have also included this second chart which shows the long term average on the CAPE value from 1881 to present.

Our conclusion is this: at the moment the US equity markets are reasonably priced against long term trends and there could be an extended period where they perform acceptably. However, they are by no means historically cheap; one could say they are about fairly priced, and the market will be very sensitive to perceived inflation in the unfolding of the story.

As long as inflation remains tamed by disinflationary pressures, money will remain parked in the debt markets, and equities will be vulnerable to blips of bad news. There are no absolute guarantees, however, we do accept that there are vast amounts of capital forced to find a home should the economic landscape suddenly change.

As a final thought, we include this study of trends in federal debt maturities.

One can only rationally conclude that the disinflationary and pro-inflationary crosswinds will sooner or later interact with violent energy. Either large sectors of the US working population will find themselves trapped by an inflation that damages them as a social class, potentially producing an extreme and irrational political response, or there may be some novel form of social irresponsibility as the American governing class tries to finesse its way out of an impossible position.

Over the past weeks we’ve been digging down into what might, or might not be the real story. Everybody seems to have an opinion or three, from world class money managers to yowling cretins, and none of them seem to fully add up. Whither the economy?

There is a bewildering array of evidence pointing to global inflation, except that it also indicates overcapacity, a la Hyman Minsky, which instead means it should be deflationary, except that supply is creating its own demand, hypothetically, in China at least, which should be inflationary, except that world shipping fell precipitously and is staying down, which means deflation, except that foodstuffs are gaining, inflationary, but Prechter says deflation, which Arun Motianey claims is the precondition for inflation, but consumer confidence plunged and the Politburo hates inflation and the Brits are certainly on the brink of a national collapse because they have collectively drunk themselves to terminal cirrhosis, credit card companies have run amok, people are cutting back like mad and saving every dime, in total contradistinction to the prior era where easy credit proliferated like rats in the New York subway system, which should be deflationary, except flooding the system with liquidity should be inflationary, except the banks won’t lend it to the  businesses that really need it which is deflationary, and China is running an annualized GDP growth of 10.5% which is just nuts…

Baffling…infuriating…the truth is nobody has a firm idea… even Soros has gotten it wrong, way wrong, on occasion. What’s up?

On one level we believe that we are beholden to mental models, or framing mechanisms, that no longer suffice to describe the complexity, nor the potential instability of this new economic condition; we’re tweaking prisoner’s dilemma models when the global economy is beginning to look like a  3D Julia Set in a sped up animation. Could be our metaphors and mental constructs no longer cut it. This baby has plain run off the known map. Some of those mathematical curiosities that we loved to play with more than a decade ago may be getting closer to necessary descriptors of the real world than we realized.

Which leaves us where? The Chicago Fed’s favorite all purpose indicator, the CFNAI, is flashing recovery. And we admit, the CFNAI is probably as good of an all purpose economic indicator as we know of, being a diffusion index of 85 indicators run through a principle components analysis.

The question then becomes, what kind of recovery is this actually? Optimally one recovers into a state of mild inflation, which encourages borrowing and sets into motion a virtuous cycle of credit expansion, hiring, equipment purchasing, product line upgrades, and so on. However, as Richard Koo of Nomura will cheerfully remind his readers, there is another potential scenario, the not so salubrious debt deflation. In this circumstance, even a subtle tilt towards deflation can induce large borrowers to use their profits to first pare down their existing debt load rather than invest in expansion and upgrading. Which, of course, leads to the unhelpful lost decade syndrome. Aided and abetted by a period of low interest rates. Like we have now.

Practically speaking, there is no way policymakers can entertain the idea of a prophylactic increase in interest rates without risking mini-depressions at the state level. But the problem is hardly restricted to the nitty gritty of keeping the street lights on at night in Colorado Springs. Japan too is facing a potential double dip back into grinding deflationary territory which in turn further deflects borrowing behavior into saving behavior (as deflations reward savers and punish borrowers)… only now it seems that the US consumer is finally learning the same lessons that the Japanese consumer learned 20 years ago.

We are of the opinion that economic phenomena often appear as social phenomena, at the level of shared values, ideals, behaviors, and shifts therein before they can be captured and quantified as numerical  sort-of facts that make it to the public by way of the media blatheroons. We look for trends that are slowly working their pernicious ways to the surface. Such as…..

We must admit we find that disturbing on a multitude of levels. We recall that deflations have strong historical connections with phases of breakdown and decay. In the late 19th century nearly the entire agricultural sector was driven to bankruptcy by an extended deflation era. Deflations can be insidiously corrosive, slow moving glaciers that crush everything before them, unlike the swifter moving tsunami of hyperinflation. Each is coupled with a powerful social mood.

We take the prospect of deflation with great seriousness and no small degree of angst. We have noted as well that the Baltic Dry index, which reflects worldwide shipping of dry bulk goods such as ores, cement, grains, and the like, has remained at a surprisingly low level since the great breakdown, in spite of a couple of recovery bumps. Simply judging by the BDI, world trade is not recovering to anywhere near even the 2007 LOW, not the high.

On the other hand, there is China, which seems to be living in an economic universe so disconnected from our own it solicits disbelief. Is this in fact some form of massive decoupling that no one can adequately explain? Is this sustainable, a true breakthrough, a new epoch that makes fools of the naysayers, the great engine that will pull us out of what would have been a deep, cold worldwide depression?

China, India, and the Asian Tigers are, to put it mildly, on some kind of roll. As one writer put it, hot enough to make the devil sweat. But, my friend, when you go from 400 billion Yuan of bank lending to 1.4 Trillion Yuan in 2 quarters, you either really know what you’re doing or you’re about to burn the house down.

China promoters, Dr. Megatrends himself, John Naisbitt, included, seem to have bought the Unstoppable Giant Awakens scenario wholesale and retail. And for all we know he could be completely correct, or not. We have a few statistics that might help us appreciate the impact of China, more of an importer than many realize. Sure, they export manufactured stuff, but they still have a ravenous appetite for raw materials. Which they must buy on world markets. Which explains the extraordinary efforts they go to to insure uninterrupted flows of the elements of manufacture.

Thus we think it is fair to say that the Chinese relationship with the global economy is far more complex that the simplistic model that they sell us stuff and buy our treasury debt with the profits. A lot of that economic activity is leaking back out into the primary producer world, places like Africa. So the model of capital and material flows is
necessarily a more nuanced process of transforming economies they encounter and being transformed themselves by those contacts. China, for all of its legalistic and authoritarian rigidities, may be a novel form of a complex adaptive system that the American founders could not have imagined.

But complex adaptive systems can fall victim to their own contradictions and instabilities as well, and as far as we know, no imperial administrators for the entire duration of history have escaped an encounter with such systems suddenly taking on an unpredictable and frustrating life of their own. No rider has fully mastered the beast, although many have tried, and many have been seduced into the illusion that this time we have finally mastered it. We should be so lucky. And we never will be. Great Moderation, anyone?

With growth come growing pains. With hyper-growth come hyper-growing pains. Lao Tzu warned of this 2,500 years ago. Sudden wealth breeds envy, unfathomable greed, lust for power, ruthlessness, and often, terrible errors of hubris. We have noticed many reports of criminality, of the organized entity sort, and abuses of power.

Does this become a long running institutional struggle between power bases or will a central authority be able to impose a stable, uniform standard and rule of law across the extremely diverse population?

We cannot help but notice that the Western structure, as relatively wealthy as it is, with its excellent university system, with a long history of economic booms and busts, could have gone from the most overweening arrogance and sense of historical imperative to one of confusion and despair in less time than it takes to grow a fairly impressive plant behind one’s house or to put a child through one stage of education. Didn’t we also think that we had conquered risk and parked our vehicle at the end of history ?

Granted,  this World Bank study of per capita electricity consumption is 4 years out of date, however, it is suggestive of how great the development gap actually may be between the USA and China/India. We tend to see this as an indication of the degree of “standard of living arbitrage” that exists between cultures.  Our energy hogging ways speak to an outsized standard of living, just as the Chinese and Indian levels of electrical energy consumption point to the degree to which they are positioned to catch up to our levels of usage, which would be correlated with square footage of living space, the use of heating and air conditioning, lighting, entertainment systems and so on.

Given this metric we would infer that there remains an enormous upside potential for their consumer economies, and perhaps a degree of downside potential for ours as more and more highly skilled, highly educated work migrates East. One might infer as well that we have lifestyle addiction issues that will only be reframed by significant changes in flows of capital, goods, raw materials, and knowledge.

Paul Krugman is clearly concerned about the deflation scenario as well, but perhaps he does not see how intimately this dynamic is tied to the almost steroid driven drive for an improved standard of living in Asia.

We wanted to double check Krugman’s  source of concern, so we composed the following two charts. In the first case, we compared the Dallas Fed’s trimmed mean deflator (the blue line) with the CPI–minus-energy chart for the same period (the red line). In both cases these do show, expressed in % change YoY, what might be taken for the beginnings of a deflationary process.

On the other hand, there is energy, our national equivalent of pure glucose intravenous drip. Here we see an entirely different process unfolding. If everything else is a reasonably steady process slowly trending, energy pricing and energy’s effects on our economy are downright manic-depressive.

We see the deflation conversation in areas like the convenience store industry, where the vice-chairman of Wal-Mart hopes to see deflationary pressures ending soon in his industry.

Hopefully, yes, we’ll be seeing that.

The Dubai and Greek crises have forced investors to pay attention to something long ignored – rising sovereign risk. According to this week’s reports, Dubai is trying to settle debts for 60 cents on the dollar. Meanwhile, there has been no real progress in the unfolding Greek debt crisis.

Given the scale of fiscal deterioration in much of the developed world, the trouble is unlikely to end with Greece. For now, however, this looks like a mainly EU-specific problem.

Germany is, for the moment, unwilling to talk about bailouts, and demands austerity measures from the Greek government. EU finance ministers stated Athens must comply with austerity demands within 30 days or risk losing control over its own tax and spend policies. But the truth is, the EU has no real enforcement mechanism, and Greece knows it.

The Greek government promised to reduce its fiscal deficit to 2.8% of GDP by 2012, and to under 9% by the end of this year. However, the EU authorities are fooling themselves into believing this to be possible – current Greek deficit is 12.7% (and that is only the official figure; Greece has forged data before). Due to both political and economic reasons chances of Greece meeting such targets are near zero. The Greek population is largely against austerity (and keen to express it via crippling strikes and riots), making it highly unlikely that the socialist Papandreou government will be able to enforce any meaningful measures.

Some 95% of Greek debt is held by a number of large European banks, so a Greek default would most likely spark a massive bank crisis in Europe. The contagion would inevitably spread to Portugal, Spain, Italy, Ireland and possibly other countries. But even if Greece is bailed out, it will unlikely meet the conditions that will come attached to a bailout, hence just kicking the problem down the road for another while.

And of course the problem is much larger than just Greece. Fundamentals are very poor across much of the eurozone, meaning that a number of countries could easily follow Greece down.

The root of the problem is the one-size-fits-all monetary policy of the euro. The monetary policy set for the centre (Germany, France) was always going to be inappropriate for the economies of the periphery. Instead of adopting stricter fiscal discipline (since monetary and exchange rate policy was no longer in their control), Greece, Spain, Portugal etc used the extremely low interest rates and high credit rating they gained access to thanks to the EMU to go on a long, wild spending spree. The cheap credit fueled housing bubbles as well as ever growing public sectors and generous welfare systems. It was inevitable that the day of reckoning would come.

Southern Europe’s competitiveness has also declined sharply as these countries joined the eurozone with an exchange rate that overvalued their currencies, raising the cost of labour.

The fiscally precarious states benefited from low rates because, in the eyes of investors, their bonds enjoyed an implicit guarantee of the stronger eurozone members. Once investors finally started paying attention to their fiscal situation, and to the risk of Greece being let to fail, the spreads between German Bunds and Greek bonds have widened considerably, increasing the country’s debt servicing costs.

In a staggering display of self-delusion the Greek prime minister said yesterday that Greece wants to be able to borrow on the same terms as other eurozone countries. I suppose we shouldn’t be surprised at such misguided sense of entitlement; entitlement, after all, is the theme of our times. Papandreou also stated “it is a fallacy to say the Greeks are reckless”. Yes, Greeks indeed are the model of prudence and their current fiscal mess and the fact they have been in default for 105 years out of the last 200 should just be ignored by the markets (or ‘socially useless’ speculators in modern day political speech).

Although distrusting Greece’s willingness and ability to reduce deficit, the markets, for the moment, continue to believe in an eventual bailout. Should it start looking like there will be no such thing after all, the spreads on Greek debt would dramatically expand and most likely push Greece into default.

Yet the fiscally responsible Germans have little appetite for bailing out Greece. A bailout, in their view, would destroy EU’s monetary (and any remaining fiscal) discipline and undermine the credibility of the euro. Not to mention that it would not solve the structural problems facing the eurozone. Since German taxpayers are hardly going to be willing to open their wallets to the profligate states every time there is a crisis, a bailout of Greece may only bring closer an eventual break-up of the EMU.

Having said that, German banks have massive exposure to Spanish, Irish, Italian and, to a lesser extent, Greek and Portuguese debt – to the tune of some 523 billion euros. Germany will undoubtedly take that into consideration when deciding on bailing Greece out or letting it fail.

So what are the options for Greece? The traditional remedy would be currency devaluation, but eurozone members don’t have such luxury. Control over their monetary policy is in the hands of the European Central Bank (ECB).

The most prudent thing for Greece would be to undertake the severe budget cuts necessary to get its fiscal deficit down to 3% of GDP over the next few years. Such extraordinary fiscal tightening would result in a few years of declining GDP and high unemployment. There is not much indication that Greek voters are even remotely considering taking a few years of pain (austerity & recession) for a future gain.

Another option is default, which would reduce the debt burden but also result in a severe and long recession/depression. Government spending would be cut drastically and immediately since Greece wouldn’t be able to borrow for quite some time. Finally, Greece could also decide to leave the eurozone, go back to drachma and, in effect, devalue its debt. It would make the country more competitive. Of course their borrowing costs would also soar. However, this appears to be the least likely path for Greece to take.

Essentially, Greece and the Greek voters should be given two choices: take the pain and make the necessary cuts or leave the EU. This would leave the decision in the hands of the Greek people, avoiding further cries of them being stripped of their sovereignty, and it would ultimately be better for EU’s monetary and fiscal discipline than a bailout and the moral hazards that come with it.

After all, Greece is not eurozone’s only problem. Budget deficits have reached unprecedented proportions in many EU countries. Concerns about the weak fundamentals and the state of public finances in Portugal, Spain, Italy, Ireland, the UK are evident in the financial markets, with rising sovereign bond yields and sliding euro.

Portugal’s and Spain’s external debt position is worse than that of Greece; their household debt is also considerably higher. Spain, apart from a nearly 10% deficit, has unemployment close to 20% and a banking system weighted down by a massive amount of overvalued real estate. Oh, and the socialist Zapatero government is not any more likely to be able and willing to cut spending than the Greeks. Italy’s and Ireland’s external debt obligations as well as GDP and unemployment rates are also worse than those of Greece. So while the markets’ focus is primarily on Greece, contagion is a very real threat. And not even Germany has the finances to bail out the likes of Spain. Given its size, a full blown fiscal crisis (or default) in Spain would most likely be the death of the euro.

The eurozone governments have to borrow approx 2.2 trillion euros from the capital markets this year to finance their budget deficits (Greece needs some 60 billion just to make it through the year); it won’t be an easy task. A wider fiscal crisis in Europe appears increasingly likely.

Yet ballooning national debts, out of control deficits and rising sovereign risks are not just a European issue. Most advanced economies have huge fiscal problems. The IMF projects the G20 government debt/GDP ratio to reach 118% by 2014. This will severely constrain economic growth.

A recent study by Carmen Reinhart and Kenneth Rogoff (‘Growth in a Time of Debt’) found that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”

The following chart shows the public debt to GDP ratios across the world.

(And let’s not forget the true public debt/GDP levels are several times higher then the explicit figures that exclude massive unfunded liabilities for public pensions, healthcare, social security.)

Consider also the high government spending as a percentage of GDP in many advanced economies today, which causes a further drag on growth, and you get a future of slow economic growth and high unemployment. (In Greece, as well as the US, UK and other countries government spending now makes for approx 50% of GDP.)

The fiscal deterioration will become worse still due to the massive demographic challenges in the developed world. The IMF estimates that increased health spending and other costs related to aging population will drive debt to GDP levels of advanced economies up by a further 50% over the next 20 years.

We will therefore see a significantly higher economic growth in low debt, and most likely sluggish growth in high debt economies such as the UK, US, much of the eurozone and Japan. (A strong rise in government bond yields of much of the developed world is also inevitable.)

But it’s not just government debt. There’s too much debt everywhere, including in the private sector (although the private sector has started deleveraging, while the public sector increased leverage). Total debt is highest in Japan at 459% of GDP and the UK at 469% of GDP (or 380% if adjusted to reflect UK’s position as a financial hub). Spain follows in the third place at 342% (in Greece total private-public debt stands at around 225% of GDP).  

Over the next decade sovereign debt crises and defaults seem inevitable. Those countries that can resort to the printing presses will take the path of a massive monetization of debt, hence reducing their debts through severe inflation. That is the most likely outcome in the US and UK. (Clearly, paying our debts back in devalued currency is simply default by another name.)

Of course the most desirable way to address the budget problems would be by radical spending cuts. The scale of fiscal tightening necessary to return to healthier debt levels would cause a medium-term drag on growth. But not reducing debt will ultimately have much greater consequences.

However, chances we will witness drastic spending cuts in the UK, US and across the eurozone in the next few years are rather slim. The culture of entitlement has made it near impossible to talk about the hard facts. Our political elites will continue to ignore the fact that the bloated welfare states have become unsustainable and we can no longer afford them. The reason is simple – it’s not what the voters want to hear. Instead of acknowledging painful reality and the need to make sacrifices, we prefer to keep kicking the problems into the future. Until the inevitable day of reckoning comes.

Indeed the developments in the US and UK are not at all encouraging.

The Obama administration is determined not to waste a good crisis and continues to focus on a massive expansion of government. Instead of letting the free markets work and acknowledging that it’s the private sector that creates wealth and will be the engine of growth, the political leaders on both sides of the Atlantic show an enormous zeal to meddle in the free markets and reinvent and fix what wasn’t broken.

Redistribution of wealth via tax hikes (as well as introduction of entirely new taxes), a ruinous healthcare reform, expensive energy and climate change legislation, pro-union policies, excessive and ill thought-out regulation… Obama has shown a deep lack of understanding (and indeed contempt) of private business and a determination to socialize the US economy.

And while the productive part of the economy is being hammered, the public sector has been enjoying an unprecedented boom. In 1902 total US government spending was approx 7% of GDP. In 1928 it came to just over 10%; two thirds of that was state and local and just 3% was federal spending (about the same as 150 years earlier, excluding increases during war periods). Government spending has since exploded, making for more than 40% of GDP – two thirds of that being federal expenditure. Public spending increases in 2009 alone came to well over $1 trillion, a rise of more than 20% from 2008.

The UK has fared even worse, with government spending increasing from about 36% of GDP to almost 55%, putting increasing pressure on the dwindling productive segment of the economy.

The following chart from the Wall Street Journal shows the shocking and unsustainable spending explosion. US government spending has grown seven times as much in real terms as median household income over the last 40 years!

And, just as in the UK, employment and compensation in the public sector have continued to increase while the private sector has taken the pain. (Public workers not only enjoy far higher wages than their private sector counterparts but also benefit from extremely generous pensions. These largely unfunded public sector pension liabilities will naturally just serve as further drag on economic growth for many decades to come.)

As the following chart from the Business Insider shows, the US has gone from producing jobs in wealth creating private industries to jobs in the wealth destroying government sector. By the end of 2007 the total number of government jobs exceeded the total number of goods producing jobs.

Indeed, whether we look at the public sector gorging itself at the expense of the private sector, or the widespread culture of entitlement and welfare state (at the expense of the dwindling numbers of hard working taxpayers), this is what has come to characterize our time: enabling the unproductive and lazy to steal from the productive and enterprising. Otherwise called socialism.

So what is being done? Do we see any plans for serious fiscal tightening and debt reduction? Quite the opposite, our leaders seem to be enjoying a rather long vacation from reality.

Obama (and Gordon Brown) have apparently not been listening to Reinhart and Rogoff, or they wouldn’t be attempting to solve our problems by issuing yet more debt.

Perhaps we shouldn’t be too surprised that debt reduction doesn’t seem to be our policy makers’ priority. Indeed, one might think our extreme indebtedness is nothing more than a minor nuisance. Neither our political elites nor the central bankers and leading economists appear to grasp the obvious: that years of cheap, excessive credit and high debt were precisely what got us into trouble. And yet we’re still happily continuing on the same path.

In only three years the Obama administration will have increased the national debt by some $4.35 trillion. (And that excludes the huge deficits of off-budget programs like Medicare, Medicaid, social security.) The budget freeze proposed by the administration for 2011 is projected to save some $15 billion (or about 0.4% of the total budget, a drop in the ocean). Note that it’s merely a budget freeze, not a cut in nominal terms. Worse still, the the vast majority of federal programs (incl. Medicare, Medicaid, social security, military, homeland security etc) are to be exempt from the freeze.

It should be obvious that the US won’t get its debt under control unless it sharply reduces government spending, including on health and pensions that have simply become unaffordable. The US is not much behind Britain and the eurozone when it comes to the horrific shape of public finances. The only advantage, for now, is the dollar’s status as the world’s reserve currency (and of course the country’s control over its own monetary policy).

But that doesn’t change the basic fact – you cannot spend your way out of a fiscal crisis. The current path is unsustainable. The Obama prescription of more debt, more spending and more taxes is a triple ticket to ruin, plain and simple.

But, it would be unfair to focus solely on the US, for here in Britain we are in an even greater mess.

The UK has not only the world’s highest total debt/GDP (along with Japan) but also one of the worst budget deficits at 12.6% of GDP. (According to OECD, only Iceland and Greece have higher deficits, at 15.7% and 12.7%, respectively. The UK is expected to post a 12.8-13% deficit this year, overtaking Greece.)

The speed of the debt run-up has been nothing short of alarming. Unsurprisingly, Britain is already paying higher interest rates to borrow than Spain or Italy. While the yields on gilts have recently risen significantly, they are heading far higher – as soon as the markets start taking a look at other basket-case economies aside of Greece. The pound has fallen by some 25% vs the dollar, and has much further to go unless the markets start seeing some credible solutions from Britain.

Yet there is no political will to face the excessive debt, no meaningful plans for deficit reduction. Gordon Brown’s government has rejected any idea of implementing spending cuts in 2010/2011. And the opposition? David Cameron said spending cuts during the early part of a Conservative government wouldn’t be ‘particularly extensive’.

Government spending has exploded over the 13 years of Labour governments and is now completely out of control. But one would look in vain for austerity measures and severe fiscal tightening, not just from Labour, but also from the (so-called) Conservatives.

The micro-cuts that both the government and the Tories are proposing will not even make a dent in the monstrous amount of public spending. The pledges to ring-fence all main areas of spending, including the wasteful, bureaucratic and inefficient NHS, instantly expose any deficit reduction plans as lacking of credibility.

What remains are tax raises. As if Gordon Brown’s hike of higher earner income tax from 40% to 50% (or 62% once national insurance contributions are added on) wasn’t bad enough, further tax increases are likely on the way. All that (along with the insanity of the additional 50% bonus tax) will only achieve one thing – further damage to the dwindling private sector already suffocated by a gargantuan web of high taxes, red tape, hostile regulation and uncertain political environment.

From Labour’s point of view, there is no harm in further undermining the only economically productive part of the economy. Expansion of government and redistribution of wealth are the objectives. What Brown and Obama have in common is their disdain for and antagonism toward anyone earning (or striving to earn) a decent income, and the desire to redistribute from the hard working and productive to the idle and unproductive.

It matters little which party wins the upcoming general elections; all three of the country’s main political parties have fully embraced ‘progressive’ (read socialist) ideas. A Tory victory may be slightly less disastrous than another Labour term, but nothing that the party is offering will set Britain onto the right path.

And the people have only themselves to blame. Thanks to the vast expansion of government too many millions are now enjoying an idle life of welfare-dependency. Add the millions more in public sector jobs with their high wages and appallingly generous pensions, and it is little wonder that politicians are unwilling to do anything that would anger the majority of the voters.

We have become a society with an overwhelming sense of entitlement – at the expense of those who still believe in self-reliance and hard work, only to see their wealth stolen by the parasites. This unsustainable situation will inevitably blow up, and deservedly so. Only then will a new cycle be able to start. And perhaps, just perhaps, we will even witness a return to common sense one day – as in smaller government, less interference in the free markets and the productive sector, less dependency and more self-reliance.

But in the meantime, as public debt is becoming a crushing burden on most developed economies, the only thing that appears certain is a widespread sovereign debt crisis (and defaults) a few years from now.

We begin with the idea that this is a recovery, however an exceptionally heterogeneous recovery that may simultaneously surprise us by the strength of the positives (we think these may show up as earnings surprises in the manufacturing sector) and the depths of the negatives, by which we mean entire swaths of the American population who are effectively hung out to dry.

This is further complicated by the undeniable fact that Afghanistan and its environs is taking on a Viet Nam flavor, the generation that was in its youthful prime in the real Viet Nam era is slowly riding off into the sunset, to be replaced by a less populous generation who have no real memory of Lyndon Johnson, Da Nang harbor, the Tet offensive, the DMZ, Jane Fonda and Tom Hayden, the SDS, or the Cultural Revolution. In a nutshell, they don’t have a living memory of just how horrendously wrong things can go as a nation is pulled deeper and deeper into a vortex of uncontrollable events. Nor how incredibly expensive these misadventures inevitably will be.

On the positive side, some components of manufacturing America are gathering momentum, benefiting from an extended period of inexpensive money, a very lean labor force, inventory liquidation, and an entire economy feeling the effects of a deferred demand for about two and one half years.

We’ve calculated the average yield on corporate bonds spanning Aaa to Baa in the following chart from 1919 to the present, which would be roughly 6% today, rolling us back to 1967 to find an equivalent cost of borrowing.

If you consider the dramatic collapse in Baa minus Aaa yield spreads, this further supports the thesis that risk appetite has significantly increased in the past months, and investors intend to put money to work instead of parking it in low risk reservoirs.

The latest developments in the Eurozone have understandably provoked a flight to safety and an exit from the lowest quality debt ranges. The depth of the potential crisis is debatable, but EU’s total GDP is slightly greater than the USA’s, so the greater probability is that this will be a drawn out drama where the southern economies and the northern economies will engage in high political drama, cryptic brinkmanship, and hidden power struggles on many levels until they can put a public face on how they sort out a new arrangement.

More striking is the Prime Rate which takes us back to the mid 1950s to find an equivalent level of generosity.

And of course, the Fed Funds rate which is basically the overnight rate, is effectively zero, for now.

Durable goods orders would appear to have reached the bottom of a natural trough and may be beginning to work their way up. Maybe.

So far we have all the ingredients for a nice recovery pop. Hungry workforce. Cheap money. Worn out stuff that needs to be fixed. Fear abating and avarice returning. Chances are very good that we’ll see one or more above average quarters in upside earnings surprises. However, as we alluded in the title, there is devilment in the recovery. One is how exceptionally uneven it is for the consumers (who, after all, are 70% of the purchasing power in this economy) and their exceptionally uneven finances.

The Board of Governors of the Federal Reserve system has prepared sector maps of the United States which look at specific measures of financial condition on a county by county basis. These show various measures of delinquency of certain types of debt overdue by three months or more. Lighter means lower and darker means higher percentage of delinquent accounts seen through three measures. First is delinquency by credit cards. Seen through this optic, some regions are in terrible shape and others relatively unaffected. Those dark blue areas probably represent entire regions who had been surviving on credit cards until those too gave out.

Second is student loans delinquent. Regionally this is a slightly different picture, however the new South and the Southwest are particularly badly affected. We see this as indicative of a young generation already becoming entrapped in a  cycle of unpayable debt. Does anyone remember Indentured Servitude ? A fine old American tradition.

Mortgages delinquent shows an exceptional concentration in California, Florida, Georgia, South Carolina, tracts along the Mississippi River, Michigan, chunks of Arizona and Nevada for example. The intense concentration in these areas seems to indicate that they were cases of particularly egregious lending practices and now have the financial stability of high class banana republics.

What might we infer from this piebald variegation of economic heterogeneity? The fist point is that any general characterization of the American economy is fully missing the point. At the moment there is not one uniform descriptor of what the economy is or how it is performing. Some regions and the industries located in them will probably rocket out of the low phase with surprising intensity, and other regions appear to be set for a long grind of reduced expectations, low horizons, lost social capital, and furious political debate and dishonesty.