The NorthFork View

Having survived the end of the Mayan calendar (I thought at least the earth’s magnetic poles were going to change and the whirlpools in the bathtub would spin in the opposite direction), we now get to fasten our seatbelts, make sure our seats and tray tables are in the upright and locked position and that our carry on items are safely stowed under our seats or in the overhead bins while we watch the ongoing saga of the “fiscal cliff.” (Apparently, Europe, China and the rest of the world are at least temporarily irrelevant.)

As you’ve probably read, heard, or otherwise been forcefed, the fiscal cliff will occur on January 1st when a number of tax-related revenue and spending measures enacted over the past decade or so are meeting the end of their legislated lifespan, stampeding a herd of austerity measures that will descend upon us and send the country reeling over the “jump” back into recession. For those who haven’t otherwise been inundated with this information, I refer you to a lengthy, but informative, FAQ on the fiscal cliff at the Washington Post’s blog.

There are many interesting discussion points wrapped up in this one phrase, such as whether it’s a cliff or more of a slope, and why if we’re so focused on reducing the deficit, what’s the problem with a strong shot of the medicine we need to move in the direction we need to go anyway. Another set of conversations, albeit beyond the pale of practicality, suggest that the U.S. should simply take the path of extreme austerity, pass a balanced budget amendment and immediately establish a 10-year plan to finance all of its $60+ trillion in current and future liabilities. On the other hand, we could just mint a dozen or so $1 trillion coins (hey, Congress has the power to coin money) to pay our debts and call it good. Neither of these ideas hopefully enter into mainstream conversation, but opinion and facts seem to merit the same bandwidth these days so according to my cynical alter-ego, anything is possible.

Ever trying to prepare for the worst but work toward the best, my thinking about our current state of economic affairs (we’ll reserve the political conversation for the pub), fairly closely parallels the sentiments of Bill Gross in his December 2012 Investment Outlook and those of Carmen Reinhart and Kenneth Rogoff in their 2011 work, This Time is Different: Eight Centuries of Financial Folly. To even pretend to put myself somewhere in the same universe as these individuals is a huge stretch of ego, but their years of insight and scholarship are something I’m more than willing to take into consideration.

In sum, Gross suggests the following challenges to future economic growth exist: We are awash in debt, which heretofore has financed much of the growth in the developed world but probably won’t be available to the same capacity going forward; globalization is a diminishing factor as many opportunities in the developed world’s markets have already been realized; structural unemployment will continue due to ongoing adoption of technology (and I would add, a somewhat permanent outsourcing of many types of jobs); and an aging population will limit consumer demand. He concludes that while cheaper energy, a housing revival and unanticipated “productivity breakthroughs” may lessen the effects of these trends, we will likely face slower growth and higher interest rates in years to come.

At great risk of oversimplifying their work, Reinhart and Rogoff present some similar, but much more broadly-constructed conclusions (not especially surprising since Gross used their research to inform some of his commentary); however, their discussion utilizes a vast quantitative dataset derived from innumerable hours of painstaking research and economic modeling. Basically, they argue that due to an overextension of credit, the U.S. indeed suffered a systemic crisis during the “Second Great Contraction” that began in 2007. Based on their research, history suggests that it typically takes years for economies to recover from systemic crises, assuming policies are adopted and behaviors are adjusted to reflect realities on the ground.

More specifically, they argue that excessive leverage throughout the 2000s (along with the creation of myriad financial instruments intended to mitigate risk, coupled with lenient regulatory oversight and loose monetary policy) fueled tremendous short-term growth. However, much of the asset-value increases occurred not just in the stock markets, but in real estate especially, where individuals were increasingly utilizing their homes as automatic cash machines to finance all kinds of purchases. Unfortunately, increased home values were attributed not only to artificial demand for homes from those who could afford them, but also from those at the lower end of the socio-economic spectrum whose monthly payments were initially tied to teaser rates that led them to take on much greater financial burden than they could possibly sustain. Once the latter individuals found it increasingly difficult to make higher payments in a rising interest rate environment, and the mirage of a healthy, growing economy began to fade, the result was a near collapse of the entire financial system due to the overextension of credit.

Reinhart and Rogoff point to a number of historical precedents that suggest recoveries from systemic failures are typically many years in the making. Further, there are no guarantees that our current situation, given poor policy choices and otherwise bad economic decisions, doesn’t become a protracted Second Great Depression. Despite our assertions and efforts to the contrary, we’re no different than other countries (and very much like ourselves) in that we can’t magically escape the conditions that created the crisis in the first place. Another point I’d add is that the degree to which global markets are correlated adds a variable to their assertions that perhaps has not been a factor in assessing the impacts of previous systemic crises. Regardless, if the fiscal cliff itself is largely irrelevant because it is simply another hyped story about short-term political maneuvering, it illuminates a much broader range of issues and conditions that must be addressed.
The key takeaway I garner from these discussions is that, as always, diversification is essential. Whether we’re talking about creating a comprehensive financial plan, allocating a composite investment portfolio, generating reliable streams of revenue, or analyzing a business proposition, to rely on any one external source for our well-being is at best ill-considered. In addition, we cannot wait for answers to be delivered to our doorstep, nor can we hold our breath until we as citizens and our elected representatives decide that making a small personal sacrifice is better than continuing down the path to a large collective and permanent loss. As our founders recognized, the only character trait that can mitigate self-interest is virtue (a bit less for ourselves so all can thrive). We need to take some personal responsibility for our actions and act accordingly, while we demand that leaders in both the public and private spheres do the same.

In a recent conversation, I was relating an article I’d read where the author concluded that we may be the first generation in history to be in a position to tell our children that, despite our knowledge of the circumstances and the fact that we have the power to take a different course of action, we ruined everything. The gal I was talking with looked at me and said, “or we could be the generation that makes the difference.”

As always, thanks for listening and responding with your insights and concerns. And of course, feel free to share with others or unsubscribe at any time.

All the best for the New Year,

Bill Stoddart

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