The Great Debate: 3Q2011 vs. 1Q2012

(Patriotic music starts. Camera pans audience of diverse college students, respectable elderly, and concerned baby boomers. People cheer and clap as they watch themselves on the screen above the stage. Two tense parties stand behind impressive lecterns. A thoughtful woman with a somber bearing steps on to the stage. She begins to speak…)

[MODERATOR]:
Ladies and gentlemen, I am Lady Liberty, moderator of tonight’s debate between 3Q2011, also known widely as The Third Quarter of 2011, and 1Q2012, the ever cheerful First Quarter of 2012. (Cheers, applause. She nods in acknowledgement.) As our audience knows well, these two quarters have expressed contradictory opinions about the global economy, have been passionate in their perspectives, and have strong feelings about the future. To begin tonight’s discussion, I would like each contestant to reintroduce themselves to our audience. 3Q2011, you came first on the calendar so let’s begin with you.

[3Q2011]:

Thank you, Lady Liberty. I’m glad I am back, but I bet your audience is not! (boos, a scattering of hisses) Truly, I only came back tonight because I have a few things to say that remain as relevant as they were a just a few short quarters ago. Look, I’ll be brief. I showed up after two years of stock market and commodity bullishness, a literal frenzy of risk taking with nothing but upside. My job? To get real, to remind the world how it really is. Congressional inaction on the debt ceiling? On my watch. Standard & Poor downgrade of the United States? On my watch. Gold at $1,900 per ounce? That’s me too. A 14% decline in equities? C’est moi! And of course, like any good contrarian quarter of late, I had a Greek meltdown to boot. I put the "sting" back in "investing" and I’m proud of it.

[MODERATOR]:

Well, thank you for your candor. 1Q2012, you have strong feelings as well. Tell us about yourself.

[1Q2012]:

Thank you for inviting me back here tonight. I have missed you all…but I bet you have missed me more! (audience roars approval) You all know me already. Jobless numbers coming down, decent earnings, strongest stock market in years. Even got interest rates moving up again and that was not easy. I feel like the sunshine after the storm tonight, St. George going up against the dragon. I spent my quarter cleaning up much of the mess made by my colleague here and the risk is back on, baby. We’re feeling good! (enthusiastic applause)

[MODERATOR]:

Well, well, it is clear we have quite the contest tonight. Before we dive in, let’s set the ground rules. During the course of the debate, audience members may not place block equity index trades or make any commercial loans. (disappointed sigh from audience) But don’t worry, the Treasury desk is always open so buy to your hearts content. (cheers)

[MODERATOR]:

First question. The European Union is in financial peril. How do you view the endgame? 3Q2011, you first.

[3Q2011]:

Très mauvais. Muy malo. Very bad. And agonizingly slow. Remember what I said last September. These folks do not have the willpower or political capital internally to make it work. The Greek government agrees to Germany’s strong-arm austerity plan, then backs down and says the people will vote, then reverses course…I mean, come on! You couldn’t make this stuff up. (laughter) The European Central Bank spent my quarter deciding whether or not to print money. Really? Really? You know, for the ancient Greeks, the prefix "EU" meant "good;" for modern Europe, it only means bad news and for a long time to come.

[1Q2012]:

Now hold on. The EU has bought itself some time. While my colleague 3Q2011 stirred up unwarranted fear and anxiety, I dedicated my quarter to calm statesmanship and tough negotiations, to giving the new president at the ECB, Mario Draghi, and Italy’s new prime minister, Mario Monti a chance to assuage unfounded fears. Are there problems in the EU? Sure, but they will not ripple out into global markets and certainly won’t spark another global recession. My quarter reflects that most people believe the European Union is a good concept that simply needs to work out some short-term challenges. Look Lady Liberty, remember how long it took the original U. S. of A. to get a sound economic footing…

[3Q2011]:

Yeah, but there was one language in the United States, no history of inter-colonial warfare, no currency futures contracts, and a world in which it took six months to get news across the Atlantic. Hardly a fair comparison…

[MODERATOR]:

Since we are talking comparisons, let’s return to this side of the pond. How do you feel about US fiscal policy?

[3Q2011]:

What fiscal policy?? (applause) Hey, I’m proud that Standard & Poor’s had the courage to tell it like it is during my quarter. I only wish that Moody’s and Fitch had been equally candid but they probably knew that they’d be putting their jobs on the line. Seems that everyone, including me, likes to bash Congress, but I think my quarter demonstrated that the real culprit here is the American voter. No different than in Europe. These representatives are elected by people who want their perks, their favorite programs and deductions and it’s on both sides of the aisle. If the vast majority of American voters do not want the US to be fiscally responsible, then heaven help the congressional representative that tries to be responsible.

[1Q2012]:

I don’t want to shock you but I actually agree with a part of 3Q2011’s analysis (collective gasp from audience)—but don’t worry, he’s mostly wrong! (jovial laughter) Look, we don’t need to worry about a fiscal crisis in the US. As my friend, 3Q2011 showed us, the US dollar still is the reserve currency of choice and the US Treasury Bond is the world’s safe haven. Where are countries, companies, and individuals going to put their money when they seek safety? Russia? China? Western Europe? Let’s be real, America is doing fine. Americans hate cutting spending, true, but they also are focused on economic growth. Consumers are shopping and borrowing again. Would they do those things if they were worried about the debt situation?

[MODERATOR]:

Lots of generalities from you both. Let’s get specific. The Ten-Year US Treasury Bond currently pays lenders 1.75% per year. Is that the right rate? If not, what should it be?

[3Q2011]:

Remember, it was during my quarter that the Ten-Year US Treasury yield broke below 2% for the first time ever, plunging to 1.71%. Whether you like the market or not, the rate is the rate. People complain about the Fed keeping rates too low, but you don’t exactly see a rush to the exits now do you? Look, I was saying back in September that the US Treasury yield should be low given our fiscal crisis, slower than normal growth prospects, and lack of investor confidence. And what is it now, a cool eight months later? Why it’s back at about 1.75%! You see, the US remains a safe haven and with all of the risk in the system, it should be low. I have a hard time imagining the yield moving up meaningfully in the next three to five years.

[MODERATOR]:

Even with inflation in the 2-4% range? How many investors will lock in real negative returns and thus knowingly lose money relative to inflation?

[3Q2011]:

A lot of them apparently. (nervous tittering in the audience) Investors do not trust equity market returns, do not want to invest in more real estate, and are concerned about fiscal mismanagement amongst our largest corporate and sovereign entities; so, they are willing if not happy to accept a negative real return.

[1Q2012]:

I disagree. It’s easy to be a bear and play into fear. Reality is, however, that we are seeing job growth—modest yes, but it is there. Americans are cleaning up their balance sheets. Individuals, corporations, even municipalities are streamlining. Interest rates are only low because we have an overactive Federal Reserve intent on keeping our cost of funds down and trying to keep the banks from imploding. Look what happened in March. In just two weeks, the ten-year Treasury shot up to 2.37%, an increase of nearly 20% in just a few days. Imagine where rates would be if the Fed would simply let the market be the market.

[MODERATOR]:

But wouldn’t that drive up the cost of debt service for the Feds and for countless municipalities, corporations, and individuals?

[1Q2012]:

There would be some pain in that regard, but at least lenders and borrows would know the real cost of doing business. Remember, uncertainty creates volatility. Give investors a clear sense of what things are worth and they can make decisions accordingly. That’s what my quarter was all about…

[3Q2011]:

Your quarter? Your quarter was goofy! It was a brief interlude of pretending that…

[MODERATOR]:

Hold on, hold on! We have time for a last comment from each of you. Please take 20 seconds each to give advice to the current quarter, 2Q2012. She has had a tough time and would benefit from your insight.

[3Q2011]:

Look kid, I know you’re young, just over half-way through, so there’s hope yet. Just tell the truth. Let folks know how bad it is and stop confusing them. You’re like spring in Colorado, hot and sunny one hour, cold and wet the next. Make some decisions so that investors, consumers, business leaders, and everyone else know what to expect and how to react.

[1Q2012]:

Look kid, I know you’re young, just over half-way through, so there’s hope yet. Just tell the truth. Let folks know how good it is and stop confusing them. You’re like spring in Colorado, cold and wet one hour, hot and sunny the next. Make some decisions so that investors, consumers, business leaders, and everyone else know what to expect and how to react.

[MODERATOR]:

Well said. This is Lady Liberty signing off. Thanks for joining us. We hope we’ve clarified things for you.

(camera pans a puzzled audience slowly rising and trying to find their way...)

Catch 2012

An older man named Yossarian stopped by the office the other day. No first name, just Yossarian. I mentioned that Yossarian was the main character in Joseph Heller’s Catch-22, the satirical 1961 novel about ironic incompetence in America’s wartime bureaucracy. The man smiled.

In our business, people sometimes bring a sealed manila envelope and ask us to look at their stuff and let them know what we think. That’s what he did.

I began to explain that I would need to learn more to properly evaluate the situation, but he just smiled, stood, and left. Puzzled, I slit open the envelope and peered inside. No statements, no investment policies, just a few words scribbled in long-hand. And though he wanted my feedback, he left no forwarding address, phone number, or other contact. So I republish his words here as one way to strive to contact him and say I think he’s on to something.

He wrote:
___________________________________________________

In my day, Catch-22 impacted those serving in US Army Air Corps flight crews by proclaiming: You are insane if you willingly fly dangerous combat missions, but if you make a formal request to be removed from duty, you have proven yourself sane and therefore cannot be removed from duty. Brutal.

As we have redefined power away from boots on the ground towards economic strength, our ironic humor has followed suit. After all, I’m a 95 year old retiree with my life savings safely earning 0% for three years despite skyrocketing cost of health care, food, and energy. Apparently, the low return is supposed to encourage me to take bold risks and thus do my part to reduce the jobless rate and trade deficit. We can’t have a bunch of slacker 90 year olds earning interest on their savings. What kind of message would that send??

Now if you look at it right, that’s funny. However, if you are not sophisticated, you might consider such a policy intolerable, but then you’d only be proving that you are unsophisticated. Welcome to Catch-2012! But wait, there’s more…

The Stimulus Catch
Consider the stimulus. Since December 2008, the US Federal Reserve has kept its Target Rate as close to 0% as possible. Ostensibly, the low rate is supposed to loosen credit markets and stimulate economic activity. However, the Fed has justified the low rate—and manipulated the bond market to keep it low—by claiming in a somber monotone that the economy is in such dire straits that extreme measures are required. So in addition to potentially stimulating economic activity, Fed policy has stimulated fear and uncertainty, both of which happen to be poorly correlated with economic activity. And to reinforce the conundrum, the Fed intends to keep the Target Rate at close to 0% until at least 2014 because that’s how bad things are. So, go shopping, grow your company, and take your banker to lunch because the economy is even worse than you thought. Stimulating indeed!

The Electoral Catch
Consider those talented candidates of both parties running for President over the past year who have made a lousy economy part of their campaign. How stressful must it be for them to see the unemployment rate declining, to hear that manufacturing numbers are picking up, that even consumer confidence is improving. NOOOOO!!! Of course, the incumbent faces a challenge as well, having proposed policy changes that play to financial insecurity and antipathy toward capital and capitalists. So prepare for Super PACs on both sides to spend a fortune messaging that our economic model is fundamentally flawed and so their candidate should be in charge of it. It’s sure to be a Catch-2012 election!

The Analytic Catch
The real trick to analyzing economic growth, unemployment, tax revenues, consumer spending, and other data points is to make it appear that it would have been far better if only you had been in charge, or if you have been in charge, then it would have been far worse if you had not been. Brilliant really, because there is no control economy to which one can compare and so no meaningful way to evaluate the assertions. By reducing economic analysis to ideological argument, we have marginalized economic data from our assessment of the economy. (Unless there is a parallel universe with an alternate reality United States where we can manipulate Fed, tax, and regulatory policies to compare them to our actual policies. Since we keep cutting the NASA budget, we’ll probably never find out about parallel universes anyway, so we’ll have to ask China to keep us posted. Another catch.)

The Too Big to Fail Catch
The Original Assumption: Big banks are vital to America’s economic health because their massive balance sheets ensure safety and better protect our economy. The Recent Reality: Federal authorities representing both Parties bail out, prop up, or otherwise provide life support to those same big banks because their massive balance sheets endanger our economy and way of life. The Lesson: Encourage greater bank consolidation because Original Assumption must have been true before it was proven false. The Impact: Confusion mixed with mild bouts of nausea.

The Fiduciary Catch
The early version of what became the Dodd-Frank Act would have established a fiduciary standard across the investment industry, requiring most financial professionals to act in the best interest of their clients. Those crazy Congressmen! Such a change would have required a retooling of how the industry works, especially how investment firms are compensated. The American consumer, however, was saved by lobbyists from the broker-dealers, banks, and insurance companies who pointed out that being held to a fiduciary duty would inhibit the industry’s ability to meet their clients’ needs. After all, how can you serve your client if you owe the client loyalty and care? Talk about Catch-2012! Senator Dodd and Congressman Frank were persuaded (legally of course) and quickly struck the fiduciary standard language from the Act. Neither Party complained, nor did consumers; thus, the industry got back to business.

The Final Catch
Enough ravings from an old man. The real catch about Catch-22 and Catch-2012 and the other ironic policies we inflict upon ourselves is that we inflict them upon ourselves. No one wakes up in the morning and says, “How can I make things really difficult for my fellow Americans by creating insensible policies and regulations?” We simply lack the humor or intelligence to plan ahead that well.
___________________________________________________

The ultimate Catch is that we are stuck with ourselves. It’s the price we pay for representative democracy. And as we watch our fellow human beings in Syria, Russia, and Myanmar struggle for the same right to be stuck with each other, we can’t help but wish them every success. May they catch the opportunity they seek.

Giving Credit Where Credit is Due

Dear Friends,

This week, we forward you a letter recently written to our good friend, Credit Markets, someone who has been taking a beating of late and yet one who has made a tremendous difference in our lives. We hope you enjoyed your holidays and found much for which to be thankful.

Sincerely,
Syntrinsic

**********************************************************

Dear Credit Markets,

In the spirit of Thanksgiving, thank you for your friendship over the past many years. While this has been a hard time, know that there are still those among us who remain your fans. You have been maligned in the press, undermined by politicians and bankers, and bemoaned by overzealous borrowers. You have caused riots, enhanced losses, and brought down governments. Still, we appreciate you.

When I was young, my grandfather told me how you helped him out after the War. He had returned ready to put the violence of WWII behind him and determined to escape the poverty in which he had been raised during the Great Depression. Unwilling to spend his life working for others, he conceived of a new idea in a highly competitive market. All he needed was some capital to compliment his sweat, intelligence and hustle. In the beginning he was not a typical banking client so you came to him via established business people who were willing to take a leap of faith—not a cheap leap of faith, but a leap nonetheless. And as his business grew, you came to him through more conventional means, banks and other commercial lenders. Fittingly, as the years went on and he became an established business person himself, you and he partnered to help other early stage entrepreneurs, some of whom never would have found credit through more formal channels, but found success because of the work you did with my grandfather.

I remember, too, how our friendship grew back when I wanted that business degree. Here I was, a long-haired nonprofit leader striving to become a business person, and unlikely as my potential success was at the time, that didn’t bother you one bit. You gave me a chance to reinvent myself professionally. Wasn’t easy of course, working 80-90 hours per week and school on top—and I’m still paying you back every month. It’s an easy payment to make however, a gentle periodic reminder of how I could depend on you at a critical time.

The other day, I heard a university professor insulting you in front of thousands of students, calling for them to refuse to pay back their own student loans. Ironically, he wanted those students to disown you, abandon you, in effect destroy you. It did not seem to occur to him that to assault you would be to punish the students (and professors) to come, those who would need you to be able to attend school, to earn that first degree or one more advanced, to improve or change careers, to reinvent themselves. You may feel discouraged to hear the disparaging remarks, to see students refuse to pay you back while their teachers cheer them on, to feel maligned by the very people you have helped educate and employ; but perhaps that is the lesson to you dear friend. Let higher education in America function without reliable credit markets for a few years and see how well that goes. They’ll be back, Credit. You’re a better friend than they realize.

Now you and I have had our tough times, too, as all friends do. Remember back in 2005 when you were daring me to get me to take out that huge residential loan? Don’t dodge it—you know the one. Sure, you weren’t the only one applying the screws, but that was certainly a low point in our relationship. Fortunately, I was able to tune you out and make a more reasonable decision. Had I gone along with you to that party, I would be in heap of trouble. I learned not to trust you as much as I thought I could. To your credit old friend (no pun intended!) you did give me some warnings, some clues along the way. A little wink wink nod nod as you proposed lending me so much that I’d for certain be in foreclosure now if I had accepted. Maybe you were just testing me, building a little character…I hope that’s the case. One thing that I have learned about our friendship is that I have to pay attention. Just because you’re in a crazy mood doesn’t mean I have to get crazy too. Not a bad lesson.

And we’ve had a few close calls along the way. Remember back in 2008? When I was starting a company and you were really sick, nearly out of commission? I thought that I had done all the right things, built a decent reputation, a proven track record, a solid business plan. Naïve I was to say the least! I had thought all those things pretty much guaranteed the relatively modest sum I needed to launch the company. Then you got sick and when you got sick everyone got nervous. I went to your friends at the banks but they were just fretting over your illness, talking about it incessantly, clearly nervous that they were sick too. I went to the private markets but they were so afraid of your condition being contagious that they shut themselves up and hid. Still, we eked it out just by a hairsbreadth and here we are today, thriving, growing, and making even more investment. Sometimes I wonder what would have happened if we had started just a month later…

It’s funny, sitting here late at night, reflecting on Thanksgiving and all the ways you have impacted me, my colleagues, my friends, my clients. You built our neighborhood, our kids’ school, our home. You helped educate me, finance my surgery, even pay for our wedding. You have enabled me to hire people, serve clients, innovate, invest, and change our little corner of the world. Sometimes I have taken you for granted, but recent events have underscored how precious you are; I truly appreciate your presence in my life.

That said, I promise to be worthy of your friendship. At a time when you are unpopular, unloved, and discredited, I will stand by your side. I will honor my commitments to you and encourage others to do the same. I will continue to trust you, to reach out, to give you opportunities to prove yourself. And I will share in the risk-taking inherent in a meaningful relationship with you.

I realize that you, dear Credit Markets, do not receive much fan mail during the holidays, but this is a funny year. As we witness the crowds of Tahrir Square and the lines at job fairs in Manhattan, help Japan and Haiti rebuild, and strive to keep our cities afloat, your friendship and good health are as important as ever. I give you thanks and look forward to many years of friendship.

The Hero

Imagine the Lone Ranger galloping over the horizon, confident that he and his sidekick Tonto will face down any evil before them with nothing more than a white stallion, silver bullets, and a healthy dose of moxy. If the villain is our stagnant economy, then who are our heroes? Obama and Biden? Bernanke and Geithner? Boehner and Ryan? Romney and Perry? Oh, hero! Wherefore art thou? The American people await a politician to save the day!

Alas, America, our wait continues. A quick check of the United States Constitution (©Copyright, 1789, Philadelphia, Founders Press) confirms that it does not empower Congress, the President, or their appointees to stimulate the economy. Repeat: It is not in the federal government’s job description to stimulate the economy. Indeed, using the word “stimulate” in political discourse in early America could have earned one a bucket of tar and bag of feathers. The notion that federal officials are responsible for being the SOURCE of economic growth rather than its regulator and partial enabler has evolved under the 20th and 21st century leadership of both parties. It is not an original notion.

There are several limitations on federal economic stimulation, including:

Limitation One: No Carlyle for Congress
While private equity partners make hefty contributions to Congress to ensure their tax advantaged status (another Commentary for another day), Congress cannot legally become a private equity partner. Congress as a body cannot launch a for-profit venture, cannot issue stock, or buy into corporations. When Congress has blurred that boundary (think Fannie Mae and Freddy Mac), it has not gone well; the resulting organizations have functioned much more like conflicted bureaucracies than thriving businesses. Their net economic impact (Additional Economic Good minus the cost to manage, sustain, and rescue said entities) reflects a poor rate of return for America the investor.

By extension, “economic stimulus” programs sponsored by government agencies acting on behalf of government officials are prone to corruption, mismanagement and ultimately, misallocation of resources. Quite simply, the federal government is not intended to be in the business of business. Government and business are the same in Russia, China, Iran, Singapore, Syria, Myanmar, and many others; however, these countries are not representative democracies. We are.

Limitation Two: You Can’t Make the Horse Drink
The Federal government can bail out General Motors or Bank of America, but cannot force consumers to buy their products. Contrary to state-controlled economies in other countries, in the American market economy even government backed companies such as banks and auto manufacturers must eventually compete in the marketplace. The government can’t—and shouldn’t—force a consumer to spend money on the products or services of the companies that the government thinks should be in business despite themselves.

Congress can manipulate that marketplace through instituting tariffs or abolishing free trade agreements, bowing to the demands of specific special interests while creating a net negative impact on consumers by artificially increasing prices and/or reducing the quality of goods and services. Such manipulation hurts the consumer and thus the economy.

Limitation Three: The Government Does Not Create Jobs
Okay, let’s acknowledge that the government creates government jobs, but those are 100% paid for by current government revenues (formerly known as “taxes”) and future government liabilities (still known as “debt,” but likely to have a new name once the PR folks get on it). Since every penny paying for a public sector job is a penny taken from the private sector, it is hard to argue effectively that such a fund transfer is enhances the long-term sustainability of the economy.

A president, for example, can initiate job training programs or marginal incentives such as a reduction in employment taxes; however, nothing the president does can compel a company to hire people. The U.S. President, regardless of party affiliation, can seek to influence job creation, ask for it, scream and pound the table for it, promise it, pray for it, and otherwise strive for it. The government can make it harder to hire people, more expensive, scarier, and riskier; however, the government will not reduce unemployment in a sustainable or cost effective manner. It’s not in their job description.

Actual job creation will only occur when businesses decide they need to hire people and can afford to do so.

Limitation Four: It’s Not Their Money
The Federal Reserve has one primary tool—the ability to set target lending rates between banks and the Federal Reserve. They have used that tool to keep interest rates low. This certainly helps keep low the US debt service cost (whew!), but also is intended to stimulate credit markets (borrowing and lending). This has not worked effectively and will not have the impact implied in press releases. The Federal Reserve cannot make banks or private investors lend money, nor can they compel consumers or businesses to borrow money. Credit is a function of confidence and desire, not just interest rates. People and businesses borrowed heavily prior to 2008 when rates were in the 5-15% range; they are not borrowing now when rates are half as much. It doesn’t matter if your last name is Bernanke or Greenspan or Volker—no Fed Chief can make people lend or borrow.

Limitation Five: Market Manipulation is Not a Long Term Strategy
The Fed has more recently evolved to become the world’s largest de facto bond manager with a $2.9 trillion fixed income portfolio. By comparison, the largest true money manager, PIMCO’s Total Return Fund, has “only” $200 billion AUM. Bernanke beats Gross by a factor of 15. The Fed has used that position and its accompanying bully pulpit to manipulate interest rates and bond valuations across sectors, currencies, and regions. While some argue that it is perfectly appropriate for the Fed to become the primary driver of bond market valuations, it was not originally imbued with that power and it is not clear that such activity can or will materially benefit the long-term economy.

Limitation Six: It’s All About (Un)productivity
When federal officials strive to stimulate economic activity by borrowing heavily to finance infrastructure (i.e. FDR) or defense build outs (i.e. Reagan), they may foster near-term gains for some including the elected official, but rarely contribute to a more sustainable economy. For example, while Reagan’s defense spending put the pincers on the USSR and helped revitalize aspects of the American economy, it also relied heavily on federal debt that we still pay for today. In hindsight, those efforts launched a thirty-plus year gorging on debt-financed government intervention that has shown no sign of abating.

If local taxpayers and businesses believe in investing in their infrastructure after doing a careful cost-benefit analysis, they will do so. A jobs program should not cost $150,000 per $50,000 job. A defense department should defend, not be used to keep people inefficiently and thus unproductively employed. It never works long-term. The federal government was shaped to provide basic protections and to NOT interfere with basic freedoms. When it steps outside of that narrow mandate, it is not productive.

“We have met the hero…”
There are schools of economic thought that would attack every assertion made herein, and we recognize that some earnestly believe that the role of the federal government should be to save us from economic uncertainty, though such powers were not granted in the Constitution or implied in either the Federalists or Anti-Federalist papers. One has to turn to Marxist and Fascist state planners to find justification for such a path.

But this discussion is not about Constitutional interpretation of governance; rather, it is a discussion about what kind of society we want to have. Do we want a society where people await rescue by others or one in which people take responsibility for moving themselves and each other forward? Do we believe that elected officials and bureaucrats can “control” or “plan” the economy better than business leaders and consumers? Pogo once remarked that “We have met the enemy and it is us.” We would argue the contrary—that “We have met the hero and it is us.”

Political leaders cannot turn around the American economy. Citizen leaders can. Political leaders will not rescue the American economy; citizen leaders will do so, as they have done since this country was born.

How?

Entrepreneurial Leadership
As in times past, this economy will be healed by those entrepreneurs who invest in their businesses by hiring talented people, creating new or better products and services, and acquiring or developing next generation technology and machinery. In every era of slow growth, there are those who are committed to an idea and possess the leadership qualities to make it into reality. Some may feel that America has lost that hunger, that edge, that desire, but such fear has been afoot since the late 18th century. Every generation thinks it was better before, and yet every generation has gone on to create new growth and discover new possibilities. In free societies people with entrepreneurial drive can thrive, and in their effort and success inspire and enhance others.

Personal Development
People who further their education and ability will stimulate the economy by becoming more valuable to businesses or creating their own. Complacent job-seekers will not do well, but that is to be expected and indeed is well-deserved. Our founding documents did not guarantee a job to anyone; they framed America as a land of in which one was free to work in any state at any job for any company one wished or to create one’s own. This revolutionary concept remains shockingly rare in a global economy in which millions are locked into grinding economic prisons.

The competitive landscape will not get easier, educational requirements will increase, the need for thoughtful employees will grow, and the global employment marketplace will become more competitive. Those who see this as a problem have a problem; those who see this as an opportunity will have better opportunity.

Responsible and Opportunistic Lenders
Banks may be reluctant to lend because of the regulatory environment, poor balance sheets, or their risk-averse business models; however, there remain financial intermediaries who recognize both their responsibility to serve their community and the opportunity to be a part of creating new wealth. Banks that simply nurse their wounds for the next decade are on the way out anyway and quickly will be supplanted by those institutions that participate in enabling new ideas.

If formal banking institutions fail to step in, there will be private investors who would rather put their capital to work than have it earn less than 1%. Why will these people still want to finance business ventures? Because we are a culture that has attracted people from all over the world who are drawn to the possibility of creating new wealth and opportunity for themselves, their families, their employees, and their communities.

Citizen Statesmanship
Polls indicate that Americans are frustrated by the lack of statesmanship in Congress and among those—vying to be elected president in 2012. This challenge has plagued American life since our inception. No recent campaign has been as ugly as that waged between Thomas Jefferson and John Adams in the first contested election in 1800, yet America went on to greatness. Study the details of any election, any Congress, and you will find gridlock, animosity, maliciousness, and embarrassingly poor governance. And yet we never have had a dictatorship, never have swung into full blown socialism or fascism, and have gone from strength to strength. While we may lack it in the District of Columbia, statesmanship has been abundant in the local communities that define American life, among business and civic leaders and ordinary citizens doing their part.

Next Steps
It is high time for citizens to stop playing into the media-driven frenzy of fear, anger, hopelessness, and despair. Unplug the TV, turn off talk radio, stop reading blogs (except this one), and get to work.

Never have ordinary citizens had such an opportunity to help heal and grow a country, not just by electing one person or another, but by using our collective ingenuity and diligence to create goods and services that are worthy of our friends and neighbors at home and around the globe. Enough of the whining. There is no Lone Ranger coming to the rescue on the back of a white donkey or white elephant. There are no silver bullets. And there is little the government can or should do unless the people of this nation are ready and willing to lead rather than follow.

It may seem crazy, but I am hopeful and appreciative of the opportunity we all have to serve each other, our country, the broader global community, and the generations to come.

Sub-Standard & Poorly

Yesterday’s Syntrinsic Commentary spoke to the larger implications of an unsustainable approach to capitalism, specifically, capitalism that requires inexhaustible credit to function.

Today, as you may know, Standard & Poor downgraded the United States debt rating from AAA to AA+ with a “negative outlook,” meaning that they expect future downgrades. Let us share a few thoughts on this action, what it means and doesn’t mean, and at least some the implications.

Who is Standard & Poor?
S&P is one of the three major rating agencies charged with providing credit ratings to companies and governments. It is a for-profit entity, like the others. It is hired and paid by the issuers it rates. The other two major rating agencies are Moody’s and Fitch.

Was this downgrade predictable?
Yes. But first, we think it bizarre that so much credence continues to be assigned to credit rating agencies that very recently assigned AAA ratings to subprime and Alt-A mortgage backed securities, auction rate securities, and other asset back issues that they did not understand and did not act particularly interested in understanding. The credit rating agencies have not yet meaningfully changed their outlook on the municipal bond market, a market that is just screaming to have its risk profile reassessed. Clearly, when one is in a “pay-to-play” relationship with issuers, one’s judgment gets cloudy.

Given that lack of rating-agency creditability, we think it is far more important to look to the markets as a barometer of the risk of a security. As far back as March 2010, corporations such as Proctor & Gamble (AA- at the time), Berkshire Hathaway (AA+), Johnson & Johnson, and even Lowes were paying lenders less than the US Treasury, implying that they were perceived by the markets as less risky than loaning to the US government. At that time, Moody’s reported that the US was at risk of losing its AAA rating, and that was well before health care reform was adopted, 8-9% unemployment proved unexpectedly persistent, and the debt ceiling required a $2.1 Trillion or 15% increase. (See: “Obama Pays More than Buffett as US Risks AAA Rating,” Bloomberg, March 22, 2010).

In short, this downgrade has been coming for a very long time, was well telegraphed, is well-deserved, and we think, probably insufficient. If a credit rating communicates the likelihood that a lender will be able to get its money back and its interest paid, then it is completely reasonable to downgrade the US still further. The only way the US can pay back lenders is by finding more/new lenders; our lenders are getting skittish and our government buys too much of our debt in its effort to force interest rates lower than the market would otherwise determine. Since the US borrows without the intent of paying down the debt, it has become a risky borrower. If anything, the credit rating agencies have been exceedingly lax in acknowledging this.

Then why have investors been BUYING Treasuries and driving yields down? Doesn’t that imply Treasuries are even less risky than before?
Ah, if only markets were truly efficient. Scared investors do scary things. We do not think that it makes sense to dump the stocks and bonds of profitable companies in order to buy the debt of a government that is being downgraded, but that is precisely what has happened over the past few weeks. Why would you sell the stock of a profitable company with excellent prospects that is paying a 2.5% dividend in order to loan money to a government that is finally being called into account for its poor fiscal management and charge them only 2.5% interest per year for 10 years? It’s a completely counterintuitive response.

For several years, we have advised that clients avoid US Treasuries and Agencies (other than Treasury Inflation Protected Securities after January 2009). That call hurt in October-November 2008 when Treasuries became a safe haven from riskier equity and commodity markets, but at that time, Treasury debt itself was not the cause of the crisis. Now it is.

But aren’t Treasuries the safest investment option during a scary time, even if the Treasuries themselves are causing the crisis?
US Treasuries are safe so long as the markets determine that they are safe. But consider some of the very tangible risks to the US Treasury market:

Imagine the impact if China, Russia, Korea, Brazil and other foreign owners of US Treasuries decide to sell into this rally and reduce their Treasury exposure and diversify across other issuers and currencies. They curtail or even cease new Treasury purchases. They announce their decision and scare other investors who also sell or reduce their purchases. Yields rise.

As yields rise, the value of Treasury bonds drops. If values drop enough, many investors may sell, particularly if they have total return objectives and are holding bonds that mature over longer periods of time.

If the duration of your bond is 4 years, then the principal value may drop 4% for every 1% rise in interest rates; if the duration is 8 years, then the value would drop 8% for every 1% rise. How much of a decline in bond values will investors accept if interest rates rise 1%? 2%? 4%? Will they really feel confident to hold to maturity? Some might, but that will not be the uniform response.

If sentiment grows that US Treasuries are not reliable and that the US dollar will continue to weaken against global currencies, then we can’t simply print our way out of this by issuing debt that our own government buys. Those who still think that the US Dollar is omnipotent and beyond reproach for all time and across the globe are ignorant of history and the other great civilizations that failed—as we have been doing—to take care of their day-to-day business like responsible adults.

Well, if Treasuries are not risk free, shouldn’t we just put everything into gold?
Gold is certainly an appropriate part of a portfolio, though far from the risk-free asset that some think it may be. Were it as risk-free as some wish, then we would not have seen gold stocks crashing this past week, nor would so many commodities have outperformed gold over the past two years as this crisis has been unfolding. Gold can whipsaw. It’s notable that while gold has appreciated significantly against the US dollar, it has not changed nearly as much versus stronger currencies. Ultimately, the world will settle on a price for gold and the rate of appreciation versus US dollars will slow.

Gold—whether bullion, futures, or related stocks—certainly has a place in a portfolio concerned about hedging currency risk.

Well then, what else should I be doing to manage my investments? Should I go to cash?
While it sounds cliché, every investor needs a portfolio that reflects their investment and/or business objectives, liquidity needs, tolerance for uncertainty, and long-term spending requirements. There are some investors who should be in cash, but then, they probably should have been in cash three weeks ago or three months ago when risky assets were far more highly priced and thus communicating more even more risk than they are today when 10-20% cheaper. There is no news this week that we did not know several months ago; the market is simply digesting a recent and high-profile policy-level failure to effectively address financial concerns about which many have known for some time.

There is no one answer to the question about the ideal portfolio for current events. That said, there are a few fundamentals that remain true:

1. High quality companies with strong balance sheets, compelling businesses, and strong management should over time provide shareholders a reasonable return on their equity.

2. When making loans to companies and governments (i.e. buying bonds), select those that are fiscally sound, likely to payback the principal and to make interest payments in a timely manner. Weak corporations, municipalities, or sovereign nations should be avoided unless you are being paid a substantial risk premium.

3. Commodity prices (energy, agriculture, metals) should appreciate over time if demand—or anticipated demand—for those resources increases. Depending on the commodity markets you are considering, look at the likelihood of increased demand and invest (or not) accordingly.

4. Real estate prices are impacted by two key factors. The first, is Location, Location, Location. You may not want to invest in office buildings in certain US downtowns or suburbs, but may find a shopping mall in the Czech Republic represents an excellent opportunity. The second is pricing and its doppelganger, liquidity. People need to live and work and play. That will not change. Real estate at a fair price makes sense.

In short, we do not see the Standard & Poor downgrade to be a reason to materially alter investment strategy unless your investment objectives have changed or you were not prepared for this environment in the first place. If your portfolio is overweight the US dollar and betting on low-quality companies, then this will be a rocky road.

As American citizens, we recognize that our country needs to do something dramatic about our revenues, expenses, balance sheet and financial decision making process. But we have been saying that for years now and investing accordingly. Perhaps S&P’s action gets the attention of a few more people who are willing and able to make a difference. If so, then we welcome the downgrade. Going forward, we hope that we can play our part in helping the United States earn back the financial credibility we once possessed.

Bad Capitalists?

Are Americans bad capitalists? As we confront the consequences of an unsustainable economic model, it’s a question we must consider.

Bad capitalists:

· misallocate assets

· lock themselves into a cycle of perpetual borrowing to finance operations

· lack a plan to meet debt obligations (other than refinancing it)

· maintain insufficient cash reserves

· lose the confidence of their stakeholders

· manipulate lenders and investors to keep them engaged

· do not acknowledge that their strategy is fundamentally flawed

· argue that time will solve their problems, or minor adjustments on the margins, or one more chance, or more of the same

Worst of all, bad capitalists undermine capitalism. They say to the world, “Human beings are too greedy, selfish, careless, and irresponsible to be entrusted with an economic system that requires discipline, self-sacrifice, hard work, and a long view.” An already skeptical world is often quick to buy that argument, ignoring its inaccuracy.

At the business level, a bad capitalist eventually looses wealth or goes out of business as it competes with good capitalists who invest more intelligently, adapt better to changing market conditions, attract and retain more talented employees, and otherwise strive for financial sustainability. But what if a nation’s economy is based upon and rewards poor capitalistic practices? We all recognize that the capitalist business cycle includes periodic failures at the business level; but, have we adequately considered the implications of failing as capitalists at the macro-economic level?

In some quarters, posing such a question would amount to heresy, for critiques of our economic model are too often viewed as criticism of capitalism rather than as a desire to improve our practice of it. The distinction is everything. And when society is rapidly losing the confidence of its neighbors and its own citizenry, a little heresy is necessary.

So where does one turn to critically examine at least some of the practices of bad capitalists? To the Marxists, of course. Countless theoretical discourses have been written since Karl Marx and Friedrich Engels published “The Communist Manifesto,” in 1848. Most critiques of capitalism have focused on how owners (a.k.a. capitalists) allegedly “exploit” employees (a.k.a. labor). But there have been economic philosophers who have focused on matters outside of capitalist-labor tension, issues that are relevant today.

In 1923, Hungarian economist and political theorist, György Lukács published his treatise, History and Class Consciousness. As a founder of what is known as “Western Marxism,” Lukács’ concluded that capitalism is inherently flawed, a conclusion with which we disagree. That said, elements of his critique are timely for those concerned with enhancing the sustainability of our economic system.

Lukács explores the concept of “reification,” which implies that capitalism is an abusive fiction that unperceptive—and unaware—participants have bought into without recognizing its true ugliness. The concept is reminiscent of the illusory world in the Hollywood trilogy, The Matrix, a fictionalized world in which citizens have been fooled into believing the visual reality around them without realizing that they are just oblivious players in a massive computer simulation.

Lukács presents capitalism as an artifice constructed by those most able to profit from moving funds around without adding genuine value. In his construct, capitalism constantly requires new participants and new monies which can feed those already in the system, seeming to create wealth but really just moving it from one unwitting owner to a more powerful one. Lukács presents capitalism as similar to a Ponzi scheme (though he does not use that term); in his worldview, people with the greatest power and influence profit from the wealth (i.e. labor, resources, monies) of those who possess less influence or control.

Defenders of capitalism might counter that capitalism creates new wealth by using public and private credit markets to facilitate the launching of new endeavors that otherwise could not happen. In effect, they argue, capitalism sets up a series of arbitrage opportunities through which someone can borrow from others at a lower rate than they expect to make by investing the borrowed funds in a venture. Much of the difference represents “new wealth” created, wealth that circulates through the economy through profits and wages that are converted into consumer spending, tax revenue, and ultimately, further opportunities to invest.

Defenders of capitalism also could look to public and private equity markets as opportunities to create new wealth by enabling owners to sell their stakes to others. The buyers expect their ownership will be rewarded through gains and income or by selling their ownership stake in the future for a premium over the purchase price. Buying and selling ownership (or expanding the ownership base through diluting current owners) can be generative if it enables new investment that adds value to the venture and its stakeholders.

So, why should capitalism’s defenders feel defensive? Don’t they adequately address Lukács’ accusation that the capitalist economy is an artifice? Aren’t credit and equity markets excellent examples of how capital can create more capital and thus generate new wealth throughout the system?

In theory, the capitalists have a sound argument; in practice, however, practice gets in the way. What happens, a Lukács advocate might ask, when one uses credit without any intention of repayment? Is a society creating new wealth when it rolls its debt over again and again with no intention of paying it back? If there is no intent to settle the debt, then can one really recognize the scenario as constructive arbitrage? If society’s functioning requires borrowing it will not repay in order to “stimulate” spending that makes it appear the economy is expanding, then hasn’t that society affirmed its members are willing participants in a Ponzi scheme?

Or look at the equity side. What happens if changing ownership is not a generative process but simply represents a transfer of wealth between parties? What if one party buys ownership, leverages up the company by borrowing beyond what is reasonable for the company to pay back, then sells it off to other public or private owners at a value inflated by the leverage it now carries but cannot repay? In this instance, there is not wealth creation for the broader economy, merely a profit for the seller that is paid for dollar for dollar by the other parties (and then some if debt financed). In this scenario, there is simply the appearance of appreciated value and wealth creation. Ideally, no one would engage in such a transaction, but if a society such as ours richly rewards buyers to perpetuate the cycle of artificial economic value generation, then the game will be played until, like any Ponzi, the jig is up and someone gets caught holding the rather expensive bag.

These observations deserve more thoughtful consideration than these few lines allow, and yet raise essential questions for us today. What action is society taking to ensure that we are not willing (or unwilling) participants in a Ponzi scheme? What sacrifices are we making so that we borrow only when we intend to pay it back with near-term assets? How do we mitigate the risk of being a society of bad capitalists? What systems or cultural shifts are necessary to increase the likelihood that we practice good capitalism?

When companies that have been “bad capitalists” fail, society absorbs those losses and enables the people impacted to try again as owners and/or employees of other ventures. However, whole societies that have been “bad capitalists” have no such safety net. If a society becomes economically unsound, it simply fails. Such failures hastened the ends of Ancient Rome, the British Raj, and the Soviet Republic. Societies that practice bad capitalism create fear and economic uncertainty amongst their citizens, causing people to distrust individual initiative, risk-taking, and the free flow of capital just when such behavior is most needed to stimulate the economy and make investments that can generate new wealth.

Lukács is wrong. We are not ignorant dupes participating in a massive Ponzi scheme; and yet, we must not willingly propagate a system that confuses perpetual leverage with sustainable growth. We stand together at a critical decision point. Generations from now, will we be remembered as bad capitalists? Or will we be honored as those who did what was necessary to preserve and improve the world’s most effective system for fostering personal freedom and opportunity?

Once Upon a Balance Sheet

Once upon a time, there was a balance sheet. It belonged to a mighty nation in the Western Hemisphere that had grown wealthy and powerful. Its people traversed the globe with confidence and bold plans.

But the balance sheet was sad. It did not feel joy or excitement commensurate with representing a great nation; indeed, the balance sheet had begun to wonder if it mattered at all anymore.

“I don’t understand,” lamented the balance sheet, “why so many people ignore me now. It used to be that people cared what I had to say, sought my wisdom and foresight. Ordinary citizens would read me and ask me questions, nod, and make important decisions. Some even claimed that having our own balance sheet was one of the reasons to form our own country in the first place. Alas, no more. Now people ignore me or worse, they even get angry at me!”

The balance sheet signed and heaved his bulk to a nearby coffee shop. He didn’t have money for a drink, but liked to hear the perspectives of the regulars. As if to confirm his fears, the regulars at the table nearby turned their backs on him. They continued their conversation but increased their volume, the way that people do when bullying a peer.

One of the regulars loudly explained the difficulties of choosing between starting social security at age 62 or age 65, noting he expected to receive benefits through his 90s. Another described the many medicines she used to manage her ailments and complained about being asked to cover a co-pay. The third rationalized the importance of extending our military might to protect democracies and aspiring democracies worldwide. Still another pointed out that no price was too high for honoring commitments to government employees.

The balance sheet winced, then sighed to signal that he was present and could hear their every word. But instead of inviting their discretion, his sigh only intensified their efforts. Backs firmly turned, the regulars proceeded to loudly expound on absorbing state obligations, rebuilding countries, bailing out banks, limiting trade, taxing economic development, and other sensitive topics designed to inflict pain on their former friend.

It worked. The balance sheet could take it no longer. He pulled out his iPad and logged into his Facebook page. He was shocked. His few Facebook friends had defriended him, and they had done so harshly. Rather than turning their backs as had the coffee shop regulars, his virtual community had made it clear that they were downright angry with him.

One former friend wrote, “Enough! Your very existence implies that we are lazy. You are a mean, vindictive balance sheet.” Another scrawled in haste, “Some friend u r. U think u r so important but I know better. U r not real.” A friend of a friend from China with strong nationalist views wrote merely, “Xie xie ni” or “Thank you very much.”

The messages were hard to read, but the balance sheet could not stop. The next was particularly cruel. “You used to be so handsome and trim, but you’ve really fallen apart. You’re a slob and don’t take care of yourself. You embarrass me. You need help. Hope you get it.”

That was enough. The balance sheet logged off and went outside to clear his head. As he walked down the street, loneliness and rejection weighed heavily on him. What could he do? He was just a balance sheet. He didn’t control the inputs. It was the regulars at the coffee shop and his former online friends who made him what he had become. He wasn’t proud to be out of shape. He knew he had lost his edge. Deep down he understood that this was the classic midlife crisis: his best years were behind him—the opportunities, the work ethic, the passion. What possible joy could there be in the future? He’d passed his prime and how those who had relied on him had rejected him.

Something had to change. But how?

“Hello!” cried a young voice. The balance sheet looked up to see a young girl. “You’re a mess,” she announced. The balance sheet nodded.

“Who did that to you?” she asked. How to explain the state of affairs to a child? Balance sheets are complex financial reporting tools capturing liabilities and assets—how could a child possibly understand?

“I bet my mom and dad did this to you. My grandparents, too. And my neighbors and teachers and coaches and my minister…” The balance sheet interrupted her. “It’s true. But how could you possibly know all of that?” he asked.

She explained that he was not the first balance sheet she had seen in a similar mess. Apparently the balance sheets for her state and her city had been moping about recently and appeared equally forlorn. The balance sheet started to explain the complexity of the situation, the off balance sheet liabilities, uncertain accounts payable, and receivables highly dependent on tax policy and the economy and…

She cut him off. “Actually,” she said, “it’s all rather easy. I’m in third grade and we’ve got addition and subtraction down pat. Our country spends more than it makes. We keep increasing that gap. In the end, you look worse and worse. Simple. Right?”

The balance sheet was moved. This girl did not ignore him or curse him as had the adults. She didn’t even blame him for having become so bloated.

As if reading his mind, the girl told him that growing up, she had learned about the balance sheet by overhearing her parents anxious late night whisperings, and in her mind she had pictured him as a monster or nightmare.

“But then,” she said, “I realized that you are not good or bad, you’re just a reflection of who we are as a society. And since my folks and their friends aren’t helping you, my friends, siblings, and I are going to have to take over. Yes, my new friend, it looks like we’re going to be together for a long time.”

The balance sheet felt a faint fluttering of hope. “It’s not going to be easy to help me change,” he cautioned her.

“I know,” she remarked with a wise, knowing look. “But this is America. We can do anything, right?”