Some less than pleasant observations from the billionaire founder of Elliott Management, Paul Singer, extracted from his periodic letter to clients.
The budget deficit for the latest fiscal year (which ended on September 30) was reported to be around $700 billion. However, this figure would be many times higher if the government’s unfunded entitlement programs were included. Even before taking into account liabilities stemming from the Affordable Care Act (ACA), which cannot even be calculated yet because so many of its assumptions are either erroneous or outright fabrications, and because many of its provisions keep getting delayed by the Administration for purposes of political advantage, the present value of the future obligations of the federal government is currently around $92 trillion. These obligations have been growing by over 10% per year since 2000, during which time nominal GDP has risen just 3.8% per year. At this rate, the federal government will owe an estimated $200 trillion on the entitlement programs by 2021 (again, excluding the effects of ACA) and $300 trillion by 2025.
These numbers are not fantasies. At present, there is no acknowledgement by a large portion of the American political establishment that this insolvency even exists. Nor have the leaders of this establishment made any concrete progress toward restoring solvency by taking up serious proposals to rein in unpayable promises. Quite the contrary: Politicians and policymakers continually tell people that such entitlement obligations will be met – a claim they must know cannot possibly be true.
Recently, we had a conversation with a mainstream economist who told us that the government is not actually insolvent because the long-term entitlements are not really liabilities that need to be counted, any more than the military budget for the year 2030 needs to be counted. This assertion is incorrect. Military spending, like any other form of discretionary spending, can be cut quickly and arbitrarily, as Washington recently made clear. And such spending is in exchange for goods and services delivered at the time the money is spent. In 2030, the government can buy many more tanks, or many fewer, than it is buying today. It has not promised to buy any amount. In fact, aside from military entitlements such as veterans’ health care, there is no obligation to spend any money at all on the military in 2030. By contrast, entitlements represent concrete governmental promises that are being made today about future spending – promises on which people are being (falsely) told that they can rely. And at the time the money is scheduled to be delivered, the recipient is delivering no goods or services. Only someone who has never run a business could say with a straight face that such obligations are not really liabilities and need not be included in the accounting.
High inflation (or hyperinflation) is one way that devious or clueless policymakers attempt to deal with unpayable promises. It is devious, because without formally imposing a tax, it takes money from savers and investors and pays it to borrowers and voters. It is clueless, because the cycle of government handouts and demands for more benefits is like a game of “chase the tail” – because it dissipates the real value of promised benefits, it brings the ultimate prize no closer while destroying the value of money and dissolving societal cohesion in the process.
The U.S. is in a “warm-up” phase on this score at present. The promises made by U.S. politicians are huge. Absent reform, they will lead to societal ruin. But so far, there has been no collapse of the dollar – possibly because there is no alternative fiat currency against which it can collapse. Gold is trading at $1,300 per ounce, not $5,000 per ounce. The $100 million co-op apartment in New York and the £100 million flat in London are thought of as oddities, not “coming attractions” for the evaporation of the value of paper money. Wage inflation is small (even though labor markets for desirable skills are tighter than most people think), and the arithmetic of government statistics (jobs, growth and inflation) is distorted and dishonest almost beyond measure.
There is something missing in investors’ reasoning that leads to their current complacency, and that is an understanding of the circularity of confidence in a fragile system. Since the system is fundamentally unsound, all it would take is a loss of confidence to set off a collapse in the purchasing power of money, a major currency or the global stock and/or bond markets. “Risk off” today still means buying U.S. Treasuries, but this may not be the case at some unpredictable but abrupt future turning point in market psychology. Markets are fast and self-reinforcing today, creating facts rather than reflecting them. We believe investor confidence today is unjustified. The leaders of the Developed World have chipped away at the solidity that would ordinarily justify confidence in their leadership, markets and currencies, such that confidence can be lost at any moment. If confidence in a sound system is unfairly lost, then countertrend forces can act to stem the panic and restore stability. But a justified loss of confidence in an unsound system would generate much more damage and be, for a period of time and price, unstoppable. That result is what governments have risked by their poor policies, their lack of attention to the risks posed by the inventions of the modern financial system, and their neglect of the fiscal balance sheet. Since this combination is relatively new, particularly the enormity of Developed World debt and obligations, as well as the complexity and extraordinarily high leverage of the financial system (especially given the size of derivatives books), there is no way to tell exactly how it all will end. Badly, we guess.
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For those who did not recognize the above formula, you are in good company. It is the equation showing that kinetic energy is a function of mass and velocity, but that the relationship is not linear: A doubling of velocity causes a quadrupling of kinetic energy.
What is the relevance to financial markets and trading? We believe some of the same elements are present when financial leverage rises beyond certain levels. Any complex portfolio contains expectations about maximum expected price movements and possible losses, together with assumptions about the dispersion of returns and correlation. Obviously when markets turn adverse, if those assumptions turn out to be overly optimistic, then losses ensue. Capital represents a cushion against losses, a cushion that is very important to the investor, but even more important to the system as a whole. When leverage goes up, it takes smaller and smaller perturbations in prices, correlations and volatility to generate serious losses requiring palliative action. But as leverage increases among key market players, the possibility of large losses and involuntary liquidation behavior creates contagion from one player to another, a kind of chain-reaction effect as losses occur too quickly for reflection and sellers become price-insensitive, causing larger losses – and even failure – to spread from one firm to another. Extreme leverage removes the cushion and the robustness of structure, and it is the proximate cause of disequilibrium. As with kinetic energy, excessive leverage is nonlinear, subject to tipping points, and can cause (and did cause in 2008) massive and abrupt systemic failure.
This nonlinearity of leverage is a function of similar positioning and contagion. We do not believe that the system today is any safer than it was when it failed in 2007 and 2008. Global leverage is up, not down, contrary to the popular misconception. Private debt is unchanged from 2007 levels, but public debt has risen globally from $70 trillion to $100 trillion. It appears that a number of major American financial institutions have de-risked themselves somewhat, although this is impossible to discern from publicly available filings (which is why rumor and conjecture will govern the way markets perceive large financial institutions in the next market crisis). European financial institutions still maintain more leverage and bigger derivatives books than their American counterparts, as well as large holdings of sovereign debt that they were coerced into buying as part of the “save-the-euro” panic.
In fact, the global financial system is arguably less safe than it was in 2008. The unquestioned creditworthiness of the Developed World governments ended the most intense phase of the 2008 crisis, as the financial system was ultimately all but guaranteed by governments. A catalyzing force for the next crisis might be a failure of confidence in one or more of those major governments or in China. Such a failure alone could cause major stress in markets, as either currencies or bond markets could experience sudden collapses. Also potentially impactful is one of the major lessons of 2008: It is wise to move assets and sell claims and securities immediately if a debtor or counterparty is perceived to be in trouble. This maxim could make the next market crisis play out on a hair-trigger, with a stressful lead-in and then a simultaneous rush to the exits.
Those who think the scenario above is an exaggeration should ask themselves the following question: After decades of advancements in human knowledge and purported innovations in the global financial system, why did 2008 turn into the worst financial crisis since the Great Depression? The answer is that the system was unsound, largely due to excessive leverage and the complexity of financial instruments. In the 80-plus years since the 1929 crash and the subsequent Depression, there clearly have been a large number of geopolitical and financial events, yet none of them caused financial collapse until 2008. Of course, we understand that a combination of public and private errors and misconceptions led to the financial crisis, but it was the unfettered use of leverage that made the episode pass over the line into systemic collapse.
We do not think policymakers have learned anything much from the financial crisis, but that fact can truly be demonstrated only as time passes. In our view, monetary policy extremism has papered over (no pun intended) the lack of fundamental reforms that would enable the Developed World to grow faster and more sustainably with financial institutions that are solid and robust enough to withstand the next periods of economic and financial stress. We believe the world’s financial institutions are still essentially dependent on governments, but the Developed World governments themselves are hopelessly insolvent. The insolvency may not be manifested in a market reaction tomorrow or even next year, but the numbers are obvious and compelling, not conjectural or fanciful. Markets focus on something when they want to, not when “visionaries” think they should.
It is important to note that mass human behavior cannot be modeled or predicted with any degree of precision. When forces are brought to bear that suggest a possible shift in direction of mass human behavior (examples include oppression, tyranny, economic underperformance, inflation, incentives and disincentives), there is no way of telling if, how or when such forces will actually result in a change of vector.