2008 Year End Situation and Methodology Update

Over the past few months, we have thought long and hard about how we can help our readers to improve their decision making processes as we enter a period of substantial uncertainty. One of the results of this review has already been rolled out, in the form of asset class valuation models that utilize a consistent "supply of versus demand for returns" methodology. In this issue, we will roll out another result, in the form of a more consistent and explicitly Bayesian methodology for communicating and updating our views on the future of the economy and the evolution of asset class valuations. From this month on, we will begin these updates with a summary of our prior view (i.e., key aspects of our existing mental model), then highlight new developments that seem to represent significant indicators as to the scenario that is developing, and where appropriate, give special attention to outlying or apparently anomalous data and what it could mean. We will conclude with an updated set of views (our "posterior distribution" in Bayesian terms), which will later become the prior for the next update.

Our Prior View

Let us begin with a description of our prior view. We first described it at length in our March 2006 Economic Update. To bring new subscribers up to date, it is worth repeating (in the future, the summaries of our priors will be much more succinct):

"A forecast is constructed in three steps. The first one is to identify the variables that drive the outcome you are trying to forecast, and the most important relationships between them. Together, these variables and relationships constitute your forecasting model. The second step is to estimate future values for these variables. The final step is to judge one's confidence in the forecast, or range of forecasts produced by your model. This is not easy, since there are multiple sources of uncertainty to contend with. "Model uncertainty" is caused by the fact that most models are inevitably simplifications of a much more complex reality. "Parameter uncertainty" is associated with our estimates (forecasts) of future values for the variables included in the model. Up to a point, good analysis can reduce these uncertainties; however, some will always remain. For that reason, managing uncertainty also requires that an individual or organization also have the capability to adjust quickly to unexpected changes in their environment. To that end, we find it very useful to identify the few "linchpin assumptions" upon which a forecast rests.

Linchpins are assumptions that will have a large impact on the outcomes of interest (e.g. future asset class returns) and are also highly uncertain. To facilitate rapid adaptation to changing circumstances, we use these linchpin assumptions to construct a set of "early warning indicators" to help us discern (hopefully ahead of others) the economic scenario that is developing.

In our basic mental model, the top layer -- the target of the forecast -- are current asset class valuations, and their expected future returns. When asset class valuations are above their historical averages, future returns are typically below them. We review these each month in our asset class valuation update. Our current conclusion is that many, if not most asset classes are fully or overvalued today, and, with a few exceptions (which we will discuss at the end of this article), their future returns are therefore likely to be lower than they have been over the last ten years.

Asset class returns result from a complex set of inputs, which one can organize in different layers. Right below asset class returns lies investor behavior. As we have discussed in previous articles, before deciding whether to buy or sell an asset, an investor has to not only assess whether he or she believes it is under, fully, or overvalued, but also assess how he or she expects other investors to behave. For example, a "value investor" will place heavy emphasis on whether his or her forecasting model indicates the asset is undervalued; in contrast, a "momentum" investor will focus on his or her forecast for future investor behavior. Broadly speaking, there is a documented tendency for many investors to be overoptimistic about future valuations, and overconfident about the accuracy of their forecasts, whether about future dividend growth or the future actions of other investors. For example, almost everyone believes they will be smart enough to "get out at the top," even though history shows that few people do. Other analyses have identified the existence of a "cynical bubble" in the last years of the technology boom, in which professional investment managers, while aware of extreme overvaluations, hesitated to sell too soon because their compensation was tied to their annual returns compared to indexes and other fund managers. Sad though it is to admit, we may well be seeing a repeat of this today. Of course, this begs the question of why many asset classes may be overvalued today. The answer to that question lies in the deeper layers of our analytical framework.

Below investor behavior lie policy decisions made by monetary authorities. A key driver of today's high valuations has been the sharp fall in global interest rates in recent years. Taking a long view of this, we go back to the late 1970s, when U.S. Federal Reserve Chairman Paul Volker raised interest rates to historically high levels to quell the sharp rise in inflation that had developed as a result of the monetary expansion that accompanied the "guns and butter" deficit financing of the Vietnam War and the 1973 and 1979 oil price shocks. In 1982, the resulting global economic slowdown triggered a crisis in developing countries that had financed growing current account deficits with short term foreign currency bank loans. Developing countries' inability to repay or rollover their loans threatened the solvency of many of the world's banks, and raised the specter of a severe global depression triggered by a debt implosion. Faced with this threat, central banks reversed their tight money supply policies and lowered interest rates, which enabled banks to rebuild their capital and developing countries to restructure their loans. Falling rates also contributed mightily to a twenty year bull market in bonds and equities. However, one can also argue that monetary loosening made a substantial contribution to the development of the massive property bubble in Japan. And we all know what happened when that collapsed: Japan has been in a prolonged deflationary recession for the better part of the last fifteen years.

More important to our current view is the fact that this process was repeated after the collapse of the technology bubble in 2001. Once again, governments were faced with the prospect of a sharp slowdown in economic growth. However, unlike twenty years previously, this time it was not the banking system that was in the most danger. Rather, it was the U.S. consumer, whose appreciating equity had supported a massive increase in borrowing. More important, with Japan and Europe in the economic doldrums, and Asian countries dependent on exports to the U.S. for their growth, a sharp slowdown in U.S. consumer spending could have led, once again, to a global recession and debt-collapse induced deflation. And so what did we see? Another burst of money supply creation, which led to falling interest rates, which in turn triggered a huge rise in residential property prices, not just in the United States, but in virtually every other country in the world. This enabled consumers, particularly in the U.S. to keep borrowing (this time against rising house values) and spending.

At the same time these developments were occurring in the monetary policy layer of our model, other developments were occurring in the real economy, which is often divided into four sectors: households and corporations (together, the private sector), the public sector, and the external sector (i.e., the current account of the balance of payments). We have already noted how households, particularly in the United States have borrowed heavily to finance an enormous consumption boom. One can argue at length about the underlying drivers of this seemingly unstoppable urge to spend, particularly at a time when more and more people faced sharp rises in job insecurity due to the spread of globalization and the intensification of competition in many industries. Our theory is that it had three causes. The first was the widening gap between the compensation earned by those at the top of the income distribution and everyone else. In no small measure, this reflects the differential impact of information technology on different types of jobs. Middle managers whose function was to aggregate and process information often found their incomes pressured by technology. In contrast, higher managers, whose jobs fundamentally involve the application of knowledge and experience, were able to use technology to leverage their skills, boost their productivity and earn higher incomes. The widening gap between incomes triggered the second cause of the leveraged consumption boom, which is our natural tendency (no doubt hardwired into us by evolution) to want to "keep up with the Joneses." The final piece of the puzzle was the absence of traditional constraints on people's borrowing and spending behavior, whether they be the prudence and moderation encouraged by religious belief or by the requirement that a bank keep its loans on its own balance sheet, rather than packaging them into securities and selling them on to other investors.

Now let us move on to the corporate sector. One of the most vivid memories of the 1980s for many U.S. corporate managers was the radical change in the market for corporate control. With the wider availability of debt financing, and the erosion in court cases of many anti-takeover defenses, it became much easier to acquire and restructure underperforming companies. As a result, corporate managers have focused with a vengeance on maximizing productivity and shareholder value. Enabled by the internet revolution, this has led not only to downsizing and consolidation in many industries, but also to the outsourcing of many business functions to those countries that offer superior cost/quality tradeoffs. While "globalization" is the short-hand term most often used to describe these developments, a more accurate description is the dawn of a new age of "near perfect competition" in many industries that has put tremendous pressure on prices (and, in turn, limited wage increases). While job losses and changes in the world's current account balances are the outcomes most people tend to focus on, another one has been just as important. In many industries, the combination of organizational changes and new technology have led to dramatic improvements in productivity, which have enabled them to meet rising demand for their products and services with far smaller increases in employment and capital investment than had previously been the case.

While these developments were occurring in their respective private sectors, western governments were gradually facing up to an even bigger problem: the enormous liabilities they face as their populations age (for more on this, see "Who's Going Broke? Rising Health Care Costs in Ten OECD Counries" by Hagist and Kotlikoff). As many writers have noted, there are a limited number of ways to deal with this problem, including substantial increases in taxes, and/or household savings, and/or economic growth, and/or cuts in state benefits provided to retirees. In addition, the fiscal impact of this fundamental challenge was further complicated by other problems. In Japan, it was the need to run large deficits in a pro-longed attempt to use higher government spending to lift the economy out of its prolonged recession; in the Eurozone, it was a need to run countercyclical government deficits, as a reluctance to pursue politically difficult structural reforms led to weak private sector growth; in the United States, it was a Lyndon Johnson-like political desire to avoid a sharp tax increase to pay for the rapidly rising cost of the Iraq war. The net result of these problems has been substantial public sector deficits in Japan, the Eurozone and the United States.

By definition, a country's current account balance of payments is equal to the difference between its domestic savings and investment. The difference between domestic savings and investment can be further subdivided into the private sector and public sector balances. Countries that invest more than they save will run current account deficits, while those that save more than they invest will run current account surpluses. The story we have told thus far can be summed up as follows: thanks to a large supply of domestic savings, Japan now runs a substantial current account surplus (as a percentage of its Gross Domestic Product), despite its large public sector deficit. In the Eurozone, public sector deficits are basically balanced by a surplus of domestic savings, leaving a current account balance of close to zero. In contrast, the United States is running very large private and public sector deficits, which have led to a record current account deficit. To fully understand the dangerous and unchartered waters in which the global economy is now sailing, we must now turn to the People's Republic of China.

In our March, 2004 Economic Review, we presented an in-depth analysis of China's goals, strategy, and risks. We will begin now as we did then, with an assumption about China's grand strategy, as summed up in the 2002 Report to Congress by the U.S. China Security Review Commission: "It is clear that China anticipates America's decline and is working to shape a world with a weaker United States and stronger competing poles of power where it can play a central role. China's strategy to achieve this objective appears to include biding its time by avoiding confrontation with the United States, and meanwhile gaining access to American investment, technology and know-how. Economic growth is a central pillar of Chinese power. The Chinese government and its industries share an overwhelming and driving goal to increase the power and international stranding of China as a nation-state."

In broad terms, China's economic strategy has resembled that of other Asian countries: use high domestic savings and foreign direct investment to finance the development of export industries which combine low labor costs, new capital equipment and competitive exchange rates to achieve success in world markets. What has been different about it has been its scale. As we have written before, the aggressive entry of China into the global economy represents a supply side shock of a magnitude not seen since the rapid industrialization at the end of the 19th century.

Over the past ten years, this strategy has, despite its potential for economic disruption, worked remarkably well. Externally, rising Chinese current account surpluses have been used to buy U.S. Treasury Bonds and thus to finance the U.S. current account deficit, while holding down the external value of China's currency. This strategy also held down interest rates in the United States, which kept housing values rising, U.S. consumers borrowing and spending, and Chinese exports growing. Domestically, China's strategy has produced stunning real growth rates -- on the order of nine percent per year -- and in the process created a large Chinese middle class. More important, the leadership of the Chinese Communist Party has remained in power, despite, or perhaps because of, these radical changes to the country's economy.

However, the Chinese growth model is now coming under increasing stress, from many different directions. These include rising domestic dissatisfaction with corruption by party leaders, increasing discontent among peasants at seizures of land (usually without compensation) for urban expansion, growing environmental problems, continued failure to reform a very inefficient and ineffective domestic banking system, overinvestment and overcapacity in many industries, and increasing difficulty in limiting the domestic monetary impact (e.g., the expansion of credit and bad loans at state-owned banks) caused by the enormous increase in its foreign exchange reserves that result from its rising current account surplus. And yet the Chinese leaders know that if the economy fails to keep growing, their hold on power could rapidly dissipate, or lead to an increase in external tensions, if they choose to use nationalism and an external threat to retain their control of the country. The most recent problem added to this mix has been a sharp rise in tensions with the United States.

From the U.S. perspective, the root causes of this growing conflict were well described in the 2005 report of the U.S. - China Economic and Security Review Commission. It began by noting that, "the U.S. - China economic relationship has continued over the past year to expand at a rapid pace. New U.S. foreign direct investment in China totaled nearly $4 billion. The trade relationship grew markedly, with U.S. imports from China outpacing U.S. exports to China by more than five to one. The result was a bilateral goods trade deficit that reached $162 billion in 2004 -- a 31 percent increase over the previous year -- and is on pace to considerably exceed $200 billion in 2005. U.S. manufacturers in a broad array of industries are under increasing competitive pressures from domestic and foreign-investor owned, China-based manufacturers. Although each U.S. industry has a unique set of competitive concerns with China, the principal crosscutting concerns are China's undervalued currency, extensive system of government subsidies (particularly those favoring export-oriented production), weak intellectual property rights protections, and repressive labor practices...China remains in violation of many critical commitments it made in order to obtain agreement that it could enter the World Trade Organization -- on a transitional basis due to the extensive economic reforms necessary for its economy to conform to the market practices of WTO members. China's continued recalcitrance is causing material injury to U.S. companies, workers, and communities. It also is contributing to a highly skewed bilateral economic relationship marked by a soaring U.S. trade deficit and a weakening competitive position for many U.S. firms."

As a result of these frictions, and reflecting the fact that 2006 is an election year in the United States, two pieces of legislation have been proposed in the U.S. Congress (the Schumer-Graham and Grassley-Baucus bills) that would mandate aggressive tariff increases and other actions should China not allow a significant appreciation of its currency versus the U.S. dollar. Because of the substantial negative impact this would have on its economic growth, Chinese leaders seem certain to resist these pressures from the United States.

In sum, we believe that the apparently healthy condition of the world economy today [remember, this was written in March 2006], with very high growth in China and the rest of Asia, recovery in Japan, hints of rising domestic demand in Europe, continued growth in the United States, and fully or overvalued (yet still strangely rising) asset class values around the world is far more fragile than it appears. To be sure, we would be the first to point out that complex adaptive systems like the global economy have an amazing ability to adapt themselves and thus stay in a relatively fragile state far longer than one might first imagine. For example, there were plenty of people who thought equity markets looked overvalued in 1998; however, the crash didn't come until 2001. As those who study complexity like to point out, natural systems can exist in three states. One is excessively stable, one is chaotic, and one exists between the first two, and marks the system's region of maximum adaptability. Clearly, the economic and financial events of the past few years paint a convincing picture of a system struggling to avoid tipping over into the chaotic region. And yet we strongly believe that is where we will end up in the not-too-distant future...[We would like to highlight a number of points]. The first is the extent to which global economic growth has become heavily dependent on the American consumer and continuing investment in China. The second is the record size of the resulting current account imbalances that need to be financed. Today these current account imbalances primarily belong to the United States and China. However, the unwinding of these imbalances implies that other nations will have to generate faster domestic growth, and accept larger current account deficits. The third point is the potential size of the required changes. For example, while the Eurozone and Japan combined account for about the same percentage of global GDP as the United States, their growth rates have been slower, and their combined current account surplus amounts to only .23 percent of global GDP, compared to a United States current deficit that amounts to (1.26)% of global GDP. Even adding India to this mix hardly makes a dent on the balance of payments front. That is a very sobering thought, when you consider that a spending slowdown by overleveraged U.S. consumers is inevitable (likely due to rising interest rates weakening the housing market, as has already occurred in Australia and the U.K.), as is reduced investment in China, which faces growing concerns about concerns about overcapacity and domestic deflation in many industries. In short, the current system's days seem numbered.

To be sure, there is another story taking shape, that claims a major global economic disruption - or, as we have described it, a trip into the chaotic region - can be avoided. This story assumes four key changes from today's situation: (1) faster domestic demand growth in Japan and the Eurozone (due to accelerating structural economic reforms); (2) a shift to lower savings, higher domestic consumption and lower investment in China; (3) depreciation of the U.S. dollar versus Asian currencies; and (4) a prolonged reduction in U.S. economic growth rates. In order to avoid a severe economic disruption, all four shifts need to happen reasonably close together. However, there are good reasons to believe this won't happen. With aging populations and state pension and health systems in questionable fiscal health, there is limited scope for increases in personal consumption (which means reduced savings) and domestic demand growth in Japan and Europe. Moreover, faster domestic demand growth also depends on more progress toward structural reforms, for which political support today seems uneven at best (rising in Germany, falling in France, and uncertain in Japan).

In China, it is hard to envision a substantial reduction in savings and rise in domestic consumption as long as its state pension and health care systems are not trusted by the population. In addition, given the critical link between political stability and economic growth in China, and given the low probability of smoothly shifting its economy away from exports and towards increased domestic consumption, it also appears that it will be hard to achieve a coordinated depreciation of the U.S. dollar versus Asian currencies. Finally, given the erosion of U.S. export capacity in recent years, as well as its increased reliance on imports (particularly for many consumption goods), it is impossible to reduce the U.S. current account deficit to a sustainable level only through faster growth abroad and dollar depreciation. The painful -- and politically unpalatable -- truth of the matter is that correcting the enormous imbalances that have built up in the global economy will require a prolonged period of slower growth in the United States.

As you can see, the joint probability that all four of the critical changes that underlie the "we can avoid a major crisis" story will occur is very low indeed. Hence our conclusion that, while we don't know which of many possible causes will set it off, at some point in the future, it seems highly likely that the world economy will go through a period of chaotic change, most likely characterized by a sudden and sharp drop in the value of the U.S. dollar, a sharp rise in U.S. interest rates, and a slowdown in global economic growth (for a good summary of the conflicting views about when this will occur, see "Global Imbalances: The New Economy, the Dark Matter, the Savvy Investor, and the Standard Analysis" by Barry Eichengreen).

Chaotic change, however, is not quite the same as random change. While their actions are basically impossible to forecast, systems operating in the chaotic region typically vacillate unpredictably between two or more poles, or, as they are technically called, "attractors" before returning to the adaptive or stable zones. For our purposes here, we will consider as attractors two familiar themes for all complex social systems: conflict and cooperation. Let us now look more closely at possible conflict-driven and cooperative scenarios for the three groups that we believe could have a great impact on a global economy operating in the chaotic zone: the American middle class, Chinese peasants, and Iranian students.

The American middle class is barely hanging on today. Health insurance, education for their children, and a secure retirement all seem increasingly out of reach. Leveraged up to their eyeballs with mortgage, auto, and credit card debt, they are working harder than ever, but with a growing fear of losing their job and lifestyle due to outsourcing, corporate consolidation, or increased foreign competition. In this context, the prolonged period of low U.S. growth needed to unwind our current global imbalances will create a head on collision between orthodox economics and political reality. In this case, the conflict-driven outcome would see waves of middle class families declaring bankruptcy, losing their homes, and becoming easy prey to demagogic calls for protectionism and higher inflation, along with much higher taxes on corporations and rich CEOs who "sold out American workers." Once this dynamic gets going, there is no telling where it will end.

Now consider the alternative: a cooperative solution that involves a more controlled form of populism.Such a movement might offer a return to a secure middle class existence, to be obtained by forsaking the excessive "borrow and buy" consumerism of the last twenty years, while accepting a larger role for government and tilt back towards community and away from radical individualism. Specifically, a new populist agenda might start with a change in bankruptcy law that makes it easier for people to shed their credit card debts while allowing them to stay in their homes. Given the extremely high real interest rates earned by credit card companies in recent years, this seems likely to garner wide political support after the economy enters its inevitably sharp and prolonged downturn. On the health insurance front, a Swiss or Australian style single payer plan should also prove popular with American voters. As in the case of the current Medicare program for senior citizens, government would provide a basic health insurance policy to all citizens. To prevent over-utilization of expensive health care services, the single payer policy would carry an annual deductible that could be scaled by income and tied to the tax system. Services would be provided by competing private sector organizations, both for and not-for profit. Elective surgery and other "luxury" items could be covered by additional health insurance policies sold by private companies.

A similar plan could be used to pay for higher education, with government providing a fixed annual loan to students, with repayments tied to the student's post-graduation income, and collections integrated into the tax system. To strengthen retirement security, the new populist agenda might call for an Australian-style mandatory defined contribution pension plan for all workers, based on a prudent mix of low-cost index funds, with required conversion to a real life annuity upon retirement. Additional retirement income could come from voluntary saving and a means-tested minimum social security benefit.

Last but not least, a new middle class populist agenda in the United States might replace the current income tax system with one that progressively taxes consumption. This would not only encourage savings, but also discourage the destructive and divisive "keep up with the Joneses" conspicuous consumption that has driven the overleveraging of the American middle class. Many of you reading these proposals are no doubt shaking your heads and saying, "impossible." And under normal political and economic conditions, you would be quite right. However, it is becoming increasingly clear that what we consider "normal conditions" are illusory, and will radically change whenever foreign institutions and/or governments believe it economically (or, more accurately, politically) expedient to stop their lending to the United States. When that day comes, it is not inaccurate to say that "all hell will break loose", which will confront U.S. political leaders with a choice. They can either go down in history as the people who presided over the destruction of the American middle class, or they can propose and support a bold new populist agenda that will mitigate some of the pain that must accompany the elimination of the extraordinary imbalances that have built up in the world economy. Only time will tell which choice they will make (for another good paper on this issue, see "Is the U.S. Bankrupt?" by Laurence Kotlikoff).

Let us now move on to Chinese peasants. Their future role is likely to be critical because of China's history of peasant revolts, and the current leadership's fear of seeing that happen again. A recent report from the RAND Corporation ("China's Internal Security Strategy" by Murray Scott Tanner) provided an insightful view of the problem faced by the Chinese leadership, and the ways they are attempting to respond to it. Tanner notes that "beginning in about 1998-1999, Beijing's internal security experts launched a serious search for a more sophisticated strategy for dealing with the persistent increases in popular protest that had begun in the early 1990s. Security officials and analysts had begun to recognize that it was probably no longer possible to force protests back down to the very low rates China witnessed in the years immediately following the 1989 Beijing massacre. These security experts explicitly recognized that growing numbers of citizens had legitimate complaints about unemployment, layoffs, illegal taxes and fees, corruption, and numerous other developmental problems that China could not solve anytime soon. Consequently, their new implicit goal was to forge an internal security strategy that would permit them to effectively contain unrest, address some of its underlying economic and policy-related causes, and prevent it from becoming a major threat to the regime's stability...."

"Beijing's goal is to reach out to the vast majority of Chinese citizens who are relatively apolitical -- especially the rapidly emerging urban economic elite -- and persuade them that only the Communist Party can provide them with economic growth, efficient governance, social stability and low crime rates, national unity, and international respect -- to offer them, if you will, clean, responsive autocracy. At the same time, the Party wants to drive a wedge of prosperity and coercion between this enormous mainstream of average citizens and the minority who try to organize opposition, promote systemic political change, or who ascribe to heterodox religious views." However, Tanner's conclusion (in February, 2006) is not optimistic: "Recent reports suggest China is encountering major setbacks in implementing its strategy to contain unrest." Symptoms of this failure include "prolonged protests, increased use of deadly force, signs of increased organization among the protestors, and rising willingness of protestors to resist police attempts to disperse them."

The outlines of a conflict-driven scenario are easy to describe: rising China-U.S. tensions spark either a fall in the U.S. dollar and/or passage of protectionist legislation that causes a sudden drop in Chinese economic growth. This causes domestic frustrations to boil over on a large scale, perhaps driven by an alliance between disgruntled peasants and newly disappointed urban workers. The result could range from increased repression to spreading chaos and falling growth to a sharp rise in tensions with Taiwan as the Chinese leaderships foments an external crisis and uses strong nationalism to regain domestic control. In short, after a sudden drop in Chinese economic growth, lots of things could happen, and few of them are good from a global economic perspective.

Is there a cooperative scenario that could help avoid this fate? The Economist recently spelled out one approach, which can be summed up as a Roosevelt style "New Deal" for the Chinese countryside. The basic idea is that a combination of land reform (creation of private agricultural property) and new government social programs (focused on health, education and retirement security) could not only buy peace in the countryside, but also speed China's transition away from exports and toward domestic consumption led economic growth. It goes without saying that implementing this approach would require overcoming a number of significant obstacles, both economic (e.g., reforming the banking system so that it becomes a far better judge of credit risk), and, perhaps more important, political (much wider private property rights and a far stronger rule of law).

However, China's challenges look easy in comparison to resolving the problem Iran currently poses to the global economy. Work on Iran's nuclear program sharply accelerated following the "9-11 attacks" in the United States and the subsequent American - led regime change in Afghanistan, and later Iraq. This program is under the control of the Revolutionary Guards, who, in their wide involvement in commerce (both legal and otherwise), desire for ideological purity, and apparently ambivalent relationship with supreme leader Ali Khamenei bear a more than passing resemblance to the Chinese People's Liberation Army. With the 2005 election of Mahmoud Ahmadinejad, a stridently anti-western former Revolutionary Guard as president of Iran, it seems increasingly clear that, as Frederic Tellier noted in his recent paper "The Iranian Moment", the country is in the middle of a transition fraught with danger. On the one hand, the political power of the Islamic ideology that dominated the country since the 1979 revolution is giving way to a new leadership philosophy based on nationalism, economic development, and (for the Guards, at least) political authoritarianism (again, the similarities with China are clear). On the other hand, though a large number of reformist candidates were disqualified before the last election by the Governing Council (headed by Khamenei), there still lurks beneath the surface of Iranian society a strong desire for reform, with half the population under 25, and many familiar with and attracted to Western culture.

Multiple writers have suggested that President Ahmadinedjad (and, behind him, the Revolutionary Guards) are betting that, in essence, economic development, leavened with Iranian nationalism, will keep young Iranians' desire for more widespread political reforms in check. Unfortunately, a focal point of their nationalist rhetoric is their program to develop nuclear weapons, which presents the United States and Europe with an agonizing choice. Given their distrust of Ahmadinejad and the Revolutionary Guards' motives, and, indeed, willingness to play by rational cold war rules of nuclear deterrence, many western nations are loathe to see Iran develop a nuclear weapon (see, for instance, "The Day After Iran Gets the Bomb" by Kenneth Timmerman, in the book Getting Ready for a Nuclear-Ready Iran, published by the United States Army Strategic Studies Institute in November, 2005). However, as multiple writers have pointed out, the very act of preemptively attacking Iran to prevent its acquisition of a nuclear weapon not only has uncertain chances for military success, but may also, by stoking the flames of Iranian nationalism, substantially reduce the probability of a viable domestic "Solidarity-like" movement ever arising to challenge the Revolutionary Guards' control. Along with the potential for a genetic mutation to set off a serious global influenza pandemic (the consequences of which we have frequently written about), the future course of events in Iran is perhaps the most important "wild card" facing the global economy today.

Unfortunately, the easiest scenario to envision is the one driven by conflict, with the Iranian leadership seeking to exploit a global economic crisis (and perhaps their deepening relationship with China) to accelerate their progress toward acquiring a nuclear weapon. To say that such a move would carry with it a very high risk of violent consequences with incalculable negative results (e.g. significant disruption of energy markets, or worse) is probably an understatement. On the other hand, one can, albeit dimly, also perceive the outlines of a cooperative scenario. In this case, young Iranians would organize and protest, not to change the regime, but rather to clearly convey to the leadership their preference for accelerating economic development (which requires rising engagement with Western Europe, and probably the United States) rather than a dramatic fall in their standard of living -- or worse. Unfortunately, if it is hard to predict how the Chinese leadership will respond to the choices forced on them by a global economic crisis, it seems infinitely more difficult to predict how President Ahmadinejad and his colleagues will react.

So, let us sum up our analysis. Our first conclusion is that at some point in the future (though the timing of this is notoriously hard to get right) the world economy will suffer a sharp negative shock, characterized by a sudden and substantial drop in the value of the U.S. dollar, a sharp rise in U.S. interest rates, and a sudden slowdown in global economic growth. This conclusion rests on the linchpin assumption that at least one of the four major changes needed to avoid this shock will not happen: (1) a significant increase in domestic demand in Japan and Europe that pushes their current accounts into deficit; (2) a sharp rise in domestic consumption in China, which significantly reduces or eliminates its current account surplus; (3) a substantial fall in the value of the U.S. dollar versus Asian currencies; and (4) a prolonged reduction in U.S. growth rates.

Assuming we are correct, and the global economic system tips over into the chaotic region, the path it will take depends on an additional set of uncertain linchpin assumptions. In the United States, the critical issue is whether the middle class supports a rational populist agenda or a more demagogic and unpredictable one. In China, the critical issue is whether an effective New Deal is offered to the increasingly angry peasantry, before they more aggressively pursue the tradition of agrarian revolt. And in Iran, the critical issue is whether young Iranians, realizing what is at stake, place their continued economic advancement above the extremely unpredictable and potentially devastating consequences of nationalist passions.

Let us now return to the top level of our model. If all four of the major changes needed to avert a crisis are executed, or, once we have entered the chaotic zone, middle class Americans, Chinese peasants and young Iranians all take the cooperative approach to the ensuing crisis, then it is likely that the inevitable global adjustment we face could take place without major long-term damage to a well-diversified portfolio. Under these circumstances, our basic advice to diversify across asset classes that perform well under inflation, normal conditions and deflation would still apply.

However, if this isn't the case -- that is, if the global economic system enters the chaotic region and one or more groups pursues a conflict-driven approach, then, as they say, all normal bets are off. Despite the strong recent performance of the global economy and many asset classes, we reiterate the fragility of the current situation. The world economy is in uncharted waters, and substantial deviations from equilibrium are a distinct possibility. The potentially severe consequences that would accompany uncontrolled rage on the part of the American middle class, Chinese peasants, and/or young Iranians would, should they occur, justify a substantial reallocation of one's portfolio toward short term government bonds (i.e., cash), real return bonds, foreign currency bonds (i.e., foreign government bonds), gold and other commodities (including timber) whose value should remain fairly stable in comparison to bonds, property, and equity which should suffer more in a prolonged global recession."

Over the nearly three years since March 2006, we have regularly updated this basic mental model. For example, we have added two "wild cards" -- developments that are hard to predict but which could cause a very substantial change in the trajectory of the world economy and financial markets: a sudden increase in the human-to-human ("H2H") communicability of H5N1 influenza (i.e., "bird flu"), without any reduction in its mortality rate, and an environmental incident that causes substantial damage and loss of life, which results in a material change in the perceived trade-off between growth and the control of carbon emissions. The most recent updates to our forecasting framework were in our September, October and November 2008 issues. In September, we looked beyond our current model, and presented a preliminary analysis of five developing flash points. These include (1) investors' growing concern about the level of the United States Government's on and off balance sheet liabilities; (2) a potential collapse of public order in Mexico; (3) the widening gap between population growth rates in younger, poorer and older, richer countries, and the sustainability of the resulting increase in immigration flows; (4) the demographic time bomb in the Middle East, as the number of unemployed young people continues to grow; and (5) the increasing tension between authoritarian and democratic countries that both utilize capitalist or semi-capitalist economic systems.

In October, we noted that, "in the United States, we have seen a sharp drop in consumer confidence and spending, and rising unemployment and loan delinquencies along with aggressive government action to maintain liquidity and capital adequacy in the financial system and forestall a deflationary debt collapse. What we have yet to see is an equally aggressive attempt to deal with the root cause of the problem: the overleveraged American consumer. We have lived through enough credit crises to conclude that 'growing your way out of debt' doesn't work. Once they reach a critical mass, the resolution of credit crises requires reducing the economic burden of underlying debt, whether through bankruptcy, debt/equity swaps, renegotiation or inflation. Until we see that happening in the United States, consumer spending will continue to fall, and (barring a dramatic increase in domestic consumption in China) will probably pull the world economy down with it..."

"Looking at the uncertain economic situation we face today, it is hard to say whether our cooperative or our conflict scenario appears more likely to develop, as there are forces pushing the global system in both directions. If we had to make a call, we would go with the conflict scenario, principally because of our doubts about China's ability to manage the transition from an economy driven by exports to one driven by domestic demand. We are also less than sanguine about the ability, and perhaps the willingness, of a President Obama to resist the legislative priorities of some of the more radical (and conflict stimulating) elements in his party, who seem likely to control the U.S. Congress for the next two years..."

"Going forward, our best estimate today is that the economic downturn into which we are headed will be long and deep, and will proceed from a deflationary to an inflationary stage. Given this outlook, we are not of the school that simply says "sit tight and it will be okay." We believe that advice runs too high a risk of turning frightened paralysis into a virtue. Hence, as we have been saying since May 2007, the first order of business for all investors is ensuring the adequacy of their liquidity reserves. Beyond that, we are strong believers in the proposition that investors can improve their risk/return tradeoff over time by following a disciplined approach to rebalancing that involves (1) automatically considering adjustments to asset class weights when a trigger based on a maximum allowable divergence of an actual weight from a target weight (e.g., 2.5% or 5%) is exceeded; and (2) taking current asset class valuations into account, with a specific objective of reducing exposure to substantially overvalued asset classes. To repeat a point we cannot make too often: when it comes to achieving long-term financial goals, the avoidance of large losses is far more important than obtaining a few more basis points of return. On the other side, we believe in increasing asset class exposures when they fall short of target weights by a trigger amount, provided that the asset class in question does not appear to be substantially overvalued. At a time like this, adherence to this approach is not easy. Yet we continue to believe it is the key to long-term investment success."

In November 2008, we took an in-depth look at the threat posed by debt deflation. We reviewed "the apparent lessons of the Great Depression of the 1930s, the history of debt deflations, and the more recent depression in Japan:

• Avoiding a collapse of the banking system and a contraction of the money supply is necessary to stave off a depression. Policymakers recognize this, and have been taking aggressive steps in this area.
  
  
• In Japan, as in the U.S. Savings and Loan crisis, re-establishing transparent values for questionable assets, and moving them off (nationalized) banks' balance sheets and onto the balance sheet of the government (e.g., into the Resolution Trust Company), seemed to speed the return of the financial system to health.
  
  
• However, while necessary, preventing a banking and money supply collapse may not be sufficient to prevent a debt deflation and depression.
  
  
• Uncertainty and confidence are critical to consumers' willingness to spend, and businesses' willingness to maintain employment and invest.
  
  
• Both too few and too many policy initiatives can further raise uncertainty.
  
  
• Beyond reduced uncertainty, however, lies the more fundamental problem of the high levels of debt on consumer balance sheets that was slowing down spending even before the financial markets crisis blew up. The following table shows OECD estimates of household debt as a percentage of household income as of 2005. Keep in mind that in 1985 the OECD average for this measure was only 40%!

• Throughout history, the essential process underway in debt deflations has been the destruction of creditors' wealth, the removal of debt from borrowers' balance sheets, and an increase in the value of and cash and real assets generating positive cash flow. With capital scarce, investors could earn very high returns, and thus were, perhaps, more willing to once again lend and invest, rather than hoard their funds in cash. Similarly, the removal of onerous debt service requirements from borrowers' backs made them more willing and able to resume spending.
  
  
• For better or worse, we live in a different world today, where creditors are either large institutions whose failure would pose systemic risk, or collective investment vehicles like pension funds and insurance companies, whose failure might well escalate uncertainty and further reduce consumer and business spending. Hence, there are political and economic obstacles to the traditional approach of allowing debt deflations to "wipe the slate clean" after periods of excessive borrowing and spending.
  
  
• The scale of the problem also seems too big for established bankruptcy courts to resolve in an acceptable period of time.
  
  
• In the absence of a politically and economically acceptable means of quickly and substantially reducing consumers' debt burden, it is hard to see how deflation and further falls in aggregate demand can be avoided. In the face of uncertainty about whether and when they can get out from under the debt they have taken on, which will inevitably be compounded by fears of losing their job, health insurance, and house, people will not spend on anything but necessities - and this will inevitably trigger further employment losses, collateral value declines, and further write downs of the value of loans and other debt securities.
  
  
• As the Japanese learned through very expensive experience, neither tax cuts nor large increases in government spending can do more than temporarily alleviate this problem. In fact, by repeatedly raising and then dashing hopes, these efforts at fiscally stimulating Japan out of depression may have worsened the problem, by reducing consumers' and businesses' expectations about  the likely impact of these programs. This is not dissimilar to the life-long consumption habits that characterized people who came of age during the Great Depression, or who experienced the high inflation of the 1970s (see "Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?" by Malmendier and Nagel).

In light of the evidence we reviewed, we reached four conclusions:

1. Historical data suggest that the risks of deflation may have been systematically underestimated by policymakers and investors.

2. That said, the deflation expectations implied by the current U.S. government yield curve appear to be excessive, given historic experience, unless one makes the further assumption that there is a high probability of serious policy errors being made by the United States and other countries.

3. While the immediate threat of a banking collapse and severe monetary contraction has been avoided, this is far from a full solution to the problem we confront.

4. The critical indicator of what lies ahead is likely to be what, if any, steps are taken to reduce household debt burdens. If a politically and economically acceptable way to accomplish this cannot be found, the probability of an extended deflationary depression significantly increases.

In sum, our prior view envisioned two possible paths the economy and financial markets can take. In what we term the cooperative scenario, the Obama administration succeeds in keeping the lid on middle class anger through a combination of programs to reduce consumer debt, increase people's sense of financial security in the medium term (e.g., through national health insurance, retirement savings, and education, tax and other reforms), and fiscal stimulus (e.g., spending on infrastructure and greener energy) that limits job losses and reductions in aggregate demand (but not necessarily personal consumption spending, which has to fall from 70% to a more sustainable level as a percentage of GDP). At the same time, the Federal Reserve continues to aggressively expand the money supply to prevent deflation from taking hold, while (along with the Treasury) providing the capital, guarantees and stronger regulatory oversight needed to restore confidence in the soundness of the United States’ financial system.

The cooperative scenario is also characterized by success by China in maintaining social peace and economic growth while reducing reliance on exports, through a combination of fiscal and monetary stimulus, improvements in the social safety net (to help stimulate personal consumption spending), more aggressive anti-corruption efforts, and the selective use of repression (which is likely to be supported by a conservative middle class eager, as in Thailand, to preserve the material gains made over the past decade). The resulting reductions in China's current account surplus will in turn make it possible for the United States to reduce its external deficit (and financing requirements), as well as the pressures placed on the U.S. public sector balance by sharp increase in private sector savings. By reducing the need for monetization of U.S. government debt, this also reduces inflation pressures in the medium term. Elsewhere, the cooperative scenario envisions a stable environment in the Middle East (and hence no sharp security driven spike in oil prices), as falling oil revenues and rising discontent among Iranian youth make the Iranian leadership wary of aggressively pursuing policies (e.g., nuclear weapon development and sponsorship of Hezbollah and Hamas) likely to bring it into armed conflict with other nations. Finally, this scenario further benefits from the absence of destabilizing shocks, such as a significant increase in human H5N1 influenza communicability, or a collapse of public order in Mexico or Egypt.

In contrast, our conflict scenario includes a failure to reduce the severe uncertainty that now confronts the U.S. middle class, leading to a worsening downward spiral of private spending cuts, rising unemployment and bankruptcies, exploding federal debt and money supply growth, and growing populist anger and demands for more extreme measures (e.g., punitive tariffs on Chinese exports and much higher taxes on incomes and wealth). While this scenario may involve an initial period of deflation, it is certain to end in high inflation. In China, this scenario involves the failure to stimulate sufficient domestic demand growth to maintain social stability, leading to aggressive attempts to maintain exports, which trigger conflicts with the United States and the Eurozone. This scenario could also see the Chinese Communist Party attempting to heighten nationalist feelings (e.g., by raising the temperature of its simmering conflict with Taiwan or perhaps Vietnam) to arrest growing peasant anger and threats to its survival in power. Another way to do this would be through closer cooperation with Iran, which, in exchange for greater Chinese economic support, might be quite willing to help raise international tensions in the Middle East (which would generate higher oil prices and government revenues). The untimely death of Egyptian President Hosni Mubarak and the temptations this would pose to Iran would only heighten the potential dangers in this scenario, as would a Russian move to side with China in a growing conflict with the West.

Potentially Significant Recent Developments

In the last two months, we have observed a number of developments that are interesting, in that the likelihood of them occurring under both of our scenarios is low. They include the following:

On the negative side, in the United States, government reaction to the financial crisis since September has been haphazard, with frequent policy shifts and no clear guiding principles. This has likely worsened the uncertainty felt by consumers and investors, and contributed to the sharp fall in spending and flight from riskier assets. There is a fine balance that must be struck in times of economic crisis between policy experimentation and policy consistency; both too little and too much experimentation can easily make a bad situation worse (see, for example, The Forgotten Man, by Amity Shlaes and "Great Expectations and the End of the Depression:" by Gauti Eggertsson of the Federal Reserve Bank of New York). In addition, while billions have been spent rescuing financial institutions (and their well-compensated employees), millions of Americans continue for struggle under the weight of mortgage, home equity and credit card debts, with no relief in sight. We have no doubt that this has generated a rising tide of anger and resentment among the American middle class, that thus far has been held in check by shock at the ferocity of the downturn, and hopes for what an Obama presidency will bring.

On the positive front, President-elect Obama's initial appointments suggest a "stay the course" strategy on the national security front, and the intention to use the opportunity presented by the current crisis to make substantial progress towards restoring the sense of security of the American middle class. For example, here is what President-elect Obama said in his 3 January 09 radio address: "The problems we face today are not Democratic problems or Republican problems. The dreams of putting a child through college, or staying in your home, or retiring with dignity and security know no boundaries of party or ideology. These are America's problems, and we must come together as Americans to meet them with the urgency this moment demands. Economists from across the political spectrum agree that if we don't act swiftly and boldly, we could see a much deeper economic downturn that could lead to double digit unemployment and the American Dream slipping further and further out of reach...We need an American Recovery and Reinvestment Plan that not only creates jobs in the short-term but spurs economic growth and competitiveness in the long-term. And this plan must be designed in a new way -- we can't just fall into the old Washington habit of throwing money at the problem. We must make strategic investments that will serve as a down payment on our long-term economic future. We must demand vigorous oversight and strict accountability for achieving results. And we must restore fiscal responsibility and make the tough choices so that as the economy recovers, the deficit starts to come down. That is how we will achieve the number one goal of my plan -- which is to create three million new jobs, more than eighty percent of them in the private sector. To put people back to work today and reduce our dependence on foreign oil tomorrow, we will double renewable energy production and renovate public buildings to make them more energy efficient. To build a 21st century economy, we must engage contractors across the nation to create jobs rebuilding our crumbling roads, bridges, and schools. To save not only jobs, but money and lives, we will update and computerize our health care system to cut red tape, prevent medical mistakes, and help reduce health care costs by billions of dollars each year. To make America, and our children, a success in this new global economy, we will build 21st century classrooms, labs, and libraries. And to put more money into the pockets of hardworking families, we will provide direct tax relief to 95 percent of American workers." In so far as this represents an accurate statement of President Obama's policy intentions, it raises the probability of the cooperative scenario developing. On the other hand, this plan is likely to run into resistance from powerful interest groups (e.g., insurance companies, doctors, teachers unions, etc.) that have frustrated past attempts at reform. It remains to be seen whether the current crisis will enable the Obama administration to overcome their opposition.

We also noted the publication of three recent OpEds by highly respected commentators that acknowledge the necessity of some type of debt reduction mechanism to speed the resolution of the current crisis (see, "Keynes Offers Us the Best Way to Think About the Financial Crisis" by Martin Wolf in the 24Dec08 Financial Times, "The Age of Obligation" by Niall Ferguson in the 18Dec08 Financial Times, and "Radical Solutions for a Crazy Crisis" by Nouriel Roubini in the 27Nov08 Forbes).

Just as interesting was a 3Dec08 OpEd in the Guardian by Ken Rogoff, former Director of Research at the IMF. Rogoff is also the co-author, with Carmen Reinhart, of an outstanding series of papers that solidly grounds the current crisis in economic history, and warns of its potential severity. In "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison", they concluded that "the precedent found in the aftermath of other episodes suggests that the strains can be quite severe, depending especially on the initial degree of trauma to the financial system (and to some extent, the policy response). The average drop in (real per capita) output growth is over 2 percent, and it typically takes two years to return to trend. For the five most catastrophic cases (which include episodes in Finland, Japan, Norway, Spain and Sweden), the drop in annual output growth from peak to trough is over 5 percent, and growth remained well below pre-crisis trend even after three years. These more catastrophic cases, of course, mark the boundary that policymakers particularly want to avoid." In "Banking Crises: An Equal Opportunity Menace", the extend their analysis to include the historical antecedents from experience in emerging market crises, and again conclude that downturns accompanied by banking crises are likely to be exceptionally severe.

Most recently, in "The Aftermath of Financial Crises", Reinhart and Rogoff reach three disturbing conclusions: "More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post -- World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn." Similar conclusions were also reached in another recent paper, "What Happens During Recessions, Crunches and Busts" by Claessens, Kose and Terrones of the IMF.

In his most recent OpEd, Rogoff notes that "modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time...As the recession deepens, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity and hedge funds. As governments try to avoid nationalisation of banks, they will find themselves being forced to carry out second and third recapitalisations.... When one looks across the landscape of remaining problems, including the multi-trillion dollar credit default swap market, it is clear that the hole in the financial system is too big to be filled entirely by taxpayer dollars.... System-wide solutions are needed. Moderate inflation in the short-run - say, 6% for two years - would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective... In addition to tempering debt problems, a short burst of moderate inflation would reduce the real (inflation-adjusted) value of residential real estate, making it easier for that market to stabilize...If inflation rises, nominal house prices don't need to fall as much." In sum, we believe that stark warnings of the dangers we face by analysts like Reinhart and Rogoff (to say nothing of the equity markets' collapse after the U.S. Congress failed to approve the Troubled Asset Relief Program when it was first proposed) have set the stage for a range of policy actions that should move the United States in the direction of the cooperative scenario. The main risk to this scenario is a repeat of the "gays in the military" flap that so damaged the Clinton administration at the start of its term in office. In our view, the issue that could do similar damage to the Obama administration is so-called "card check" legislation, that would replace the use of secret ballots for workers deciding whether to support workplace unionization with the use of "check cards" which would have to be filled out in full public view of union "organizers." At a time when public blame for the U.S. automakers' woes attaches as much to unions as to the management of these companies, and when the gap between taxpayers and public sector unions has grown wide and increasingly bitter, card check could be an explosive issue that squanders the political capital needed to pass programs critical to reducing uncertainty.

While events in the United States on balance seem to be heading in the right direction, the same cannot be said about China, where there is growing evidence that critical nation may instead be following a path towards the conflict scenario. On 4Dec08, Reuters reported comments by Zhou Tianyoung, a well known researcher at the Central Party School that trains China's future top leaders. Zhou warned that "China risks massive social turmoil [in 2009] as the economy slows and the number of angry jobless grows...This is extremely likely to create a reactive situation of mass-scale social turmoil." These comments should be read in the context of growing support in China for the so-called "Charter 08" manifesto released on 10 December, that is signed by over 300 leading academics, lawyers and journalists, and calls for an end to one party rule, free elections, religions freedom and strengthening of the rule of law. In sum, there are clear indications that domestic political conflict is growing in China as we enter 2009.

A weakening economy seems likely to further fuel this conflict. A report showed Shanghai residential property prices falling ten percent in the second half of 2008, which strikes at the source of the rising wealth of the urban middle class. Then on 26Dec08 of Zhou Xiaochuan, governor of The People's Bank of China (the central bank made the following remarks: "although the [Chinese] government has pledged to boost consumption to sustain growth, we still face difficulties in identifying which areas and which measures we should take to spur spending." The similarly timed announcement of Chinese policy moves to support companies in labor intensive export industries, and other steps to slow the reduction in China's current account surplus imply that the nation's leaders are pessimistic about the expected impact of their policy reforms and stimulus program on domestic demand growth. The details of this program are well covered in the World Bank's most recent China Quarterly Update; also, for more on Chinese reluctance to expand consumption spending, see "Prudent Asia is Unlikely to Bail Out the West" by David Pilling in the 10Dec08 Financial Times.

Our pessimistic view of emerging developments in China was reinforced by Chinese leaders' comments during their December meetings with U.S. Treasury Secretary Henry Paulson. Zhou Xiaochuan, the Governor of The People's Bank of China (the central bank), noted "the important reasons for the U.S. financial crisis include excessive consumption and high leverage." And, in an ironic echo of the advice the United States has given to over-indebted developing countries in the past, Zhou recommended that the U.S. "should speed up domestic adjustment, raise its savings rate and reduce its trade and fiscal deficits." Zhou's remarks ignore a fundamental point: China cannot have it both ways - absent much larger (and unlikely) current account deficits in Europe and elsewhere, smaller U.S. current account deficits cannot be achieved without a sharp reduction in China's current account surplus. This point was very succinctly summed up by the Financial Times' Martin Wolf in his 2Dec08 column: "This then is the endgame for the global imbalances. On the one hand are the surplus countries. On the other are these huge fiscal deficits. So deficits aimed at sustaining demand will be piled on top of the fiscal costs of rescuing banking systems bankrupted in the rush to finance excess spending by uncreditworthy households via securitised lending against overpriced houses. This is not a durable solution to the challenge of sustaining global demand. Sooner or later -- sooner in the case of the UK, later in the case of the US -- willingness to absorb government paper and the liabilities of central banks will reach a limit. At that point crisis will come."

"To avoid that dire outcome, the private sector of these economies must be able and willing to borrow, or the economy must be rebalanced, with stronger external balances as the counterpart of smaller domestic deficits. Given the overhang of private debt, the first outcome looks not so much unlikely as lethal. So it must be the latter. In normal times, current account surpluses of countries that are either structurally mercantilist -- that is, have a chronic excess of output over spending, like Germany and Japan -- or follow mercantilist policies -- that is, keep exchange rates down through huge foreign currency intervention, like China -- are even useful. In a crisis of deficient demand, however, they are dangerously contractionary. Countries with large external surpluses import demand from the rest of the world. In a deep recession, this is a "beggar-my-neighbour" policy. It makes impossible the necessary combination of global rebalancing with sustained aggregate demand. John Maynard Keynes argued just this when negotiating the post-second world war order. In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy. Some argue that an attempt by countries with external deficits to promote export-led growth, via exchange-rate depreciation, is a beggar-my-neighbour policy. This is the reverse of the truth. It is a policy aimed at returning to balance. The beggar-my-neighbour policy is for countries with huge external surpluses to allow a collapse in domestic demand. They are then exporting unemployment. If the countries with massive surpluses allow this to occur they cannot be surprised if deficit countries even resort to protectionist measures."

Finally, Iran seems to be pursuing a more conflict oriented line as its government's domestic fiscal and political situation deteriorates with falling oil prices and the continued trade and investment embargo by western nations intended to curb its nuclear program. It may well be more than coincidence that the recent increase in rocket attacks by Hamas (whose main backer is Iran) on Israel from Gaza occurred just as President Ahmadinejad was forced to introduce what is sure to be extremely unpopular legislation ending domestic subsidies on fuel and electricity ahead of the presidential election in June, 2009. Could this be a ploy to raise oil prices by further ratcheting up Middle East security worries that were already high in the wake of the Mumbai attacks and the renewed threat of India attacking an already fragile (and nuclear armed) Pakistan? Or, to take this argument one step further, could Ahmadinejad be trying to trigger Iranian involvement in a larger conflict that would heighten nationalistic feelings and deflect the anger of Iranian youth from the country's quickly deteriorating economic conditions? Clearly, the means, motive and opportunity are present, so this hypothesis cannot be rejected at this point. In sum, it seems more likely that events in Iran are developing in the direction of the conflict rather than the cooperative scenario. While domestic frustration among Iranian youth is undoubtedly rising, the chances of this triggering large-scale collective action and replacement of the Ahmadinejad government with a much more moderate regime still seem remote.

Updated Mental Model, Critical Uncertainties, and Asset Allocation Implications

In 2007, United States private consumption expenditures represented almost 15% of world GDP, on a purchasing power parity basis (70% of U.S. GDP, which accounted for 21% of world GDP). That spending (and the consumer credit extension that supported it for so long) is now in freefall. The following table, which we have frequently used in the past, helps to understand the implications of this drop.

These data are based on the October 2008 World Economic Outlook issued by the IMF. The nine countries and regions covered account for almost 70% of global GDP, calculated on a purchasing power parity basis. The third, fourth and fifth columns describe the relationship that we refer to as "the economic balance equation." According to this accounting identity, the sum of a nation's private sector balance (Total GDP less private consumption - which equals private savings - less private investment) plus its public sector balance (revenues less expenditures) must equal its current account (external) balance with the rest of the world. This table helps clarify the crux of the current crisis. Given the fall in U.S. private consumption spending, either its current account deficit must shrink, or its public sector deficit must rise. If the former is to happen, then it must be accomplished through a combination of a decrease in China, Japan, and the Middle East's current account surpluses, or a rise in the Eurozone's current account deficit. Falling oil prices will account for some of this adjustment. But mathematically, they cannot fully offset the fall in U.S. private consumption. For this to happen, China, Japan and the Eurozone must either stimulate private consumption spending or increase government consumption. Unfortunately, all these regions face considerable obstacles to increased private consumption, not the least of which are strong cultural norms that value saving, which have been further reinforced by the current climate of global uncertainty and fear. This leaves an increase in government spending. Here the level of government debt that Japan accumulated during its prolonged battle against the forces of deflation and stagnation constrains their ability to run large government deficits today. That leaves the Eurozone and China, two areas that might both expect to benefit from a weaker United States.

We therefore seem to be currently engaged in the macroeconomic equivalent of a game of chicken. On the one hand, in the absence of greater fiscal deficits in China and the Eurozone, the United States faces a choice between a deep and prolonged recession/depression or the accumulation of debilitating amounts of debt to finance extremely high fiscal deficits for a prolonged period of time, during which inflation, trade protectionism and international conflicts will inevitably increase. On the other hand, China and the Eurozone face a choice between running greater fiscal deficits or living in a slower growing, inflation ridden world that could easily devolve into four blocs: An Asian bloc led by China; an Americas bloc led by the United States (which might incorporate a greater Anglosphere that also includes India); a European region characterized by an uneasy tension between Russia and the E.U.; and a very unstable but resource rich Middle East.

If the world pursues cooperative solutions in 2009, the damage to the world economy and investors' portfolios will be far less than if the world heads down the conflict ridden path, either by accident or because of the intentional actions of one or more parties. In the near term, we will be paying close attention to the way critical micro and macro uncertainties are being resolved.

At the micro/agent based modeling level, there are two central uncertainties. The first is whether the Obama administration will be able to reduce the insecurities and confusion facing the American middle class, before they metastasize into destructive and unpredictable populist anger. The second is whether growing economic and political frustration in China reaches a tipping point where it can no longer be held in check by increased government spending and higher levels of repression. Both of these micro level issues involve a mix of cognitive and emotional changes at the individual level, and their amplification through social interaction.

At the macro level, the central uncertainties are whether potential South Asian/Middle Eastern conflicts can be held in check and whether a balance can be struck between the United States, China and the Eurozone that enables current account imbalances to reduced over time without a violent disruption of world trade and financial markets. On the first issue, the actions of India and Pakistan, and Israel and Iran, will determine whether current conflicts explode or are held in check. On the second macro issue, the evolution of events in China will be critical.

Let us now turn to the asset allocation implications of this analysis, as we prepare to enter the Chinese year of the ox, which (accurately, we hope) is characterized by prosperity through fortitude. Here is our assessment (from our Asset Class Valuation Update) of current asset class over and under valuations at the end of December 2008:

Probably Overvalued	U.S., Japan, Swiss and India Government Bonds; Swiss Commercial Property
Likely Overvalued	Japan Real Return Bonds; Equity in U.S., Japan, and India
Possibly Overvalued	Canadian and Eurozone Government Bonds
Possibly Undervalued	Japan Commercial Property; US AAA Corp. Bonds
Likely Undervalued	Commercial Property in Australia, Canada, Eurozone, UK and US
Probably Undervalued	Timber; Equity in Australia, Eurozone and UK; Canada Commercial Property

Looking forward, we divide economic and financial conditions into three possible states, under which different asset classes will tend to outperform; hence, the highest returns from tactical over and underweights will be earned by those investors who best anticipate these turning points. We are currently in the state we term Uncertainty/Deflation, in which government bonds, equity volatility and timber will perform well. However, apart from timber, these asset classes appear to be either fully or even (in the case of many government bond markets) overvalued today. This is not to say that they may yet see further price appreciation, if the conflict scenario develops and our stay in the current state is extended. However, some of these gains, particularly in the case of nominal government bonds, seem likely to be reversed when the economy moves into the Inflation state, which the current explosion of money supply creation has made virtually inevitable.

When this occurs, one would expect to see real return bonds, commercial property, commodities (including gold coins) and timber outperform, as they all help to preserve the real value of an investor's capital. Today, two of these (commercial property and timber) seem undervalued, and that may also be the case (on a forward looking view) for the other two as well.  In the inflation state, it is also not clear to us how various currencies will perform. Over the past year, we have seen, central banks financing virtually all the U.S. current account deficit, and a sharp appreciation of the dollar as the 2008 crisis worsened, due to a rush by global investors into the perceived safety of short term U.S. Treasury securities. However, with record-setting U.S. fiscal deficits on the horizon (not to mention very substantial off balance sheet liabilities for future health care and retirement spending), one cannot dismiss a rush out of the dollar at some point in the future, particularly if the Obama administration fails to significantly reform the U.S. health care and retirement savings systems, and/or if massive fiscal stimulus fails to reignite economic growth. However, there remains the equally significant question of where one heads after rushing out of the U.S. dollar. While the Euro offers deep and liquid markets, its attractiveness will depend on how it handles the current crisis (the riots in Greece and crises at multiple banks are not good omens), and how the larger macroeconomic and global political environment evolves in the months ahead. In the past, we have argued that the Australian and Canadian dollars are even more attractive than the Euro, given the strength of their underlying resource endowments and their very significant progress on managing immigration, health care and retirement income security issues. However, neither Australia nor Canada offers sufficiently deep and liquid markets to absorb a large flow of money out of U.S. dollar assets. That leaves gold and oil, two commodities with deep markets that can also serve as relatively liquid stores of value. So in addition to a hedge against inflation, these two assets are potentially attractive as hedges against a sharp fall in the U.S. dollar.

At some point, as happened in the early 1980s, the inflation dragon will be forced back into its cave -- the presence of Paul Volker on President Obama's team suggests this might happen relatively quickly after it makes its inevitable appearance. We expect the demise of inflation to mark a return to the normal state, which will favor the performance of equities in all regions of the world. As noted above, we believe that in many markets, equities are already significantly undervalued. Indeed, just looking at dividend yields -- which studies have shown to deliver the bulk of long-term equity returns -- it is hard not to be tempted by Taiwan (8.2%), Netherlands (8.0%), Singapore (6.9%), Sweden (6.8%), Norway (6.4%), Australia (6.7%), France (5.4%), Hong Kong (4.6%), the UK (4.5%) and Switzerland (4.4%). This raises the question of whether it makes sense to overweight them today. In response, we like to point out the old saying that a stock that is down 90% is one that went down 80% and then another 50%! For investors with long horizons and sufficient resources (financial, emotional and social) to live with the possibility that last drop may not yet have occurred, and with the possibility that the world may yet slip into a prolonged period of heightened conflict, an overweighting of some equities looks attractive today. However, for investors who are more worried about not getting caught out by the next stage of the current crisis, an overweight in inflation hedges should be a less stressful course of action to pursue.

We also continue to believe that, regardless of overall market conditions, a small allocation to equity market neutral active strategies can benefit most investors' portfolios, provided the EMN fund or funds have a low historical correlation of returns with those on broad asset classes (for better or worse, this is the best indicator individual investors are likely to have when it comes to predicting future correlations). Investors who wish to "outsource" opportunistic tactical allocations across asset classes should also consider a small (e.g., no more than five percent of total assets) allocation to a broadly based TAA or Global Macro fund, such as PIMCO's publicly traded (in the U.S.) All Asset Fund or, in Australia, Blackrock's Asset Allocation Alpha Fund. Finally, we stress (yet again) the importance of taking a prudent approach to managing liquid reserves (the category in which we include cash and physical gold coins). In light of the elevated levels of uncertainty we confront, precautionary savings should be higher than normal in relation to funds allocated to long-term investments in the above mentioned asset classes and active strategies.

| 2008 Year End Double Issue: Key Points | This Month's Letters to the Editor: Commodies: Supply, Demand and Equilibrium; Construct of DJAIG; Benefits of ENM in Model Portfolios; Liquidity Reserves; and the Purpose of our Monthly Asset Valuation Update | Global Asset Class Returns | Asset Class Valuation Update | What Will We Tell The Clients? | 2008 Year End Situation and Methodology Update | Product and Strategy Notes: How to Deal with Real Debt Burden; Why He Madoff with Their Money; Great Writing Not to be Missed; Interesting Data Returns; Thought Provoking Research; and New Products | 2007-2008 Benchmark Portfolios - All Currencies |